Two recent decisions of the US District Court for the Southern District of New York may complicate future debt exchange offers. The cases address the validity, under the Trust Indenture Act of 1939, as amended (the Act), of indenture amendments that delete substantive covenant protections in the context of out-of-court debt restructurings. Such amendments are a common feature of debt exchange and cash tender offers and are often essential to achieve a restructuring outside of bankruptcy court. Kaye Scholer recently represented the debtor in a significant out-of-court restructuring in which these issues were addressed. While the ultimate impact of these cases on restructuring transactions is yet to be determined, we briefly summarize the cases below and outline some of their potential effects.
The Education Management and Caesars Transactions
Marblegate Asset Mgmt. v. Education Mgmt. Corp.i involved a proposed out-of-court debt restructuring which released a parent company guarantee of existing notes and divested the parent guarantor and the subsidiary issuer of substantially all of their respective assets. Pursuant to a consent solicitation undertaken in conjunction with an exchange offer for the existing notes, all guarantees of the existing notes were released and the successor obligor provisions contained in the governing indenture were deleted. As a result of the consent solicitation and the restructuring transactions, while the issuer’s obligation to pay principal and interest on the existing notes was unmodified, all non-participating (and therefore non- consenting) noteholders were left (i) without the benefit of the parent guarantee and (ii) with payment obligations (and potential claims for payment) against a shell issuer.
MeehanCombs Global Credit Opp. Funds, LP v. Caesars Ent. Corp.ii also involved a proposed out-of-court debt restructuring made possible by a cash tender offer and consent solicitation with respect to existing notes. In Caesars, the issuer offered to repurchase existing notes at a substantial premium to their current market price. In conjunction with the cash tender offer, the issuer obtained the consent of tendering holders to the elimination of an “asset rich” parent guarantee and the deletion of the successor obligor provisions contained in the governing indenture. As in Education Management, the specific payment obligations in the indenture were unmodified. Following the amendment of the indenture pursuant to the consent solicitation, the issuer proceeded to divest substantial assets.
The plaintiffs (the non-consenting noteholders) in each case challenged the amendments to the indentures, arguing that they violated Section 316(b) of the Act.
The District Court Decisions and Section 316(b)
The Education Management court declined to grant equitable relief to the plaintiffs who were seeking an injunction to stop the proposed restructuring.iii However, the court went on to explore the merits of their case “in the hopes of providing clarity for subsequent litigation in this and other cases.”iv In this portion of the opinion, ultimately irrelevant to the court’s decision not to grant the injunction, the court concluded that the plaintiffs had demonstrated a likelihood of success in their claim that the proposed restructuring violated the Act.
Section 316(b) provides that “the right of any holder of any indenture security to receive payment of the principal of and interest on such indenture security . . . shall not be impaired or affected without the consent of such holder. . . .”v As previously understood, the Act protects a legal right to seek or demand payment, not a practical right to the principal and interest itself. vi The Act does this by protecting each holder against amendments of certain “core terms”—the most significant of which being the basic obligation to pay principal and interest on specified dates—without unanimous consent. The Education Management court, however, reasoned (based largely on its review of an unpublished court case and the legislative history of the Act) that the Act should be read as “a broad protection against nonconsensual debt restructurings” protecting each noteholder’s “substantive right to actually obtain” payment, and not merely the “legal entitlement to demand payment.”vii
Based on this reasoning, the Education Management court found that the proposed restructuring would “effect a complete impairment of dissenters’ right to receive payment” and was therefore illegal under the Act.viii According to the court, Section 316(b) “was intended to force bond restructuring into bankruptcy where unanimous consent could not be obtained.”ix
Citing favorably the reasoning in Education Management, the Caesars court concluded that the plaintiffs’ allegations were sufficient to state a claim under Section 316(b).x According to the court, the removal of the parent guarantee was “an impermissible out-of-court debt restructuring achieved through collective action[;] . . . exactly what [Section 316(b)] is designed to prevent.”xi
A Recent Restructuring and the Cases
A team of Kaye Scholer attorneys drawn from the Finance, Bankruptcy & Restructuring and Corporate groups recently completed an out-of-court debt restructuring of one of the firm’s clients (the Company). An essential component of the restructuring was an offer to exchange the Company’s existing senior notes for new PIK notes and equity in the restructured company and thereby reduce the Company’s debt service burden. Pursuant to a related consent solicitation, the indenture governing the existing notes was amended to delete substantially all of its restrictive covenants, many of which would have otherwise prohibited essential components of the debt restructuring. Ninety-nine percent of the existing Company noteholders participated in the exchange offer, which we were able to complete in seven days, and all of the tendering holders consented to the proposed amendments.
Significantly, and unlike Education Management and Caesars, the Company consent solicitation did not strip the guarantees associated with the existing notes. Furthermore, while the successor obligor provisions contained in the Company indenture were deleted, the Company’s planned restructuring did not include a sale of all or substantially all of the Company’s assets in a manner that would leave the non-tendering noteholders with a shell company obligor.
The Education Management and Caesars decisions leave room for broad interpretation by future courts. Consequently, the full extent of their impact on bond issuers’ ability to complete debt restructurings outside of bankruptcy court is not yet clear. Among various issues, the broad language of these opinions could make it difficult to determine at the outset of any restructuring whether the proposed deletion or material modification of any indenture covenant “impairs or affects” a bondholder’s right to receive payment in a manner contrary to these rulings. Indeed, the deletion of any covenant will, to some degree, impair or affect a bondholder’s substantive right to actually obtain payment. Furthermore, it should be noted that amendments of indentures governing bonds that have not been registered under the Securities Act of 1933, and are therefore not subject to the Act, may be impacted by these decisions as a matter of contract interpretation since nearly all indentures contain language that mirrors Section 316(b). xii As a note to legal practitioners, until the full extent of the Education Management and Caesars decisions becomes clear, any legal opinion delivered in connection with an out-of-court debt restructuring should contain appropriate disclosure of the decisions.
Finally, while we await further guidance from the courts, one point is clear: the deletion of guarantees and successor obligor provisions in future tender and exchange offers and consent solicitations should be approached cautiously and evaluated in light of these decisions.