SARAH L. REID AND ROBERT W. SCHUMACHER

Transcription

1 AUTOMATIC ASSIGNABILITY OF CLAIMS: THE TENSION BETWEEN FEDERAL AND NEW YORK STATE LAW SARAH L. REID AND ROBERT W. SCHUMACHER More and more often, sophisticated investors in distressed debt who purchase the beneficial interests in debt securities at a deep discount before or after an issuer files for bankruptcy are bringing suit against financial institutions in their capacities as indenture trustees for injuries that allegedly occurred years prior to their acquisition of the securities. In this article, the authors examine the applicability of federal and New York law to these claims. Financial institutions, in their capacities as indenture trustees, have faced increasing litigation from sophisticated investors in distressed debt who purchase the beneficial interests in debt securities at a deep discount before or after an issuer files for bankruptcy. In these types of litigations, investors seek to recover from indenture trustees for injuries that allegedly occurred years prior to their acquisition of the securities. Thus, while the investors themselves have not suffered direct injuries, and presumably had full knowledge of an indenture trustee s alleged misconduct prior to their purchases of the securities at issue, they nevertheless assert negligence, breach of contract and fiduciary duty claims against indenture trustees and seek recovery for injuries that their predecessor(s)-in-interest allegedly directly sustained. Sarah L. Reid is a partner, and Robert W. Schumacher an associate, in the Litigation Group of Kelley Drye & Warren LLP. The authors can be reached at sreid@kelleydrye.com and rschumacher@kelleydrye.com, respectively. Published in the September 2008 issue of The Banking Law Journal. 725

2 BANKING LAW JOURNAL While problems with an investor s standing to pursue such a windfall would seemingly preclude their right to bring suit, investors file state law pleadings in order to exploit the glaring difference between state and federal law concerning the automatic assignability of claims to after-the-fact plaintiffs. Specifically, Section of the New York General Obligations Law ( GOL ) automatically assigns common law claims against an indenture trustee from a bond s transferor to transferee. Thus, under New York state law, secondary purchasers are permitted to essentially step into the shoes of all previous bondholders to pursue recovery for state law claims. This is in marked contrast, however, to the federal securities law the Trust Indenture Act of 1939 (the TIA ) 1 under which courts have held that, absent express assignment, claims do not automatically travel with a security and remain with an injured party. In addition to analyzing the federal prohibition against the automatic assignment of claims, and New York state s seeming interest in promoting the negotiability of debt securities in the market through GOL , this article raises various issues created by the tension between the two conflicting laws. Specifically, and of particular interest to indenture trustees, the dueling theories subject potential defendants to the threat of double liability for the same alleged wrongful conduct: to the original holders under federal law, and to subsequent purchasers based on state claims. Moreover, and of particular interest to investors, recent decisions in the United States District Court for the Southern District of New York suggest that courts may be hesitant to allow prospective plaintiffs to presumptively avail themselves to GOL , absent an evidentiary showing that New York law applies to a transaction. Finally, and of particular interest to potential plaintiffs and defendants alike, this article highlights that only state law claims are actually subject to automatic assignability under GOL , but that the issue of when and to what extent such claims are preempted by the TIA is very much an open question. FEDERAL LAW PROHIBITING AUTOMATIC ASSIGNMENT The TIA was designed to provide a uniform system of federal regulation of federally-qualified trust indentures. The TIA was enacted as part of the 726 Published in the September 2008 issue of The Banking Law Journal.

3 AUTOMATIC ASSIGNABILITY OF CLAIMS securities law reforms in order to address widespread national abuses in the issuance of corporate bonds under indentures. 2 It is unquestionable that Congress intended to legislate over trust indentures to deal with the problem on a national scale. 3 Section 302 of the TIA describes the purpose of the TIA as to benefit the national public interest and the interest of investors. 4 The legislative history of the TIA indicates that Congress sought to nationalize the issues of concern in the TIA and sought to attack a national problem in a uniform way in light of the large volume of debt securities traded on national exchanges. 5 Congress explained that the inadequacy [of indentures] presents a national problem which cannot be dealt with effectively by the States. 6 Where an indenture is federally qualified under the TIA, as most indentures are today, the duties imposed upon an indenture trustee under the TIA are a part of and govern every qualified indenture, whether or not physically contained therein[.] 7 Indeed, Sections 310 through 318 of the TIA form the core of the [TIA] in that they outline the substantive duties that the indenture must impose on the trustee 8 and enforcement of these TIA-mandated indenture terms is not a matter relegated to state law. 9 As the Third Circuit noted in Zeffiro v. First Pa. Banking & Trust Co.: It is hard to believe that Congress would have established uniform standards to govern indentures and then paradoxically have allowed the application of those standards to depend on the law of the state of the suit. The interpretation of the indenture provisions mandated by the [TIA] does not depend on ordinary contract principles [or] the intent of the parties but depends on an interpretation of [the TIA]. It would be contrary to the purposes of the [TIA] to have the trustee held to certain standards in one state court and potentially different standards in another. Thus, federal court jurisdiction is necessary to achieve the uniform standards intended by the [TIA]. 10 Pursuant to federal law, secondary purchasers of debt securities are precluded from bringing claims based on injuries sustained by prior holders unless such claims were expressly assigned. Put another way, TIA claims are not automatically assigned to subsequent purchasers of debt securities Published in the September 2008 issue of The Banking Law Journal. 727

