Research on Law Relating to Interpretation of Bond Indentures I – New York

Author: LegalEase Solutions


Our client, a New York Attorney, specializing in interpreting bond indentures for investors, would like to know how New York courts interpret specific restrictive clauses in bond indentures included to secure the interests of the bondholders.  Our client requires case law interpreting the clause: “The Company will not, and will not allow its Restricted Subsidiaries to, directly or indirectly, declare or pay any dividend to the holders of the Company’s equity.”  Our client requires research specifically discussing how New York courts interpret the phrase “directly or indirectly” in that context.

Questions Presented

  1. Would New York courts restrict indirect payment of dividends by an unrestricted subsidiary if the restrictive clause restrains the Covenanter from “directly or indirectly” declaring or paying dividends?


Short Answers

  1. Probably yes. Under New York law interpretation of indenture provisions is a matter of basic contract law.  Therefore, courts would interpret a restrictive covenant to give effect to purpose of the entire contract, ie;  to secure the interest of the bondholder.



The most important right of bondholders is the right to receive payments of interest at stated intervals and payment of principal when the bonds mature.  As creditors of a Corporation, bondholders may be prejudiced if the corporation takes actions that would risk its financial status.  Stockholders can also force the Corporation to act contrary to the interests of bondholders by causing distribution of corporate assets through dividends.  Therefore, in order to secure their money and the interest accrued, bondholders would prefer corporate assets to stay within the Company.  To this effect, bondholders generally include in the bond indenture, stipulations restricting the company and its subsidiaries from “directly or indirectly” declaring or paying any dividend to its stockholders.  The rights and protections of bondholders are secured through such stipulations in bonds.

As creditors, bond holders are deemed to have a contractual relationship with the Corporation.  Under New York law interpretation of indenture provisions is a matter of basic contract law“, U.S. Bank N.A. v. U.S. Timberlands Klamath Falls, L.L.C., 864 A.2d 930 (Del. Ch. 2004) at 939, 940 (applying New York law).  Therefore, general rules of contractual interpretations are applied in interpreting bond indentures.

A line of cases with regard to the interpretation of the terms of indentures and debentures have come up before New York courts.  In Van Wezel v. McCord Radiator & Mfg. Co., 20 N.Y.S.2d 91 (N.Y. Misc. 1939), a debenture agreement covering the issue of bonds provided that only the trustee of the holders of the bond could bring an action against the issuer for the benefit of all holders.  An obligation in the debenture agreement related to sinking fund requirements, which the issuer failed to fulfill, prompting the subject action.  The court held that the debenture agreement restricted bond holders from proceeding against the issuer other than through the trustee, which executed the underlying agreement with the issuer. The purpose of the restrictive provisions was meant to ensure that all recoveries from the issuer in relation to the debentures would be applied for the benefit of all holders of bonds. In interpreting the debenture agreement, the court held

Where a debenture must be construed its peculiar provisions will govern the court interpreting it. Id. at 98.

Broad v. Rockwell International Corp., 642 F.2d 929 (5th Cir.-OLD 1981), is a case that turned on the construction of an indenture. The event that triggered the lawsuit was the acquisition of Collins by Rockwell International Corporation, a Delaware corporation, in a cash merger. The question before the court was the form of survival of the conversion rights of the debenture holders under the terms of the Indenture upon merger. The plaintiff alleged that the defendants breached the terms of the Indenture, breached their respective fiduciary duties, and violated various provisions of the federal securities laws.  The district court held that the defendants’ interpretation of the Indenture and their actions in accord with that interpretation were correct and non actionable as a matter of state law.  The appellate court reversed and remanded on the pendent state-law claims; a majority of the full court, however, vacated the panel’s decision under Fifth Circuit Local Rule 17 and ordered that the appeal be reheard en banc.  On the issue of interpretation, the court stated:

Under New York law, a written contract is to be interpreted so as to give effect to the intention of the parties as expressed in the unequivocal language they have employed. Due consideration must be given to the purpose of the parties in making the contract, and a fair and reasonable interpretation consistent with that purpose must guide the courts in enforcing the agreement. The interpretation of an unambiguous contract provision is a function for the court rather than for a jury, and matters extrinsic to the agreement may not be considered when the intent of the parties can be gleaned from the face of the instrument. A court may not rewrite a term of a contract by “interpretation” when that term is clear and unambiguous on its face. In interpreting the contract, a court must be concerned with what the parties intended, but only to the extent that they evidenced what they intended by what they wrote. Neither may a court rewrite a contract to accord with its instinct for the dispensation of equity under the facts of a case.

Id. at 946. (internal citations omitted)

The Texas court, in that case, interpreted the indenture by applying settled principles of New York law in construing the Indenture.

