In January 2017, a divided panel of the United States Court of Appeals for the Second Circuit issued its widely reported opinion in Marblegate Asset Management, LLC vs. Education Management Corp., in which the majority held that the “right ... to receive payment” set forth in Section 316(b) of the Trust Indenture Act of 1939 (TIA) prohibits only nonconsensual amendments to an indenture’s core payment terms and does not protect the practical ability of bondholders to recover payment.

Background

Education Management Corporation (EDMC), a for-profit provider of higher education, is the parent company of Education Management Finance Corporation and Education Management, LLC (the EDM Issuer). The EDM Issuer had incurred $1.3 billion of secured debt and $217 million of unsecured notes. The unsecured notes were issued pursuant to a TIA-qualified indenture. Both the secured and unsecured debt were guaranteed by EDMC. By late 2014, EDMC’s indebtedness became unsustainable and it sought to restructure its debt.

Since a bankruptcy filing would have caused EDMC to lose significant federal funding, it sought to effect an out-of-court restructuring and ultimately obtained the consent of its creditors to a restructuring consisting of a series of related transactions: (i) the secured lenders would release EDMC’s parent guarantee of the secured debt, thereby triggering an automatic release of EDMC’s parent guarantee of the unsecured notes; (ii) the secured lenders would exercise their contractual rights to foreclose on substantially all of the assets of EDMC and the EDM Issuer; and (iii) the secured lenders would then sell these assets to a newly formed subsidiary of EDMC (New EDM). Creditors that had consented to this restructuring would receive debt and equity in New EDM, while unsecured noteholders who did not consent would receive nothing from New EDM and would be left with claims against the EDM Issuer (which would be an empty shell). Ultimately, the holders of 99% of the secured debt and over 90% of the unsecured notes consented to this out-of-court restructuring. However, Marblegate, an owner of unsecured notes, did not consent to the out-of-court restructuring and sued to enjoin the restructuring.

District Court Proceedings

Marblegate alleged that the proposed EDMC restructuring impaired its right to payment in violation of Section 316(b) of the TIA and of an indenture provision substantially tracking Section 316(b) of the TIA. Section 316(b) of the TIA reads as follows:

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 ...

(Emphasis added).

In alleging a violation of Section 316(b) of the TIA, Marblegate asserted that Section 316(b) forbids not only impairment of a bondholder’s formal right to payment, but also impairment of a bondholder’s practical ability to receive payment. EDMC countered that Section 316(b) prohibits only impairment of the formal right to payment. The district court judge, Judge Katherine Polk Failla, ruled that Marblegate was likely to succeed on the merits of its TIA claim. Although the judge found the language of TIA to be ambiguous, she determined based on legislative history that transactions that “effect an involuntary debt restructuring. ... that seeks to involuntarily disinherit the dissenting minority” would impair a bondholder’s right to payment in violation of Section 316(b). Nonetheless, the district court, balancing the hardships and considering other remedies that would be available to protect Marblegate’s interests, declined to enjoin the restructuring.

Following the district court’s ruling, EDMC consummated most elements of the out-of-court restructuring, but left the EDMC parent guarantee in place, pending a final ruling by the court on the merits. EDMC then counterclaimed, seeking declaratory relief permitting it to remove the EDMC guarantee of the unsecured notes owned by Marblegate. In a subsequent ruling addressing the merits, the district court ruled, consistent with its earlier ruling, that EDMC’s restructuring, if completed, would violate Section 316(b) of the TIA. Accordingly, the court ordered that EDMC continue to guarantee payment of debt service on the unsecured notes owned by Marblegate.

Second Circuit Majority Opinion

The Second Circuit, in a 2-1 opinion, overruled the district court and held that EDMC’s out-of-court restructuring did not violate Section 316(b) of the TIA.1 The Second Circuit majority opinion agreed with the district court that the language of the TIA itself was ambiguous. The majority viewed the word “right” as suggesting a concern with the legally enforceable obligation to pay, not a bondholder’s practical ability to collect payment, and viewed the phrase “impaired or affected” as arguably supporting a broader reading of the statute.

Turning then to Section 316(b)’s legislative history, the Second Circuit majority rejected the district court’s interpretation of that history. The majority held that Section 316(b) of the TIA was intended only to protect against formal amendments to the core payment terms of the indenture without bondholder consent and was not intended to prohibit “other well-known forms of reorganization like foreclosures.” The majority also observed that the district court’s interpretation of Section 316(b) would be difficult to apply, as it would require a court to determine whether a particular transaction is “‘an out of-court debt restructuring ... designed to eliminate a non-consenting holder’s ability to receive payment.’” This in turn may depend on “the subjective intent of the issuer or majority bondholders, not the transaction techniques used.”

The majority concluded that although it narrowed the scope of Section 316(b) of the TIA, it was not leaving dissenting bondholders without recourse:

By preserving the legal right to receive payment, we permit creditors to pursue available State and federal law remedies. ... The foreclosure in this case therefore may be challenged by other creditors under State law. ... Moreover, where creditors foreclose on a debtor’s collateral and sell the collateral to a new entity meant to carry on the business, the debtor’s other creditors may be able to sue the new entity under State law theories of successor liability or fraudulent conveyance . ...

Second Circuit Dissenting Opinion

Judge Chester Straub issued a dissenting opinion in which he disagreed with both the district court and the Second Circuit majority opinion and held that the plain language of Section 316(b) of the TIA prohibits an issuer from “engaging in an out-of-court restructuring that is collusively engineered to ensure that certain minority bondholders receive no payments on their notes.” In the dissent’s view, the fact “that Congress used the broad phrase ‘impaired or affected’ implies that it did not intend Section 316(b) to be limited in its scope to mere amendments.” Given Judge Straub’s view of the plain reading of the statute, he felt no need to examine the legislative history. The dissent was also not persuaded by the majority’s policy arguments. While Judge Straub acknowledged that “[c]ertain undesirable consequences might well arise” were his reading to be adopted, the proper remedy for such concerns is legislative action, not judicial action.

Some Observations

The majority’s decision, if not reversed, provides greater flexibility to distressed companies to engage in out-of-court restructurings and exchange offers without risking claims under Section 316(b) of the TIA. Of course, any such out-of-court restructuring would need to comply with the covenants of the governing indentures. The Marblegate decision stands for the proposition that transactions which otherwise comply with an indenture will not be deemed prohibited solely by virtue of Section 316(b) of the TIA, so long as they do not legally impair a right to payment. This highlights the importance of negotiating for proper protections as part of an original issuance and carefully reviewing indenture covenants before purchasing bonds on the secondary market.

As the Second Circuit itself noted, “sophisticated creditors, like Marblegate, can insist on credit agreements that forbid transactions like the Intercompany Sale.” As the Second Circuit noted in its opinion, even if a transaction is not prohibited by the TIA or by the indenture, there may be other federal and state law claims available to dissenting bondholders such as successor liability or fraudulent conveyance claims. In pursuing such claims, the particulars of an indenture’s no-action clause should of course be considered.

Finally, Section 316(b) of the TIA protects two separate bondholder rights against impairment: (i) the right to receive payment and (ii) the right to institute suit for the enforcement of payment. The holding in Marblegate only expressly interprets the scope of the right to receive payment. The Marblegate holding does not specifically address what type of actions a bondholder would be permitted to pursue in exercise of its right to institute suit for enforcement of payment. So, for example, if an issuer were in breach of an indenture covenant with the effect of impairing payment of its bonds, a bondholder may argue that the Section 316(b) right to sue overrides the constraints of the no-action clause in this circumstance. Whether there will be future litigation along these lines remains to be seen.