A recent case in New York State Supreme Court, One Williams Street Capital Management LP v. U.S. Education Loan Trust IV, LLC (Sup. Ct. N.Y. Cty. May 15, 2015), affords a useful opportunity to review the applicability and scope of §13-107 of the New York General Obligations Law, which provides that a transfer of a bond “vests in the transferee all claims or demands of the transferrer.” The court observed that §13-107 extends to all claims, whether in contract or in tort, including fraud. However, §13-107 is limited in its scope to claims against obligors and certain other direct actors with respect to the transferred instrument. Claims against collateral parties must be transferred, if at all, in accordance with the norms of otherwise applicable common law.
The plaintiffs in the case were former holders of $10 million worth of notes backed by government-guaranteed student loans. The notes were originally issued in October 2007, and in 2008 were converted into “auction rate notes.” Accordingly, defendant U.S. Education Loan Trust IV, LLC (ELT), the issuer of the notes, and defendant Bank of New York Mellon (BNYM), the trustee and the auction agent for the notes, were required to hold monthly auctions for the notes. When ELT and BNYM failed to hold the auctions, the notes were automatically converted to interest-bearing notes at the rate of one month LIBOR plus 2.50%, until redeemed or until a successful auction was held.
At a certain point, the defendant sponsors of ELT learned from BNYM that auctions were shortly to begin, with the result that the interest rate on the notes would be reset. The plaintiffs alleged that this was concealed from the plaintiffs and non-party Merrill Lynch, Pierce, Fenner & Smith, who together owned the entire issue of the notes. An auction did in fact occur, after which defendants took position that the interest rate on the notes had been effectively reduced to zero.
Plaintiffs commenced their action in June 2012, and after some legal skirmishing over the years, in January 2016, they and non-party Merrill Lynch sold all of their notes at auction. Then, in June 2016, the plaintiffs amended their complaint to allege a number of causes of actions against the defendants, including, among others, fraud against ELT and BNYM, aiding and abetting fraud against BNYM, and fraudulent conveyance against ELT. Defendants BNYM and ELT moved to dismiss the claims against them, arguing lack of standing under the New York General Obligations Law §13-107.
Section 13-107(1) of the New York General Obligations Law provides as follows:
Unless expressly reserved in writing, a transfer of any bond shall vest in the transferee all claims or demands of the transferrer, whether or not such claims or demands are known to exist, (a) for damages or rescission against the obligor on such bond, (b) for damages against the trustee or depositary under any indenture under which such bond was issued or outstanding, and (c) for damages against any guarantor of the obligation of such obligor, trustee or depositary.
The statute was definitely interpreted by the New York Court of Appeals in Bluebird Partners, L.P., v. First Fidelity Bank, N.A., 97 N.Y.2d 456 (2002). In that case, plaintiff Bluebird Partners was seeking to hold to account the trustees under an indenture governing two tranches of equipment notes issued by Continental Airlines. The notes were issued in March 1987, and in December 1990 Continental filed for Chapter 11 protection. A fund manager, Gabriel Capital, began accumulating the notes in December 1991 and subsequently transferred them to Bluebird Partners, an entity that Gabriel Capital formed for this purpose in January 1994. Bluebird Partners commenced its action in 1997 against the trustees and their respective law firms, asserting that the trustees’ delay in moving for adequate protection and their failure to move to lift the automatic stay constituted a breach of their fiduciary duties.
In 2001, the Appellate Division of the New York State Supreme Court dismissed the claim on the grounds that Bluebird Partners was a transferee of the certificates and, under §13-107, Bluebird Partners was required to demonstrate its own injury in order to recover damages. Because Bluebird failed to do so, it could not sue the trustees.
The Court of Appeals reversed. As interpreted by the Court of Appeals, “the wording of General Obligations Law §13-107 makes it eminently clear that the buyer of a bond receives exactly the same ‘claims or demands’ as a seller held before the transfer.” Because Gabriel Capital had standing to sue the trustees before it transferred the bonds to Bluebird Partners, Bluebird Partners, as buyer, acquired Gabriel Capital’s rights, including its right to sue the trustees.
Interestingly, the Court of Appeals left open the question of whether §13-107 should be pre-empted by federal law. In an earlier iteration of this same case played out in federal court, Bluebird Partners, L.P. v. First Fidelity Bank, N.A., 85 F.3d 970 (2nd Cir. 1996), the Second Circuit held that Bluebird Partners could not sue the trustees under the Trust Indenture Act (TIA). The court there observed that federal securities law claims are not automatically assigned to subsequent purchasers upon the sale of the security giving rise to the claims. The Second Circuit therefore declined to recognize a rule of automatic assignment of claims under the TIA. The defendants in Bluebird pointed to another section of the General Obligations Law, which they maintained mandated deference to the TIA as interpreted by the Second Circuit.
