In his recent decision in RJ Capital, S.A. v. Lexington Capital Funding III, Ltd., 10 Civ. 25 (PGG), 2011 U.S. Dist. LEXIS 82912 (S.D.N.Y. July 28, 2011), Judge Paul G. Gardephe dealt with a noteholder’s creative attempts to circumvent noncompliance with a “no action” clause in an indenture that required several conditions to be met before suit thereunder could be brought. Judge Gardephe’s opinion partially granting a motion to dismiss highlighted that basic tenets of contractual interpretation govern even complex securities contracts, and courts will not brook attempts to recharacterize contractual claims to circumvent the intent of the contract. Nevertheless, the plaintiff’s creativity paid off when the court held that, because requiring strict compliance with the no action clause could lead to an absurd result, some leniency was warranted.

The Securities Arrangement

RJ Capital, S.A. (“RJ Capital”) held notes issued by Lexington Capital Funding III, LLC (“Lexington Capital”). An indenture governed the notes, and designated the Bank of New York Trust Mellon Company (“BoNY”) as the indenture trustee, which entailed, among other things, serving as an agent for payments of principal and interest on the notes. The indenture contained a no action clause, which set forth several conditions a noteholder was required to meet before bringing suit under the indenture. Specifically, a noteholder was first required to notify the trustee of default, ensure that holders of 25% of the outstanding notes request that the trustee institute proceedings to correct the default, offer to indemnify the trustee for its legal expenses and subsequently wait 30 days, at which point a noteholder could bring suit if the trustee had not initiated a proceeding and the majority of noteholders had not instructed the trustee to refrain from bringing suit. The indenture further provided that Harding Advisory, LLC (“Harding”) would serve as collateral manager, and Lexington Capital entered into a Collateral Management Agreement with Harding to formalize the arrangement.

Under the Collateral Management Agreement, Harding agreed to supervise and direct the maintenance of the collateral, and to assist BoNY in providing Lexington Capital with various reports and data.

Confusion over Payment Calculations

  The suit arose from a dispute over the method of calculating the amounts of principal payments on the notes. The indenture contained provisions setting forth an “account payment priority.” Initially, Lexington Capital calculated distributions of principal and interest payments without applying the account payment priority. BoNY, as the trustee, distributed those payments into RJ Capital’s accounts.

Lexington Capital later revised its principal payment distributions — but not its interest payment distributions — to incorporate the account payment priority. As a result, RJ Capital allegedly received approximately $500,000 less in principal payment distributions than it otherwise would have, and sued Lexington Capital, BoNY and Harding to recover its losses. RJ Capital sought to vindicate its alleged rights by asserting claims sounding in contract, quasi-contract, breach of fiduciary duty, diversion, tortious interference with contract, specific performance and declaratory judgment.

The Contract Claims and the “No Action” Clause

The indenture’s no action clause set forth several conditions a noteholder was required to meet before bringing suit on the contract. RJ Capital conceded that it had not satisfied those conditions, but argued that the clause did not apply to its breach of contract claims because RJ Capital based its claims upon allegations of mismanagement, and because the terms of the clause did not apply to actions against indenture trustees, such as BoNY. At the outset, the court noted that no action clauses are generally enforceable, but went on to address RJ Capital’s arguments that the clause at issue did not apply to its claims.

The court first rejected RJ Capital’s assertion that claims of mismanagement removed a suit from the scope of a no action clause. The court noted that RJ Capital cited to only one case to support its argument, Metropolitan West Asset Management, LLC v. Magnus Funding, Ltd., No. 03 Civ. 5539 (NRB), 2004 U.S. Dist. LEXIS 11761 (S.D.N.Y. June 25, 2004), in which noncompliance with a similar no action clause was held not to bar mismanagement-based claims of wrongful liquidation of collateral against the trustee and investment manager. In Metropolitan West, the no action clause applied only to claims seeking payment on the notes, thus the claims of wrongful liquidation of collateral which would not affect the priority of payments from that collateral were held to be outside the scope of the no action clause.

