A typical bond indenture provides that prior to the incurrence
of an event of default, a trustee's obligations are limited to
those specifically set forth in the indenture. It is only following
the occurrence of an event of default that the trustee's duties
of prudent conduct seem to ripen. This often leaves trustees and
bondholders in a state of uncertainty over what actions, if any, a
trustee may be obligated to take as the financial condition of an
issuer worsens but has not yet crossed the default line. A recent
case from the Eastern District of Pennsylvania, Becker v. Bank
of New York Mellon Trust Company, N.A. (E.D. Pa. March 23,
2016), suggests that depending on the facts, the documentation and
the governing law, a court could impose liability on a trustee for
failing to act prudently even before an event of default, at least
under indentures not governed by the Trust Indenture Act.
The Facts
J.P. Morgan Trust Company and its successor, the Bank of New
York Mellon Trust, acted as trustee for an industrial development
bond issue whose beneficiary was The Lower Bucks Hospital in Lower
Bucks, Pennsylvania. As is customary, the bonds were nominally
issued by the Borough of Langhorn Manor Higher Education and Health
Authority, but the hospital, through a loan arrangement, bore the
responsibility for debt service on the bonds. Bonds in the amount
of $35,980,000 were initially issued in 1992, with the Bank of New
York Mellon succeeding as trustee under the indenture governing the
bonds in October 2006. Two initial UCC-1 financing statements were
filed in the hospital's name and were continued in 1997.
Sometime thereafter the hospital changed its name to Temple Lower
Bucks Hospital Inc., and for about six years following the name
change, no amendments to the financing statements were filed to
correctly identify the debtor. In February 2003, the hospital
notified the indenture trustee, who was then J.P. Morgan, of the
name change, and in March 2003, J.P. Morgan filed a new financing
statement with the Pennsylvania Secretary of State correctly
identifying the hospital by its then current name.
In May 2006, the hospital again changed its name, this time to
Lower Bucks Hospital, but during J.P. Morgan's tenure as
indenture trustee no continuation statements were filed to
correctly record the second name change. In October 2007, Bank of
New York Mellon filed a continuation statement, still identifying
the hospital by its prior name. It was only on October 16, 2009,
that the trustee filed an amendment to the financing statements
correctly identifying the debtor as Lower Bucks Hospital. Then, on
January 13, 2010, the hospital filed for relief under Chapter 11 of
the Bankruptcy Code. Shortly thereafter, in April 2010, the
hospital commenced an adversary proceeding in bankruptcy against
the indenture trustee to avoid the security interests and liens
against the hospital's gross revenues and revenue accounts,
claiming that the trustee's security interest had lapsed
because an amendment to the UCC-1 statement had not been filed
within four months after the name change as required by Section
9-506 of the UCC. The amendment filed in October 2009, the hospital
claimed, was subject to avoidance as a preference under Section 547
and 550 of the Bankruptcy Code.
As indenture trustee, Bank of New York Mellon chose to act as the
bondholders' sole representative in the adversary proceeding,
which was ultimately settled through court-mediated negotiations
leading to a consensual plan of reorganization. Bank of New York
Mellon both negotiated on behalf of the bondholders and also acted
to protect its own interest by obtaining third-party releases under
the plan relieving it of liability to bondholders. Under the
settlement the bondholders paid $8,150,000 to the trustee.
In fall 2011, a bondholder sued to vacate approval of the plan on
the grounds that the releases were not properly disclosed and that
bondholders were not adequately represented in the settlement
because of the trustee's conflict of interest. In December
2011, the bankruptcy court confirmed the plan while preserving for
the plaintiffs the issue of enforceability of the releases. The
bankruptcy court ultimately declined to approve the releases, a
ruling that was affirmed by the district court and ultimately by
the Third Circuit. Returning to court, the plaintiffs then sued
Bank of New York Mellon on a number of theories, including breach
of fiduciary duty under the bond documentation and breach of
contract.
The Court's Analysis
Applying Pennsylvania law as prescribed in the bond documents,
the court inter alia addressed the fiduciary duty claims.
Bank of New York Mellon maintained that prior to default its duties
were limited to those specifically set forth in the indenture,
which did not include a duty to ensure lien perfection under the
indenture and related loan agreement. Turning for guidance to
rulings of the Pennsylvania Supreme Court, the court conceded that
the "nature and duties of the corporate trustee are primarily
to be ascertained from the trust instrument." However, the
court went on to find that Pennsylvania law imposes upon trustees
"common law duties arising from the nature of the fiduciary
relationship." The court observed that under Pennsylvania case
law "the primary duty of a trustee is the preservation of the
assets of the trusts and the safety of the trust assets." This
fundamental common law duty arising out of the nature of the
fiduciary relationship applies, the court said, to an indenture
trustee as well. The court held, therefore, that even prior to
default the trustee was required to act "prudently, in good
faith with undivided loyalty, using reasonable care under the
circumstances." There being triable issues of fact as to
custom and practice in the corporate trust industry, and other
matters, the court denied the defendants' motion for summary
judgment.
The Takeaway
While decided under Pennsylvania law, the case holds out a
number of lessons of general applicability for trustees and
bondholders. This is yet another instance where inattention to
seemingly ministerial actions such as the filing of continuations
and amendments to financing statements can have substantial
consequences down the road. Also, trustees are well-advised to
consider whether they may have conflicts that interfere with their
ability to honestly and impartially represent the interest of
bondholders, with potentially harsh consequences to both
bondholders and the trustee if such conflicts exist and are not
addressed. Finally, courts may be inclined to impose liability on
trustees on general law principles outside the four corners of the
indenture documentation, where the circumstances so warrant and the
governing law so permits, even prior to an event of default. For
bonds governed by the TIA, Section 315(a) deems incorporated
(unless expressly excluded) a provision that prior to default an
indenture trustee is not liable except for performance of the
duties specifically set forth in the indenture. Many indentures,
particularly those in the municipal bond world, are not governed by
the TIA, however. Trustees and bondholders, caveat
emptor.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.