Indenture Trustees Still Face Potential Conflicts of Interest
Kelly, Joseph F., Jr., American Banker
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. …