In contrast, RJ Capital alleged only that it had not received proper payment on the notes, an event plainly constituting a default under the indenture, and falling within the scope of the no action clause. The mere invocation of “mismanagement” did not serve to somehow remove the alleged breached obligation from the scope of the no action clause. The court further noted that, even were claims of mismanagement grounds for exemption from a no action clause, RJ Capital alleged no specific facts suggesting mismanagement or impairment of collateral. Because RJ Capital could muster no convincing argument for the non-application of the no action clause against Lexington Capital and Harding, the court held RJ Capital’s non-compliance with the clause to bar its breach of contract claims against Lexington Capital and Harding.

The court found more merit in RJ Capital’s argument that the no action clause did not bar claims against BoNY. The no action clause contained language that required a noteholder to give notice to trustee of any default, and request that the trustee bring suit to repair the default. RJ Capital had already given notice to the trustee, BoNY, of BoNY’s alleged breach. The court held that requiring RJ Capital to comply further with the no action clause and request that BoNY bring suit against itself would present an “absurdity.” The court thus held that further compliance with the no action clause was not required and the contractual claims against BoNY could go forward.

Breach of Fiduciary Duty, Unjust Enrichment and Breach of Implied Covenant of Good Faith and Fair Dealing

In addition to its claims for breach of contract, RJ Capital asserted claims for breach of fiduciary duty, unjust enrichment and breach of the implied covenant of good faith and fair dealing. The court found that RJ Capital based its breach of fiduciary duty claim upon BoNY’s allegedly improper application of the account payment priority, the same factual assertion supporting its breach of contract claim. Because a plaintiff may not pursue a breach of fiduciary duty claim arising out of the same facts as a breach of contract claim, the court dismissed this claim against BoNY. Similarly, because a plaintiff may not recover on theories of quasi-contract when no party disputes the existence of a contract governing the dispute, the court dismissed as duplicative RJ Capital’s quasi-contract claims of unjust enrichment and breach of the implied covenant of good faith and fair dealing.

Diversion, Tortious Interference with Contract and Specific Performance

RJ Capital also alleged a cause of action for diversion, under which corporate officers or directors may be liable for misappropriation of corporate assets, and a claim of tortious interference with contract against Harding based upon Harding’s alleged provision of flawed information that induced Lexington Capital and BoNY’s breaches of the indenture. The court dismissed both claims as entirely without merit. First, the complaint alleged no facts involving the diversion of corporate assets by an officer or director. Second, the allegation that Harding provided information to Lexington Capital was insufficient to make the required showing that Harding had intentionally induced Lexington Capital to breach its obligations under the indenture.

The court also dismissed RJ Capital’s claim for specific performance, noting that specific performance is not a distinct cause of action, but instead is an equitable remedy for breach of contract. The court reserved judgment, however, on whether specific performance would ultimately be an acceptable remedy.

Declaratory Judgment

Finally, the court allowed a claim for declaratory judgment to survive. Under the Declaratory Judgment Act, a court may declare the rights of an interested party if declaratory relief would “serve a useful purpose in clarifying and settling the legal relations in issue.” Although resolution of the breach of contract claims would settle the controversy with respect to past distributions, it would not clarify the proper method of calculation of future distributions under the agreement, which the court had found to be ambiguous. Therefore, in order to preclude the need for future suits over the proper calculation of distributions, the court allowed the claim to go forward.

The Take-Away

RJ Capital was unable to evade the no action clause in the indenture by attempting to recharacterize its breach of contract claims. Nevertheless, its creative arguments that unyielding adherence to the contractual language would lead to absurd results did preserve some of its claims against the trustee. Finally, despite non-compliance with the no action clause, RJ Capital’s suit provided the means to define its rights vis-à-vis each of the defendants by way of declaratory judgment, thus the clause did not provide the defendants with the comprehensive shield they may have desired