Section 316(b) of the Trust Indenture Act, which prohibits action that would deprive individual bondholders of the right to receive principal and interest, has taken center stage of late with rulings on the scope of its applicability. But another provision of Section 316 of the TIA drives in the opposite direction, and is equally fundamental to the architecture of indenture debt as commonly issued in this country. Section 316(a)(1) prescribes the default rule that a majority of bondholders have the power to direct the remedial actions of the trustee. Even indentures that are not governed by the TIA routinely include such a provision. Surprisingly, there is little case law on TIA 316(a)(1), or the equivalent non-statutory language, that explores the scope and limitations of majority rights. Beyond TIA 316(a)(1) itself, there is the broader question of when a trustee may decline to follow the direction of even a majority of bondholders or even disregard their economic interests.
Time, Method and Place
Section 316(a)(1) provides as follows:
(a) The indenture to be qualified – (1) Shall automatically be deemed (unless it is expressly provided therein that any such provision is excluded) to contain provisions authorizing the holders of not less than a majority in principle amount of the indenture securities or if expressly specified in such indenture, of any series of securities at the time outstanding (A) to direct the time, method and place of conducting any proceeding for any remedy available to such trustee, or exercising any trust or power conferred upon such trustee, under such indenture ...
A threshold issue is the interpretation of the phrase “to direct the time, method and place of conducting any proceeding.” Is the power of the majority to direct limited to procedural matters, as “time, method and place” would seem to indicate? Or does the power of direction extend to substantive matters, that is to say a direction to the trustee to take, or refrain from taking, a particular remedial course of action?
The one case specifically interpreting TIA 316(a)(1) would seem to indicate that the power of direction under 316(a)(1) is substantive. In Continental Bank of Trust Co. of N.Y. v. First National Petroleum Trust 67 F. Supp. 859 (D.R.I. 1946), the court found that a provision in the indenture allowing a majority of holders to direct the indenture trustee’s conduct of remedial activity, as permitted under Section 316(a)(1), could not be used to direct a forbearance in the payment of interest. The mandatory provisions of TIA Section 316(b) (and TIA Section 317), the court held, overrode 316(a)(1)’s authorizing the indenture trustee to take direction from a majority of holders. By implication, however, a direction of majority holders that did not contravene by Section 316(b) would be binding on the trustee, notwithstanding that the direction related to a matter of substance rather than procedure.
In accord is the well-known case of Delta Air Lines, Inc., 370 B.R. 537 (Bankr. S.D.N.Y. 2007), in which the bankruptcy court held that a trustee was authorized to settle claims in bankruptcy over the objection of complaining minority holders. While the case involved a municipal security and was not governed by the TIA, the operative language for bondholder direction was the same, a “time, method and place” formulation. This, according to the court, gave majority bondholders a power of direction with respect to the trustee’s negotiation and agreement of settlement. The majority bondholders in Delta had supported the settlement entered into by the trustee, and the court therefore declined to invalidate the settlement on the application of a small minority of the bondholders.
There is at least one case expressly to the contrary. In Electroglas, Inc. (Bankr. D. Del. 2009), the court was asked to rule on whether a trustee could be compelled at the direction of the majority noteholders to credit bid. The court first determined that the majority holders of the notes were unable to credit bid the notes themselves. It then ruled that the trustee was also not required to follow a direction of the majority noteholders in this regard. The court stated, “I read [the section on direction by a majority] to provide that, once the Trustee decides upon an action, a majority of Noteholders may direct the Trustee to take that action at a certain time or place or according to a specific method. However, a majority of Noteholders may not force the Trustee to take a certain substantive action. That is, a majority of Noteholders may only prescribe procedure to the Trustee.” The court in Electroglas, however, would appear to be an outlier.
Prejudice to Other Holders
Notwithstanding the court’s decision in Electroglas, and in keeping with the implications of Continental Bank, the common wisdom regarding TIA Section 316(a)(1), and correlative indenture language, is that majority bondholder direction to a trustee may extend beyond merely procedural matters. This power of direction is not unfettered, however. While not provided for in the TIA, it is common for indentures to include a qualifier on majority control to the effect that “the trustee may refuse to follow any direction that conflicts with law or the indenture or that the trustee determines is unduly prejudicial to the rights of any other noteholder or that would involve the trustee in personal liability.” (A corresponding provision routinely appears in the section on noteholder suits, to the effect that “a noteholder may not use the indenture to prejudice the rights of another noteholder or to obtain a preference or priority over another noteholder.”)
So, for example, consider a situation in which the majority noteholders were invested in two layers of the capital structure, and it would be economically advantageous to them to advance the interests of the second tranche over the first. The bondholders therefore direct the trustee to desist from exercising remedies in favor of the bondholders under the first tranche in order to improve the position of the holders under the second tranche. Under standard indenture provisions, the trustee may be within its rights to ignore the direction.
Section 316(a)(1) and related provisions speak of remedial action, which presumes that a default has occurred under the indenture. The considerations are different pre-default, as illustrated in Elliott Associates v. J. Henry Schroder Bank & Trust Co., 838 F. 2d 66 (2d Cir. 1988).
In that case, the issuer called convertible debentures for redemption. Because the conversion was solidly “in the money,” all debenture holders were incentivized to convert prior to the redemption date. Under the terms of the indenture, the issuer was required to give the trustee 50 days’ advance notice of the redemption date, unless the trustee agreed to shorter notice. If the redemption date were to have occurred after the full 50 days after notice, it would have fallen between a record date for the payment of interest and the corresponding interest payment date. This, the plaintiff claimed, would have entitled debenture holders to one final payment of interest notwithstanding the conversion. In fact, however, the trustee notified the issuer that it was satisfied with a shorter notice period, so that the redemption date occurred prior to the record date for the payment of interest. The plaintiff claimed that the trustee had breached its duties when it acquiesced to the shorter notice period by failing to take account of the economic interests of the debenture holders to receive the interest payment.
The Second Circuit, affirming the district court, disagreed. According to the court, “so long as the trustee fulfills its obligations under the express terms of the indenture, it owes the debenture holders no additional, implicit pre-default duties or obligations except to avoid conflicts of interest.” Since the trustee was given express discretion to waive the full notice period, and provided the waiver did not financially benefit the trustee at the expense of debenture holders, the debenture holders could not complain about the trustee’s failure to consider their financial interest in a later redemption date. Presumably, the trustee would have been justified in ignoring even an express directive of majority debenture holders in these circumstances. (The district court also accepted the issuer’s position that, even had the redemption date fallen after the record date, converting holders would not have been entitled to an interest payment. The Second Circuit found it unnecessary to address this point.)
Electroglas notwithstanding, the common wisdom holds that majority bondholders should be able to control their trustee in exercising substantive rights and remedies under an indenture. But there are limits. Bondholders, even majority bondholders, cannot direct action in a manner that is inconsistent with express terms of the indenture. As discussed in the companion article on the recent case of U.S. Bank National Association v. Triaxx Prime CDO 2006-1, Ltd., even a trustee or collateral agent may not exercise its discretion to take contraindicated action, notwithstanding a determination that the action was in the best interests of bondholders. Also, a majority cannot use its rights of direction in a manner that would prejudice minority holders, and rights of direction are likely not available in the absence of a default. Thus, while majority direction is a foundational tenet of indenture architecture, like most other things in life, “it depends.”