Merit Decision: Sale of Municipal Bond Does Not Give Buyer Automatic Right To Sue Bank. Paul Cheatham I.R.A. v. Huntington Natl. BankA

By Marianna Bettman on August 29, 2019

“We hold that R.C. 1308.16(A) does not operate to allow the automatic assignment of rights upon a transfer of title; it sets forth only the shelter rule of securities—the transferee takes all rights in the thing transferred that the transferor had the power to give.”

Justice Stewart, opinion of the court.

On August 22, 2019, the Supreme Court of Ohio handed down a merit decision in Paul Cheatham I.R.A. v. Huntington Natl. Bank, 2019-Ohio-3342. In an opinion written by Justice Stewart, the court held that absent a valid assignment, the sale of a municipal bond does not automatically vest in the buyer all causes of action the seller had the right to bring related to the bond. The judgment was unanimous, with Chief Justice O’Connor and Justices French and Donnelly joining the majority opinion in full. Justice Fischer concurred in the judgment and paragraphs 1 through 23 of the majority opinion. Justice Kennedy concurred in judgment only, with an opinion joined by Justice DeWine. The case was argued February 19, 2019.

Case Background

In 1998, Lucas County, Ohio, issued $6.59 in municipal bonds to back the construction of the Villa North Heath Care and Rehabilitation Center. Lucas County’s participation was only to make the bonds federally tax exempt. The real obligor was the Foundation for the Elderly, Inc.

Appellant, Huntington National Bank, entered into a trust indenture with Lucas County in which Huntington agreed to collect payment on the bonds and distribute funds to the bondholders. Huntington was paid a fee to do this.

In June of 2003, Foundation for the Elderly defaulted on the bonds, and by December 2003, Benchmark Healthcare became a substitute obligor and also defaulted. Huntington notified bondholders of both defaults and obligor substitutions. Benchmark twice attempted reorganization under Chapter 11 of the Bankruptcy Code, but by July 2009, reorganization failed. The bankruptcy was dismissed, and Huntington filed a foreclosure action against Benchmark.

Appellee Paul Cheatham I.R.A. (“Cheatham IRA”) began purchasing the bonds in November 2003, after the default by the Foundation for the Elderly, and continued purchasing the bonds through 2007 at a fraction of their face value, even after Benchmark filed for bankruptcy.

Out of an initial bond issue of $6.59 million, bondholders ultimately received five cents on the dollar. The Cheatham IRA filed a class action complaint alleging that Huntington had breached the trust indenture, and did not do enough to protect bondholder interests, leading to a low final distribution. The IRA sought as damages the value of the bonds had Huntington acted immediately on default to accelerate interest and principal payments, plus disgorgement of the bank’s fees, to be distributed to the bondholders based on their proportionate share of the bonds.

The Cheatham IRA sought class certification of more than 50 bondholders who owned bonds secured by the Villa North project as of the date of final distribution (November 19, 2014). The trial court denied the class certification, finding that commonality had not been established.

The Appeal

The Sixth District Court of Appeals, with one separate concurrence, reversed the denial of class certification. In doing so, the appeals court held that a contract claim for breach of the trust indenture arises out of the contract with the bondholders, and thus is a “right in the security” that automatically transfers to subsequent purchasers pursuant to R.C. 1308.16(A).

Key Statute Involved in this Appeal

R.C. 1308.16(A) (Ohio’s codification of UCC 8-302) (“a purchaser of a certificated or uncertificated security acquires all rights in the security that the transferor had or had power to transfer.”)

Other Key Precedent

R.C. 140.01(J) (“‘Bond proceedings’ means one or more ordinances, resolutions, trust agreements, indentures, and other agreements or documents, and amendments and supplements to the foregoing, or any combination thereof, authorizing or providing for the terms, including any variable interest rates, and conditions applicable to, or providing for the security of, obligations and the provisions contained in such obligations.”)

Abraham Lincoln Ins. Co. v. Franklin S. & L. Assn., 434 F.2d 264 (8th Cir.1970) (“It is clear that after property has passed into the hands of a bona fide purchaser, subsequent purchasers, even those with notice of asserted defenses, take clear of the defense.”)

Bluebird Partners, L.P. v. First Fid. Bank, N.A., 85 F.3d 970 (2d Cir. 1996) (Under federal law, claims are not automatically assigned to the subsequent purchaser of a security because the law “protect[s] those who are injured . . . not those who subsequently purchase securities at the reduced price.”)

