In a highly anticipated decision, a divided panel of the U.S. Court of Appeals for the Second Circuit ruled in Marblegate Asset Mgmt., LLC v. Educ. Mgmt. Corp., 846 F.3d 1 (2d Cir. 2017), reh’g denied, No. 15-2124 (2d Cir. Mar. 21, 2017), that an out-of-court debt restructuring which impaired the practical ability of noteholders to be repaid did not violate section 316(b) of the Trust Indenture Act of 1939 (the "TIA"), because it did not amend an indenture’s "core payment terms." The Second Circuit’s decision reversed a 2014 district court ruling, which had concluded that section 316(b) provides "broad protection against nonconsensual debt restructuring" and prohibits such restructuring transactions if they adversely impact a noteholder’s practical ability to be repaid. See Marblegate Asset Mgmt. v. Educ. Mgmt. Corp., 75 F. Supp. 3d 592, 610 (S.D.N.Y. 2014).

The Trust Indenture Act

The TIA was enacted to provide protections to holders of debt securities whose indentures are qualified under the statute. 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, 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 . . . .

15 U.S.C. § 77ppp(b). Section 316(b) protects minority bondholders by prohibiting a majority from agreeing to modify the bondholder’s right to receive payment without the consent of each minority bondholder.

Marblegate

In 2014, section 316(b) came under judicial scrutiny when for-profit education company Education Management Corp. ("EDMC") restructured approximately $1.3 billion in secured debt and $217 million in unsecured notes, which were issued by EDMC’s subsidiaries, by means of an out-of-court exchange offer. Under the restructuring, secured creditors of EDMC’s subsidiaries foreclosed on their collateral and transferred those assets to a newly formed subsidiary of EDMC. In addition, the secured creditors released the guaranty of their debt by EDMC, which caused a release of EDMC’s guaranty of the unsecured notes pursuant to the terms of an indenture that was qualified under the TIA. Although the transaction did not amend the unsecured notes’ payment terms (or the indenture at all), dissenting noteholders were left with nothing but claims against the EDMC subsidiaries, which at that point had no assets.

Two noteholders (collectively "Marblegate") sued to enjoin the exchange offer, alleging that it violated section 316(b) by effectively depriving them of the practical ability to collect on the notes. Relying on a 1999 decision, the district court denied Marblegate’s motion for a preliminary injunction due to the adequacy of Marblegate’s legal remedies but found that Marblegate would likely succeed on the merits of its claims under the TIA. See Marblegate Asset Mgmt. v. Educ. Mgmt. Corp., 75 F. Supp. 3d 592 (S.D.N.Y. 2014) (relying on Federated Strategic Income Fund v. Mechala Grp. Jamaica Ltd., 1999 BL 8776 (S.D.N.Y. Nov. 1, 1999)). Shortly after the court handed down this ruling in December 2014, a different judge in the same district broadly interpreted section 316(b) in two cases as likewise prohibiting parties from stripping guaranties from dissenting bondholders in out-of-court restructurings without the bondholders’ unanimous consent. See BOKF, N.A. v. Caesars Entm’t Corp., 144 F. Supp. 3d 459 (S.D.N.Y. 2015); MeehanCombs Global Credit Opportunities Funds, LP v. Caesars Entm’t Corp., 80 F. Supp. 3d 507 (S.D.N.Y. 2015). EDMC proceeded with the exchange offer, but as a consequence of the district court’s ruling, EDMC altered certain terms to protect Marblegate’s rights in the event of a final ruling in Marblegate’s favor, including removal of the parent guaranty cancellation. EDMC then sought a declaration from the court that cancellation of the parent guaranty as part of the exchange offer did not violate section 316(b) of the TIA.

The district court ruled in Marblegate’s favor on the merits of its TIA claim. See Marblegate Asset Mgmt., LLC v. Educ. Mgmt. Corp., 111 F. Supp. 3d 542 (S.D.N.Y. 2015). The district court explained that at least two courts had ruled that section 316(b) "protects only the legal right to demand payment, rather than any substantive right to receive it, and thus that only formal modification of the right to sue or the payment terms impairs or affects the right to demand payment" (citing YRC Worldwide Inc. v. Deutsche Bank Trust Co. Am., 2010 BL 149963 (D. Kan. July 1, 2010; In re Nw. Corp., 313 B.R. 595 (Bankr. D. Del. 2004)). However, the court also noted that at least two other courts had interpreted section 316(b) more broadly as protecting a bondholder’s right to receive payment, ruling that a debt restructuring depriving dissenting bondholders of assets against which to recover violates the TIA (citing MeehanCombs, 80 F. Supp. 3d at 515; Mechala, 1999 BL 8776 at *5–7).

