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May 15, 1992


The opinion of the court was delivered by: SHIRLEY WOHL KRAM


 Plaintiffs UPIC & Co. and United Pacific Life Insurance Company are, respectively, the registered holder and beneficial owner of $ 12 million of subordinated notes issued by defendant Kinder-Care Learning Centers, Inc. ("KCLC"), and bring this action to recover principal and interest due under the notes. *fn1" Defendant KCLC now moves, pursuant to Rule 12(b)(6) of the Federal Rules of Civil Procedure, for an order dismissing the complaint for failure to state a claim upon which relief can be granted, and, pursuant to Rules 12(b)(7) and 19, for dismissal of the complaint for failure to join a party needed for a just adjudication.


 Pursuant to an indenture *fn2" dated December 23, 1987 (the "Indenture") and qualified under the Trust Indenture Act of 1939, *fn3" 15 U.S.C. § 77aaa et seq. (the "TIA" or "Act"), between KCLC as obligor and Amsouth Bank N.A. as Indenture Trustee, KCLC issued certain senior subordinated reset notes, including three-year subordinated notes (the "Notes" or "Securities"). Pursuant to a Securities Purchase Agreement also dated December 23, 1987 (the "Agreement"), UPIC purchased and became the registered holder of $ 12 million in principal amount of the Notes.

 Under the terms of the Notes, KCLC was obligated to pay semi-annual interest on the outstanding principal of the Notes until such time as the principal had been paid in full. Under the terms of the Indenture, KCLC also was obligated to reset the rate of interest payable on the Notes on December 15, 1990 (the "Reset Date"), and to give notice of the new rate to registered holders of the Notes (the "Noteholders" or "Securityholders") within 30 days after that date.

 On or about the Reset Date, KCLC provided to the Noteholders, including UPIC, notice of the reset interest rate on the Notes. KCLC also provided to the Noteholders notice of the provisions of the Notes and Indenture that require KCLC, at the Noteholders' option, on or within 30 days after the Reset Date (the "Buy-Back Period"), to repurchase the Notes for their outstanding principal amount, together with accrued interest (the "Repurchase Option").

 During the Buy-Back Period, UPIC elected to exercise the Repurchase Option and provided timely notice to KCLC of its election. KCLC failed to repurchase the Notes as demanded by UPIC. As a result, the $ 12 million principal amount of the Notes held by UPIC, together with accrued interest, became due and owing as of January 14, 1991. KCLC also failed to pay interest due on the Notes as of the Reset Date (December 15, 1990), in the amount of $ 780,000, and has failed to pay accrued interest on such sum.

 The complaint in this action alleges two claims. On the first, UPIC seeks to recover the $ 780,000 in interest due and payable as of the Reset Set, together with accrued interest; on the second, UPIC seeks to recover the $ 12 million principal amount of the Notes due and payable under the Repurchase Option, together with accrued interest.

 KCLC now moves to dismiss the complaint on three grounds. First, KCLC contends that under the Indenture a Noteholder's right to payment of the principal of and interest on the Notes is "completely" subordinated to the prior payment of the entirety of KCLC's senior indebtedness; since UPIC does not allege prior payment of KCLC's defaulted senior indebtedness, it fails to state a claim upon which relief can be granted under New York law. Second, UPIC lacks standing to commence this action having failed to provide the Indenture Trustee the 60-days written notice required by the Indenture. Third, UPIC's failure to join the Indenture Trustee warrants dismissal given the Indenture Trustee's fiduciary obligation to all subordinated noteholders under the Indenture, and the possibility of KCLC incurring inconsistent obligations by being required to make direct payment to the plaintiffs notwithstanding its obligation to senior creditors under the Indenture (the "holders of Senior Indebtedness").

 Subsequent briefing, however, indicates that KCLC's position is qualified. KCLC does not dispute that TIA Section 316(b) grants UPIC the "procedural right" to commence this action at least with respect to interest due on the Notes, and admits that the Indenture's notice provision requiring 60-days written notice to the Trustee of an event of default under the Indenture "may be overridden by the right to sue provisions of Section 5.07 [of the Indenture] with respect to UPIC's claim for $ 780,000 in overdue interest." KCLC argues, however, that although the TIA guarantees UPIC the "procedural right" to bring this action it does not automatically permit UPIC to reduce its claims on the Notes to judgment since the issue of "whether a judgment may be obtained depends on the substantive provisions of the relevant instruments and state law . . ." KCLC Sur-Sur-Reply Letter-Brief dated May 29, 1991. And, according to KCLC, because the TIA applies only to UPIC's claim for payment of interest on the Notes, and not to UPIC's claim for failure to repurchase the Notes pursuant to the Indenture's "special" repurchase provisions, UPIC lacks standing with respect to their $ 12 million repurchase claim, having failed to give the required notice to the Trustee under Indenture Section 5.06.