Courts have been consistent in their interpretation of bonds.    The classical rules of contractual interpretation like “plain meaning” of the terms and restricting the terms to the “four corners” of the contract are applied in interpreting bonds.  In Alpert, id., the United States District Court for the Southern District of New York has detailed New York law on interpretation of written contracts:

Under New York law, a written contract is to be interpreted so as to give effect to the intention of the parties as expressed in the unequivocal language they have employed. Construing an unambiguous contract provision is a function of the court, rather than a jury, and matters extrinsic to the agreement may not be considered when the intent of the parties can fairly be gleaned from the face of the instrument. A court may neither rewrite, under the guise of interpretation, a term of the contract when the term is clear and unambiguous, nor redraft a contract to accord with its instinct for the dispensation of equity upon the facts of a given case. When language contained in a contract is clear, the court is to give effect to the contract and grant summary judgment without reference to extrinsic evidence.

Id. at 299. (internal citations omitted) (emphasis added).

Like New York contracts, indentures too have an implied covenant of good faith and fair dealing.  Geren v. Quantum Chem. Corp., 832 F. Supp. 728, 737 (D.N.Y. 1993).  In Geren, id., the Defendants, a corporation and its officers, advisers, and lenders, requested a dismissal of plaintiff bondholders’ suit for damages, which was based on a distribution of a special dividend that caused a decline in the bonds’ market value.  In finding that the defendants did not violate an implied duty of good faith and fair dealing because the indentures did not restrict the amount of debt that defendant corporation could have incurred or bar the special dividend’s issuance, the court stated that “an implied covenant, however, can only impose an obligation consistent with other mutually agreed upon terms in the contract.” Id. at 738.

In Metropolitan Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504, 1515 (D.N.Y. 1989), the investors filed motions for summary judgment alleging breach of the implied covenant of good faith and fair dealing. The corporation and CEO filed cross-motions for judgment on the pleadings or, in the alternative, for summary judgment. The court denied the investors’ motions and granted the corporation and CEO summary judgment. It held that the fruits of the indentures did not include an implied restrictive covenant to prevent the incurrence of new debt to facilitate the LBO. The court reasoned that the investors did not invoke an implied covenant of good faith to protect a legitimate, mutually contemplated benefit; rather, they sought to have the court create an additional benefit for which they did not bargain. It found that the investors’ cause of action in equity also failed, because they were informed participants in a largely impersonal market and possessed the financial sophistication and size to secure their own protection; therefore, they did not require a court’s equitable protection.  The court held

In contracts like bond indentures, an implied covenant derives its substance directly from the language of the indenture, and cannot give the holders of debentures any rights inconsistent with those set out in the indenture. Where plaintiffs’ contractual rights have not been violated, there can have been no breach of an implied covenant.

Id. at 1517.

It is an elementary rule for the construction of contracts that ambiguous phrases are to be taken most strongly against the covenanter, whose words they are.  Lubin v. Pressed Steel Car Co., 146 Misc. 462, 466 (N.Y. Misc. 1933). See also.Prescott, Ball & Turben v. LTV Corp., 531 F. Supp. 213 (D.N.Y. 1981).  In choosing among the reasonable meanings of a promise or agreement or a term thereof, that meaning is generally preferred which operates against the party who supplies the words or from whom a writing otherwise proceeds.  Restat 2d of Contracts, § 206.

In Lubin, 146 Misc. 462, 466 (N.Y. Misc. 1933), the corporation issued a series of bonds to provide corporate funds for the payment of indebtedness contracted by it and its subsidiaries in the usual course of business and to provide additional working capital. Id.  Under the terms of the bond, on which the bondholder instituted the instant suit, it was provided that the corporation would unconditionally pay the principal and five percent interest.  Id.  The bondholder duly presented the bond for payment, and the corporation refused.  Id.  The corporation contended that a provision of the indenture stated that the bondholder did not have the right to institute a suit against the corporation without first giving written notice to the trustee.  Id.  The court held that the “while it is true that the bond and the indenture must be read together in order to arrive at the intent of the parties, this rule is limited by the further proviso that the two instruments must be consistent, and that where an inconsistency exists as between the two instruments the provisions of the bond must prevail because that is the instrument on which the holder primarily relies….”  Id. 

However, the normal rule of construction that any fair doubt as to the meaning of the words chosen by the drafting party should be resolved against that party is inapplicable when there is only one possible and reasonable interpretation. Broad v. Rockwell International Corp., 642 F.2d 929, 948 (5th Cir.-OLD 1981).

A bond indenture is type of corporate security.  A bondholder obtains rights from a bond indenture, ie;  a contract for bonds.  The significance of a bond indenture is that bondholders have no grounds for claiming rights and protections unless the terms of the bond itself creates the rights and protections in fairly clear terms.   Unless the terms of the bond restrict, the corporate management can use the corporate funds invested by bondholders to promote its own interests over those of bondholders.  The above discussion throws light on the fact that in the process of interpretation of bond contracts, courts tend to give contract language its literal meaning, even where there is little indication that the debtor corporation and the bondholders intended that meaning.

In Gordon v. Elliman, 306 N.Y. 456 (N.Y. 1954), a declaration of dividends had not been made by the appellee company and the appellant initiated suit to compel them to do so. The court held that “whether or not dividends shall be paid, and the amount of the dividend at any time, is primarily to be determined by the directors, and there must be bad faith or a clear abuse of discretion on their part to justify a court of equity in interfering; accordingly, unless fraud, bad faith or dishonesty on the part of directors can be shown, their judgment in withholding a dividend from the stockholders will be regarded as conclusive.“  Id. at 459.

