Second Circuit Court of Appeals Lifts Cloud of Uncertainty over Bond Restructurings – Marblegate Asset Mgmt., LLC v. Educ. Mgmt. Fin. Corp., 15-2141-cv(CON) (2d Cir. 2017); Marblegate Asset Mgmt. v. Educ. Mgmt. Corp., 111 F. Supp.3d 542 (S.D.N.Y. 2015) (“Marblegate II”); Marblegate Asset Mgmt. v. Educ. Mgmt. Corp., 75 F. Supp.3d 592 (S.D.N.Y. 2014) (“Marblegate I”).
On January 17, 2017, the Second Circuit Court of Appeals reversed the controversial decisions issued two years earlier by the Southern District of New York in Marblegate I and Marblegate II. The District Court had endorsed an expansive interpretation of Section 316(b) of the Trust Indenture Act of 1939 (the “TIA”), which raised meaningful concerns over an issuer’s ability to negotiate and execute exchange offers and other out-of-court restructurings without unanimous noteholder consent. In reversing those decisions, the Second Circuit has restored certainty to the restructuring world.
In 2014, Education Management Corporation (“EDMC”), a large for-profit provider of college and graduate education, sought to restructure $1.522 billion in secured loans and unsecured notes, both issued by its subsidiary Education Management LLC and guaranteed by EDMC. EDMC negotiated a restructuring support agreement with its creditors that contemplated two possible out-of-court transactions, the first requiring the consent of 100% of its creditors, and the second taking place if that consent could not be obtained. Falling just short of the required 100%, EDMC was forced to pursue the second alternative, under which: (i) the secured lenders would release EDMC’s guarantee of their loans, which would also automatically release EDMC’s guarantee of the unsecured notes pursuant to their terms; (ii) the secured lenders would exercise their contractual right to foreclose on substantially all of EDMC’s assets; and (iii) the secured lenders would sell the assets to a new subsidiary of EDMC in exchange for new debt and equity to be distributed only to consenting creditors. Non-consenting creditors would be left with claims against an entity that no longer held any assets, and without the benefit of the EDMC guarantee.
The Marblegate plaintiffs were among the holdouts and sought to enjoin the restructuring, alleging that it violated the TIA and the terms of the TIA-qualified indenture governing the unsecured notes. While the District Court denied relief to the plaintiffs, it went on to explore in dicta the merits of their case, concluding that the plaintiffs had demonstrated a likelihood of success on their claim that the proposed restructuring violated Section 316(b) of the TIA.
Section 316(b) of the TIA provides that “the right of any holder of any indenture security to receive payment of the principal of and interest on such indenture security … or to institute suit for the enforcement of any such payment … shall not be impaired or affected without the consent of such holder….” This language had generally been construed narrowly to protect only a legal right to seek payment by requiring the consent of each holder to amend certain “core terms,” such as the indenture’s payment and enforcement terms. After a review of the TIA’s legislative history, the District Court reasoned that the TIA should be read instead as “a broad protection against non-consensual debt restructurings” protecting each noteholder’s “substantive right to actually obtain” payment, and not merely the “legal entitlement to demand payment.” Applying this expansive interpretation of the TIA, the District Court found that the nonconsensual restructuring contemplated by the RSA would “effect a complete impairment of dissenters’ right to receive payment” and therefore was illegal under the TIA. The court further stated that Section 316(b) of the TIA “was intended to force bond restructurings into bankruptcy where unanimous consent could not be obtained.”
The Second Circuit, in a 2-1 decision, agreed with the District Court that Section 316(b) is ambiguous as to whether it prohibits more than just formal amendments to bond payment terms that eliminate the right to sue for payment. However, following its own extensive analysis of the relevant legislative history, the Second Circuit ultimately concluded that “Congress did not intend the broad reading that … the District Court embraced.” In its analysis, the Second Circuit noted that the legislative history of Section 316(b) “exclusively addressed formal amendments and indenture provisions like collective-action and non-action clauses,” and that nothing in the legislative history indicated that the TIA was enacted to prohibit “well-known forms of reorganization like foreclosures.” Finally, the Second Circuit also noted that, even if a transaction is not prohibited under the TIA, minority bondholders retained their remedies under other state and federal laws, citing to theories of successor liability and fraudulent transfers as examples.
The Second Circuit’s decision lifts the cloud of uncertainty that has hung over out-of-court bond restructurings since late 2014. Although the Second Circuit’s analysis of the legislative history gives much weight to the fact that the challenged transaction involved a foreclosure, the Second Circuit’s narrow reading of Section 316(b) is not limited by that fact. As a result, the traditional interpretation of Section 316(b)—only prohibiting nonconsensual amendments to an indenture’s core payment and enforcement terms—has now been restored in the Second Circuit.
