As cases from the sea of failed residential mortgage-backed securities (RMBS) trusts from the first decade of the millennium continue to wind their way through the courts, the corpus of case law on duties and liabilities of trustees continues to accumulate data points. One such recent case is Phoenix Light SF Limited v. The Bank of New York Mellon, which was decided in the Southern District of New York in September 2017.
The decision involved numerous RMBS trusts for which Bank of New York Mellon (BNYM) served as trustee. Three of the trusts were governed by indentures, while 17 of the trusts were governed by pooling service agreements. All the trusts experienced events of default, and at issue were the obligations and potential liability of BNYM, as trustee, as a consequence of these events of default.
As a general and widely ensconced principle, prior to the occurrence of an event of default, the duties of a trustee are limited to the contractual responsibilities that are expressly enumerated in the governing documents of the indenture or other trust documentation. Following the occurrence of an event of default, a trustee’s obligations “come more closely to resemble those of an ordinary fiduciary,” citing Royal Park Invs. SA/NV v. HSBC Bank USA, NA, 109 F. Supp. 3d 597 (S.D.N.Y. 2015). In Phoenix Light, the plaintiffs alleged that BNYM breached both its pre-event of default and post-event of default duties. The alleged breach of pre-event of default duties involved failure to give contractually mandated notices of breaches of representations and warranties regarding mortgages sold to the trusts and failure to enforce repurchase obligations against the RMBS seller. Post-event of default, the plaintiffs alleged, BNYM breached its duty of prudent action.
The court’s ruling was rendered in response to BNYM’s summary judgment motion to dismiss all of plaintiffs’ claims, and of course turned on the specifics of the documentation governing the various trusts at issue in the case. Nonetheless, the decision offers insights into various issues that may arise with respect to the obligations of trustees generally.
Knowledge After an Event of Default
Under Section 315(c) of the Trust Indenture Act (TIA), whose provisions are typically found in indentures irrespective of whether a particular indenture is qualified under the TIA, after the occurrence of an event of default, indenture trustees are required to exercise:
such of the rights and powers vested in it by [the] indenture, and 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.
Although this might seem self-evident, the TIA and indentures that follow in its path do not expressly state that a trustee must have knowledge of an event of default before its duty to act as a prudent person will arise. Dispelling any doubt in this regard, Phoenix Light held explicitly that a trustee must have knowledge of the event of default before its heightened post-default standard of conduct comes into play. Of course, what constitutes knowledge can vary depending on the particular formulation of an indenture, or indeed the inclination of a particular court interpreting an indenture.
Trustee’s Discovery of Breach
In an RMBS structure, mortgages are sold to a securitization vehicle, subject to representations and warranties that the mortgages comply with certain underwriting standards. Often, the trustee will be required to provide notice upon “discovery” that a particular mortgage is noncompliant. The question of what constitutes a trustee’s discovery, akin to what constitutes a trustee’s knowledge, is unsettled. The Phoenix Light decision noted that there were a number of approaches adopted by the courts, from actual knowledge to inquiry knowledge — where the trustee has sufficient information triggering a duty to investigate — to something in between.
The court determined in the particular case that it was not required to reach a definitive conclusion on the issue. Based on the facts available on summary judgment, the court held, a trier of fact could find that the trustee had either actual knowledge or inquiry knowledge. Nonetheless, the judicial split on the issue could be relevant in other circumstances in which a trustee may be required to take action on the basis of incomplete knowledge or awareness.
BNYM conceded that events of default had occurred with respect to the trusts. Plaintiffs alleged that BNYM did not act prudently after default to ensure that the holders received the “benefits and protections” under the related trust documentation. In opposition, BNYM maintained that it had no duty to act, because “it had reasonable grounds to believe that an indemnity was not reasonably assured.”
