On January 17, 2017, in a long-awaited decision in Marblegate Asset Management, LLC v. Education Management Finance Corp.,1 the US Court of Appeals for the Second Circuit held that Section 316 of the Trust Indenture Act ("TIA") does not prohibit an out of court restructuring of corporate bonds so long as an indenture's core payment terms are left intact. This is true even if the restructuring leaves the issuer an empty shell without any assets with which to pay on the bonds, which is what happened in the restructuring of Education Management Corporation ("EDMC").

The Second Circuit decision restored greater certainty to corporate bond restructurings following a series of decisions in the Southern District of New York that shook up the industry's long-held assumptions about the reach of Section 316(b) of the TIA.2 Section 316(b) states that "the right of any holder of any indenture security to receive payment of the principal of and interest on such indenture security ... or to institute suit for the enforcement of any such payment ... shall not be impaired or affected without the consent of such holder."3 Until recently, many understood this section to guarantee only a "legal" right to payment. In other words, a bondholder's "practical" right to receive payment may be impaired by a restructuring, and this was permissible so long as the indenture's terms regarding payment and ability to sue on such payment were left unchanged.4 However, in a series of decisions involving challenges to out-of-court restructurings of TIA-qualified bonds issued by Caesars and EDMC, the Southern District of New York held that certain nonconsensual restructurings also violated this section because they materially impacted the issuer's practical ability to perform its payment obligations.5

The Second Circuit's decision resolves-for now, at least-this "legal" versus "practical" right debate by holding that Section 316(b) "prohibits only non-consensual amendments to an indenture's core payment terms."6 There remains some possibility that the decision could be overturned by a rehearing en banc, Supreme Court review, or even further legislation. However, these possibilities are unlikely, meaning that the Second Circuit's decision is likely to inform out-of-court restructurings of TIA-qualified bonds for years to come.

The Transaction and District Court Decision

In 2014, EDMC found itself saddled with $1.5 billion in outstanding debt and an enterprise value of far less. However, a traditional bankruptcy court restructuring was not available to EDMC because, as a for-profit education provider, it would lose its eligibility for Title IV funds if it filed for bankruptcy. EDMC's debt load included $217 million in unsecured debt consisting of bonds issued by a subsidiary and guaranteed by EDMC. EDMC negotiated a proposed restructuring with secured and unsecured creditors that would result in a 55 percent recovery for secured creditors and 33 percent recovery for unsecured creditors. This restructuring, however, required voluntary participation by all creditors, and if such consent was not reached, then the Intercompany Sale would take place. Via the Intercompany Sale, secured creditors would (1) release EDMC's parent guarantee of their loans, triggering the release of EDMC's parent guarantee of the unsecured notes, (2) foreclose on all assets of EDMC and its subsidiaries, and (3) sell those assets back to a new subsidiary of EDMC. This new subsidiary would then distribute debt and equity to the consenting creditors. Thus, even though not a single term of the indenture would be altered, the Intercompany Sale would render the issuer an empty shell, and any non-consenting creditors would be left with worthless notes.

Two Marblegate investment funds ("Marblegate") did not consent to the proposed restructuring and sought to block the Intercompany Sale with a court-issued injunction. After EDMC agreed to keep in place the parent guarantee, the Intercompany Sale went forward. Following a bench trial, the district court held that the restructuring violated Section 316(b) and that EDMC must continue to honor the parent guarantee and pay Marblegate 100 percent on its notes.7 EDMC appealed that decision to the Second Circuit.

The Second Circuit Decision

The Second Circuit reversed on appeal. Its decision examined the text and legislative history of Section 316(b) and discussed the practical implications of interpreting that section to prohibit more than formal indenture amendments. First, the Second Circuit found that the text of Section 316(b) did not resolve the question. The prohibition against impairing or affecting a bondholder's "right … to receive payment" could reasonably be interpreted to prevent restructurings like the one pursued by EDMC. Thus, the Second Circuit agreed with the district court that Section 316(b) is "ambiguous insofar as it 'lends itself to multiple interpretations' that arguably favor either side on that issue."8

Next, the Second Circuit examined the legislative history of the TIA, which was enacted in 1939, through a review of contemporaneous reports and congressional testimony. The Second Circuit concluded that the TIA's drafters 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."9 However, Congress did not intend a broad reading of Section 316(b) that would prevent restructurings such as foreclosures. Rather, the provision was enacted to address formal amendments and indenture provisions like collective-action clauses and no-action clauses.

While resting its holding on an analysis of legislative history, the Second Circuit also addressed an "additional difficulty" it had with the workability of the interpretation of Section 316(b) urged by Marblegate.10 If Section 316(b) prevents an "out of court debt restructuring … designed to eliminate a non-consenting bondholder's ability to receive payment," then a court must examine the "subjective intent of the issuer or majority bondholders, not the transactional techniques used."11 The court observed that such an inquiry would necessarily be fact intensive and would not lend itself to a bright-line rule that may be uniformly applied. The Second Circuit also observed that adopting a narrow interpretation of Section 316(b) would not deprive Marblegate or similar minority/hold-out bondholders in similar situations from still being able to pursue other creditor remedies arising under state law theories of successor liability and fraudulent conveyance.

Dissent: Judge Chester Straub dissented from the majority opinion, arguing that the text of Section 316(b) actually does resolve the issue and does so in favor of protecting a bondholder's practical right to payment. "Nothing in the language … cabins the prohibition on impairing or affecting the 'right … to receive payment' to mere amendment of the indenture."12 Indeed, the restructuring that EDMC carried out "did not simply 'impair' or 'affect' Marblegate's right to receive payment-it annihilated it."13 To the extent such an interpretation led to a "parade of horrors" as predicted by the EDMC, it was the legislature's role to fix it: "We must not forget the longâ€standing imperative that making law is the job of the legislature and not of the courts."14

Impact

The Second Circuit's decision is likely to restore confidence in the legality of out-of-court restructurings and friendly foreclosures such as that used in EDMC, which will in turn lead to more issuers choosing to restructure outside of bankruptcy court. Issuers also may be more willing to do registered offerings rather than private placements.