4 BANKING LAW JOURNAL they remain with the injured party. 11 Specifically, in Bluebird Partners, L.P. v. First Fid. Bank, a case where the plaintiffs asserted both federal and pendent state law claims, the Second Circuit held that federal claims for damages against an indenture trustee under the TIA are not automatically assigned to subsequent purchasers of the underlying securities. 12 [T]he proper inquiry for determining the transferability of claims upon the sale of a security is whether the subsequent purchaser was injured by the misconduct. 13 Similarly, in LNC Invs., Inc. v. First Fid. Bank, 14 the United States District Court for the Southern District of New York held that a plaintiff lacked standing to sue an indenture trustee on certificates purchased after the trustee resigned because, at that time, the market had already ensured that the price paid for the notes, which was mere cents on the dollar, reflected the diminished value of the security and hence the subsequent purchaser was not injured. The court elsewhere held that [b]ecause there is no automatic assignment under the TIA, [plaintiff, a secondary purchaser of certificates] lacks standing to sue [the indenture trustee] as to those certificates. 15 Thus, secondary purchasers of debt securities have no standing to assert [federal] claims arising from misconduct that occurred and injury that was sustained before they purchased their certificates. 16 Accordingly, absent requisite express assignments, investors in distressed securities would seemingly be unable to purchase bonds at a deep discount and then seek to recover from the indenture trustee, based on federal TIA claims, for the value of the security based on conduct that pre-dated the investor s purchase. NEW YORK LAW PERMITTING EXPRESS ASSIGNMENT Notwithstanding the federal prohibition of automatic assignment of claims, the New York state legislature has nonetheless provided distressed debt investors with access to the courts. Specifically, GOL , which provides, a transfer of any bond shall vest in the transferee all claims or demands of the transferor, whether or not such claims or demands are known to exist, is New York s statutory exception to the federal rule of express assignment. Adopted in 1963, GOL was derived entirely from Section 728 Published in the September 2008 issue of The Banking Law Journal.

5 AUTOMATIC ASSIGNABILITY OF CLAIMS 41(4) of New York s Personal Property Law ( PPL 41(4) ), which, after being passed into law in 1950, reversed the then-existing state law requiring express assignment of claims. 17 Proponents of PPL 41(4) argued that a system requiring express assignments was likely to produce results that would be contrary to the understanding and intent of the parties involved in the transfer of a bond. 18 As they reasoned, bonds, like stocks, are generally thought to embody the promises on the face of, and underlying, a security, as well as any rights related to that security. Therefore, parties to a bond transaction would usually not intend for residual rights to remain with the bond s transferor unless expressly specified. 19 Moreover, some argued that federal law at the time of PPL 41(4) s enactment actually supported the automatic assignment of federal claims. 20 Thus, proponents of the state law advocated that passage of PPL 41(4) was necessary to create uniformity among federal and state law. 21 At the time PPL 41(4) was being considered by the legislature, critics of the law contemplated the possibility that litigious parties, much like today s distressed debt investors, would buy bonds for the sole purpose of bringing suit based on alleged past misconduct. 22 However, this concern was seemingly mitigated by the belief that, if automatic assignment did not exist, a litigious bond purchaser, in those pre-depository Trust Company days, could easily request an express assignment for causes of action against the trustee. Moreover, critics reasoned that, because an indenture trustee s duties were deemed to be narrow in scope, resulting litigation would be relatively non-burdensome. 23 These critics were prescient in their concern, as the modern practical effects of GOL are obvious. Indeed, based on this statute, the New York Court of Appeals has held that accrued common law claims against indenture trustees are automatically transferred to subsequent bondholders, regardless of whether the purchasers were holders at the time of the alleged breach. 24 Thus, under GOL , secondary purchasers have been permitted to purchase distressed bonds at a deep discount and then seek to recover from the indenture trustee, based on state common law claims, for the full value of the security based on conduct that pre-dated the investor s purchase. Published in the September 2008 issue of The Banking Law Journal. 729

