When a corporation or government issues a bond, the investors who purchase the security—the bondholders—are effectively lenders to the issuer. In most cases, bondholders appoint a bond trustee to monitor the issuer and its compliance with the provisions of the bond. That’s similar in spirit to a bank appointing a lending officer to monitor a company the bank lends to. However, there’s more to the story. This article highlights ways bond trustee services, along with a related set of services called agency services, are critical to the corporate and municipal marketplaces.
What is a bond trustee, and what are its duties?
The issuer’s and the bond trustee’s duties are set out in a contract called a trust indenture (sometimes called a bond indenture). In general, the bond trustee collects the funds to pay scheduled interest and principal on the bonds and receives financial and other periodic reports from the issuer.
If the issuer misses a payment or fails to fully meet its obligations under the trust indenture, the trustee notifies the bondholders and, if appropriate, enforces the bond obligations if the issuer cannot or will not comply. It is very common for investors who hold a majority of defaulting bonds to come together and work with the trustee, often directing the actions of the trustee on behalf of all the bondholders.
Quite often, there are no available funds to cover the fees and expenses incurred in enforcing a bond obligation. An indenture trustee is not obligated to risk its own funds in the pursuit of remedies on behalf of bondholders. Therefore, most indentures provide that the fees and expenses the indenture trustee incurs are paid from any recoveries, before any funds go to the bondholders. Indenture trustees may also require satisfactory indemnity from directing bondholders before risking its own funds.
What are the differences between a bond trustee and a paying agent?
A paying agent has different duties than a bond trustee, although the bond trustee often acts in both roles. The paying agent collects and distributes the principal and interest payments on the bonds. Unlike a trustee, a paying agent has no ability to enforce the bond payment obligations. If there is a paying agent but no bond trustee, there is no independent party available to protect the rights of the bondholders if there is a default on the bonds.
Why is a trustee important? Why does this role exist in a bond issuance?
During the Great Depression, many people who owned defaulting bonds had no protection and lost some or all of their investment. Congress and the Securities and Exchange Commission (SEC) recognized that bond investors may have difficulty protecting their rights when there is no indenture trustee in place. As Congress found, bond investors are often geographically dispersed and may not even know who the other bondholders are. One investor who owns a small percentage of the outstanding bonds may find the cost to protect their rights is disproportionately too high to be worth the effort. Congress therefore passed the Trust Indenture Act of 1939‡ (TIA), which is administered by the SEC.
The TIA requires that corporate bond issuers appoint indenture trustees for most bond issues greater than $10 million. State and municipal bond issuers may also appoint indenture trustees but are not required to under the TIA. Certain bonds exempted from the Securities Act of 1933 are also exempt from the requirement to appoint an indenture trustee.
Indenture trustee should be large financial firms likely to remain in place to protect investors’ interests for the life of the bond. Moreover, once an indenture trustee is appointed, it cannot resign from that role for the life of the bonds, unless a qualified replacement indenture trustee is appointed.
These measures were intended to increase investor confidence that the bond obligations will be enforced, thus making the bonds more valuable to the investors. It also makes the bonds less expensive to the issuer because bond investors, confident that the indenture trustee will be in place for the life of the bonds, are willing to accept a lower interest rate.
How does UMB acting as indenture trustee differ from UMB acting as a lender?
An indenture trustee is not a lender. When UMB acts as indenture trustee, we provide a service to the bond issuer and to the bondholders. As an indenture trustee, UMB does not itself risk loss of an investment, because UMB did not make the investment. Rather, our duty is to protect the rights of the bondholders, as set out in the bonds, the trust indenture, and related documents. And even the duty to protect bondholders is subject to the right of the indenture trustee never to risk its own funds in the pursuit of investor remedies.
Is UMB a creditor when acting as an indenture trustee?
UMB is not a creditor in the amount of the bonds themselves. As indenture trustee, UMB did not lend the money and it is not owed the money for its own account. However, as the appointed representative of bondholder interests, the indenture trustee is typically named as the “creditor” in the schedules of a company filing for bankruptcy. The only claim UMB typically has for its own account is for the fees and expenses incurred in providing its services.
How did UMB become involved in trustee and agency services?
UMB has been providing corporate trust services for more than 75 years. Under the TIA, we have expanded our national recognized trustee and agency services to the corporate and municipal marketplaces. When we started offering these services, there were hundreds of banks that had corporate trust departments.
Over the past several decades, the industry has become more specialized and highly skilled, and fewer banks now have the required expertise and systems to effectively serve clients in this space. UMB, on the other hand, has committed more to provide these institutional services. Our expertise has grown in recent years to include specialty trust and asset-backed securities (ABS) services, including our recent appointment as an approved Global Aircraft Trading System (GATS) trustee, a new platform from the Aviation Working Group that facilitates the secure trading and financing of aircraft equipment.
UMB is a nationally recognized and ranked provider of bond trustee and agency services to the corporate and municipal marketplaces. Visit umb.com to learn how we can support your organization’s trust and escrow needs, or contact us to be connected with a corporate trust team member.
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