Reaffirming its previous conclusion that the text of section 316(b) "lends itself to multiple interpretations," the district court in Marblegate reexamined the legislative history and purpose of the TIA but ruled, as before, that "they support[ ] a broad reading meant to inhibit involuntary debt restructurings outside the formal mechanisms of bankruptcy." After thoroughly canvassing the legislative history—including a 1936 report of the Securities and Exchange Commission (the "SEC"); the language of proposed 1937 legislation and the 1938 predecessor to the TIA; testimony; debates; commentary; congressional reports; and an SEC manual from June 1958 which analyzed section 316(b)—the district court concluded that: (i) a series of textual changes to what became section 316(b) demonstrates that the TIA’s protections were broadened from a mere right to sue into a more substantive right; and (ii) the purpose of the TIA, as expressed consistently throughout its legislative history, is "to prevent precisely the nonconsensual majoritarian debt restructuring that occurred here, even if the [TIA’s] authors did not anticipate precisely the mechanisms through which such a restructuring might occur." The district court accordingly ruled that cancellation of the EDMC guaranty would violate section 316(b).

The Second Circuit’s Ruling

A divided Second Circuit panel reversed, concluding that section 316(b) of the TIA "prohibits only nonconsensual amendments to an indenture’s core payment terms." Adopting this narrow reading of section 316(b), the majority wrote that "[a]bsent changes to the Indenture’s core payment terms . . . Marblegate cannot invoke Section 316(b) to retain an ‘absolute and unconditional’ right to payment of its notes."

At the outset, the Second Circuit noted that the "core disagreement" in the case is whether the phrase " ‘right . . . to receive payment’ [in section 316(b)] forecloses more than formal amendments to payment terms that eliminate the right to sue for payment." The court agreed with the district court’s finding that the statutory language is "ambiguous insofar as it ‘lends itself to multiple interpretations’ that arguably favor either side on that issue."

"On the one hand," the majority explained, "Congress’s use of the term ‘right’ to describe what it sought to protect from non-consensual amendment suggests a concern with the legally enforceable obligation to pay that is contained in the Indenture, not with a creditor’s practical ability to collect on payments." On the other hand, Marblegate’s "broad reading" of the term "right" as including the ability to collect payments leads to "both improbable results and interpretive problems." Such a broad interpretation, the majority reasoned, "would transform 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."

Having concluded that the language of section 316(b) is ambiguous, the majority relied upon the legislative history of the TIA, as well as its expressed concern about the "workability" of Marblegate’s interpretation.

Initially, the majority concluded that "Congress did not intend the broad reading that Marblegate urges and the District Court embraced." According to the majority, the drafters of the TIA were "well aware of the range of possible forms of reorganization available to issuers, up to and including foreclosures like the one that occurred in this case but that the District Court concluded violated Section 316(b)." Foreclosure-based reorganizations, the majority explained, were widely used at the time of the TIA’s drafting. However, the legislative history of the TIA and section 316(b) indicates that section 316(b) does not prohibit foreclosures even when they affect a bondholder’s ability to receive full payment. Instead, the majority wrote, "the relevant portions of the TIA’s legislative history exclusively addressed formal amendments and indenture provisions like collective-action and no-action clauses."

Next, the majority examined what it characterized as an "additional difficulty" with Marblegate’s broad interpretation of section 316(b) and addressed a "potential concern" with its holding. According to the majority, Marblegate’s approach would require a determination in every case as to whether a challenged transaction constitutes an "out-of-court debt restructuring . . . designed to eliminate a non-consenting holder’s ability to receive payment." This approach, the majority noted, "turns on the subjective intent of the issuer or majority bondholders, not the transactional techniques used." The majority explained that the Second Circuit has previously "expressed a particular distaste" when interpreting "boilerplate indenture provisions based on the ‘relationship of particular borrowers and lenders’ or the ‘particularized intentions of the parties to an indenture,’ both of which undermine ‘uniformity in interpretation.’ "

The Second Circuit majority rejected Marblegate’s argument that the right to receive payment is "impaired" within the meaning of section 316(b) "when the source of assets for that payment is deliberately placed beyond the reach of non-consenting noteholders." According to the majority, such a description could apply to "every foreclosure in which the value of the collateral is insufficient to pay creditors in full." The court also rejected the argument that section 316(b) "permits ‘genuinely adversarial’ foreclosures but prohibits the type of foreclosure that occurred here." The majority wrote that "neither the text nor the legislative history of Section 316(b) supports a distinction between adversarial and ‘friendly’ foreclosures."

Limiting section 316(b) to formal indenture amendments of core payment rights, the majority explained, "will not leave dissenting bondholders at the mercy of bondholder majorities." Specifically, the majority noted, Marblegate and other similarly situated creditors have recourse in the form of "State and federal law remedies," such as the imposition of successor liability and fraudulent transfer avoidance. Moreover, "sophisticated creditors, like Marblegate, can insist on credit agreements that forbid transactions like [the one at issue]."