The phrase “directly or indirectly” used in the bond indenture will be interpreted applying the traditional rules of contractual interpretation, ie;  applying the implied covenants of good faith and fair dealing.  Most importantly, when a particular right is asserted by an express covenant, the scope and effect of an implied covenant should be considered in the light of the framework provided by such express covenant.  See Reback v. Story Productions, Inc., 15 Misc. 2d 681, 181 N.Y.S.2d 980, modified and aff’d, 9 A.D.2d 880, 193 N.Y.S.2d 520 (1st Dep’t 1959).  The primary purpose behind including a restrictive covenant in the bond indenture retraining subsidiaries from “directly or indirectly” paying off or declaring dividends is to secure the bondholder’s right to receive interest and the money invested.  It is clear that the intention of the provision is to restrict payment/declaration of dividends.  The phrase “directly or indirectly” should therefore be construed to give effect to that intention.

Under New York law, in construing an ambiguous term, the entire contract must be considered, and, that interpretation which best accords with the sense of the remainder of the contract should be favored so that every part of the contract is made effective. Broad, 642 F.2d 929, 947 (5th Cir.-OLD 1981).  A specific provision should not be set aside in favor of a catch-all clause.  Id.

If the contract contains certain express terms or stipulations, it has to be read in the frame work of the agreement.  In U.S. Bank N.A. v. U.S. Timberlands Klamath Falls, L.L.C., 864 A.2d 930 (Del. Ch. 2004) a Delaware Court, applying New York law  upheld a   trust indenture covenant which stipulated that  the company and its restricted subsidiaries may not incur debt without giving the indenture trustee an equivalent lien in the assets. In this case, the Plaintiff, an  indenture trustee sought a  declaration that the Defendant U.S. Timberlands Klamath Falls, L.L.C. (“Issuer”) violated several provisions of the indenture by entering into transactions with a related third-party, which is a subsidiary of the issuer.  The Indenture precluded the Issuer, and any of its “Restricted Subsidiaries,” from incurring additional debt unless their earnings are more than sufficient to service their debt. The indenture also  prohibited the payment of dividends, the redemption of stock, the retirement of subordinated debt, or the making of any investments other than “Permitted Investments,” unless the Issuer’s financial condition meets certain exacting (and intricate) standards. Id. at 943- 946.   Finding that Klamath exercised substantial voting power over the operations of Yakima and that a vast majority of Yakima’s equity capital was provided by Klamath, the court held that Yakima was a subsidiary of Klamath. The Indenture precludes Klamath, and its Restricted Subsidiaries, from incurring liens on Klamath’s assets, unless the note holders are provided an equal and ratable lien in those assets. 952

New York law governs the Indenture in this case, and under New York law “interpretation of indenture provisions is a matter of basic contract law.” If a contract is unambiguous, a court is required to give effect to its unambiguous terms. The Indenture plainly states that an entity is a Subsidiary of the Issuer if the Issuer has a “majority ownership interest entitled to vote in the election of directors, managers [etc.].” Klamath had such a majority ownership interest. The Indenture makes no reference to a control requirement. This court will not read such a requirement into the plain language of the Indenture.

Id. at 945.

An indenture trustee derives its powers and rights from the indenture itself, and those powers are specifically limited to those given to it through the terms of the indenture. Id. at 940.

In normal course, courts do not upset the express language of the trust indenture and the only deviation permissible is in the face of an unforeseeable emergency which is not provided for by the parties to the indenture. Though the court of equity is empowered to follow a different course in such situations, this power is to be exercised with great caution.  In Chase Nat’l Bank v. Manila Electric Co., 180 Misc. 483 (N.Y. Misc. 1943) where the trustee sought to deviate from the provisions set forth in the trust indentures as to the sinking fund provisions in the wake of take over of various properties on which liens were held, the New York Supreme court determined that the take over of the properties due to seizure of territory in a war was an unanticipated and unforeseeable event as to all parties involved.

It is well settled that ample power resides in a court of equity, to be “exercised with great circumspection”, to permit a necessary deviation from a trust indenture in the face of an emergency unforeseeable and not provided for by the parties to the indenture and which threatens the corpus. Id. at 486

The court held that in such situations the broad ground of the equity power of the court can be utilized.  In a proper case any deviation from the provisions of a trust indenture for the protection and promotion of any of the rights of the beneficiaries of the trust is well within the broad and plenary powers of a court of equity.  Id. at 487.


In New York, interpretation of bonds/indentures is matter of basic contract law.  Bonds are created in order to secure the interest of the bondholders by preventing the corporation from acting contrary to their interest by the distribution of corporate assets through dividends.  Therefore, restrictive clauses in bond indentures will be construed by New York courts in a manner that would give effect to that purpose.  The phrase “directly or indirectly” in the context would be interpreted in terms of the intention of the covenant to restrict payment/declaration of dividends in order to secure the interests of the bondholders.