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Trust Indenture Definition
A trust indenture is an agreement used during the signing of a bond contract between a bond issuer and a trustee that documents the terms and conditions governing the trustee’s conduct as well as the trust beneficiaries’ rights. The trust indenture represents the interests of the bondholder by underlining a set of rules and responsibilities that each entity party to the agreement is obliged to follow. A trust indenture also includes certain directives regarding the circumstances that may lead to a default and the processes that need to be followed thereupon.
A Little More on What is a Trust Indenture
A government organization or a private corporation often needs to raise additional capital for various purposes. Many times, such organizations raise capital from either lenders or investors by issuing them bonds with the intermediation of a bank or a trust company that acts as a third-party trustee. This process of issue of bonds occurs under the purview of a legally-binding agreement entered into by the bond issuer and the trustee. Such an agreement is known as a trust indenture.
The passage of the Trust Indenture Act (TIA) as federal law in 1939 made it mandatory for bond issues valued over $5 million to incorporate a trust indenture signed by both the bond issuer as well as the bondholder. The TIA was passed as an amendment to the Securities Act of 1933.
A trust indenture includes various details such as
- The trustee’s personal details, such as name and contact information.
- The terms and conditions that the bond issuer, investor (or lender), and trustee are obliged to follow during the life of the bond.
- The role played by the trustee, especially with respect to handling unpredicted events.
- The various attributes of the bond, such as maturity date, face value, coupon rate, payment schedule, and reason for the bond issue.
- A clear description of the circumstances that may lead to a default and the remedial procedures that need to be followed thereupon. In fact, a trust indenture espouses a collective action mechanism that allows both creditors as well as bondholders to collect in an equitable and systematic manner in the event of a default.
A trust indenture underlines protective or restrictive covenants. This includes placing restrictions on an issuer that issues a callable bond. A callable bond is one where the issuer of the bond can pay out an early settlement of their debt by redeeming the bond before the stated maturity date. In case of callable bonds, a trust indenture has provisions to safeguard the interest of the bondholder by including a call protection. A call protection specifies a time period during which the bond issuer is restricted from repurchasing its bonds from the market. Once the period specified in the call protection passes, the bond issuer is permitted to exercise its right to call on certain call dates specified by the trust indenture. The trust indenture also specifies the call premium, i.e the price that the issuer of the bond is liable to pay to repurchase the bond.
Another characteristic that is common to most trust indentures is the inclusion of subordination clauses that restrict the amount of additional debt that the issuer can incur. A subordination clause also subordinates all subsequent debts to prior debts. Such a provision is especially helpful for bondholders as it safeguards them from default risk.
In case of corporate bonds with aggregate principal issues of $5 million and above, it is also mandatory to file a copy of the trust indenture with the Securities and Exchange Commission (SEC). Besides corporate bonds issues worth less than $5 million, the above rule also does not apply to municipal bonds as well as government issued bonds. The reason why entities such as municipalities and government bodies are exempted from such an obligation is that such entities usually opt for a trust indenture as a form of reassurance to prospective investors and not as a device to enforce compliance of a federal law. Moreover, it is also possible that certain government bond contracts may exclude trust indentures provided that the rights and obligations of the issuer and bondholders are clearly documented in a bond resolution.
References for Trust Indenture
Academic Research on Trust Indenture
The corporate trust indenture project, Rodgers, C. (1964). Bus. Law., 20, 551. This paper elaborates the background and objectives of the Corporate Trust Indenture Project and describes its progress till the time of publication. The objectives of the project are: To draft practicable model provisions for standardized debenture indentures. To draft comparable sets of model provisions for mortgage indentures. To develop a viable technique of incorporating such model provisions by reference. To draft samples of standardized debenture and mortgage indentures to demonstrate the incorporation of model provisions by reference and indicate their relationship with the negotiated provisions of the incorporating indenture. To provide an explanation of the model provisions using annotations and commentaries.
The Trust Indenture Act and International Debt Restructurings, Shuster Jr, G. W. (2006). Am. Bankr. Inst. L. Rev., 14, 431. This paper reappraises section 316(b) of the Trust Indenture Act (TIA) and evaluates its current and potential implications for debt investors within the U.S. as well as foreign businesses. It provides an explanation of the various interests that section 316(b) is designed to protect. The paper also explains if those interests are implicated in international debt restructurings and describes the role of the TIA in influencing the impact of such restructurings.
