The Second Circuit has answered the question that many issuers, indenture trustees and noteholders have struggled with over the last couple of years—what actions (in connection with a restructuring or other liability management transaction) subject the issuer, and the indenture trustee, to claims that they are violating provisions of the Trust Indenture Act in implementing the proposed transaction? The Second Circuit’s answer, provided in its ruling in the Marblegate Asset Mgmt., LLC v. Educ. Mgmt. Corp., 2017 WL 164368 (2d. Cir. Jan. 17, 2017), is clear: section 316(b) of the Trust Indenture Act only restricts amendments to an indenture’s core payment terms, absent the consent of each noteholder. What section 316(b) does not do, according to the Second Circuit, is prohibit issuers from taking other actions that ultimately affect minority debt holders’ ability to collect under the indenture, including negotiating out-of-court restructurings of the notes with a majority of debt holders if such actions do not include changing the indenture’s core payment terms. The Second Circuit’s decision provides clear guidance (and likely quite a bit of relief) to indenture trustees and others who conduct business in distressed industries.

Section 316(b) of the TIA

As a refresher, the Trust Indenture Act of 1939 (the “TIA”), 15 U.S.C. § 77aaa et seq., provides various requirements for indenture trustees and issuers with respect to securities issued under TIA-qualified indentures. Despite its relatively uneventful history, in the last few years the TIA has been the subject of significant litigation, as well as many panel discussions and articles, with the market focused on one particular provision of the TIA—section 316(b). That section 316(b) was drafted to protect the “moms and pops”—those noteholders who want to get paid on their notes on the terms agreed in the indenture, even if other noteholders, or all of the other noteholders, are willing to agree to modified terms in connection with an issuer’s attempt to strengthen its financial condition (and perhaps increase the likelihood of repayment for all noteholders). Section 316(b) provides:

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[.]

15 U.S.C. § 77ppp(b) (emphasis added). Section 316(b) of the TIA cannot be waived or excluded from an indenture subject to the TIA. Accordingly, outside of bankruptcy, a majority of noteholders cannot affect an individual noteholders’ right to payment of principal or interest. But, what does that mean?

Several relatively recent restructurings were challenged by minority noteholders claiming that certain transactions sanctioned by the majority noteholders and permitted under the terms of the indenture nevertheless violated the TIA. The District Court for the Southern District of New York determined in the Marblegate case that section 316(b) protects minority noteholders’ practical, not merely legal, right to payment, and section 316(b) is violated whenever the transaction affecting the noteholders’ right to payment effects an involuntary debt restructuring.

The issuer appealed the Marblegate district court’s decision to the Second Circuit, which (as noted above) disagreed with the district court, ruling instead that section 316(b) is intended to only protect a debt holder’s legal right to payment, as set forth in the indenture’s terms.

To provide the setting for the Second Circuit’s analysis, the facts of the challenged restructuring in the Marblegate-EDMC litigation follow.

Overview of Marblegate-EDMC Litigation

In 2014, Education Management Corporation and certain of its affiliates (“EDMC”), for-profit education companies, negotiated an out-of-court restructuring with the majority of its debt holders. Prior to the restructuring, EDMC had US$1.305 billion in secured debt and US$216 million in unsecured notes. Relevant here, the unsecured notes were qualified under the TIA. The notes were issued by an EDMC subsidiary, with EDMC guaranteeing the subsidiary’s obligations to the noteholders. The notes’ indentures provided that the guarantee could be released either by a majority vote of the noteholders or by a corresponding release of the guarantee by the secured lenders.

The EDMC restructuring provided the secured term lenders with new debt and equity in a new EDMC subsidiary (for a 55 percent recovery of value), while holders of the unsecured notes received equity amounting to approximately a 33 percent recovery of value. The secured lenders released the EDMC guarantee, which pursuant to the indenture was to result in the release of the noteholders’ guarantee as well. The lenders foreclosed on the assets of the EDMC entities and then sold the assets back to a new subsidiary of EDMC. The debt and equity distributions were made by this new subsidiary. Only consenting creditors were entitled to distributions from the new subsidiary. Those non-consenting creditors were left to assert their claims against the original EDMC obligors, who, after the sale, no longer had any assets to satisfy the claims. As summarized by the district court, “although the Intercompany Sale would not formally alter the dissenting Noteholders’ right to payment on their Notes, it was unequivocally designed to ensure that they would receive no payment if they dissented from the debt restructuring.”

