Bondholders have long feared "the tyranny of the majority" and historically have found limited comfort in a provision of the Trust Indenture Act (the "TIA") that provides minority bondholders with a veto over proposed legal modifications to core payment terms. In the immediate wake of the Second Circuit's recent decision in Marblegate Asset Management v. Education Management Corporation,1 (overturning the 2014 District Court decision and narrowing the practical protective scope of the TIA) some commentators have declared that it is now "open season" for companies and their restructuring advisors to design aggressive and coercive exchange offers, at the expense of minority bondholders.
This analysis overlooks the words of the decision. The Second Circuit actually declared that its decision "will not leave dissenting bondholders at the mercy of bondholder majorities" and specifically articulated a range of legal theories that minority bondholders may use in litigation to enforce their rights.
This client alert describes the decision and lists legal theories that bondholders may invoke when faced with a coercive out-of-court restructuring that intends to eviscerate the core payment terms provided for in an indenture.
The 2014 District Court decision in Marblegate3 and the 2015 District Court decision in Caesars4 shook up the industry's long-held assumptions about the reach of Section 316(b) of the TIA, a Depression-era statute governing bond indentures. Section 316(b) of the TIA was designed to protect certain "sacred rights" of holders of public bonds, and specifically states: "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 indentured 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" (emphasis added).
Prior to these recent District Court decisions, lawyers and bondholders understood Section 316(b) of the TIA to guarantee only a "legal" right to core payment terms (e.g, payment of principal or interest, maturity date, and the ability to enforce those terms). In other words, impairing a bondholder's "practical" ability to receive payment by a restructuring would be permitted so long as the indenture's "sacred rights" were unchanged. This understanding began to change when the Marblegate and Caesars District Court decisions held that non-consensual out-of-court restructurings could violate Section 316(b) ifthey materially affected an issuer's practical ability to perform its payment obligations through a disposition of asset, removal of guarantees or stripping of covenants which left minority bondholders holding "a worthless right to collect principal and interest."
The Second Circuit reviewed the District Court's Marblegate decision and restored -for now5-the previous understanding of the "legal" versus "practical" debate by holding that Section 316(b) "prohibits only non-consensual amendments to an indenture's core payment terms." By interpreting the TIA as protecting a narrow "legal" interpretation of core payment terms, instead of focusing on practical economic consequences of indenture modifications during a restructuring, the Second Circuit's decision provides more certainty to issuers and majority bondholders that their out-of-court restructurings will be not be disturbed. The decision will also diminish the liklihood of success of an array of recent lawsuits commenced under the TIA, in which bondholders sought to challenge various corporate transactions based on allegations that the transactions made issuers less financially capable of paying their debts.
So where does Marblegate leave holdout bondholders? In the post-Marblegate world, Section 316(b) will no longer be used as leverage against issuers by holdout bondholders, unless actual legal amendments to the sacred core payment terms are made. Instead, as the Second Circuit notes, bondholders will need to rely on other federal and state laws to enforce their contractual agreements and protect themselves from potentially harmful borrower/majority bondholder actions.
To that end, state law provides several avenues for individual bondholders/creditors to pursue recovery from third parties when they believe their ability to collect principal and interest payments have been compromised. Assuming injured bondholders comply with the relevant no-action clauses contained in their indentures6, the following bodies of law may provide a remedy or cause of action against other company entities and potentially, the consenting majority bondholders:
- Fraudulent conveyance statutes: This is the primary body of law to remedy actions by debtors trying to avoid paying their debts. Under New York's fraudulent conveyance statute, a creditor can set aside transfers that are intended to "hinder, delay, or defraud" creditors or that are made without "fair consideration" while the debtor is insolvent. See, e.g., N.Y. Debt. & Cred. Law§§ 273, 276.
- Post-judgment remedies: State law also recognizes post-judgment remedies that facilitate debt collection by creditors, including restraining a judgment debtor's disposition of property and collecting debts from certain transferees. See, e.g., N.Y. C.P.L.R.§§ 5222, 5229, 5225(b).
- Article 9 of the Uniform Commercial Code: Actions by secured lenders in connection with foreclosure and dispositions are generally subject to the requirement of commercial reasonableness. See, e.g., N.Y. UCC § 9-610(b), 9-625(b), (c)(1).
- Successor liability laws: In certain situations (i.e. where assets are sold to a successor company intending to step into the seller's shoes and continue on the business) the minority holders may be able to file suit against successors for performance under the original investment agreement.
- Covenants of good faith and fair dealing: In addition to seeking to enforce specific breaches of covenants (such as breaches of sharing and priority of payment provisions), contracts-including indentures- generally provide a baseline level of protection for the expectations of contracting parties through the implied covenant of good faith and fair dealing. New York's implied covenant of good faith and fair dealing requires that anyone exercising discretion in enforcing a contract, must act reasonably and may not act arbitrarily, irrationally or in bad faith to deprive the contracting parties the fruits of their bargain.
- Commercial tort claims: (such as Intentional Interference with Contract, Unjust Enrichment and Economic Duress) may also be available depending on the facts and circumstances.
The above list is not meant to be exclusive and the potential success of any claims depends heavily upon the specific factual circumstances. Moreover, the above list does not take into account the various claims that creditors may have if the issuer enters bankruptcy such as: preference, recharacterization, subordination and breaches of fiduciary duty causes of action.
Assuming the Second Circuit's Marblegate decision stands, companies in financial distress will have greater opportunity to implement more aggressive out-of-court restructurings of their TIA registered bond debt, including the use of intercompany sales, releasing guarantees, and stripping other covenants to coerce holdouts to participate. Clients should be aware, however, that they may still possess certain federal and state law rights to help defend against the "tyranny of the majority."