6 BANKING LAW JOURNAL ISSUES RAISED BY CONFLICTING STATE AND FEDERAL LAW REGARDING AUTOMATIC ASSIGNMENT The obvious tension between federal law prohibiting automatic assignment of claims, and New York s seeming interest in promoting the negotiability of debt securities in the market via automatic assignment, raises a number of issues of which investors and financial institutions should be aware. First, GOL subjects indenture trustees to the threat of double liability for the same alleged wrongful conduct: to the original holders under federal law based on TIA claims, and to subsequent purchasers based on state claims. Although the TIA s main purpose is to protect holders who are injured, the TIA also seeks to ensure that indenture trustees are not subject to excessive liability. The TIA expressly limits the recovery of overall compensatory damages to actual damages alone. 25 This provision has been construed to limit a bondholder s recovery for indenture trustee malfeasance to out of pocket loss. 26 Congress has therefore made clear its intent that indenture trustees may be held liable to compensate injured investors for the investors actual losses, but may not be required to pay more. Such policy discourages the bringing of groundless suits against the trustee. 27 Yet, application of GOL to claims under federally-qualified indentures eviscerates the actual damages provision of the TIA as it permits federal and state law claims to be pursued against the same indenture trustee by different sets of bondholders in different courts based on the exact same conduct. Put another way, whenever an injured investor sells a bond, federal claims remain with the seller, while state claims based on the same alleged facts pass to the subsequent purchaser, subjecting the indenture trustee to potential double liability for the exact same alleged wrong. Second, perhaps showing a preference for the federal prohibition of automatic assignments, recent decisions from the Southern District of New York have called into question whether investors may avail themselves of GOL for state law claims unless they are able to meet certain evidentiary hurdles. Specifically, while either an indenture s or bond s New York choice-of-law provision would appear to confer the benefit of New York law (and hence the benefit of GOL ), courts have suggested that such provisions are not always determinative. Courts have indicated that the 730 Published in the September 2008 issue of The Banking Law Journal.

7 AUTOMATIC ASSIGNABILITY OF CLAIMS question of whether New York law applies to a transaction may be answered by performing a complex choice-of-law analysis on the contracts of sale incident to the secondary transfer of the securities, not the rights under the securities themselves. For example, in Semi-Tech Litig. LLC v. Bankers Trust Co., 28 the indenture between Semi-Tech and Bankers Trust Company contained a New York governing law provision. 29 In response to Bankers Trust s motion to dismiss for lack of standing, the plaintiffs (who represented the interests of subsequent assignees of the Semi-Tech notes), argued that their claims traveled with the notes pursuant to GOL The court held that an indenture s New York governing law provision had no relevance to the question whether the contracts of sale [of notes] operated to assign certain rights of action. 31 Specifically, the court stated that [t]his question is controlled, as to each sale, by New York choice of law principles. This is because the choice-of-law analysis and the interpretation of the indenture is different from the law that governs the sale of notes between the plaintiffs and their prior holders. They are different transactions. Under these circumstances, the court, even though eventually denying the motion to dismiss, refused to presumptively apply GOL because the plaintiffs had not pled or established who held the notes at the times state law claims accrued, much less their successors in interest. 32 The court s refusal to apply an indenture s choice-of-law provision to the contracts incident to the transfers of securities was followed in Racepoint Partners, LLC v. JPMorgan Chase Bank. 33 Racepoint also involved an analysis of claims allegedly transferred to secondary purchasers pursuant to GOL In granting the defendant s motion to dismiss with leave to replead, the court held that: Plaintiffs do not, however, allege facts to show that New York law governed every prior transfer of the notes at issue in this case, such that their transferrers would have automatically acquired the claims of all the previous noteholders through the operation of Section More recent caselaw, however, suggests that, under New York s liberal Published in the September 2008 issue of The Banking Law Journal. 731

