Court holds that TIA § 316(b) prohibits only non‐consensual amendments to an indenture’s core payment terms.

The US Court of Appeals for the Second Circuit limited the ability of minority bondholders to challenge majority-controlled workouts that are implemented out of court (outside the chapter 11 process) in a January 17 ruling in Marblegate Asset Management, LLC et al. v. Education Management Finance Corp. et al.[1]

By a two-one vote, the Second Circuit ruled that section 316(b) of the Trust Indenture Act (TIA)[2] bars contractual but not practical impairment of the payment rights of non-consenting minority holders.

Background

Marblegate arose from a workout. The obligor, in financial distress, negotiated a deal with its creditors in which the relevant obligors would be subject to a foreclosure sale that would effectively eliminate their ability to make any payment to creditors. Under the terms of the deal, creditors were offered debt and equity in a new corporate entity, which would be the recipient of the foreclosed assets. Unsecured bondholders who declined to accept the deal would be left with their debt technically intact, albeit with a claim against now asset-less obligors (and a disclosure document stating that they would not be paid anything). Of the bondholders, 98% consented. Marblegate—holding 2%—did not consent and brought suit.

The claim in Marblegate turned on a hotly debated phrase in section 316(b) of the TIA:

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, except as to a postponement of an interest payment consented to as provided in paragraph (2) of subsection (a) of this section, and except that such indenture may contain provisions limiting or denying the right of any such holder to institute any such suit, if and to the extent that the institution or prosecution thereof or the entry of judgment therein would, under applicable law, result in the surrender, impairment, waiver, or loss of the lien of such indenture upon any property subject to such lien.[3]

The question is whether the phrase “the right. . .to receive payment of the principal and of interest. . .shall not be impaired or affected without. . .consent” means only that indenture provisions governing principal and interest may not be amended without the holder’s consent, or whether the practical ability of the obligor to make payment of those amounts may not be impaired—through other actions or amendments—absent consent.

Marblegate prevailed in district court, where Judge Katherine Failla accepted the latter view, holding that the TIA protects the “ability” of the holder to receive payment. The company argued that the TIA protects only the contractual right to receive payment, and that a transaction that strips assets from an obligor—leaving it contractually bound but unable to meet its obligations—does not violate the TIA.

The company appealed, and the case was brought before the Second Circuit.

Second Circuit Ruling

On January 17, the Second Circuit agreed with the company and reversed the district court’s decision.

Circuit Judge Raymond Lohier (writing for himself and Judge José Cabranes) began by observing that section 316(b) is ambiguous. He expressed concern that a broad ruling would effectively hobble consensual workouts by “transform[ing] a single provision of the TIA into a broad prohibition on any conduct that could influence the value of a note or a bondholder’s practical ability to collect payment.”[4] The majority reviewed the legislative history of the section at length, construing a 1936 SEC report and testimony of then SEC Chairman William O. Douglas and others to support the conclusion.

Circuit Judge Chester Straub dissented, reasoning that the plain text of the TIA barred the transaction. Quoting the district court, he observed that “[t]he text poses two questions: what does the ‘right . . . to receive payment’ consist of, and when is it ‘impaired or affected’ without consent?”[5] He concluded, as had the district court, that limiting the scope of the statute to modifications of contractual payment clauses “nearly eliminates the import of the terms ‘impair’ and ‘affect’ and imposes qualifications in Section 316(b) that simply do not exist.”[6] A right to receive a payment is impaired (“annihilated” in this case, he wrote) when the obligor is stripped of the assets with which it would make payment. Judge Straub noted that the US Congress could have drafted section 316(b) more narrowly to prevent only amendments to indentures had its intent been so limited.

The Second Circuit reversed and remanded to the district court. One remaining issue, related to the survival of a parent guaranty, is left somewhat murky by the text of the decision and this issue may be clarified by the district court on remand. Nevertheless, the essential rule of the case is clear—so long as core payment terms are not amended, section 316(b) of the TIA does not support litigation challenges by non-consenting lenders asserting that the obligor has been stripped of the financial ability to honor those obligations.

Key Takeaways

The Second Circuit’s decision will likely help debtors and bondholder groups seeking to effect restructurings outside of chapter 11. Holdouts who object to exchange treatment that impairs the practical ability of the obligor to satisfy their claims—but not their technical contractual right to be paid—will not prevail under the TIA.

The panel ruling in Marblegate may not be the last word. En banc review in the Second Circuit is rare, but this is the kind of case that might interest the full court, given the significance of the issue and the panel split.