Judge Kevin Gross of the U.S. Bankruptcy Court for the District of Delaware handed down an important ruling last week that turned aside most of an unusual challenge to the fees and expenses of an indenture trustee in the long-running Nortel chapter 11 case.  The dispute has been watched closely by financial institutions that serve as trustees on bond issuances.  (Kelley Drye & Warren LLP represented a large creditor in the Nortel case but took no part in the issues discussed here).

The Trust Indenture Act of 1939 requires that a qualified financial institution be appointed as a trustee to protect the interests of noteholders for most issuances of private bonds or notes.  The duties are mainly ministerial.  When a default occurs, however, such as when the issuer files for bankruptcy, an indenture trustee can find itself in a precarious situation.  Different groups of noteholders may have disparate views, for example, as to whether the indenture trustee should seek to exercise remedies under the bond indenture, or work to reach a consensual restructuring of the debt.  Most bond indentures have language that requires the indenture trustee to exercise its duties in the same manner as a “prudent person” would use in the conduct of his or her own affairs.  Bond indentures also contain substantial protections for indenture trustees, such as broad indemnification for actions undertaken in good faith.  In addition, and of no small importance in bankruptcy situations, bond indentures provide trustees with the right to be paid out of recoveries ahead of the repayment of the notes for the trustee’s “reasonable” fees and expenses, including any fees of outside counsel.  This priority right of payment is usually referred to as the “charging lien.”

The dispute that arose in Nortel between one of the indenture trustees and its noteholders stemmed from the extraordinary length and complexity of that case.  Nortel filed for bankruptcy in January 2009.  An official committee of unsecured creditors (the “Nortel Committee”) was named shortly afterwards.  It has long been deemed consistent with the “prudent person” standard for indenture trustees for unsecured notes to serve on official committees of unsecured creditors in chapter 11 cases, and the indenture trustee for Nortel’s 7.875% unsecured notes sought and obtained appointment.  By the time Nortel succeeded in obtaining confirmation of its plan of reorganization in January 2017, the indenture trustee had incurred fees and expenses of approximately $8 million.

The outstanding amount due on the 7.875% notes at the time the case commenced was approximately $150 million. Nortel’s plan provided for payment in full of the $150 million, but no postpetition interest.  It also provided for payment of up to $4.25 million of the indenture trustee’s fees and expenses, which meant that the indenture trustee would have the right to obtain payment of its remaining fees and expenses out of the $150 million payment under the plan.

At the plan confirmation hearing, the 7.875% noteholders requested that the indenture trustee not be permitted to exercise its charging lien with respect to the remaining $3.75 million of fees and expenses, pending a determination by Judge Gross of the reasonableness of such fees.  A substantial basis for the objection was that it was not “reasonable” for the indenture trustee to exercise its charging lien with respect to a portion of the fees incurred in serving on the Nortel Committee for the eight years of the case.  Judge Gross confirmed the plan and reserved the noteholders’ rights.

After settlement efforts failed, an evidentiary hearing was held in late February.  At the hearing, the 7.875% noteholders contended that they were not challenging the appropriateness of the indenture trustee sitting on the Nortel Committee per se, but noted that when an indenture trustee does sit on a committee, it is essentially carrying out two sets of duties – one to noteholders under the bond indenture, and one to all general unsecured creditors.  The 7.875% noteholders argued that the exercise by the indenture trustee of the charging lien for payment of fees and expenses must be limited to fees incurred on behalf of the noteholders only.

The indenture trustee argued that its obligation to act as a prudent person required it to be involved in many aspects of the case, even if they may not have directly benefited the noteholders. It noted that day to day involvement in a case of Nortel’s size and complexity was necessary, as it was not feasible “to parachute in and out” when necessary to protect the noteholders’ interests.  It further contended that the determination as to whether involvement was prudent had to be made at the time, and should not be subject to hindsight.

Judge Gross overruled most of the 7.875% noteholder objections.

In making his ruling, he looked closely at the language of the 7.875% bond indenture, noting that the indenture trustee “[is] authorized in performing its duties to ‘act through agents or attorneys,’ and to ‘consult with counsel of its selection.’” He also considered the “prudent person” standard under New York law (the governing law of the indenture), and stated that “prudence is not something the Court can readily review in hindsight.”  He framed the questions to be decided as “whether the Indenture Trustee acted prudently in assigning the Lawyers to their tasks, and whether the Lawyers’ work was reasonable.”  With a few exceptions, Judge Gross answered both questions in the affirmative.

In response to the objections, Judge Gross looked carefully at the work done by the indenture trustee’s lawyers in connection with the indenture trustee’s role as a member of the Nortel Committee. He went on to describe the 7.875% noteholders’ objection as a “hindsight exercise[,]” adding that “[i]t simply was implausible for the Indenture Trustee or the Lawyers to know whether at the time they were performing the work that the Noteholders’ interests did not need protection, or whether what they learned through the Committee would be of no benefit to the Noteholders.”  He concluded that “[t]he matters at hand were too important to leave to chance that the Committee Work would have no impact on or significance to the Notes.”

Judge Gross did reduce a portion of the fees based on certain other factors, including for times when the firms representing the indenture trustee had multiple lawyers participating on committee calls or attending meetings.

In the final part of his ruling, Judge Gross distinguished the recent Supreme Court case of Baker Botts v. Asarco, and determined that the indenture trustee’s counsel could also recover from the charging lien its fees for defending against the 7.875% noteholders’ objection.  The Supreme Court in Baker Botts ruled that Bankruptcy Code provisions governing the payment of professionals entitled to compensation from a debtor’s bankruptcy estate do not provide an exception to the so-called “American Rule”, which states that each side in a dispute pays its own costs.  In contrast, Judge Gross held that a bond indenture “is a contract which qualifies for an exception to the American Rule.”  He cited the language of the indenture that expressly called for the issuer to indemnify the trustee for “the costs and expenses of defending itself against any claim or liability in connection with the performance of any of its powers or duties hereunder[.]”

The importance of this last point should not be overlooked. Together with its strong recognition of the breadth of the “prudent person” standard, Judge Gross’s Nortel decision significantly strengthens the ability of financial institutions to get paid for undertaking the duties of a trustee under bond indentures.