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.