8 BANKING LAW JOURNAL pleading standards, a complaint alleging application of a New York governing law provision in the indenture or on the face of the security will be enough to survive a motion to dismiss, though will not prejudice the parties right to raise the argument at summary judgment. In Excelsior Funds, Inc. v. JPMorgan Chase Bank, N.A., 35 the defendant argued that the court should dismiss plaintiffs claims for lack of standing for a failure to allege in the complaint facts necessary to show that New York law governed each prior transfer of the notes at issue. While the court denied the defendant s motion, holding that the complaint satisfied liberal pleading standards for application of GOL , particularly where the notes at issue contained a New York governing law provision, it specifically stated that [a]s in Semi-Tech, the parties can brief after any appropriate discovery whether New York choice of law rules indicate that New York substantive law applied such that [plaintiff] has obtained the right to pursue the claims of the prior holders of the Notes. 36 Similarly, the New York state court presiding over the remanded Racepoint Partners, LLC v. JPMorgan Chase Bank, N.A., 37 refused to dismiss plaintiffs claim predicated on GOL at the pleadings stage, though left open the issue for the parties to brief the question of whether New York s choice of law rules dictate that New York substantive law applies so that [secondary purchasers of notes] have obtained the right to pursue the claims of the predecessor noteholders. As this caselaw suggests, some federal courts have raised significant hurdles for investor-plaintiffs to receive the benefit of GOL While the recent Excelsior Funds, Inc. and Racepoint Partners, LLC cases indicate that the choice-of-law analysis may be more appropriate after conducting discovery on the issues, it is apparent that some courts are hesitant to presumptively apply GOL to every transaction. This will put the onus on investors to prove that New York law applies to their transactions by proving requisite relevant New York contacts incident to the sales of the notes between investors and their prior noteholders. 38 According to the court in Semi-Tech Litig. LLC, the onerous task of identifying all prior noteholders and other pertinent facts related to the transfers may therefore be required in order to obtain any alleged benefit that New York law affords. 39 Third, assuming that an investor is successful in proving that New York law does in fact apply to the acquisition of a debt security, a question arises 732 Published in the September 2008 issue of The Banking Law Journal.

9 AUTOMATIC ASSIGNABILITY OF CLAIMS as to which claims are automatically transferred under GOL In essence, this is a question of whether claims based on alleged violations of TIA mandated provisions can be considered state law claims, or whether they are preempted under the TIA. The TIA provides for dual state and federal regulation. 40 At the same time, the TIA has mandated statutory provisions which have no real common law counterpart. The Supremacy Clause of the United States Constitution invalidates all state laws that interfere with, or are contrary to, federal law. 41 One example of preemption arises where an actual conflict exists between federal and state law when the state law stands as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress. 42 While no court has definitively addressed the issue, it appears that state claims based on TIA-mandated provisions of an indenture could be ripe for preemption because, as the Third Circuit in Zeffiro observed, [i]t is hard to believe that Congress would have established uniform standards [through the TIA] to govern indentures and then paradoxically have allowed the application of those standards to depend on the law of the state of the suit. 43 Nonetheless, New York state courts have permitted plaintiffs to pursue claims based on TIA-mandated indenture provisions by pleading them as state law claims. For example, after the dismissal of their federal TIA claims, the Bluebird plaintiffs re-filed their action in New York state court alleging state claims of breach of contract, breach of fiduciary duty and negligence, claiming that the indenture trustee failed to take necessary action to protect value of certain collateral after the issuer filed for bankruptcy. 44 The Bluebird plaintiffs claims survived all the way through trial and yielded a substantial jury award. 45 CONCLUSION The divergence of federal and state law on the issue of automatic assignability raises significant issues for investors seeking to recover under multiple theories for injuries sustained by prior noteholders, and indenture trustees seeking to defend against such lawsuits. In light of the issues raised in this article, the careful investor in distressed securities should be aware of the risk Published in the September 2008 issue of The Banking Law Journal. 733

