This week the U.S. Court of Appeals for the Second Circuit issued its highly-anticipated ruling in Marblegate Asset Management, LLC v. Education Management Corp. (“Marblegate”). At issue in Marblegate was whether Education Management Corp. (“EDMC”) violated the Trust Indenture Act when it implemented a restructuring that impaired the rights of Marblegate Asset Management, LLC (“MAM”). The Second Circuit reversed the District Court’s decision in favor of MAM, and held that EDMC’s restructuring did not violate the TIA. The Second Circuit’s majority opinion is narrow and finds that the TIA “prohibits only non-consensual amendments to an indenture’s core payment terms.” The dissenting opinion views the facts from a completely different perspective and states that Section 316(b) should protect bondholders from “collusively engineered” restructurings.

What is Section 316(b)?[1]

Section 316(b) has been traditionally read to prohibit majority bondholders from collusively agreeing to modify a bond’s core terms. Under this interpretation, Section 316(b) prohibits an indenture from allowing “majority actions” to modify core terms of the indenture such as the payment of principal and interest. The terms of Section 316(b) are among those automatically incorporated into indentures.

On its face, the statue seems to be clear and unambiguous in protecting the “right” of a noteholder to receive payment when due and to sue for enforcement of such payment. The statute also prevents a majority of noteholders from modifying an indenture to alter the amount owed or the date on which it much be paid, and from stripping noteholders of standing to sue for payment upon maturity.

Why the Interest in Marblegate’s Appeal?

Courts agree that Section 316(b) is ambiguous and does not address the parameters of what facts actually give rise to a violation of the “right” to receive payment when due and to enforce payment. The interest in Marblegate arises because the stakes are high for issuers, bondholders and indenture trustees in out-of-court restructurings. First, there is a need to protect the value of the issuer and to implement a business-based restructuring that a majority of the issuer’s creditors can support using a process that reduces both legal and business risk to the extent possible. Second, there is a desire to mitigate the risks that arise when there are litigious non-consenting bondholders seeking to prevent the restructuring from proceeding or to exclude themselves from the process. Third, for those issuers that are unable to access chapter 11 because of government contracts or participation in other government programs, the ability to restructure out-of-court is critical to protecting and preserving value for the issuer’s creditors. Out-of-court restructurings should not be “held up” by minority non-consenting bondholders to the point that they cannot reasonably proceed.

What’s the Story?

EDMC, an education company, was facing serious financial challenges. Because of its dependence on federal funding, EDMC was not in a position to file for bankruptcy. After protracted negotiations, EDMC sought to swap $1.2 billion in secured debt for $400 million in refinanced loans plus a controlling equity stake in the reorganized company. EDMC also sought to swap $216 million in unsecured debt, which included MAM’s holdings, for a minority equity position, with existing shareholders retaining a 4% stake.

Unsecured noteholders were offered two options: exchange their debt for equity or retain their notes. If any noteholders chose the latter option, the secured lenders would exercise their contractual rights to foreclose on the issuer’s assets and release a guarantee of the notes by the issuer’s parent company. All noteholders agreed in the indenture that the secured lenders could exercise these rights. The consenting creditors executed a Restructuring and Support Agreement (“RSA”) that provided for among other things an intercompany sale as part of the restructuring.

MAM objected to EDMC’s restructuring and litigation ensued. Positing that EDMC could not do indirectly that which it could not do directly, MAM argued that under Section 316(b) EDMC could not implement a restructuring that stripped them, as non-consenting minority noteholders, of their practical ability to collect payment on their notes. MAM convinced the District Court, after the denial of a preliminary injunction and after the restructuring was essentially completed, that its notes should continue to be guaranteed and should be paid in full. EDMC appealed, arguing that Section 316(b) was not violated because EDMC did not formally amend the payment terms of the indenture that governed the notes.

The Second Circuit majority, after an arduous review of the legislative history behind Section 316(b), reversed and remanded the matter back to the District Court focusing on two themes. First, MAM’s argument that Section 316(b) was violated was held to be unworkable. The Second Circuit found that to adopt such a position would require the reviewing court to make a determination in every case as to whether the challenged restructuring constitutes an out-of-court restructuring designed to eliminate non-consenting holders’ ability to receive payment. Second, the Second Circuit focused on other remedies that were still available to MAM to collect outstanding principal and interest under federal and state law. In the Second Circuit’s view, EDMC’s restructuring did not violate the TIA because MAM could still collect principal and interest due under applicable federal and state law as its rights to pursue collection were not impacted by the restructuring.

To understand the Marblegate ruling, it is helpful to consider the primary terms of EDMC’s restructuring. EDMC’s restructuring process provided for an intercompany sale that occurred in the form of a foreclosure sale that was followed by (1) the secured creditors releasing the secured parent guarantee, (2) the capitalization of the new EDMC subsidiary with the assets of the original EDMC issuer’s assets, and (3) consenting bondholders participating in the debt-for equity exchange.

The issue before the Court was whether Section 316(b) protects a non-consenting bondholder’s right to receive payment through an out-of-court restructuring that essentially eliminates the right to payment but does not change the core terms of the bonds. The Second Circuit said yes in its majority opinion. The dissent said no, asserting that the restructuring process did not simply impair or affect MAM’s right to receive payment, it annihilated it. In contrast, the dissent found that an out-of-court restructuring impairs or affects a non-consenting noteholder’s right to receive payment when it is designed to eliminate a non-consenting noteholder’s ability to receive payment, and when it leaves bondholders no choice but to accept a modification of the terms of their bonds. The majority also found other legal remedies the non-consenting holder could exercise to collect payments due under its bonds.

