Restructurings are all about alternatives. It is one thing for a creditor to hold an instrument that entitles it to payment of $X on Y date. But if the debtor does not have the cash to satisfy the obligation when due, some type of restructuring must occur.

Whether the restructuring takes place in or out of court is, again, usually a function of alternatives. Does the restructuring have the support of creditors, and if so, which ones and how many? In the US, such considerations are often a primary determinant of whether a restructuring can be accomplished out of court or must undergo the formal chapter 11 process.

Background

The Bankruptcy Code contains detailed provisions that limit how creditors’ claims may be impaired under a chapter 11 plan. Included in the Bankruptcy Code are elaborate rules and mechanisms for the protection of creditors who may not support the restructuring, such as the "best interests" test, and the "cram-down" procedures. But which minimum standards apply to an out-of-court restructuring? How are minority interests protected there?

In the US, the Trust Indenture Act of 1939 (TIA) provides for certain protections to be granted to the holders of bonds issued under the TIA. Included among those protections are those set forth in TIA Section 316(b), which states that "the right of any Holder of a Note to receive payment of principal, premium…and interest on the Note…or to bring suit for the enforcement of such payment…shall not be impaired or affected without the consent of such Holder." (emphasis added).

Marblegate Asset Management LLC v Education Management Corp

Recently, in Marblegate Asset Management, LLC v. Education Management Corp., the US District Court for the Southern District of New York addressed the question of whether an out-of-court debt restructuring violates Section 316(b) when it does not explicitly modify any payment term, but nonetheless leaves bondholders no choice but to accept the proposed modification to the terms of their bonds.

Marblegate involved an issuer, EDMC, that needed to restructure roughly $1.5 billion in debt. Since EDMC’s business relied on federal student loan programs for the majority of its revenue, and access to those programs would cease upon a bankruptcy filing, an in-court restructuring through chapter 11 was not a viable option. Accordingly, EDMC launched an exchange offer and consent solicitation under which bondholders would receive different treatment, depending on the extent to which the exchange/consent offer was accepted.

If the offer achieved 100 percent bondholder acceptance, then the bonds would be converted into equity convertible into common stock of the issuer’s parent-guarantor. But if less than 100 percent of the bondholders consented, then EDMC would implement an alternative restructuring under which its assets would be transferred to another subsidiary via a foreclosure sale by the senior lenders, and the parent guaranty would be released. Under this alternative, the nonconsenting bondholders would be left with recourse only against an issuer that then would be an empty shell.

In its decision, the court described the situation this way:

The restructuring, supported and adopted by an overwhelming majority of bondholders, did not directly amend any term explicitly governing any individual bondholder’s right to receive payment. Nevertheless, the restructuring gave dissenting bondholders a Hobson’s choice: take the common stock, or take nothing. In effect, Marblegate bought a $14 million bond that the majority now attempts to turn into $5 million of stock, with consent procured only by threat of total deprivation.

Ultimately, the court held that the proposed restructuring violated Section 316(b). Relying heavily on the legislative history of the TIA, she found that the TIA is "meant to inhibit involuntary debt restructurings outside the formal mechanisms of bankruptcy." That is, the ruling endorsed the view that the TIA’s protections are not merely procedural, i.e. protecting the right of bondholders to "bring suit for the enforcement of such payment," as the statute provides. Rather, the opinion says that the TIA provides more substantive protections, and was enacted "to prevent precisely the nonconsensual majoritarian debt restructuring that occurred here, even if the Act’s authors did not anticipate precisely the mechanisms through which such a restructuring might occur."

Analysis

The Marblegate decision is significant, but not revolutionary, for several reasons. First, unlike the dramatic transaction proposed in the EDMC restructure, most out-of-court restructurings involve covenant strips, or other amendments, that do not remove valuable assets from bondholder recourse; the "Marblegate standard" should allow most of these restructurings to proceed. Second, Marblegate presented a fairly unusual fact pattern: since a chapter 11 filing would have destroyed the business, nonconsenting bondholders could not utilize their ability to exercise that option to block EDMC’s plan, or negotiate a better deal. " The opinion says that the TIA provides more substantive protections, and was enacted ‘to prevent precisely the nonconsensual majoritarian debt restructuring that occurred here, even if the Act’s authors did not anticipate precisely the mechanisms through which such a restructuring might occur.’"

Marblegate does, however, give issuers and bondholders something to think about. The implications of the case go beyond SEC-registered bonds that are subject to the TIA. This is so because many bonds issued without registration rights in "144A for life" transactions customarily contain indenture language similar to that of Section 316(b).

Since "144A for life" bonds are not required to contain the mandatory TIA provisions, issuers may seek to alter or remove those provisions in new debt. In particular, some issuers of 144A for life bonds may seek to sidestep the Marblegate problem by reducing the consent threshold for changes to "payment terms" below 100 percent, so as to provide more incentives for consent without the threat of asset-shifting and guarantee removals. Bondholders need to be wary of such changes, and be sure that they are adequately compensated for any increased risk posed thereby.