The Trustee and the Trust Indenture: A Further Study, Posner, L. S. (1937). The Yale Law Journal, 46(5), 737-800. This paper scrutinizes the duties of trustees named in indentures and evaluates the scope of protection that the trustees stand to derive from the exculpatory clauses incorporated in these indentures. The author also evaluates the increasing apprehension among the public regarding the content and structure of trust indentures, which, he contends, could result in federal as well as state statutes seeking to regulate the drafting process of these instruments.
Trusteeship under the Trust Indenture, Palmer, G. E. (1941). Columbia Law Review, 41(2), 193-220. This paper performs a detailed analysis of the utilities of a trust device in providing holders of corporate obligations with the security of a mortgage or a pledge of property. The author solely focuses on the relationship of the trustee with the holders of the security. The paper also describes how the use of intangible assets as security has significantly increased and how such assets are being viewed as viable alternatives to using mortgages on physical properties to secure bonds.
The trust indenture as bargained contract: the persistence of myth, Riger, M. (1990). Corp. L., 16, 211. The author scrutinizes the misconceptions associated with typifying trust indentures as bargained contracts. He also highlights the persisting incompetence of the corporate bond indenture as an instrument of bondholder protection. The paper cites recent events of leveraged buyouts, corporate restructurings as well as hostile takeovers as evidence of the inadequacies of the bondholders’ contract.
The Trust Indenture Act of 1939 Needs No Conflict of Interest Revision, Smith, R. B., Case, S. H., & Morison, F. J. (1979). The Business Lawyer, 161-171. This article seeks to disprove the notion propagated by Campbell and Zack regarding the necessity for amendments to the Trust Indenture Act of 1939 to remove an alleged anomaly in the form of a conflict of interest. The authors contend that maintaining the status quo effectively serves the public interest in protecting investors. They also explain the role played by the Federal Securities Code in continuing the apposite provisions of the Trust Indenture Act of 1939.
The Forgotten Securities Statute: Problems in the Trust Indenture Act, Johnson, H. F. (1981). U. Tol. L. Rev., 13, 92. This article highlights certain issues in the Trust Indenture Act of 1939 pertaining to the actions of trustees and the repercussions of such actions. The author explains that without an indenture, it would be extremely difficult for security holders to enforce compliance with the terms of the loan agreement and to initiate legal proceedings in the event of a default. This lands the trustees in a clear dilemma because while on one hand, default proceedings will most certainly result in bankruptcy, on the other, a failure to act will constitute negligence on their part.
Updating the Trust Indenture Act, Friedman, H. M. (1973). U. Mich. JL Reform, 7, 329. In general, trustees are entrusted with the responsibility of safeguarding debt holders’ interests by policing the loan and mortgage provisions that are incorporated in the indenture under which securities are issued. The role of such trustees was explicitly elaborated in the Trust Indenture Act of 1939, which assured debt holders that high standards of conduct would be observed in protecting their interests.
Responsibility of Trustees under the Federal Trust Indenture Act of 1939, Katz, W. G. (1940).ABAJ, 26, 290. This article elaborates the responsibilities of corporate trustees in the context of the Trust Indenture Act of 1939. These responsibilities, the author contends, are usually limited to those explicitly mentioned in the indentures. The model indenture provisions suggest that this provision essentially eliminates the need for immunity clauses pertaining to recording, application of proceeds, taxes, insurance, and such like.
Implied Civil Liability Under the Trust Indenture Act: Trends and Prospects, Dropkin, C. E. (1977). Tul. L. Rev., 52, 299. The trust indenture is an instrument that is widely employed in corporate debt financing to set certain terms and conditions for extending credit to the obligor corporation and to empower the trustee to effect certain remedial measures in the event of a default. With the development of the American corporate enterprise, there has been a significant growth of trust indentures. However, with continued growth, these agreements have also become increasingly complicated.
The trust indenture act of 1939: The corporate trustee as creditor, Obrzut, F. R. (1976). UCLA L. Rev., 24, 131. The trust indenture makes it obligatory for corporate trustees to protect the rights of the debt holders. However, these corporate trustees often assume the roles of creditors of the corporate obligors, and consequently, gain stakes in the enterprise. This duality of role of corporate trustees often raises conflict of interest issues, especially in the event of a default, when trustee-creditors compete with the debt holders for rights to the obligor’s remaining assets for repayment of their respective loans.