Consolidated Edison, Inc. v. Northeast Utilities, 318 F.Supp.2d 181 (S.D.N.Y. 2004) (Section 8-302 “applies primarily to disputes over the quality of title and the competing ownership rights passed from transferor to transferee.”)

Pilkington N. Am. v. Travelers, 2006-Ohio-6551 (2006) (A chose of action is a “proprietary right in personam, such as a debt owed by another person, a share in a joint-stock company, or a claim for damages in tort.”)

Fraternity Fund Ltd. v. Beacon Hill Asset Mgt., L.L.C., 479 F.Supp.2d 349 (S.D.N.Y. 2007) (“Section 8-302(a) thus primarily concerns issues of title, such as defenses against enforcement of ownership rights… It does not provide for the automatic transfer of fraud claims against third parties.”)

Casserlie v. Shell Oil Co., 2009-Ohio-3 (2009) (taking other states’ interpretations of the UCC into account to promote uniformity)

Read the oral argument preview of the case here and an analysis of the argument here.

Huntington’s Proposition of Law Accepted for Review

Absent a valid assignment of claims, the mere sale of a municipal bond does not automatically vest in the buyer, by operation of R.C. 1308.16 (Section 8-302 of the Uniform Commercial Code), all claims and causes of action of the seller relating to the bond that arose before the transaction.

Does the Court Adopt Huntington’s Proposition of Law?

Yes

Merit Decision

Analysis

History Lesson

Before the 17^th century a chose in action (which includes a contract right or a legal claim for money) could not be transferred to another person. By the 17^th century the law had evolved to allow for the assignment of a chose in action. Ohio allows such assignments.

Undisputed Facts

The Cheatham IRA purchased its bonds after Huntington allegedly breached the trust indenture, and never received any assignment of the rights to causes of action from any bondholders who held the bonds at the time of the alleged breach. And the Cheatham IRA conceded that if its interpretation of R.C. 1308.16 is wrong, namely that the seller of a bond gives the purchaser all the rights the seller had before the sale, then class certification is not justified in this case.

No Automatic Transfer of Accrued Breach of Contract Claim

While the language of R.C. 1308.16(A) might superficially support the conclusion that any rights of the seller automatically transfer to the buyer of the bonds, the drafting history shows otherwise.

Shelter Principle

The official comment to R.C. 1308.16(A) states “Subsection (a) provides that a purchaser of a certificated or uncertificated security acquires all rights that the transferor had or had power to transfer.” This is known as the shelter principle, and it means people cannot transfer rights they do not own or control.

UCC Should Be Interpreted to Maintain Uniformity

In fact, R.C. 1301.103(A)(3) requires exactly that. The opinion from the Sixth District is an outlier. No other jurisdiction has interpreted R.C. 1308.16(A) (UCC8-302(1)) as doing anything other than stating the shelter principle. Nor is there any intent from the Ohio General Assembly to abandon the common law rule that choses in action do not transfer automatically. Furthermore, the court’s interpretation of the statute is consistent with the federal Trust Indenture Act, and federal law underpins the analysis of whether Ohio law should allow for the automatic transfer of common-law claims to a subsequent purchaser.

Bottom Line

Justice Fischer only signed on to the first 23 paragraphs of the majority decision, summarized above. But the majority goes on for another 13 paragraphs, specifically to address the Cheatham IRA’s argument that this case involves a breach of the trust indenture, and that the breach- of-contract claim is a “right in the security” under R.C. 1308.16(A) that adheres to and travels with the bond.

The Trust Indenture

What is a Trust Indenture?

“A document containing the terms and conditions governing a trustee’s conduct and the trust beneficiaries’ rights.”

The Cheatham IRA argues that a breach-of-contract action that arises from conduct occurring before the bondholder acquired the bond is a “right in the security” under R.C. 1308.16(A) which attaches to and travels with the bond. Therefore, a class action of current bondholders is appropriate, and those bondholders can bring a claim for breach of the trust indenture even if the breach occurred before they bought the bonds. The balance of the majority opinion (and the part Justice Fischer did not sign on to) explains why this position is incorrect.

