Historically, a corporation issuing public debt would give first crack at any indenture trustee business to its principal lending banks. On a public bond issue, it was quite common for a corporation's lead lender to also serve in the capacity of indenture trustee.
Indeed, it seemed to make good business sense for the corporation to choose as its indenture trustee the same banking institution with which the company interfaced daily.
Despite this apparently logical relationship, it was clear in 1939 when the Trust Indenture Act was enacted, as it is clear today, that there is always a potential conflict between the bank acting in its interest as a lending banker and the same institution acting as a fiduciary indenture trustee for bondholders.
If a borrowing corporation finds itself in financial distress, the lending bank naturally wants to be repaid. So do the bondholders who loaned money to the corporation and are represented by the same bank.
Predefault Safety Steps
There are, of course, many potential conflicts which may exist even before a default of an indenture trustee's bonds. Until the Trust Indenture Reform Act of 1990 amended sections, the 1939 act stood as the statutory guidepost for indenture trustees.
One section of the original indenture act declared that there was a conflict of interest at any time indenture securities were outstanding and there was any one of nine tainted relationships. These included:
* The bank serving as trustee under more than one indenture trust for the same company.
* The trustee being closely connected with the issuer's underwriters.
* Corporate ownerships relationships which might put the bondholders in opposition to the bank's interests.
Flagging the Problem
Strangely enough, there was no explicit prohibition against the same institution serving as both lender to, and indenture trustee for, the same borrower.
Nonetheless, upon a default under the indenture, a banking institution that also served as a significant lender to a borrower would typically resign as indenture trustee and seek a successor.
A key element in the old conflict-of-interest approach was the prohibition against certain relationships at any time the securities were outstanding.
As the banking relationships between large borrowers and lending financial institutions have become even more complicated in recent years, the conflict-of-interest provisions enacted in 1939 have become increasingly cumbersome.
Large loans are typically syndicated among a significant number of banks, which increases the risk of conflicts among the syndicate participants. The syndicate lenders frequently face a number of annoying questions.
First, or course, the syndicate bank asks itself if it also had indenture trusteeships for the same borrower on the bank's corporate trust side. If so, were there any overt violations of the the act's proscriptions?
And even if not, did the syndicate bank want to take a state or common-law risk of being both a lender and a fiduciary at the same time?
Or, was the amount of the syndicate bank's loan relatively small, possibly decreasing the risk of a conflict of interest?
Then again, why should an indenture trustee give up its fee-generating trust business, since indenture trustees typically perform only ministerial duties predefault?
Virtually no lender disagreed that there was a conflict risk when there had been a financial default under the trust indenture.
Upon default, the borrower is obviously verging on bankruptcy and both the bank and the bondholders are looking to get paid from the same pot.
In addition, the sorts of relationship conflicts described by the Trust Indenture Act become more focused upon default. Surely, a financial institution cannot serve as indenture trustee for more than one competing bondholder group making claims on the same bankrupt estate.
Beyond the Theoretical
Nor can a bank easily meet its post-default fiduciary duties upon default if there are cross-ownership interests between the bank and the issuer. The elaborate offending relationships described in the act were no longer theoretical upon default.
But the old provisions made no distinction between predefault and post-default conflicts. The nine conflict relationships spelled out were proscribed at all times.
The Trust Indenture Reform Act provides a post-default conflict of interest standard, permitting an indenture trustee to continue serving as a fiduciary, notwithstanding the proscribed conflicting relationships, as long as there has been no default under the indenture.
90 Days to Cure Ills
Upon default, the trustee has 90 days to eliminate the conflict of interest unless the default has been cured. If the default or conflict remains, the trustee must resign at the end of the 90 days.
The reform act, at last, expressly recognizes that upon default, a creditor relationship becomes a prohibited conflict of interest.
In enacting these reforms, Congress found no evidence of trustee abuses prior to a default.
In fact, the 1936 Securities and Exchange Commission report underlying the indenture act only cited instances of trustee abuse in situations where there had already been a default on the bonds.
The SEC's current position, as stated in a memorandum supporting the reform legislation, is that in the absence of default, the indenture trustee's duties are essentially ministerial, consisting largely of maintaining security holders' lists and transmitting interest payments to holders.
Prior to default, in the SEC's view, there is no incentive for a trustee - even one with a technical conflict of interest - to withhold these services.
The SEC also asserts, somewhat questionably, that there is no historical evidence showing a trustee in dereliction of its duties in the absence of default.
The fact is that predefault breaches of fiduciary duty have been addressed in a number of cases, notwithstanding the SEC's benign view of the trustee's predefault role.
Although the 1939 act, as amended in 1990, does not expressly set forth predefault conflicts, it is important to remember that the statute does not purport to exonerate a predefault indenture trustee from either state law or common law liability for breach of fiduciary duty based upon a conflict of interest.
Put another way, the 1990 reform certainly should not be viewed as giving banking institutions carte blanche to conduct traditional lending activities predefault with no risk of a conflict of interest if the institution also serves as indenture trustee for the borrower.
A Rose by Any Other Name
A conflict is a conflict, and the Trust Indenture Act, as amended, does not purport to insulate offending relationships.
For example, if a lending bank improves the nature and value of the collateral for it loan knowing that the borrower is in financial extremis, it is by no means clear that it can put its head in the sand as the borrower moves toward a default on the debentures for which the banking institution acts as a fiduciary indenture trustee.
On the other hand, it would appear that smaller members of a banking syndicate with no real role in the loan due diligence or oversight should not be subject to the same scrutiny as the lead lenders who remain close to the borrower's business operations.
There may also be a danger in undue reliance by indenture trustees on the merely "ministerial" nature of their predefault duties.
While an indenture trustee is generally entitled to rely on certificates of covenant compliance it receives from appropriate company officials, does the indenture trustee have the right to ignore widely reported negative information in the business press about the borrower?
And what if other members of the management on the bank's lending side know that the borrower cannot meet various debt tests or comply with other covenants? Is there really a Chinese Wall which protects the corporate trust department in such situations?
The indenture trustee is far from naked in fending off such possible conflict-of-interest claims. While some cases have looked more critically at an indenture trustee's predefault duties, courts generally agree that - prior to default - an indenture trustee is more like a stakeholder whose duties and obligations are exclusively defined by the terms of the indenture.
In sum, difficult questions about the indenture trustee's role in modern corporate financing are being raised with greater frequency.
Key factors include:
* Increased activism of corporate debtholders.
* The obvious flood of contentious litigation.
* The manifest interest of the court and public in the role of banks and others in highly leveraged transactions.
The possibility of a conflict-of-interest burden will continue to make corporate trust departments uncomfortable. While the recent amendments are a reasonable attempt to clarify complex relationships, the conflict-of-interest problem remains a significant concern for many banks and debtholders.
Mr. Kelly is a partner and head of the bankruptcy workout group at the law firm of Dow, Lohnes & Albertson in New York.