The Examiners: Recalibrate the TIA for Today’s Debt Markets

How does bondholders’ use of the Trust Indenture Act affect companies’ ability to complete out-of-court restructurings?

The Trust Indenture Act needs to be recalibrated for 21st century debt markets. Markets have evolved so a large portion of corporate debt is no longer covered by securities laws, and even when securities laws apply, courts have been interpreting the TIA to reach both too far and not far enough.

The TIA was originally drafted for a world of ma-and-pa bondholders and portfolio lending by banks. That world is gone. Debt securities are now almost entirely an institutional market, but that makes concerns about conflicts of interest and sharp dealing all the more acute. At the same time, there are many more issuances of unregistered securities and the loan/bond distinction has become ever more tenuous: Syndicated loans are rated and trade (with CUSIPs!) in secondary markets like securities. It makes little sense for the TIA’s strictures to apply to only part of the market, as that just invites regulatory arbitrage. Whatever the TIA should do, it should cover everything that walks and talks like a debt security.

Too Far

Courts have recently been interpreting the TIA to prohibit not only impairments to the right to payment of principal and interest, but also impairments to credit enhancements, such as guaranties, that protect the right to payment of principal and interest. This is never what the TIA was designed to cover because, when so interpreted, it either proves too much or lacks an administrable standard. Every covenant is designed to protect the right to payment of principal and interest, so either an out-of-court restructuring isn’t possible without every creditor’s consent or there is no principled way to determine which sorts of covenants can legally be altered in an exchange offer without every creditor’s consent. The TIA should not be pressed into doing the work that is properly performed by more flexible, standards-based doctrines such as good faith and fair dealing that look to the creditor-debtor relationship rather than the inter-creditor relationship.

The extension of the TIA’s protections beyond the traditional understanding of the right to payment alters the out-of-court restructuring equilibrium by increasing the bargaining power of holdout creditors. This makes out-of-court restructurings less likely. The 1939 act was never meant as a stand-alone statute; it was designed to go hand-in-glove with the Bankruptcy Act of 1938 (and its 1978 heir). The types of out-of-court restructurings that the TIA prohibits are expressly permitted in the bankruptcy process. Bankruptcy, however, adds safeguards for creditors: independent committees with fiduciary duties, financing for committee professionals, disclosure requirements, a prohibition on side payments and “gifting,” a good-faith-plan requirement, the best interest test, classification rules, and dual-class voting, all under a judicial eye. Thus, a broader reading of the TIA is likely to shift more restructuring into the chapter 11 process. Chapter 11 imposes additional costs to restructurings; those costs are the price of additional creditor protections. The problem is that the additional costs of chapter 11 are not fully internalized by the holdout creditors, so we are likely to end up with more in-court restructurings than should occur in an optimal world.

Not Far Enough

The Second Circuit has recently interpreted the TIA to exclude from its coverage most asset-backed securities (see Ret. Bd. of Policemen’s Annuity & Benefit Fund v. Bank of N.Y. Mellon), meaning that the multitrillion-dollar mortgage-backed-security market lacks the protections that exist for corporate bonds. There are important differences in the deal structure of structured securities and corporate bonds, most notably the requirement in asset-backed securities for the servicer to proactively prosecute “putbacks” of securitized assets that do not comply with representations and warranties. The putback requirement requires that the servicer take notice of representation and warranty violations itself, as other parties generally lack the ability to observe these violations. In contrast, defaults on corporate bonds are readily manifest (and the TIA requires reporting by the issuer of the defaults). These differences militate for greater, rather than lesser, investor protections in asset-backed securities, as investors in asset-backed securities have less ability to protect their interests. Not surprisingly, the mega-settlements of billions of dollars of representation and warranty claims on mortgage-backed securities have re-enacted the very problems the TIA was designed to prevent: non-representative, non-fiduciary protective committees forcing through less-than-transparent settlements that compromise the claims of all security holders with the connivance of conflicted trustees.

It is time to update the Trust Indenture Act. The TIA is the single most important protection for investors in debt securities, but it has lost its way. We need a 21st-century law that is recalibrated to reflect the realities of reflects modern debt markets and provides a baseline of fairness for all investors.

Adam J. Levitin is a professor of law at Georgetown University Law Center in Washington, D.C.