Settlement of collection disputes over amounts and payment terms for bond-related claims, including in bankruptcy cases, involves issues of binding minority bondholders and releasing the indenture trustee, as well as straightforward determinations of collectability economics. Bondholders unhappy with a proposed settlement can be bound nevertheless when the deal is incorporated into a bankruptcy plan of reorganization and majority bondholders out-vote them, but only if certain requirements are met. A recent bankruptcy court decision, In re Lower Bucks Hosp., 471 B.R. 419 (Bankr. E.D.Pa. 2012) (“LBH”), district court appeal pending, provides important new guidance on analyzing indenture trustee conflicts of interest in this context, the adequacy and placement of required disclosures to bondholders concerning third-party releases and settlement authority.
We have enclosed an article published in the most recent ABI Journal describing the case and lessons for bankruptcy lawyers. This Client Alert is written for indenture trustees and investors.
Our take-away from the LBH opinion is that an indenture trustee should take a cautious and deliberate path to negotiating settlements of bondholder claims with release provisions, and bondholders should read indenture trustee notices carefully - including information in sections that might seem “boilerplate” - and raise any conflict of interest concerns promptly with the indenture trustee. More specifically,
As early in the bankruptcy case as possible, the indenture trustee should implement a comprehensive communication protocol with all bondholders, deploying, as and when appropriate, the Electronic Municipal Market Access (“EMMA”; emma.msrb.org, the central repository maintained by the Municipal Securities Rulemaking Board), DTC, direct mailings and telephonic bondholder meetings. Bondholder communications should include timely notices of material bankruptcy developments, strategically-vetted updates on settlement negotiations, and information concerning the scope of any direction provided by controlling majority bondholders or third-party credit enhancers.
If a claim has been asserted by the debtor or another party implicating the indenture trustee and its indemnification rights, the indenture trustee should promptly make a preliminary determination as to whether the claim is more likely than not to create a conflict of interest with the bondholders. Potential conflicts of interest are particularly troublesome when there is no directing majority bondholder group. In such cases, if the indenture trustee concludes that the claim presents a significant risk of a potential conflict, it may want to bring in a successor trustee to evaluate pursuit of bondholder claims. As recognized by the LBH court, the original indenture trustee will continue to pursue its indemnitee rights. In any event, the indenture trustee should make full and conspicuous disclosures of the claim to bondholders, including, to the extent of available information, the background, nature and details of the asserted claim. Given the critical comments of the LBH court on using the standard bondholder notice format to convey critical information to bondholders, consider incorporating special cautionary banners or legends in written notices using bold, italic or underlined text.
Once the material terms of a settlement have been agreed upon, the indenture trustee should provide bondholders with written notice of its recommendation as to the reasonableness of the settlement, the basis therefore, and the complete details of any proposed release of claims. The description of each release contemplated by the settlement should, at a minimum, address (a) asserted claims and causes of actions; (b) risk factors and benefits evaluated in determining that such release is in the best interest of the bondholders (which may duplicate in part the factors bearing on reasonableness); and (c) the procedural consequences to the bondholders of the release.
All pleadings filed in connection with approval of the proposed settlement (e.g., bankruptcy court stipulations resolving adversary proceedings, Rule 9019 motions and disclosure statements, and state court petitions for trust instructions) should include clear and conspicuous references to any contemplated releases and emphasize or restate disclosures to bondholders. In satisfaction of Bankruptcy Rule 3016(c), to the extent it may apply, information regarding releases should describe the merits and value of the potential claims being released (i.e., risk factors and benefits), and be separated in proximity and distinguished by conspicuous language (bold, italic or underlined text) from information on debtor releases. The LBH court further suggested that any third party release discussion should be referenced in summaries included in the front of the disclosure statement, a suggested placement analogous to the placement of investment risk factors in the context of a speculative securities offering disclosure.
The LBH court was very vocal in its disappointment that the indenture trustee’s counsel only made vague references to the third-party releases in the global settlement during the Rule 9019 hearing on settlement approval. Counsel to indenture trustees should take extra measures to make sure the record before the court clearly describes releases and the risk factors evaluated in determining that such releases are in the best interest of bondholders.