 In opposition, UPIC acknowledges the Indenture's subordination provisions but argues that TIA Section 316(b) grants it the unfettered right to bring an action to enforce the Notes notwithstanding provisions of the Indenture or state law to the contrary. Specifically, UPIC contends that the TIA guarantees its right to have its claim reduced to judgment and that KCLC's basic premise -- that UPIC seeks to negate the Indenture's subordination provisions -- is erroneous since the Indenture's subordination provisions are activated, if at all, only when UPIC seeks to enforce its judgment. UPIC argues alternatively that, should the Court reach the issue of whether the Indenture provides for "complete" or "inchoate" subordination, *fn4" the Indenture provides for "inchoate" subordination, permitting it to bring suit and obtain a judgment notwithstanding KCLC's failure to satisfy its senior indebtedness.


 I. Motion to Dismiss for Failure to State a Claim

 When evaluating a motion to dismiss under Rule 12(b)(6), the allegations of the complaint are to be construed in the light most favorable to the plaintiff and accepted as true, see Scheuer v. Rhodes, 416 U.S. 232, 40 L. Ed. 2d 90, 94 S. Ct. 1683 (1974), and a complaint shall not be dismissed unless it appears that the plaintiff can prove no set of facts entitling it to relief. Conley v. Gibson, 355 U.S. 41, 2 L. Ed. 2d 80, 78 S. Ct. 99 (1957); Cortec Industries, Inc. v. Sum Holding L.P., 949 F.2d 42 (2d Cir. 1991), cert denied, 112 S. Ct. 1561, 118 L. Ed. 2d 208 (1992). In reviewing a pleading on a motion to dismiss under Rule 12(b)(6), the Court generally looks only to the pleading itself. See Fed. R. Civ. P. 12(b); Ryder Energy Distrib. Corp. v. Merrill Lynch Commodities, Inc., 748 F.2d 774 (2d Cir. 1984). In determining whether UPIC's claims may be subject to dismissal, however, the Court may properly refer to the Indenture and its exhibits (including the Notes) which are annexed to KCLC's notice of motion and are integral to UPIC's claims. See Field v. Trump, 850 F.2d 938, 949 (2d Cir. 1988), cert. denied, 489 U.S. 1012, 103 L. Ed. 2d 185, 109 S. Ct. 1122 (1989).

 A. Trust Indenture Act Section 316(b)

 Section 316(b) of the TIA, 15 U.S.C. § 77ppp(b), entitled "prohibition of impairment of holder's right to payment," proscribes certain so-called "majority action clauses" in indentures to be qualified under the Act. Section 316(b) expressly prohibits use of an indenture that permits modification by majority securityholder vote of any core term of the indenture, i.e., one affecting a securityholder's right to receive payment of the principal of or interest on the indenture security on the due dates for such payments:

Notwithstanding any other provision of the indenture to be qualified, the right of any holder of any indenture security to receive payment of the principal of and interest on such indenture security, on or after the respective due dates expressed in such indenture security, or to institute suit for the enforcement of any such payment on or after such respective dates, shall not be impaired or affected without the consent of such holder . . . .

 * * *

 15 U.S.C. § 77ppp(b). The Indenture itself incorporates the requirement of TIA Section 316(b) in its Section 5.07, which provides:

The right of any Holder of a [Note] to receive payment of principal of and interest on the [Note], on or after the respective due dates expressed in the [Note] or to bring suit for the enforcement of any such payment on or after such respective date, shall not be impaired or affected without the consent of the Holder.

 Indenture § 5.07.

