Several recent cases in the United States District Court for the Southern District of New York have created ambiguity about when distressed exchange offers violate Section 316(b) of the 1939 Trust Indenture Act (the “TIA”). It appears that plaintiffs’ lawyers are using this ambiguity to challenge distressed exchange offers. The threat of litigation may give minority bondholders a powerful tool to hinder less than fully consensual out-of-court restructurings and provide them with increased leverage in negotiations.

Section 316(b) of the TIA states that:

Notwithstanding any other provision of the indenture to be qualified, the 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 separate cases last year, plaintiffs used this provision to challenge restructurings by Education Management LLC,1 and Caesars Entertainment Operating Co. Inc. (“CEOC”).2 Education Management had taken out secured loans and issued unsecured bonds, both backed by a guarantee of its parent, Education Management Corp (“EDMC”). In 2014, a financially distressed EDMC negotiated an out-of-court restructuring agreement which provided for an “intercompany sale” to take place if less than 100% of creditors accepted. Under the terms of the intercompany sale, the secured lenders would release the parent’s guarantee of the secured loans, which (by the terms of the indenture) would automatically release EDMC’s guarantee of the bonds. Education Management’s assets would be transferred to a new subsidiary that would issue debt and equity to creditors who consented to the restructuring. Effectively, bondholders who did not consent to the restructuring agreement would be stuck holding the obligation of Education Management, an empty shell. The plaintiffs were bondholders who did not accept the restructuring agreement. The court held that the restructuring violated Section 316(b) of the TIA, opining that Section 316(b) not only protects the formal legal right to receive payment under an indenture, but also restricts nonconsensual out-of-court debt reorganizations, even where no express terms of the indenture are violated.

The court reached a similar conclusion in cases involving indenture debt issued by CEOC. As part of a restructuring, CEOC amended the indenture to remove the guarantee of its parent and/or modify the restriction on disposing of “substantially all” of its assets. The court held that this also ran afoul of Section 316(b), calling it an “impermissible out-of-court debt restructuring achieved through collective action.”

In neither of these cases did the court provide a well-defined limiting principle for when out-of-court restructurings violate Section 316(b). In the reported cases, the plaintiffs were challenging somewhat unusual restructuring maneuvers. But what about garden-variety changes to principal amount, final maturity, interest rate or time for payment of interest in a distressed exchange offer? It was once assumed that all these were permissible, so long as they were allowed for, or at least not prohibited, under the terms of the particular indentures. As a result of the recent Southern District decisions, market participants are now unsure whether such changes rise to the level of prohibited “out-of-court debt restructurings.”

It appears that plaintiff firms are aware of this murkiness and are attempting to profit from it. In the last few months, three lawsuits challenging distressed exchange offers have been filed on behalf of retail holders of unsecured bonds. Each lawsuit involves registered bonds issued by an energy company — Vanguard Natural Resources LLC; Cliffs Natural Resources; and PetroQuest Energy Inc. — which suffered financial distress from declining oil prices. The company made an offer to noteholders to exchange outstanding unsecured bonds for new secured bonds. The offers, however, were made available only to qualified institutional buyers (QIBs), and retail holders were excluded. In each action, the plaintiffs argued that the exchange violated Section 316(b) because they never consented to having their bonds subordinated to the new secured bonds. These lawsuits all ask damages, but in an appropriate case, plaintiffs might also seek to enjoin a disputed exchange.

The three lawsuits are still in their preliminary stages, and no reported decisions have been rendered. The Education Management case is on appeal to the Second Circuit. Oral argument took place on May 12, 2016, and the case awaits decision. Depending on the outcome, the uncertainty over the interpretation and implementation of Section 316(b) may recede or new issues may arise. In the interim, Section 316(b), which attracted scant attention in the 75 years or so since passage of the TIA, will continue to occupy center stage in the out-of-court debt restructuring arena and, at least for the moment, has become a new weapon in the arsenal of parties challenging out-of-court restructurings.