10 BANKING LAW JOURNAL of relying on GOL for automatic assignment. That said, the use of GOL by distressed debt investors to buy claims for pennies on the dollar and pursue recovery against third parties for the alleged injuries of prior holders is problematic because, among other reasons, litigation s primary use should not be as a speculative investment vehicle but rather to adjudicate real disputes between parties. Encouraging such legal speculation contributes to a diversion of scarce legal resources from cases with injured plaintiffs to one where wealthy plaintiff funds gamble on the possibility of thirdparty recovery to increase their return. At some fundamental level, courts should be used to address an aggrieved party s injuries, and not to increase a savvy investor s portfolio. NOTES 1 15 U.S.C. 77aaa, et seq. 2 See, e.g., Securities and Exchange Commission Report on the Study and Investigation of the Work, Activities, Personnel and Functions of Protective and Reorganization Committees, Part IV, Trustees Under Indentures (1937); Hearings on H.R Before a Subcommittee of the Committee on Interstate and Foreign Commerce, 75th Cong., 3d Sess. 20 (1938) ( Hearings ) (summary submitted by Commissioner Douglas). 3 Zeffiro v. First Pa. Banking & Trust Co., 623 F.2d 290, 301 (3d Cir. 1980) U.S.C. 77bbb. 5 Zeffiro, 623 F.2d at 299 (citing Senate Committee on Banking and Currency, Report on the Trust Indenture Act of 1939, S. Rep. No at 3-4 (1939); Hearings at 18, 31). 6 H.R. Rep. No at 25 (1939) U.S.C. 77rrr(c) (setting forth the provisions of Sections 77jjj of this title to and including 77qqq of this title are a part of and govern every qualified indenture, whether or not physically contained therein ). 8 Zeffiro v. First Pa. Banking & Trust Co., 473 F. Supp. 201, 206 (E.D. Pa. 1979), aff d, 623 F.2d 290 (3d Cir. 1980). 9 Zeffiro, 623 F.2d at Id. at Bluebird Partners, L.P. v. First Fid. Bank, 85 F.3d 970, (2d Cir. 1996); In re Nucorp Energy Secs. Litig., 772 F.2d 1486, 1490 (9th Cir. 1985). 12 See Bluebird, 85 F.3d at Published in the September 2008 issue of The Banking Law Journal.

11 13 Bluebird Partners, L.P. v. First Fid. Bank, 896 F. Supp. 152, 156 (S.D.N.Y. 1995), aff d, 85 F.3d 970 (2d Cir. 1996) WL , at *10-14 (S.D.N.Y. Aug. 27, 1997). 15 Id. at *10, * Id. at * See Recommendation of The Law Review Committee to the Legislature Relating to the Transfer with Bonds of Claims Connected Therewith, State of New York Law Revision Commission, Rep. No. 65 at 71 (1930). 18 Id. 19 Id. 20 See id. (citing Phelan v. Middle States Oil Corporation, 154 F.2d 978 (2d Cir. 1946)). 21 See id. at Id. at Id. 24 Consol. Edison, Inc. v. Ne. Utils., 318 F. Supp. 2d 181, 186 (S.D.N.Y.), rev d on other grounds, 426 F.3d 524 (2d Cir. 2005); Bluebird Partners L.P. v. First Fid. Bank, 97 N.Y.2d 456 (2002)) U.S.C. 77www(b). 26 LNC Invs., Inc., 1997 WL , at * See, e.g., Hearings at 41 (SEC Chairman William O. Douglas) (undertaking provision protects the trustee against the risk of so-called strike suits ) F. Supp. 2d 319 (S.D.N.Y. 2003). 29 See id at See id. at , Id. at See id WL (S.D.N.Y. Oct. 26, 2006). 34 Id. at * WL , at *5-6 (S.D.N.Y. March 28, 2007). 36 See id. at *6. 37 Decision and Order, Racepoint, Index No /2006 (N.Y. Sup. Ct. Nov. 7, 2007). AUTOMATIC ASSIGNABILITY OF CLAIMS 38 See Nucorp, 772 F.2d at 1492 ( We must construe the contracts of sale between the [parties] ). 39 See Semi-Tech, 272 F. Supp. 2d at U.S.C. 77vvv(b) (providing that jurisdiction of offenses and venue of suits shall be governed by Section 22(a) of the Securities Act of 1933, which states that: [t]he district courts of the United Sates and the United States courts of any Territory Published in the September 2008 issue of The Banking Law Journal. 735

12 BANKING LAW JOURNAL shall have jurisdiction of offenses and violations under this title concurrent with State and Territorial courts of all suits in equity and actions at law brought to enforce any liability or duty created by this title. ). 41 See Resolution Trust Corp. v. Diamond, 45 F.3d 665, 674 (2d Cir. 1995). 42 See Clean Air Mkts. Group v. Pataki, 338 F.3d 82, 87 (2d Cir. 2003). 43 See Zeffiro, 623 F.2d at See, e.g., Bluebird Partners, L.P. v. First Fid. Bank, 784 N.Y.S.2d 479, 480 (N.Y. App. Div. 2004). 45 See id. 736 Published in the September 2008 issue of The Banking Law Journal.