United States: Second Circuit Rules That Section 316(b) Of The Trust Indenture Act Only Protects Core Payment Terms Of Bond Indentures

The Court of Appeals for the Second Circuit issued an important ruling on January 17, 2017, in Marblegate Asset Management, LLC v, Education Management Finance Corp.,1 when it adopted a narrow reading of Section 316(b) of the Trust Indenture Act of 1939,2 holding that the statute only protects against non-consensual restructurings that affect a bondholder's right to payment.

The ruling reverses a ruling from the United States District Court for the Southern District of New York (the "District Court"), which had held that the issuer's restructuring violated the Act because it impaired the bondholder's right to payment.

The ruling is a clear victory for companies with publicly issued bond indebtedness who seek to restructure outside of bankruptcy by making it easier to bind non-consenting bondholders.

Background

Education Management Finance Cor. ("EDMC") is a for-profit education company that operates  post-secondary schools under the names Argosy University, the Art Institutes, Brown Mackie College and South University. At its peak, it operated at 109 locations, but it is in the process of closing approximately 40 Brown Mackie College and Art Institute operations. EDMC has been the subject of numerous lawsuits and investigations in recent years that alleged that it made misleading claims to recruit students. Other lawsuits alleged that it overstated its job placement record for graduates and made misleading claims about its graduates' ability to find employment. In November 2015, EDMC settled some of the outstanding claims with a group of federal and state regulators and agreed to pay a $95.5 million settlement, however, other investigations and litigations remain outstanding.

As a consequence of the multiple investigations and lawsuits, enrollment at EDMC's schools began to decline; and in response it began closing schools, laying off staff and attempting to reduce expenses. To fund its operations, EDMC was heavily reliant on having its students obtain federal student loans through Title IV of the Higher Education Act of 1965.3 But under that statute, neither EDMC nor its students would be eligible for such aid if EDMC filed for bankruptcy.

In 2014, EDMC had approximately $1.5 billion in outstanding debt, $1.3 billion of secured debt and approximately $217 million of unsecured notes (the "Notes"), issued under an indenture qualified under the Act. The Notes were issued by a subsidiary, but guaranteed by the parent company. As a result of EDMC's declining operations and litigation pressure, EDMC was in severe financial distress and at risk of defaulting on its debt.

In 2014, EDMC negotiated with its senior secured creditors and developed a plan to restructure a portion of its secured debt by deferring some payment obligations and waiving certain covenant defaults. As part of the agreement, the parent company also agreed to guarantee the secured debt. EDMC also agreed to a plan with its junior secured creditors under which the junior secured debt would be exchanged for a package of new junior secured loans and 77% of EDMC's parent company stock, and the Notes would be exchanged in their entirety for 19% of the EDMC common stock. EDMC estimated at the time that the exchange would result in a write-down of 45% for the junior secured lenders and 67% for the holders of Notes.

The agreement with the junior secured lenders holders was contingent on 100% acceptance by the holders of Notes. If there were any holdouts, the alternative plan (called the "Intercompany Sale"), was that the junior secured lenders would foreclose on their collateral under the Uniform Commercial Code, transfer the assets to a new subsidiary of EDMC ("Newco"), and release the parent company guaranty. That latter release would have the effect of releasing the parent guaranty of the Notes. EDMC would then issue new debt and equity to consenting secured creditors and holders of Notes. Non-consenting Note holders would retain their claims against the EDMC subsidiary that had issued the Notes, but that entity would have no assets because the assets had been transferred to Newco, and would no longer have a parent guaranty. The alternative restructuring plans devised by EDMC and its creditors were designed to obtain full creditor agreement for the first plan.

District Court Litigation

Marblegate Asset Management, LLC ("Marblegate"), which held $14 million of the Notes, sued in the District Court to enjoin consummation of the Intercompany Sale on the ground that it violated section 316(b) of the Trust Indenture Act. The relevant portion of the language Marblegate relied on provides:

[T]he 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...

In the District Court, EDMC's argument was that §316(b) only precluded changes in the core terms of the Indenture relating to terms of payment and the ability of a Note holder to bring suit, neither of which was affected by the Intercompany Sale. Marblegate argued that its practical ability to receive payment would be rendered worthless if the Intercompany Sale were completed because the issuer of the Notes would have no asset, and it was losing the benefit of the parent guaranty. Marblegate further argued that to endorse EDMC's reading would allow issuers and senior creditors to collude to restructure indebtedness to strip rights from bondholders while leaving payment terms intact. The District Court did not grant an injunction to block the Intercompany Sale, but determined that Marblegate was likely to prevail on the merits of its claims, ruling that the Act "protects the ability" of Note holder to receive payment, and that even if the payment terms themselves were unaffected, §316(b) protects against involuntary restructurings.

