In a pair of recent decisions,1 two federal courts in the Southern District of New York have broadly interpreted Section 316(b) of the Trust Indenture Act (“TIA”)2 to limit the ability of parties to strip guarantees from dissenting bondholders in an out-of court restructuring without the bondholders’ unanimous consent. In doing so, these courts clearly indicated that Section 316(b) protects bondholders “against non-consensual debt restructurings” that, as a practical matter, materially impair their ability to collect their debt and rejected the narrower interpretation that Section 316(b) only protects bondholders from “majority amendment of certain ‘core terms’.” These are also important decisions because they protecut a bondholder’s substantive right to receive actual payment, and not just the bondholder’s procedural right to sue under the indenture. As a result of these decisions, minority bondholders may now have increased leverage when negotiating with issuers and other creditors, which could manifest itself in various ways: (1) a minority bondholder could delay or otherwise disrupt the consummation of some types of out-of-court restructurings with the increased cost, delay, and uncertainty of litigation; (2) issuer’s counsel will be more reluctant to issue a legal opinion concerning a proposed indenture amendment; (3) even outside the context of a restructuring, certain exchange offers that involve exit consents may be called into question; and (4) more issuers may resort to Chapter 11 earlier, where unanimity is not required, to effectuate restructurings.
Education Management Corp.
In the first of these decisions, the court in Marblegate (hereinafter “EDMC”) admonished defendant Education Management Corporation (“EDMC”) against stripping EDMC’s guarantee of notes issued by its wholly-owned subsidiary from Marblegate and its co-plaintiffs (the “EDMC Plaintiff Noteholders”) even though the Court ultimately refused their request to enjoin or halt EDMC’s out of court restructuring of more than $1.5 billion of debt.3 As a for-profit college institution that derived almost 80% of its revenue from federal student aid programs under Title IV of the Higher Education Act of 1965,4 EDMC could not file for bankruptcy without jeopardizing its eligibility to receive Title IV funds and thus, bankruptcy was not a viable option.5 At the time, EDMC’s expert valued the company at $1.05 billion and the $20 million of notes held by the EDMC Plaintiff Bondholders stood behind roughly $1.305 billion of secured debt6 and consequently, were “out of the money”. After extensive negotiations with an ad hoc group of asset management firms that collectively held 80.6% of EDMC’s secured debt and 80.7% of the subsidiary’s unsecured notes, the parties agreed on a proposed restructuring whereby the outstanding debt would be converted into a smaller amount of debt and equity, through one of two potential paths, depending upon whether unanimous consent was obtained in a proposed exchange offer. As EDMC was unable to obtain the consent of 100% of its creditors, the restructuring support agreement obligated the signatories to implement an alternative transaction pursuant to which (i) the secured lenders would release EDMC of its separate guarantee of the secured debt, thereby triggering an automatic release of EDMC’s guarantee of the notes under the indenture; (ii) the secured lenders would foreclose on substantially all of the assets; (iii) the secured lenders would immediately sell the assets back to a new subsidiary of EDMC; and (iv) the new subsidiary would then issue debt and equity to the consenting creditors under the restructuring support agreement.7 Dissenting creditors, however, would be left with claims against issuers without any assets and would have no recourse against the parent under the guarantee by operation of the senior secured loan documents and the indenture governing the notes.
Finding neither path acceptable, the plaintiffs—non-consenting noteholders—petitioned the court for a preliminary injunction to block the proposed restructuring, arguing that their rights under Section 316(b) of the TIA were violated by the guarantee-stripping amendment. That section provides:
Notwithstanding any other provision of the indenture to be qualified, the right of the holder of any indenture security to receive payment of the principal 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 . . . .8
In the end, the court denied the preliminary injunction, refusing to improve the negotiating leverage of holders of $20 million in notes to stop a $1.5 billion restructuring. That said, the Court did not end its analysis there -- which it could have done. Instead, the Court emphatically stated that the EDMC Plaintiff Noteholders had demonstrated a likelihood of success on the merits because Section 316(b)’s protection of the bondholders’ “right to receive payment” should be viewed as a substantive right, not merely a legal entitlement to demand payment.9 Thus, in the Court’s view, the termination of the EDMC parent guarantee was a step too far in a nonconsensual out-of-court restructuring – a step prohibited by Section 316(b)’s protection of a bondholder’s right to payment. Furthermore, the Court reasoned that the protections afforded by the TIA against nonconsensual out-of-court debt restructurings supersede any terms in the debt instruments that would impair or affect the creditor’s right to actually receive payment on its notes.10 For example, even though the removal of EDMC as a guarantor of the unsecured debt was permitted by the indenture, Section 316(b) of the TIA supersedes those provisions in the context of the particular transaction under review because they would prevent the Plaintiffs from actually receiving payment under the notes. The Court further stated that the proposed restructuring was precisely the type of transaction that the TIA was designed to preclude because it was specifically intended to ensure that dissenters to the restructuring support agreement would not receive payment of their notes notwithstanding the express provisions of the indenture.
In reliance in part on the decision in EDMC, the Court in MeehanCombs (hereinafter referred to as “Caesars”) also employed Section 316(b)’s protection of the right to receive payment to strike the termination of a parent guarantee in the context of the proposed restructuring of Caesars Entertainment Corp. (“CEC”) and its direct operating subsidiary Caesars Entertainment Operating Co., Inc. (“CEOC”). While it is not clear how much debt the plaintiff noteholders held in the aggregate in Caesars, the numbers, like those of the holdout noteholders in EDMC, were extremely modest in Caesars in comparison to the $1.5 billion of notes outstanding and the secured debt that stood ahead of those notes.11 The Court was clearly not enamored with the out-of-court restructuring approved by CEC, CEOC and their creditors in August 2014 for several reasons. First, in the court’s view, the transactions “effectively left CEC free to transfer CEOC’s assets without any obligations back to CEOC’s debts.”12 Second, consenting creditors were paid “an extraordinary one hundred percent premium over market” in exchange for their consent. Third and most importantly for these purposes, the transactions included the termination of the CEC guarantee which was extremely meaningful given the court’s characterization of CEC as the “asset-rich parent company”. Accordingly, the Court characterized the removal of the CEC guarantee as “an impermissible out-of-court debt restructuring achieved through [the] collective action [of the majority holders of Caesars’ debt]” – a result “TIA section 316(b) is designed to prevent.”13
Interestingly, both of these decisions came at the outset of the respective cases: first, in EDMC in the context of a request for a preliminary injunction and second, in Caesars in the context of a motion to dismiss the complaint. Both courts stressed the importance of the TIA’s policy of protecting minority holders from what the courts viewed as oppression by the majority holders and the debtor-issuers. Effectively, the Courts added the existence and continuation of guarantees to the “sacred rights” afforded all lenders or noteholders in most deals and highlighted the importance of bankruptcy as a tool to get a less than wholly consensual deal done despite the fact that EDMC could not file for bankruptcy as a practical matter. Ultimately, in EDMC, the Court quoted prior case-law highlighting holders’ right to payment as “absolute and unconditional” and drew a line in the sand at the release of the guarantee. In the case of Caesars, CEOC ultimately filed for bankruptcy highlighting the importance of the CEC guarantee of the notes. Based on these decisions, troubled companies and their creditors will have to reconsider the extent of what they can accomplish in an out-of-court restructuring on a less than wholly consensual basis. Covenant-stripping that occurs in these exchange and restructuring transactions will not disappear, but relieving a guarantor of its obligations as part of a global resolution will not easily survive judicial scrutiny as a result of these decisions.