On April 25, 2012, the U.S. Court of Appeals for the Eleventh Circuit overturned a decision by the U.S. District Court for the Northern District of Georgia permitting noteholders to proceed with a fraudulent transfer suit against the issuer of their notes, despite a clause in the indenture prohibiting such suits. The Eleventh Circuit held that the prohibition in the indenture, otherwise known as a “no-action clause”, should be strictly enforced, and that the noteholders were thus barred from bringing fraudulent transfer claims against the issuer and its officers and directors. Akanthos Capital Mgmt, LLC, et al. v. CompuCredit Holdings Corp., et al., Case No. 11-13227 (11th Cir. Apr. 25, 2012). The Eleventh Circuit’s decision comports with the majority of courts that have interpreted no-action clauses in this context and provides greater certainty in the marketplace regarding the litigation risks associated with bond issuance.
No-action clauses appear frequently in indentures and generally preclude noteholders from pursuing remedies directly against the issuer. Remedies against the issuer are to be pursued instead by the indenture trustee on the noteholders’ behalf, and only if a certain percentage of noteholders request such relief. This system is designed to prevent a small group of bondholders from commencing an action adverse to the economic interests of the majority, and to prevent a multiplicity of suits against the issuer regarding the same subject matter.
In Akanthos, a group of hedge funds owning certain notes issued by CompuCredit, a subprime financial services provider, brought fraudulent transfer claims under Georgia’s Uniform Fraudulent Transfers Act against CompuCredit and its officers and directors. The hedge funds alleged that CompuCredit, while on the brink of insolvency, issued a dividend to its shareholders and planned to spin-off the only profitable portion of its business and distribute the proceeds to its shareholders. The hedge funds alleged that CompuCredit’s actions were detrimental to noteholders and were fraudulent transfers intended to benefit certain insiders holding a large percentage of the company’s stock.
The defendants moved to dismiss the fraudulent transfer claims, arguing, among other things, that the claims were barred by a no-action clause in the indenture. The clause stated that the noteholders were prevented from pursuing “any remedy with respect to” the indenture, unless one of two exceptions were satisfied.
A relevant exception permitted noteholders to bring suit if: (1) a noteholder provided the indenture trustee with a notice of default, (2) at least 25% of the noteholders requested the trustee to pursue a remedy, (3) a noteholder agreed to indemnify the trustee for any costs incurred, (4) the trustee did not respond to the noteholder’s demand within 60 days of receipt of the notice and offer for indemnity, and (5) within the 60-day period, the majority of the noteholders did not give to the trustee an instruction inconsistent with the request for a remedy.
The hedge funds acknowledged that they did not take the steps necessary to qualify for the exception. Nevertheless, the District Court held that the no-action clause did not bar their fraudulent transfer claims because (i) their claims were not based on the terms of the indenture, but rather were “extra-contractual” in nature, (ii) the hedge funds held a majority of the notes, and thus the underlying purpose of the no-action clause was satisfied, and (iii) CompuCredit’s issuance of a dividend on only 20 days’ notice excused the hedge funds from strict compliance with the exception’s 60-day requirement under the “prevention doctrine”. Accordingly, the District Court disregarded the no-action clause in the indenture and denied the defendants’ motion to dismiss the litigation.
On appeal, the Eleventh Circuit overturned the District Court’s decision, concluding that the hedge funds’ fraudulent transfer claims were barred by the plain language of the no-action clause. The Eleventh Circuit determined that each of the District Court’s three reasons for disregarding the no-action clause were flawed.
First, with respect to the District Court’s determination that the no-action clause did not apply because the hedge funds’ action was based on an “extra-contractual” fraudulent transfer theory, the Eleventh Circuit noted that the no-action clause in CompuCredit’s indenture barred all actions “with respect to” the indenture, and that a fraudulent transfer action was logically such an action. The Eleventh Circuit found that the overwhelming weight of authority had similarly held that no-action clauses bar such suits. Further, under New York law, which governed the CompuCredit indenture, no-action clauses are to be strictly enforced unless there is evidence of trustee misconduct. As there was no evidence of this in the case, the Eleventh Circuit held that the no-action clause applied.
The Eleventh Circuit then dispensed with the District Court’s ruling that because the hedge funds owned a majority of the notes, the no-action clause was not needed to protect the noteholders from adverse actions by a minority, and the clause need not be enforced. The Eleventh Circuit stated that the “best evidence of what parties to a written agreement intend is what they say in their writing.” The indenture set forth a series of detailed conditions that must be satisfied in order to except any noteholders funds from the application of the no-action clause. Because the hedge funds had not satisfied these conditions, the Eleventh Circuit held that standard rules of contract interpretation required enforcement of the no-action clause.
Lastly, the Eleventh Circuit disregarded the District Court’s determination that the “prevention doctrine” excused the hedge funds from strictly complying with the indenture’s no-action rules. By way of background, the indenture permitted noteholders to commence an action against CompuCredit if, among other things, the noteholders notified the indenture trustee that CompuCredit had defaulted, and following the issuance of such notice, at least 60 days had passed without a response from the trustee. When CompuCredit provided 20 days’ notice of the dividend payment, the hedge funds initiated litigation against CompuCredit to challenge the dividend, even though the hedge funds had not waited 60 days from the date that a default notice had been sent to the indenture trustee. In the litigation, the hedge funds acknowledged that they had not satisfied the indenture’s 60-day waiting period, but argued that the 20-day dividend notice rendered compliance impracticable and excusable under the “prevention doctrine”. The District Court agreed, finding that the hedge funds were prevented from satisfying the 60-day waiting period due to the brief notice of the dividend payment.
However, the Eleventh Circuit noted that the “prevention doctrine” is typically invoked by a party to a contract when compliance with the contract is “wrongfully” prevented from occurring by another party to the contract. The Eleventh Circuit further noted that the indenture expressly provided that CompuCredit could issue a dividend on 20 days’ notice. Accordingly, CompuCredit was within its rights to issue the dividend upon 20 days’ notice and did not “wrongfully” prevent the hedge funds from satisfying the exception to the no-action clause set forth in the indenture. Thus, the Eleventh Circuit found the “prevention doctrine” inapplicable and the hedge funds in violation of the indenture’s no-action rules.
Notably, the Eleventh Circuit also rejected the hedge funds’ argument that the no-action clause was inapplicable to CompuCredit’s officers and directors because those individuals were not parties to the indenture. The Eleventh Circuit held that no-action clauses apply “equally to claims against non-issuer defendants as to claims against issuers” and that CompuCredit’s officers and directors could rely on the clause to shield them from liability.
Akanthos reaffirms that the plain language of an indenture should determine the rights and remedies thereunder and that contracts employing standard and reasonable terms should only be overridden in extreme circumstances, which were not present in this case. Had the District Court’s decision stood, significant uncertainty could have accompanied future bond issuance, resulting in an increase in the cost of capital. This decision serves as a reminder that the time to seek broader rights and remedies is during the negotiation of a contract, and that courts will typically hold parties, particularly sophisticated ones, to the bargains that they strike.