For those interested in a more thorough explanation of the case, here is a summary of the facts, issues and holding of the LBH opinion, along with an explanation of other cases addressing bondholder settlements that bind dissenting bondholders and release indenture trustees:
Debtor Lower Bucks Hospital (“LBH”) filed a Chapter 11 bankruptcy case, owing nearly $25 million in hospital revenue bond indebtedness along with $36.5 million in pension plan underfunding liability and $7.5 million in trade debt. As is typical, the loan and security agreement under which a municipal authority issued the bonds included broad indemnification rights in favor of the authority against LBH that were assigned to the indenture trustee, with exceptions for losses arising from bad faith, gross negligence, willful misconduct or fraud. LBH further indemnified the indenture trustee for any liabilities it might incur in performing its powers and duties under the Indenture, with exceptions for Trustee gross negligence or willful misconduct. A separate provision limited the indenture trustee’s liability to conduct constituting willful misconduct or negligence. Thus, while the indenture trustee might be liable to bondholders for its own negligence, debtor LBH indemnified the indenture trustee against losses from any action short of gross negligence, bad faith or fraud. And the indenture trustee could exercise a charging lien to deduct amounts owed to it, including indemnification claims, before making any payments on the bonds.
Debtor Claims and Settlement
LBH asserted its own claims against the indenture trustee, contending that the initially-perfected security interest had lapsed. The indenture trustee argued various defenses, counterclaims and third party claims, and negotiated a settlement. It provided for the indenture trustee’s secured claim to be allowed in the amount of $8.15 million and paid in full under a plan to be filed by LBH, with specified provisions for treatment of other creditors. LBH and the indenture trustee granted each other mutual releases. The settlement agreement also provided for the “release of any and all claims and causes of action arising under or in any matter related to the Bond Documents against the … Indenture Trustee by any and all parties, including without limitation all Bondholders, to the extent permitted by applicable law.” LBH, 471 B.R. at 429-30.
LBH requested bankruptcy court approval of the settlement by a motion served on bondholders through delivery to record bondholder Depository Trust Company (“DTC”). The indenture trustee also informed bondholders of bankruptcy events through eight notices, one of which summarized the proposed settlement. Of critical importance to the bankruptcy court, neither the motion nor any of the unofficial notices highlighted the bondholder release of the indenture trustee, although the release provision was quoted. The judge explained in the LBH opinion that he did not notice or appreciate the significance of the release of the indenture trustee by non-debtor third parties, the bondholders, nor did he intend to prevent bondholder suits against the indenture trustee for the asserted loss of a perfected lien.
LBH’s reorganization plan incorporated the settlement. Again, the bondholder release provisions were quoted, but not highlighted and LBH’s arguments of indenture trustee negligence and the indenture trustee’s defenses were not described. One bondholder noticed, and argued that bondholder claims against the indenture trustee could not be released, that the indenture trustee had a conflict of interest and the bondholders had no representation in settlement negotiations, and that the indenture trustee was liable for losses due to the LBH suit and compromise of it under theories of breach of fiduciary duty, negligence and breach of contract. The indenture trustee continued to post notices to bondholders, one of which simply reported that the objecting bondholder’s motion to reconsider the settlement agreement had been filed and that the indenture trustee intended to contest it.
An overwhelming majority of bondholders voted to approve the plan. Pursuant to procedural agreements, the settlement agreement remained intact and the plan was confirmed, with both orders subject to separate consideration of the bondholders’ release of the indenture trustee. In the LBH opinion, the court concluded that the indenture trustee made a plausible case for approval of the bondholder release, but the bondholders’ votes on the plan did not show they acquiesced in the release because of inadequate disclosures. The court proposed re-solicitation, but the indenture trustee declined and the order became final and has been appealed.