Marblegate Asset Management, a holder of the unsecured notes, first filed a motion seeking to enjoin the proposed restructuring, arguing that it violated section 316(b) of the TIA because it impaired, without Marblegate’s express consent, its right to payment. The court denied the motion for a preliminary injunction on the basis that Marblegate had adequate remedies at law, but the court also found that Marblegate would likely succeed on the merits of its claims under the TIA.

EDMC proceeded with the restructuring in 2015, and Marblegate sought declaratory and monetary relief based on its continued assertions of violations under the TIA. In light of the district court’s earlier decision regarding the preliminary injunction, EDMC did not release the parent guarantee in favor of the noteholders, but instead filed a counterclaim against Marblegate, seeking a declaration that the guarantee could be released without violating the TIA.

The district court sided with Marblegate, finding that the right protected in section 316(b) of the TIA was to be interpreted broadly, consistent with the legislative history. See Marblegate Asset Mgmt., LLC v. Educ. Mgmt. Corp., 111 F. Supp. 3d 542, 556-57 (S.D.N.Y. 2015). The purpose of the TIA, stated the district court, was to ensure that minority bondholders would not “be forced to relinquish claims outside of the formal mechanisms of debt restructuring.” As such, while EDMC’s proposal did not directly amend any term explicitly governing any individual bondholder’s right to receive payment, it did give “dissenting bondholders a Hobson’s choice: take the common stock, or take nothing.” The threat of total deprivation was “without resort to the reorganization machinery provided by law.” As such, and while recognizing the potentially troubling implications of rewarding holdouts, the court concluded that it was “beyond peradventure” that section 316 of the TIA was violated by EDMC’s actions. EDMC appealed the district court’s decision to the Second Circuit.

Second Circuit’s Analysis

The issue before the Second Circuit was whether the release of the parent guarantee of the notes would violate section 316(b) of the TIA. The court of appeals, as courts typically do, looked first to the statute’s language for an answer, noting that the “core disagreement” between the parties was whether the phrase “right… to receive payment” in section 316(b) of the TIA has the effect of prohibiting more than formal amendments to the indenture’s terms that would eliminate the right to sue for payment. 2016 WL 164368, at *4. Like the district court, the court of appeals found the statute’s language ambiguous, requiring the court to review the legislative history of this provision. That review, however, led the court of appeals to a conclusion opposite of that reached by the district court.

The district court’s ruling that section 316(b) protects noteholders’ practical rights to repayment was based in part on its view that Congress, at the time the TIA was enacted, understood involuntary out-of-court restructuring to operate in a straightforward fashion, with a majority of bondholders voting to amend the payment or interest provisions of the indenture. According to the district court, Congress at the time did not contemplate the various mechanisms (such as foreclosure) that issuers and majority noteholders could use to effect nonconsensual reorganizations. If they had, the district court believed that they would have intended for TIA section 316(b) to protect minority noteholders in those circumstances. The Second Circuit disagreed. It concluded that Congress was in fact aware of the various out-of-court mechanisms that parties could potentially use to restructure obligations under an indenture and nonetheless limited minority noteholders’ rights to those legal rights set forth in the indenture.

In so holding, the Second Circuit cited provisions in an eight-part report published by the Securities and Exchange Commission (SEC) starting in 1936, which demonstrated, according to the Second Circuit, that the SEC report drafters (and by inference the drafters of the TIA) were well aware that reorganizations could be achieved through foreclosure, but were instead focused on the lack of judicial supervision in a “‘reorganization by contract,’ not foreclosure-based reorganizations.” Id. at *8. The Second Circuit also cited to testimony of then-SEC Chairman William O. Douglas, the “main proponent” of the proposed TIA, during which Douglas stated that the effect of what is now section 316(b) “is merely to prohibit provisions” authorizing the majority to force a non-consenting holder to certain changes in its right to payment. Douglas said “[i]n other words, this provision merely restricts the power of the majority to change those particular phases of the contract.” Id. (In support of its broader read of the legislative history, the district court stated that Douglas understood that the provision that would become section 316(b) was intended to prevent “a majority forcing a non-assenting security holder to accept a reduction or postponement of his claim for principal.” 111 F. Supp. 3d at 550 (internal citations omitted).

Ultimately, the Second Circuit said that it was convinced by its review of the legislative history that, in enacting section 316(b) of the TIA, “Congress sought to prohibit formal modifications to indentures without the consent of all bondholders, but did not intend to go further by banning other well-known forms of reorganizations like foreclosures.”[1] 2017 WL 164368, at *10.

