After nearly fifteen years of unsuccessful attempts to recover $71 million worth of securitized bonds after the 1990 bankruptcy of Continental Airlines, Inc., Bluebird Partners L.P. may have suffered its final defeat. In a recent decision by a New York trial court in Bluebird Partners v. The Bank of New York, et al., No. 601016/1996 (New York Co. June 7, 2010), the court granted summary judgment to defendant Bank of New York (“BNY”), holding that the bank behaved prudently in establishing a litigation reserve fund as the collateral trustee in the airline’s bankruptcy.

A Contentious History

In 1987, Continental Airlines, Inc. (“Continental”) issued, in three series, $350 million of bonds that were secured by over $400 million in aircraft and airplane parts (the “Collateral”). Bluebird Partners L.P. (“Bluebird”) owned more than $71 million of the first series of bonds issued by Continental. When Continental filed for bankruptcy and ceased making payments on the bonds in December 1990, approximately $180 million of the bonds remained outstanding, secured by collateral then valued at roughly $175 million. During the course of the bankruptcy proceeding, the value of the collateral decreased by about $100 million. In February 1994, Bluebird commenced a federal action against several trustees of the bonds (“series trustees”), alleging various forms of breach related to their purported failure to protect the bondholders’ interest in the Collateral during the bankruptcy proceeding.

In December 1995, BNY replaced NationsBank of Tennessee, N.A. (“NationsBank”) as the Collateral Trustee under a Secured Equipment Indenture and Lease Agreement and several modifying agreements (collectively, the “Indenture”). By the time BNY succeeded it, NationsBank had established a litigation reserve fund in the trust, which held approximately $34 million at the point of the succession. The reserved fund was established pursuant to the terms of the Indenture that provided for the indemnification of all expenses, including attorneys’ fees, incurred by the series trustees in the performance of their duties, and in the wake of the Bluebird litigation against the series trustees. The amount in the reserve fund, $25.6 million, was based on NationsBank’s calculation of the amount of indemnification claims of the series trustees and several law firms it had incurred as of April 1995.

In February 1996, Bluebird brought a separate action in New York state court, which included BNY as a defendant. The suit alleged that the Collateral Trustee did not have the right to establish a litigation reserve in the trust, and that any funds contained therein were wrongfully withheld from the bondholders. BNY moved to dismiss all but two causes of action, which the court granted in part in December 1996, holding that “the Controlling Documents . . . require that the collateral trustee reserve adequate funds for the defendants’ expenses including litigation expenses, which the defendants are entitled to.” The Appellate Division later dismissed Bluebird’s breach of contract claim. Accordingly, when BNY filed for summary judgment in May 2010, only two causes of action remained.

Bluebird’s first remaining claim was that BNY breached its fiduciary duty to the bondholders “[b]y failing to release all of the remaining funds held in trust for the [bondholders], other than those funds reasonably necessary to satisfy the justifiable and necessary expenses of the Trust.” The second remaining claim was for a declaratory judgment “limiting defendants’ purported lien on the trust funds to an amount determined to be reasonably necessary to satisfy defendants’ indemnity rights, if any, (not in excess of $5 million) and [ordering] BNY [to] make immediate distribution of all remaining funds and not unduly prolong the duration of the Trust.”

Applying the Prudent Man Standard

Addressing the merits of BNY’s motion for summary judgment, the court first acknowledged the obligation of BNY as Collateral Trustee to create and maintain a litigation reserve fund. The court further noted that the first priority payments under the Indenture were for the indemnification of the series trustees’ reasonable expenses, with the second priority payment including “the principal then due and payable, of premium (if any) and interest” on the outstanding bonds. Accordingly, the only issue left for the court to resolve was the question of whether that the amount of money BNY held in the litigation reserve fund was reasonable.

To analyze the reasonableness of the amount, the court invoked federal and New York State law, as well as the Indenture’s own terms, to apply the prudent man standard. The court cited the New York Appellate Division decision in Beck v. Manufacturers Hanover Trust Co., 218 A.D.2d 1, 11-13 (1st Dep’t 1995), for the established rule that a trustee, in the event of a default, “must act with undivided loyalty to the trust’s beneficiaries and must exercise its rights and powers under the indenture using the same degree of care and skill as a prudent man would exercise under the circumstances in the conduct of his own affairs.” Additionally, the court explained that a trustee must act not only prudently, but also in accordance with the rights and powers conferred on it by the indenture, as articulated by the Trust Indenture Act’s provision on “Duties and responsibilities of the trustee,” 15 U.S.C. § 77(c), which requires a similar degree of prudence as that demanded by New York law. Under the federal statute, upon the event of default, “[t]he indenture trustee shall exercise . . . such of the rights and powers vested in it by such indenture, and . . . use the same degree of care and skill in their exercise, as a prudent man would exercise or use under the circumstances in the conduct of his own affairs.”

In the case of the Continental bonds, the terms of the Indenture explicitly granted the Collateral Trustee the authority to reserve funds in its possession “sufficient to pay reasonably anticipated fees and expenses of each [series trustee] and its own fees and expenses incurred in its capacity as Collateral Trustee.” In so doing, the Collateral Trustee was required to “use the same degree of care and skill in their exercise, as a prudent man would exercise or use under the circumstances in the conduct of his own affairs.”

The Undisputed Facts

Rejecting Bluebird’s procedural argument that “questions of reasonableness and prudence are fact intensive and cannot be decided on summary judgment,” the court relied on the Court of Appeals decision in Matter of Bank of New York, 35 N.Y.2d 512, 519 (1974), which held that evidence of prudence and good faith could be found in the record at the summary judgment stage. Having determined that the Collateral Trustee could establish a litigation reserve fund and that the series trustees were entitled to priority payment before the bondholders, the court then applied the prudent-man standard to assess the measures taken by BNY to account for the amount contained in the reserve fund. BNY argued that its actions were the result of “logical, common-sense reasoning of [its] trust officers,” with its methodology and ultimate calculations the product of consultations with its Default Advisory Committee and legal counsel. The court agreed, referencing the Bank’s extensive analysis, which included “soliciting fee estimates from the defendant trustees, totaling those estimates and adding 10% to cover unfor[e]seen contingencies.” Moreover, the court noted the bank’s argument that, “whenever there was an adequate amount of money in excess of the litigation reserve, BNY distributed that excess money” to the bondholders.

The court again cited the Court of Appeals’s decision in Matter of Bank of New York to underscore that prudence is measured without the benefit of hindsight. It reiterated, “[a]t the time that BNY established the reserve it did not know that some of the trustees would settle with Bluebird and/or waive their fees,” and could not account for the possibility that some of the series trustees’ fee requests could be rejected based on their improper conduct. Rather, “BNY was not required to be prescient in making its decisions regarding the amount of money in the litigation reserve . . . it was simply required to act as a prudent man in similar circumstances.” Having established that BNY did just that, the court held that Bluebird failed to raise a material question of fact and summary judgment dismissing Bluebird’s claims was appropriate.