Indenture Trustee Conflicts of Interest
The LBH indenture trustee argued that it could not reasonably be expected to release its indemnification claims against the bankruptcy estate while exposed to potential losses to bondholders and defense costs, and distributions to bondholders would need to be held back pending the exercise of its charging lien rights. Accordingly, the indenture trustee took into account its own indemnification claims along with amounts due on the bonds when negotiating a settlement.
The objecting bondholder argued that once the indenture trustee became aware of claims that its actions might be responsible for bondholder losses, it had to obtain separate representation for the bondholders. Indentures commonly oblige an indenture trustee to act at the direction of a majority of bondholders, upon providing satisfactory indemnity, and it is preferable for such bondholders to participate directly in any settlement negotiations. There was no such involvement in the LBH case, and the indenture trustee argued that it was the only party empowered under the indenture to represent the bondholders collectively. It argued that without indenture trustee consent, there could be no settlement.
The LBH court reasoned that the indenture trustee acted as both a “bondholder representative” and as an “indemnitee” on its personal exposure with respect to the settlement. The indenture trustee’s indemnity claims had to be resolved for a reorganization plan to be confirmable. The court said that whether the indenture trustee acted as a contractual agent or as a fiduciary, once it chose to act as the bondholders’ representative and participate in negotiations on their behalf, it was obligated to represent their interests faithfully. LBH, 471 B.R. at 453. Such faithful representation does not does not preclude an indenture trustee from protecting its own rights to reimbursement and indemnification, though. The indenture trustee’s duties of loyalty can be balanced with its personal interests and met by the transaction being fair, fully disclosed, and court-approved.1
Settlements Can Bind Minority Bondholders and Release Indenture Trustees, If Adequately Noticed
Indenture trustees generally are not authorized by their indentures to vote bondholder claims on a reorganization plan. The LBH court said that meant the indenture trustee could only settle the adversary proceeding against it by agreeing on terms for a consensual plan, without depriving the bondholders of the right to vote. LBH, 471 B.R. at 458. In the Third Circuit where the LBH case was filed, a non-debtor such as an indenture trustee can receive a release of liability under a plan when certain findings are made, but in other jurisdictions, third party plan releases are impermissible (but settlement releases are allowed).2
In both such jurisdictions, the mechanism to settle indenture trustee/bondholder claims against a debtor’s estate, debtor defenses/counterclaims, indenture trustee indemnification/reimbursement claims, and bondholder claims against the indenture trustee is two-fold. It entails both approval of a settlement agreement with release provisions under Bankruptcy Rule 9019 or a separate state court suit, such as a trust instruction proceeding,3 plus bondholder votes on a plan incorporating the settlement. For a court to approve a settlement and plan that binds minority bondholders, especially if it includes third-party releases, courts want to see bondholder support through their plan votes - after bondholder receipt of adequate notice. LBH, 471 B.R. at 456-57.
Delta Air Lines: A Settlement Binding All Bondholders
The Delta Air Lines decisions show how bondholders can be provided with sufficient due process to warrant approving settlements of bond claims, binding dissenting bondholders and releasing bondholder claims against indenture trustees.4 The Delta settlement eliminated the ability of individual bondholders to bring claims against the indenture trustee for alleged failures to act prudently, and authorized the indenture trustee to settle for less than the full value of the bonds despite indenture provisions protecting minority rights by prohibiting the impairment of a bondholder’s right to receive payment of bond principal and interest without that bondholder’s consent.
In Delta, the indenture trustee settled at the direction of a majority of bondholders, the bankruptcy court found that the settlement was fair and reasonable and in the interest of all bondholders, and the settlement was incorporated into a reorganization plan that was approved by a large majority of bondholders.5 Minority bondholders objected to the settlement, but the court found that the indenture trustee had “developed an exceptionally full and open process of communication with all of the 1992 Bondholders,” including multiple notices about material events in the bankruptcy case posted on a website and delivered to bondholders through DTC, and involvement of an informal “bondholders committee.” Delta, 370 B.R. at 542-43.