What Marblegate Means for Bondholders

As the Second Circuit noted, bondholders should consider what changes to credit agreements are necessary to better manage out-of-court restructurings. From a pragmatic perspective, holders often recognize the loss mitigation of an out-of-court restructuring and often want to limit imposing restrictions on the out-of-court restructuring process in a credit agreement or an indenture. It is true that more care needs to be taken in connection with issuers that have government contracts or who participate in government programs that would make initiating a chapter 11 unworkable. The underwriting, disclosure and negotiation of an issuance with this kind of issuer cries out for careful thought in terms of what the parties can agree to and how best to avoid the Section 316(b) trap. Even with the Second Circuit’s recent ruling, the law is neither clear nor predictable as to when an out-of-court restructuring process crosses the line and actually “impairs” or “affects” a non-consenting bondholder’s ability to receive payment. The narrow ruling all but suggests that express modification of the core terms is required. It would be at best risky to rely on this interpretation even though it is arguably a fair statement of what the Second Circuit said.

When implementing an out-of-court restructuring, bondholders need to consider that, absent a bankruptcy filing, there are no bankruptcy protections for the issuer or the bondholders participating. As a result, participants are exposed to third party creditor attacks, particularly those of non-consenting bondholders, seeking payment of unpaid principal and interest and recovery for other damages. Parties participating in the restructuring process would be wise to consider, evaluate and provide for potential third party litigation risk, particularly if there is a litigious non-consenting bondholder.

What Marblegate Means for Trustees

Marblegate has the potential to be a trap for the unwary indenture trustee. A trap, because an indenture trustee has a fiduciary obligation to represent all of the bondholders. This includes the consenting and sometimes directing, majority bondholders and the non-consenting bondholders as well. A first consideration should be well-drafted, documented and circulated notices to all bondholders regarding the out-of-court restructuring process. More notice instead of less in this situation will serve an indenture trustee well. Too often, majority holders direct the indenture trustee to retain counsel to represent the indenture trustee. Often the process focuses almost entirely on the participation and direction of the majority holders with little timely or complete communications to non-participating holders. For an indenture trustee to discharge its fiduciary duty to all of the holders, timely and accurate notices are vitally important. Indenture trustees involved in an out-of-court restructuring processes should retain independent disclosure counsel to help prepare fulsome disclosures, particularly when there are known non-consenting or adverse holders. This eliminates the risk of a one-sided disclosure driven by the majority.

Indenture trustees should also consider the exercise of remedies under the indenture and who is or should be protecting and preserving those remedies. Trustees, in the absence of receipt of appropriate written direction with indemnity, often take the position it is their job to collect principal and interest. In out-of-court restructurings in light of Marblegate, an indenture trustee must evaluate what steps may be necessary to protect and preserve other federal and state law remedies that could be used to collect outstanding principal and interest including, among others, (1) challenges to a foreclosure process, (2) fraudulent transfer claims, and (3) successor liability claims. As with the disclosure process, when there are non-consenting holders, indenture trustees should retain independent legal counsel to represent the trustees in determining what steps need to be taken, if any, to protect and preserve federal and state law remedies under the indenture that could be used to collect unpaid principal and interest.

If asked to participate in an out-of-court restructuring process, trustees should be aware that, absent a bankruptcy process, there are no court ordered releases, no discharges and no winding-up of the trustee’s obligations under the indenture. These are but a few of the issues a trustee needs to consider in negotiating direction letters, appropriate indemnities and releases. This can be particularly complicated if the issuance is secured and collateral must be released. If there is a non-consenting bondholder objecting to the process and seeking to litigate other remedies, the trustee should retain counsel to consider how best to protect the trustee as the restructuring process is implemented.

Lastly, indenture trustees must be cognizant and responsive to the potential and actual conflicts of interests between bondholders. When there is a clear adversarial relationship between holders, an indenture trustee needs independent counsel to advise the trustee on how best to discharge its fiduciary duty to all of the holders. Independent counsel can play a pivotal role in ensuring that the indenture trustee is not caught in the middle of a “no win” fight and that all of the holders receive sufficient (and the same) information necessary to participate fully in the process. When it is clear that the conflict is going to be unresolved, having independent counsel to protect the trustee in connection with actions following the implementation of an out-of-court restructuring is critical.

Conclusion

Marblegate would have been a non-event had EDMC been in a position to use the bankruptcy process to restructure. That being said, issuers and bondholders are focused on and concerned about restructuring expenses gutting the value of the restructuring process. More and more parties are seeking to implement out-of-court restructurings through restructuring support agreements. To the extent the parties think that they can achieve a consensual restructuring out-of-court, Marblegate has reduced the leverage of non-consenting bondholders, who now must evaluate the litigation risk and expense of pursuing other federal and state law remedies to collect outstanding principal and interest. It completely reverses the District Court’s order that EDMC continue to pay principal and interest to MAM.

By not allowing Section 316(b) to be used to disrupt the EDMC restructuring, the Second Circuit has recognized the clear importance of business-oriented consensual restructurings to the detriment of non-consenting bondholders. One has to wonder if the result would have been different if MAM was joined by other non-consenting holders, but the group did not constitute a majority. There is a reason for Section 316(a) and Marblegate’s narrow holding provides little guidance for circumstance that go beyond the bare facts of the case. MAM lost its marbles, but not its right to attempt to collect them again under other federal and state law theories.