Specifically, §13-101(3) of the General Obligations Law provides that “[a]ny claim or demand can be transferred except … where a transfer thereof is expressly forbidden by … a statute of the United States. …” (emphasis supplied). The Bluebird defendants argued that either §13-101 directs that §13-107 be interpreted to conform to the TIA or alternatively that the TIA pre-empts §13-107. The Court of Appeals remanded the case to consider these arguments. In August 2002, the Appellate Division (297 A.D.2d 223, 746 N.Y.S.2d 475 (1st Dept. 2002)) rejected both of these arguments. It held that the New York legislature charted its own course in the matter of securities laws and rejected the argument that §13-107 conflicted with the federal statute.
The distillation of the Bluebird decisions is that under §13-107 claims travel with the corresponding debt.
Application in the U.S. Education Loan Trust Case
Following the holdings in Bluebird, the court in the U.S. Education Loan Trust case held that the plaintiffs lost their standing to sue on their notes when the notes were transferred. The plaintiffs raised two counterarguments.
Section 13-107 and Ancillary Parties
First, they cited to a subsequent Court of Appeals case, Public School Employees’ Retirement System v. Morgan Stanley & Co., 25 N.Y.3d 543 (2015), where the court held that claims with respect to certain notes did not travel with the securities. That case, as interpreted in U.S. Education Loan Trust, provides useful instruction on the limits of §13-107.
In Public School Employees’ Retirement System, a fund had acquired certain notes issued by a structured investment vehicle. The fund then sold the notes to its affiliate, and the affiliate was subsequently merged into a third entity. The issuer of the notes held a significant number of subprime mortgages, and in the financial downturn went into receivership. The transferee holder of the notes sued both Morgan Stanley, as arranger and placement agent of the notes, and the rating agencies for fraud. The question in the case, certified to the New York Court of Appeals by the Second Circuit, was whether an assignment of a fraud claim could be inferred from the facts and circumstances where there was no express language of transfer. The Court of Appeals confirmed that fraud claims are freely assignable in New York but held that in this particular case, the record was devoid of any proof of assignment of the fraud or other tort claims. Following precedent, the Court of Appeals held “where an assignment of fraud or other tort claims is intended in conjunction with the conveyance of a contract or note, there must be some language — although no specific words are required — that evinces that intent and effectuates the transfer of such right.”
The court in U.S. Education Loan Trust readily distinguished Public School Employees’ Retirement System. Section 13-107, the court said, by its terms speaks of claims for damages against a obligor, guarantor, trustee or depositary. The defendants in Public School Employees’ Retirement System were ancillary parties — an arranger and rating agencies — to whom §13-107 simply does not apply. While the fraud claims in that case did not automatically travel with the transferred securities, the case had no application to U.S. Education Loan Trust, where the issuer and the trustee were being sued.
Section 13-107 and Ancillary Claims
The plaintiffs also maintained that §13-107 applied only to claims on the bonds themselves and not to claims that were merely related to the bonds. The plaintiffs pointed to another subsequent Court of Appeals decision, Quadrant Structured Products v. Vertin, 23 N.Y.3d 549 (2014), in which the court distinguished between claims on the particular securities and tort claims relating to the securities for purposes of a no-action clause in an indenture. In U.S. Education Loan Trust, they argued, their claims were not on the notes themselves but in tort for actions that were related to the notes.
The court rejected this argument as well and said that Bluebird “made it ‘eminently clear’ that §13-107(1) provides the purchaser has ‘exactly the same claims or demands as the seller had before the transfer’ even if those claims are merely ‘related’ to the bonds at issue.”
Section 13-107 is a peremptory statute that can work either for or against a bondholder. Absent express language to the contrary, a transferor loses its claims on the debt once the debt is assigned, and its transferee picks up those claims upon acquiring the securities. This principle applies to all claims on the bonds, whether they are for non-payment or rescission or whether they relate to ancillary wrongs, such as fraud or misrepresentation. But §13-107 has its limitations. It is effective only with respect to claims against a defined set of actors enumerated in the statute — an issuer, a guarantor, a trustee for the bonds or a depositary to whom the bonds are entrusted. It will not work its magic against other persons, such as underwriters or placement agents, who may be intimately connected with the issuance of the bonds but who fall outside the scope of §13-107. It behooves debtholders to understand both the reach and the limitations of this uniquely New York statute.
Debtholders should also take to heart the teachings of Public School Employees’ Retirement System. Tort claims, including claims for fraud, can be assigned under New York law. However, an assignment will not be inferred, and must be made by express language. Where §13-107 does not apply, and a purchaser intends to acquire tort claims associated with the debt, it should exercise the necessary care to do so explicitly.