The LBH Difference
In the LBH case, the indenture trustee posted notices about the bankruptcy case on a bondholder website and described the settlement there, as well as delivering notices to bondholders through DTC. But the court held that the content was too opaque. It concluded that the bondholders needed to know about the allegations against the indenture trustee being released by the plan in more detail. While indenture trustee notices to bondholders often follow a standard format, the LBH court said that “the general similarity of the serial notices would make it less likely that the recipients would parse carefully any of the later documents.” LBH, 471 B.R at 461.
The LBH decision held that Bankruptcy Rule 3016(c) applies to third party release provisions in reorganization plans. Rule 3061(c) provides that when a plan includes an injunction against conduct not otherwise enjoined by the Bankruptcy Code, the plan and disclosure statement have to describe the actions and entities being enjoined in specific and conspicuous language, such as bold, italic, or underlined text. In some cases, an express release of an indenture trustee or other third party has been brought to the attention of bondholders voting on a plan by a provision on each ballot to be checked by the voting bondholder.6 In the LBH case, this didn’t happen, and the court said that the existence and significance of the bondholder release of the indenture trustee was obscured by being placed among boilerplate disclosures and not included in the summary of key terms. The LBH decision did not say a settlement with a bondholder release is impossible, or that dissenting bondholders could not be bound; it only ruled that the indenture trustee notices and LBH disclosure statement were not sufficiently clear.
The district court in the LBH appeal may provide further perspective on indenture trustee and bondholder settlement issues. In the meantime, the LBH bankruptcy court opinion and the Delta cases provide useful guidance on methods to obtain effective approval of settlements binding on bondholders.
This client alert was written by Susan M. Freeman and Bryant D. Barber. Susan is a partner in the Bankruptcy Practice Group and Bryant is a partner in the Municipal Finance Practice Group at Lewis and Roca LLP in Phoenix, Arizona. They represent Wells Fargo Bank, N.A. as Indenture Trustee in the Las Vegas Monorail bankruptcy case.
1. For an extensive analysis of the history and principles of fiduciary duties, see Susan Freeman, Are DIP and Committee counsel Fiduciaries for Their Clients’ Constituents or the Bankruptcy Estate? What is a Fiduciary, Anyway?, 17 Amer. Bankr. Inst. L. Rev. 291 (Winter 2009).
2. See, e.g. In re Lowenschuss, 67 F.3d 1394 (9th Cir. 1995); but see In re Station Casinos, Inc., 2010 Bankr. LEXIS 5380 at *56-61, 84, 94-99 (Bankr. D. Nev. Aug. 27, 2010) (creditors approved settlement with third party releases in plan ballots).
3. See, e.g. Minn. Stat. § 501B.16 under which a trustee may obtain an order instructing the trustee, beneficiaries, and any other interested parties in trust administration matters that is binding in rem upon the Trust Estate and upon the interests of all beneficiaries. The court can be asked in to determine that a settlement agreement, including terms regarding indenture trustee reimbursement, indemnification and releases, is consistent with the indenture trustee’s fiduciary duties and in the best interest of bondholders.
4. See In re Delta Air Lines, Inc., 370 B.R. 537 (Bankr. S.D.N.Y. 2007), aff’d. Kenton Cnty. Bondholders Comm. v. Delta Air Lines, Inc. (In re Delta Air Lines, Inc.), 374 B.R. 516 (S.D.N.Y. 2007), aff’d sub nom., Ad Hoc Comm. v. Delta Air Lines, Inc., 309 Fed. Appx. 455 (2d Cir. Feb. 9, 2009).
5. Criteria that the indenture trustee and court would consider in determining whether a settlement agreement is reasonable includes: a) The probable validity of the claims; b) The apparent difficulties in enforcing the claims through the courts; c) The collectability of a judgment recovered; d) The delay, expense, and trouble of litigation; e) The amount of the compromise as compared with the amount and collectability of a judgment; and f) The view of the parties involved. Cogdell v. Fort Worth National Bank, 544 S.W. 2d 825, 829 (Tex. App. 1976) (citing In re Ortiz Estate, 27 A.D.2d 368, 374 (Del.1942)).
6. See, e.g. Station Casinos, 2010 Bankr. LEXIS 5380 at *54.