Bond Trustees, and the Rising Challenge of Activist Investors
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, Fiduciary Duties | 0

By Steven L. Schwarcz (Duke University School of Law)

Steven L. Schwarcz

Large financial institutions, such as U.S. Bank or Bank of NY Mellon, typically administer the governance of bond indentures—the contract under which bonds are issued—on behalf of the investors; in that role, they are called indenture trustees or, more colloquially, bond trustees. In Bond Trustees, and the Rising Challenge of Activist Investors, the 2020 TePoel Lecture at Creighton University School of Law, I examine how bond trustees should respond to this challenge.

Bondholders are the primary beneficiaries of indenture governance, just as shareholders are the primary beneficiaries of corporate governance. As beneficiaries, bondholders and shareholders have much different expectations. Indenture governance and corporate governance have evolved differently to meet those different expectations.

For example, because bondholders are only entitled to receive principal and accrued interest on their bonds, indenture governance has evolved to protect that recovery. In contrast, because shareholders, as residual claimants of the firm, are entitled to (and thus expect to receive) the firm’s surplus value, corporate governance has evolved to increase that value.

Most people would consider corporate governance as more important than indenture governance. In part, that’s because corporations and stock markets are highly visible to the average person. Also, a corporate manager’s job—to try to increase shareholder value—involves more judgment and discretion, and thus can be more interesting (and more desirable of scholarly study), than an indenture trustee’s job of merely protecting bondholder recovery.

Still, indenture governance is critically important. Domestically and worldwide, the amounts invested in bonds dwarfs the amounts invested in stock. Recent data show, for example, that global bond issuance is almost 30 times greater than global equity issuance.

An indenture trustee’s governance duties turn on whether the trustee is acting pre-default, or post-default. Once an indenture defaults, the law requires the indenture trustee to act on behalf of the bondholders as would a prudent person in similar circumstances regarding its own affairs. Many post-default decisions—such as whether to accelerate the maturity of the bonds or to liquidate collateral—involve difficult judgment calls. These decisions are made more difficult by what I have called a “protection gap”: when things go wrong, investors often blame parties with deep pockets, especially indenture trustees, for failing to protect them. Post-default indenture governance becomes even more complicated when the bondholders themselves have conflicting interests, caused, for example, by conflicting payment priorities or conflicting sources of payment.

Notwithstanding its complexities, post-default indenture governance is informed by case law. And perhaps because of its complexities, post-default indenture governance is also informed by legal scholarship. In contrast, pre-default indenture governance is not yet well informed by either case law or legal scholarship. The rising challenge of activist investors is now making it critical to also understand what an indenture trustee’s pre-default duties should be.

Historically, an indenture trustee’s pre-default duties have been seen as ministerial and limited to the specific terms of the indenture, such as selecting bonds for redemption and preparing and delivering certificates. Since the financial crisis, some investors argue that indenture trustees of securitized bond issues, in which investors are paid from collections on underlying financial assets such as mortgage loans, should have pre-default fiduciary duties. Indeed, complaints in recent lawsuits allege that those indenture trustees should “police the deal” for the investors.

These allegations are not compelling. Indenture trustees receive relatively tiny fees and don’t even negotiate the terms of the indentures. In contrast, the institutional investors in securitized bond issues, including activist investors, are highly sophisticated. Indenture trustees could not understand complex securitized bond issues better than those investors.

Furthermore, parties other than indenture trustees are assigned monitoring duties to protect the investors. Notably, securitized bond issues require a party, usually called a servicer, to service and collect payment on the underlying financial assets. In litigation following the financial crisis, which caused widespread defaults on residential mortgage loans, some investors argued that indenture trustees in mortgage securitization transactions should have monitored or supervised the performance of the mortgage-loan servicer.

Imposing such duties on the indenture trustee would be duplicative and expensive. Rather, an indenture trustee that actually becomes aware of servicing problems should act in a common sense and practical manner. For example, it might enter into conversations with the servicer about its performance and communicate the results of those conversations to the investors. It also might seek, or request the investors to provide, formal investor directions.

Typically, indentures allow investors with at least 25-50 percent of voting rights to direct the indenture trustee to act.

The full TePoel Lecture is available here: https://ssrn.com/abstract=3543656.

For a related Roundtable post, see Steven L. Schwarcz, Indenture Trustee Duties: The Pre-Default Puzzle.

Indenture Trustee Duties: The Pre-Default Puzzle
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, Fiduciary Duties | 0

By Steven L. Schwarcz (Duke University School of Law)

Indenture trustees act for the benefit of the investors in a company’s bonds. They perform this role for virtually all companies that issue bonds, whether in the United States or abroad. The existing scholarship on their duties focuses on the post-default scenario. In many countries, including the United States, the law then imposes a ‘prudent person’ standard. This Article, in contrast, examines an indenture trustee’s “pre-default” duties.

It is critical to try to define those duties because activist investors, including hedge funds and so-called “vulture fund” investors that purchase defaulted bonds at deep discounts, increasingly are making pre-default demands on indenture trustees, who must know how to respond. Also, the manner in which they respond can have widespread economic consequences because the bond market is huge—in 2018, approximately $43 trillion in the United States and $103 trillion worldwide.

Activist investors are also suing indenture trustees for losses on their bonds, alleging they should have taken pre-default actions to protect the bonds. To avoid the risk of liability, indenture trustees should know how they should discharge their pre-default duties.

The indenture trustee’s pre-default duties have not been seriously re-examined since enactment of the Trust Indenture Act of 1939, although the bond market has changed dramatically since then. Institutional investors now dominate; there are few individual retail investors. By virtue of their sophistication and the size of their bondholding, institutional investors face less of a collective action problem than retail investors had faced. Also, as mentioned, certain activist investors increasingly are engaging in high-risk strategic investing.

Whether or not due to these market changes, there are at least two views today of the indenture trustee’s pre-default role. By far the dominant view—and the view that comports with existing law and the plain language of indentures—is that indenture trustees have no pre-default fiduciary duties to investors. Rather, their duties are ministerial and limited to the usually administrative functions specified in the indenture. Since the 2007-08 financial crisis, however, some investors argue that indenture trustees—especially those of securitized bond issues, who act for the benefit of investors whose right to payment is limited to collections on specified financial assets (such as mortgage loans)—should have some pre-default fiduciary duties.

My Article analyzes what an indenture trustee’s pre-default duties should be, starting by considering the possible normative frameworks for legally imposing duties in a business context. I consider two potentially overlapping frameworks: to correct market failures, and to maximize efficiency. I also consider a formalistic rationale for legally imposing duties—because securitized bond issues involve purchased financial assets, they more closely resemble a traditional trust; and trustees of a traditional trust have fiduciary duties.

Based on its analysis, the Article concludes (among other things) that, pre-default, the indenture trustee’s duties should only be those specified in the indenture. The Article also applies that standard to the types of issues that may arise in lawsuits against indenture trustees.

For example, even prior to a formal default, one or more investors may demand that the indenture trustee take some enforcement or other remedial action to try to correct a problem. Compliance with that demand could be expensive, reducing the value of the estate for investors generally. Taking remedial action could therefore create a conflict if it would disproportionately benefit only certain investors. Absent instructions from the requisite investor threshold contractually required to direct the indenture trustee, the trustee should have the right to refuse to take a demanded action. In case of doubt, an indenture trustee could itself seek instructions. The Article also examines practical issues—and practical ways to resolve those issues—that might sometimes impair formation of the requisite investor threshold to direct the indenture trustee.

The full article is available here.