Thus, because the Marblegate transaction neither amended any of the terms of the indenture nor prevented any dissenting bondholder from exercising its legal right to sue to collect on its bonds, the majority concluded that the exchange offer did not violate section 316(b) of the TIA.

Dissenting Opinion

In a dissenting opinion, Judge Chester Straub examined whether section 316(b) prohibited EDMC "from engaging in an out-of-court restructuring that is collusively engineered to ensure that certain minority bondholders receive no payment on their notes, despite the fact that the terms of the indenture governing those notes remain unchanged." Judge Straub concluded that the plain meaning of section 316(b) "compels" the conclusion that such conduct is prohibited and, for this reason, would have affirmed the ruling below.

Judge Straub was persuaded by Marblegate’s reading of section 316(b); that is, "the right to receive payment is ‘impaired’ or ‘affected’ when the ability to receive payment under the bond is stripped away—not only through formal amendment of a bond’s payment terms, but also by other means." He rejected EDMC’s argument that "[n]othing in Section 316(b) . . . entitles bondholders to actual payment on their notes," emphasizing that the argument "nearly eliminates the import of the terms ‘impair’ and ‘affect’ and imposes qualifications in Section 316(b) that simply do not exist." According to Judge Straub, even if the term "right" in section 316(b) were defined as a "legal entitlement" or "claim," it is "unquestionable that the ‘right’ to receive payment can be ‘diminished’ or ‘affected’ without actual modification of the payment terms of the indenture."

If Congress "intended merely to protect against modification of an indenture’s payment terms," Judge Straub wrote, "it could have so stated," yet nothing in the express language of section 316(b) limits the prohibition on impairing or affecting the right to receive payment to "mere amendment of the indenture."

Finally, in his dissent, Judge Straub noted that "Congress recently abandoned two proposals to amend § 316(b), first through a 2015 highway bill rider and then through an omnibus appropriations legislation rider." These proposals would have amended section 316(b) to provide that bondholders’ rights would not be impaired under the circumstances present in Marblegate and Caesars. Recognizing that the bond market "has surely undergone significant alterations since the enactment of the TIA, including that the main players are now sophisticated corporate entities on both sides," Judge Straub wrote that the court should refrain "on its own accord" from altering the TIA, adding that " ‘none of this establishes why the plaintiffs should be barred from vindicating their rights under the [TIA]’ as it currently stands" (citation omitted).

Outlook

In jurisdictions that are bound by, or adopt, the Second Circuit’s decision, the effect will be to narrow substantially the grounds for attacking out-of-court restructurings based on section 316(b). Companies seeking to effectuate an out-of-court restructuring involving an exchange offer or consent solicitation of outstanding bonds that does not amend the indenture to impair core payment terms will likely take comfort in Marblegate. Conversely, nonconsenting bondholders will likely be more hesitant to challenge such a transaction under section 316(b).

Marblegate came closely on the heels of another significant ruling concerning the application of section 316(b) of the TIA to exchange offers. In Waxman v. Cliffs Natural Resources Inc., 2016 BL 406073 (S.D.N.Y. Dec. 6, 2016), the district court dismissed a complaint alleging that a debt-for-debt exchange offered only to institutional investors and non-U.S. persons, with no related consent solicitation, violated section 316(b).

In 2016, Cliffs Natural Resources Inc. ("Cliffs") commenced an offer to exchange outstanding unsecured notes for new secured notes with a lower principal amount and a higher interest rate. Two noteholders who were not eligible to participate in the exchange offer commenced class action litigation alleging that the exchange offer was barred by section 316(b) because it impaired their ability to collect on their notes by effectively subordinating their unsecured notes to the proposed new secured notes. The court granted Cliffs’ motion to dismiss the complaint.

According to the court, section 316(b) "sprang from concerns about majorities abusing minority holders, which did not occur here." It explained that, unlike in the cases broadly interpreting section 316(b), there was no vote or majority action of any kind and "there was no de facto bankruptcy reorganization executed outside the supervision of a bankruptcy court, as required by this set of cases." In fact, the court emphasized that "none of the indicia of an involuntary, out-of-court pseudo-bankruptcy outlined in the instructive cases" was present: (i) the plaintiffs were not "forced to relinquish claims" outside bankruptcy court protections, nor were they left with "no practical ability to receive payment" by virtue of the effective subordination of the plaintiffs’ notes; and (ii) the exchange offer did not dispose of any assets, amend any terms of the indentures, or modify or remove any guaranty or collateral. In short, the court wrote, the plaintiffs "were not left holding a ‘worthless right to collect principal and interest.’ " Jones Day represented Cliffs in the Cliffs litigation.

Taken together, Marblegate and Cliffs suggest that, although the pendulum previously had swung in favor of a broad reading of the protections given to noteholders under section 316(b) in connection with exchange offers, it is now swinging in the opposite direction.

On March 21, 2017, the Second Circuit denied Marblegate’s petition for rehearing en banc of the court’s decision in Marblegate.