The Intercompany Sale was closed in January 2015 and Marblegate continued to hold out.4 After the Intercompany Sale closed, the balance of the litigation in the District Court centered on whether the parent guaranty was validly released, or whether it continued to benefit the Note holders. On that issue, the District Court ruled in favor of Marblegate, holding that the release of the parent guaranty would violate §316(b), and EDMC appealed.

Second Circuit Decision

On appeal, the Second Circuit reversed the District Court's ruling. After acknowledging that the statutory language was ambiguous, the Court ruled that the proper reading of §316(b) was limited to restructurings that directly affected rights to payment or to maintain litigation to enforce the right to payment, but did not cover other forms of amendments. To reach its conclusion, the Court extensively explored the legislative history of the Act and determined that: "Congress sought to prohibit formal modifications to indentures without the consent of all bondholders, but did not intend to go further by banning other well-known forms of reorganizations like foreclosures."5

The Court also expressed concern that Marblegate's reading of §316(b) would require courts to determine on a case-by-case basis whether a challenged transaction was designed to frustrate the rights to dissenting bondholders. The Court said that such an inquiry would require a determination of the subjective intent of the parties to a transaction and could lead to inconsistent interpretations of the Act, a result that would be avoided by adopting its more restrictive reading.6 The Court finally suggested that bondholders could protect themselves against reorganizations such as the Intercompany Sale by requiring appropriate covenants in indentures7 or bringing other enforcement actions, such as fraudulent conveyance suits.8

The dissent argued that the Intercompany Sale was prohibited by the plain meaning of the Act, and argued that the majority's opinion read the "impaired or affected" language out of the statute. It also said that the majority was blinding itself to the facts of the Intercompany Sale, where the Note holder saw their issuer entity stripped of assets and its parent guaranty released, thus destroying, on a practical basis, their ability to be paid. That result, it argued, contravened both the language of §316(b) and the policy underlying the Act. The dissent responded to the majority's argument that courts would become embroiled in determining whether a particular transaction violated §316(b) by saying that if the statute was flawed, it was up to Congress to fix it, but that the Court had a duty to apply the law as enacted.

The Practical Importance of Marblegate

The result in Marblegate has enormous practical importance. It frees the way for companies and the majorities of their creditors to restructure public debt through voluntary transactions without worrying that nonconsenting bondholders will be able to block those transactions by bringing litigation under the Act.

Bankruptcy reorganizations can be expensive and slow; issuers will almost always prefer to avoid them where possible. But one of the vexing issues in out-of-court restructurings involving public debt is how to deal with holdout bondholders. Marblegate offers at least one solution to that problem. The corollary is that the decision substantially reduces the leverage of holdout bondholders.

Footnotes

1. Case 15-2124-cv(L) (hereinafter, "Slip Opinion").

2. 15 U.S.C. §77ppp(b) (the "Act").

3. 20 U.S.C. §§1070-1099.

4. In January 2015, Moody's lowered the ratings on all of EMC's debt to "D" on the grounds that the Intercompany Sale was, in substance, a payment default. https://www.thelayoff.com/t/zrmpQIY.

5. Slip Opinion at 33.

6. Slip Opinion at 38.

7. The Court's pronouncement about covenants does not, however, reflect the realities of the bond market. The substance of indenture covenants is a reflection of market conditions when the bonds are issued, do not necessarily reflect bondholders' views to protect them against issuer risk. Moody's Investors Service has noted, for example, that covenant packages in high-yield issuance are often reactive to adverse market events, but that the responses typically lag the occurrence of the credit defaults. Moody's also noted that when bond markets are strong, issuers may be successful in negotiating indentures with more limited covenant packages. See,  Special Comment Request for Comment on Moody's Indenture Covenant  Research & Assessment Framework, Moody's Investor Service, September 2006, accessed Janaury 25, 2017, at: https://www.treasurers.org/ACTmedia/MoodyCovenentAssessmentconsultationSept06.pdf.

8. Slip Opinion at 40-41.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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