Does Your Bond Deal Seem Too Good To Be True? Maybe it Violates the Indenture

Contributed by Debra McElligott
Although the Weil Bankruptcy Blog generally focuses on developments in the chapter 11 context, from time to time we cover cases outside of the bankruptcy world that may interest our readers.  Among the challenges restructuring professionals frequently face are analyzing bond indentures, identifying parties’ respective rights to determine whether potential transactions are permissible, and invoking their clients’ rights to payment and other protections.  As we have seen in the recent decisions in Marblegate and Caesars, parties sometimes turn to section 316(b) of the Trust Indenture Act to protect their rights to payment under an indenture.  But what if holders are fully paid through a transaction that nonetheless violates the indenture?  The New York State Supreme Court recently addressed this situation in Emmet & Co. v. Catholic Health East, in which the court concluded that certain holders were entitled to compensatory damages stemming from a tender offer, redemption, and total return swap that violated the governing indenture.  
Background: A Creative Transaction
In 1994, a hospital owned by the non-profit Catholic Health East, or CHE, issued municipal bonds in connection with a debt refinancing.  CHE defeased the bonds several years later, but they remained callable.  In 2011, CHE sent a letter to bondholders stating that all holders who tendered their bonds by a certain date would receive 101% of the principal amount and that all bonds not tendered would be redeemed at par on a later date.
Upon receiving the tender offer and redemption notice, the plaintiffs sent objection letters to the bond trustee arguing that the transaction violated the indenture.  Additionally, plaintiff Emmet & Co., a bond dealer, filed a complaint and unsuccessfully moved to enjoin the tender offer and redemption.  The court refused to grant an injunction because Emmet & Co. failed to show that it would suffer irreparable harm, and did not hear the complaint because Emmet & Co. did not have the 25% of bonds required to bring an action under the indenture.
After the transaction closed, CHE sold the tendered bonds to Merrill Lynch through a total return swap, which directed all income from the bonds to Merrill Lynch without transferring title and, as explained below, allowed CHE to profit from the tender offer.  Emmet & Co., along with investment advisory firm First Manhattan Co., then filed a class action against CHE and Merrill Lynch for breach of contract and tortious interference with the indenture.  CHE filed a motion to dismiss, and the plaintiffs cross-moved for summary judgment on liability.
Interpreting the Indenture
First, the court considered whether the combination of the tender offer and redemption violated the indenture.  The indenture permitted redemption of less than 100% of all bonds outstanding only if those bonds were randomly selected by lot.  The plaintiffs argued that CHE non-randomly redeemed less than 100% of the bonds because even though the tendered bonds were still outstanding, CHE redeemed only the non-tendered bonds.  CHE, on the other hand, argued that it redeemed 100% of the bonds through the combined tender offer and redemption – it simply offered an extra 1% to the holders who tendered earlier.
The court disagreed with CHE, holding that it violated the indenture by non-randomly redeeming less than 100% of the bonds.  The court stated that CHE conflated the concept of notifying 100% of the holders of the purchase with actual redemption of the bonds as the term was used in the indenture.  Moreover, the court found that CHE conceded in the notice to redeeming less than 100% of the bonds, as it explicitly stated that tendered bonds “shall not be subject to redemption at par on the Redemption Date.”  The court added that redemption of the non-tendered bonds would only have been a 100% redemption if CHE had cancelled the tendered bonds, which it did not intend to do because it would have had nothing to gain by paying an extra 1% to purchase them.  Finally, the court noted that CHE could not claim that the bonds remained outstanding for the purposes of the total return swap, but did not exist for the purpose of determining whether 100% of the bonds were redeemed.
The court also considered whether the total return swap violated the indenture, which required all bonds “purchased or redeemed” to be immediately cancelled and not resold.  The court did not find it relevant that the bonds had been purchased through a tender offer, which is “simply an offer to purchase bonds at a specific price.”  Similarly, it was not important that CHE retained title under the total return swap and thus technically did not “sell” the bonds.  Rather, the court emphasized that once purchased, the bonds must “be destroyed by the trustee,” and that this language made executing the total return swap without violating the indenture impossible.
Finally, the court examined CHE’s motives for entering into the transaction.  The court noted that the prior defeasance of the bonds made a tender offer valueless to CHE.  The market value of the bonds, however, had risen in the years since their issuance because interest rates had declined.  CHE thus entered into a tender offer that cost 1% more than redemption because it thought it could resell the tendered bonds at a price between the redemption value and the market value through the total return swap.  The court emphasized that this type of transaction should not be permissible because the market price of callable bonds accounts for the risk of redemption, and if investors understood that this type of transaction would be permitted, the bonds would not have traded in excess of their redemption price.  As such, the court held that the plaintiffs should be awarded damages commensurate with the harm suffered by selling their bonds below the market rate.  It did, however, strike the plaintiffs’ demand for punitive damages, finding them inappropriate in a case involving sophisticated financial professionals and a disagreement about complex issues.
As the Emmet case illustrates, questions related to an indenture can arise both because of terms that are precisely defined (for example, “redemption” in this case) in a way that differs from their plain meaning and terms that that are undefined (such as “purchase”) and thus silent on whether certain types of transactions are contemplated by them.  The opinion offers a reminder that parties must not only analyze and understand the language of the indenture, but also think about the ways a court might interpret provisions that give rise to disagreement based on the nature and fairness of a particular transaction.