Although varying in particulars across the trusts, all documentation contained fairly common language to the following effect:
No provision of this Indenture shall require the Indenture Trustee to expend or risk its own funds or otherwise incur any financial liability in the performance of any of its duties hereunder, or in the exercise of any of its rights and powers, if it shall have reasonable grounds for believing that repayment of such funds or adequate indemnity against such risk or liability is not reasonably assured to it under this Indenture [or related documents].
As noted by the plaintiffs, under the relevant documentation, the trustee was contractually entitled to indemnification from the trust fund, the sponsor of the securitization, the seller and the servicer. BNYM asserted that this indemnity was inadequate because the servicer, from whom the trustee would be seeking indemnification, was the breaching party and, as to certain of the trusts, those trusts were now on the brink of insolvency.
The court held that BNYM had failed to demonstrate, at least for purposes of summary judgment, that it was not reasonably assured of indemnity. The court categorized BNYM’s argument as ipse dixit. Also, the court said, the trustee made no showing that at the time of the default, the promises of indemnity were unreliable even as to those trusts that were subsequently in the zone of insolvency.
The court’s observations suggest that a trustee must be prepared to adduce particular facts if it determines not to act on the basis of the absence of an assured indemnity, where on its face the relevant documentation provides for contractual indemnity. Unsupported allegations of the trustee’s uneasiness with the creditworthiness of the indemnitor, or even an indemnitor’s subsequent insolvency, may not justify the trustee’s refusal to act at the time of default.
BNYM further argued that it was justified in failing to act because, after providing notice of the default to certificateholders, it received no direction or instruction. Plaintiffs, on the other hand, maintained that “a prudent person would have demanded that the servicer improve its practices and compensate the Trusts for its past failures,” among other things, even without direction.
The court observed that “BNYM points to no contractual provision or court decision holding that, as a matter of law, a prudent person would simply issue a Notice and passively wait for certificateholder direction.” In the court’s view, whether the trustee could simply issue a notice of default and wait for instruction, or whether it was obligated to take remedial initiatives, was a question for the jury.
The lesson here appears to be clear. A trustee that limits itself after default to ministerial action could be second-guessed at trial, and the absence of express direction from noteholders may not be a defense. A trustee must make a careful evaluation of available courses of action after default, and be prepared to justify its determinations to a trier of fact post hoc.
The Prevention Doctrine
Certain of the trusts provided that “the Trustee shall not be deemed to have knowledge of an Event of Default until a Responsible Officer of the Trustee shall have received written notice thereof.” The plaintiffs argued that notwithstanding this provision, the trustee had post-default duties where it had actual knowledge of the default, notwithstanding that it did not receive written notice. The plaintiffs argued, moreover, that the trustee itself was required to provide written notice under the so-called prevention doctrine. Under that doctrine, a trustee “may not excuse its failure to perform the additional duties required of it after an Event of Default by pointing to its own failure to give notice.” Fixed Income Shares: Series M v. Citibank N.A, 130 F. Supp. 3d 855 (S.D.N.Y. 2015). Or put another way, “a party may not insist upon performance of a condition precedent when its nonperformance has been caused by the party [it]self.” Royal Park Invs. SA/NV v. Deutsche Bank Nat’l Tr. Co. (S.D.N.Y. Feb. 3, 2016) (both cases cited by the court).
The court readily disposed of the plaintiffs’ argument. The trust documentation was express in its requirement that the trustee receive written notice from a third party, and the prevention doctrine was therefore wholly inapplicable. The doctrine, however, is something to bear in mind, where the trustee itself is required to give notice. The trustee may not escape liability for actions that would have devolved on the trustee had such notice been given.
As in all RMBS cases, Phoenix Light turns on the specific facts, circumstances and posture of the case, and more particularly on the formulation of the trustee’s duties and responsibilities in the relevant trust documentation. Nonetheless, there is sufficient commonality among trust documentation, not limited to RMBS, that makes the discussion of principles in the case relevant to the duties and responsibilities of a trustee generally. The takeaways regarding knowledge attributable to a trustee and its duties to act should find general application.