 Enactment of Section 316(b) is attributable to the Securities Exchange Commission's concern about the motivation of insiders and quasi-insiders to destroy a bond issue through insider control, and the generally poor information about a prospective reorganization available to dispersed individual bondholders. *fn5" In 1939, the Commission addressed this concern by seeking to have recapitalizations placed under regulatory and judicial control. See Senate Comm. on Banking and Currency, Trust Indenture Act of 1939: Report to Accompany S. 2065, S. Rep. No. 248, 76th Cong., 1st Sess. 26 (1939) [hereinafter "Senate Trust Indenture Report "] ("Evasion of judicial scrutiny of the fairness of debt-readjustment plans is [intended to be] prevented by [Section 316(b)'s] prohibition."); see also Jerome Frank, Some Realistic Reflections on Some Aspects of Corporate Reorganization, 19 Va. L. Rev. 541, 568-69 (1933) (Jerome Frank, later chairman of the SEC, arguing for active court supervision of reorganizations). The Commission accordingly recommended to Congress legislation, in the form of Section 316(b), that would bring contractual recapitalizations under Bankruptcy Court jurisdiction.

 Section 316(b) tends to force recapitalizations into bankruptcy court by frustrating a distressed firm's efforts to successfully complete a consensual workout. When a distressed or nearly bankrupt firm seeks to reorganize its financial structure, the incentives among those financially interested in the firm would generally be to contract to the efficient solution and avoid the transaction costs of a bankruptcy proceeding. R. H. Coase, The Problem of Social Cost, 3 J.L. & Econ. 1 (1960); In re Chateaugay Corp., 961 F.2d 378 (2d Cir. 1992) ("The debtor and its creditors share an interest in achieving a successful restructuring of the debtor's financial obligations in order to avoid the uncertainties and daunting transaction costs of bankruptcy."). In a workout affecting bondholders, however, Section 316(b) tends to frustrate such a consensual workout. By guaranteeing a bondholder's right to receive payment of the principal of or interest on the security, Section 316(b) creates a disincentive for bondholders to exchange their bonds for stock or for bonds with different terms. Bondholders aware of the perceived advantage of refusing to participate in the workout -- payment in full after, and if, the recapitalization succeeds -- will do so, seeking to benefit from the workout at the expense of those who would renegotiate their credits or offer new capital. The holdouts thus seek to be "buoyed-up" by the workout's participants.

 The "buoying-up" effect places the distressed firm under further stress. In order to overcome the effect, nearly equal treatment of bondholders is necessary since equal treatment reduces the incentive for bondholders to hold out. *fn6" A reduced incentive to hold out enhances the firm's ability to achieve near unanimous agreement on the terms of any contemplated recapitalization and thereby increases the chances of a successful consensual workout. Without equal treatment of creditors, the near consensual unanimity necessary for a successful workout is frustrated by holdouts and the buoying-up effect, and the workout fails. See Bond Workouts, supra n.4, at 234. The Securities Exchange Commission was undoubtedly aware that requiring unanimity in bondholder voting -- rather than mere majority action -- would frustrate consensual workouts and help induce bankruptcy. And convinced that insiders or quasi-insiders would damage bondholders, the Commission welcomed the prospect. See Bond Workouts, at 234 n.4.

 B. Applicability of Section 316(b)

 On this motion, the parties have framed the issues such that the Court is called upon not merely to interpret TIA Section 316(b) but, in large measure, to construe provisions of the Indenture which are in apparent conflict with Section 316(b), namely, the subordination provisions of the Indenture's Article 6 (the "Subordination Clause") and the 60-day notice provision of Section 5.06. Significantly, KCLC admits that TIA Section 316(b) (and Section 5.07 of the Indenture) guarantees UPIC's absolute and unconditional right to recover interest under the Securities, and thus "overrides" the subordination and notice provisions of the Indenture. KCLC thus acknowledges the absolute and unconditional nature of the right afforded a noteholder under Section 316(b), at least with respect to overdue interest. KCLC contends, however, that in this case such right applies only to UPIC's claim for payment of interest and not payment of principal. KCLC argues that, because UPIC's claim for principal is based upon KCLC's failure to repurchase the Notes under a "special" repurchase obligation akin to payment on principal redemption or acceleration (to which Section 316(b) does not apply), Section 5.07 does not afford UPIC an absolute and unconditional right to bring a claim to recover the principal amount of the Notes. KCLC urges that in order to determine whether UPIC is entitled to bring an action to recover the principal amount of the notes, the Court must construe the Indenture's subordination provisions under state law to determine whether the Subordination Clause provides for ...

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