The court of appeals highlighted the unpredictability it would be introducing if it were to adopt Marblegate’s interpretation of TIA section 316(b), focusing on the subjective nature of the test articulated by the district court—whether the issuer and/or majority bondholders intended to eliminate a non-consenting holder’s ability to receive payment as part of an out-of-court restructuring. The court stated that this subjective test would undermine the possibility of uniform judicial interpretation of the TIA on this issue. Indeed, earlier in its opinion, the court of appeals noted the “improbable results and interpretative problems” that would result under Marblegate’s broad interpretation of the clause “right…to receive payment.”

Indenture trustees, issuers and bondholders (and their counsel) already were feeling the effects of the broad interpretation. Transactions previously treated as relatively routine became suspect, and in some cases dissenting minority bondholders brought litigation seeking to bar those transactions as violating the TIA under the expanded interpretation of section 316(b). See, e.g., Waxman v. Cliffs Natural Resources Inc., 2016 WL 7131545 (S.D.N.Y. Dec. 6, 2016).

In Cliffs the district court held that a private exchange offer that was only open to certain institutional investors and non-US holders did not violate the TIA. Cliffs Natural Resources Inc., a mining and natural resources company faced with falling commodities prices, announced a private debt exchange in January 2016. Cliffs offered to exchange certain series of unsecured senior notes for newly issued senior secured notes. Although exchanging holders accepted a significant haircut, they received a higher interest rate, a lien on certain assets of Cliffs with a priority between the first lien and second lien notes, and guarantees by Cliffs’ subsidiaries.

The existing unsecured notes were registered under the Securities Act of 1933 (the “Act”), but the exchange offer was structured as a private placement and accordingly the only holders who were eligible to participate were (i) qualified institutional buyers or “QIBs” (as defined in Rule 144A of the Act) and (ii) non-US persons (as defined in Rule 902(k) of Regulation S of the Act). This is a common mechanism used by issuers to avoid the expense and additional time required in a registered offering.

The plaintiffs were holders of the existing unsecured notes but, as domestic non-QIBs, not eligible to participate in the exchange. They commenced a class action alleging that the exchange offer violated the TIA, arguing that the exchange offer impaired their rights to receive principal and interest because their notes were now effectively subordinated to the new secured notes.

The plaintiffs conceded that they had no TIA claim under the narrow interpretation of section 316(b), but argued instead that the exchange was impermissible under the expanded interpretation. The district court disagreed, noting that even under the broad interpretation of section 316(b), a transaction would not be suspect unless it included “at least: (1) a transfer of assets; or (2) removal or material modification of inter-corporate guarantees or security interests” 2016 WL 7121545, at *5. The exchange offer conducted by Cliffs involved none of these and had no indicia of a de facto out-of-court reorganization, and the court therefore rejected the plaintiffs’ argument that an exchange offer not open to non-QIBS violated the TIA.

The Second Circuit’s ruling will reduce the challenges raised—and importantly the threat of these challenges—to liability management transactions, at least in this circuit. Issuers, noteholders and particularly indenture trustees have been operating with little direction on whether proposed amendments, collateral releases or exchanges will later be deemed part of an out-of-court restructuring that runs afoul of the TIA. That is no longer the case. (It will still be possible for these transactions to be challenged under state and federal law, with possible claims including breach of fiduciary duty, fraudulent transfer, and successor liability, but these claims have always been available to noteholders, and clearer parameters for such claims are available in the case law.)

The Second Circuit’s decision, which we believe will be strong persuasive authority for other courts given its careful, reasoned analysis, provides clear guidance and comfort to parties in working with issuers on liability management transactions and out-of-court restructurings. The rule for now in the Second Circuit is this: Amendments to indentures’ core payment terms violate section 316(b) of the TIA absent 100 percent consent. Amendments to other provisions of indentures, implemented as part of restructuring or liability management transactions or otherwise, do not violate section 316(b) of the TIA, even if dissenting debt holders’ rights to payment are affected.

[1] The Second Circuit narrowed the relevance of language relied on by the district court (stating that “the bill does place a check or control over the majority forcing on the minorities a debt-readjustment plan”), arguing that that language was intended to relate more “exclusively” to a discussion on collective-action clauses. The Second Circuit went on to cite testimony of Edmund Burke, Jr., referred to as the principal drafter of the TIA, as well as provisions of an SEC Report that was published shortly after the TIA was enacted. That report, stated the Second Circuit, clearly demonstrates that Congress knew of foreclosure-based reorganizations and was not unaware of these mechanisms, as suggested by the district court.