Indenture Language Relied on by Cheatham IRA

The indenture states that it is “for the benefit, security, and protection of all present and future holders and owners of the Bonds.” But this language does not support the class action, as the Cheatham IRA argues. It says nothing about whether a subsequent bondholder can sue for a pre-existing breach of the trust indenture. Nor does that language provide for automatic transfer of any chose in action arising from a violation of the indenture. It just defines who has standing to sue, and limits Huntington’s liability to third parties.

Furthermore, Section 11.03 of the trust indenture specifically states that any rights not specifically mentioned in the indenture shall not be implied.

The rest of the majority opinion distinguishes cases relied on by the Cheatham IRA.

Who Actually Suffered an Injury Here?

The sellers who had to sell the bonds at a reduced price, not buyers like the Cheatham IRA which bought them at a deep discount.

The Cheatham IRA has always maintained that its claim is based on Huntington’s alleged failure to act when it received notice of the initial default. But only those who owned bonds at the time of this initial default could sue for breach of the trust indenture.

Class Action Inappropriate

This appeal was from the trial court’s refusal to certify a class action for lack of commonality. That decision was correct. Since the Cheatham IRA conceded that if a breach-of-contract claim did not automatically transfer, a class action is not viable.

Is There Anything Left?

Yes. The court expresses no opinion on whether any breach-of-contract claims accrued after the Cheatham IRA bought the Villa North bonds.

Justice Kennedy’s Concurrence in Judgment Only

Justice Kennedy agrees with the majority holding that absent a valid assignment of claims, the sale of a municipal bond does not automatically vest in the buyer all causes of action that arose before the sale. To her, the language of R.C. 1308.16(A) is dispositive of the matter.

Here’s that language again:

“a purchaser of a certificated or uncertificated security acquires all rights in the security that the transferor had or had power to transfer.”

Kennedy specifically zooms in on “rights in the security.” “Security” is statutorily defined, but “rights” and “in” aren’t. For that we look to Webster’s Third New International Dictionary-a favorite source for Kennedy for defining common undefined everyday terms. Here, “rights” means “a claim or title to property or a possession,” while “in” here is “used as a function word to indicate the specific object, sphere, or aspect to which a qualification is restricted.”

Kennedy’s main point about these definitions is that “in” limits “rights” to “security.” Put all this together and R.C. 1308.16 (A) can only mean one thing: the buyer of the bond “acquires the legally recognized title to the bond that the seller had the power to transfer.” (This is what the majority held in the first part of its decision).

The Sixth District decided that the Cheatham IRA’s claim for breach of the trust indenture arose out of the contract with the bondholders, and therefore was a “right in the security” that passed to a subsequent purchaser pursuant to R.C. 1308.16(A). But the trust indenture is not a security. It’s just a document that defines the terms and conditions of the trustee’s conduct and the beneficiaries’ rights. So, if you are following this logic, a claim by a bondholder against a trustee for breach of the trust agreement that accrued before the bondholder bought the bond is not a “right in the security.” “To find otherwise would require this court to read the phrase ‘related to’ into R.C.1308.16(A),” wrote Kennedy.

Justice DeWine joined this opinion.

Concluding Observations

Student Contributor Carson Miller and I both correctly called this one for Huntington. This is what I wrote after argument:

“I don’t know much about this area, but I’m calling this for Huntington. If the decision of the Sixth District really is a total outlier, that is contrary to the point of the U.C.C. I think the Court is going to adopt the proposition of law proposed by Huntington and hold that in order for a buyer to have a cause of action in these circumstances there must be an express assignment from the seller. Whether those who held the bonds in June of 2003 had a valid grievance with the Bank under the Trust Indenture is another matter, and doesn’t sound like it would necessarily be a walk in the park for the Bank.”

And here’s what Carson wrote:

“Huntington likely gets the win here, but with the Justices offering little from the bench it is difficult to be confident either way. Justices DeWine and French both hinted that Cheatham’s argument sidestepped the issue before the Court and failed to address the Sixth District’s holding. Indeed, much of Cheatham’s argument was devoted to the terms of the Trust Indenture, rather than the statutory interpretation issue this case is purportedly about. Huntington’s final argument might be its most effective: the U.C.C is meant to be applied similarly across jurisdictions, and the Sixth District’s interpretation would make Ohio the only jurisdiction in the country to automatically transfer causes of action in bond sales.”

And finally, as a side note, J. Philip Calabrese, who argued the case for Huntington National Bank, has since been appointed to the Cuyahoga County Court of Common Pleas. The blog wishes him the best.