On January 17, 2016, the United States Court of Appeals for the Second Circuit resolved a major issue that had affected the efficacy of out-of-court restructurings involving notes issued under the Trust Indenture Act when it reversed the decision of the U.S. District Court for the Southern District of New York in Marblegate Asset Mgmt., LLC v. Education Mgmt. Finance Corp.1 In short, the Second Circuit held that the once relatively obscure Section 316(b) of the Trust Indenture Act of 1939 (the “TIA”)2 protects only the limited right of noteholders to sue for payment under the fixed terms of an indenture and not the broad right to actual payment or a “practical ability to collect payment.” Since the District Court issued its decisions3, the adoption of the substantially broader view of Section 316(b) has had a chilling effect on out-of-court restructurings that could have effectively eliminated a troubled company’s ability to implement a non-consensual debt restructuring in a situation involving notes issued under a TIA qualified indenture.4 It has also impacted the commercial decisions of financially healthy issuers in respect of structuring tender offers with “covenant stripping” exit consents and even the initial decision whether or not to issue notes under indentures that are TIA qualified.

EDMC’S Proposed Restructuring

As many investors and industry professionals have come to learn, the Marblegate case arose from the out-of-court restructuring of Education Management’s (“EDMC’s”) approximately $1.5 billion debt burden which consisted of roughly $1.3 billion of bank debt and just more than $200 million of notes governed by an indenture qualified under the TIA. The bank debt was secured by a senior lien on all of the assets of EDMC’s subs, including the issuer of the notes, and both the bank debt and the notes were guaranteed by EDMC as parent of the borrower of the bank debt and of the issuer of the notes. The parent guarantee issued in respect of the notes could be released automatically upon a release of the parent guarantee in favor of the senior bank debt. Because EDMC and its subsidiaries, as a for-profit education enterprise, relied heavily on federal funding, EDMC would lose its eligibility for such funding under federal law if it filed for bankruptcy. Therefore, an EDMC bankruptcy was out of the question.

As a result, EDMC proposed a dual alternative structure to reorganize its debt: one proposal that provided for certain distributions to holders of bank debt and holders of the notes if both groups unanimously consented to the restructuring; and a second option, implemented through a foreclosure sale by the holders of the bank debt, that would result in (i) the release of both parent guarantees, (ii) a sale of the foreclosed assets to a newly formed subsidiary of EDMC, and (iii) distributions of new debt and equity to the secured lenders and equity in the new subsidiary to consenting noteholders. Non-consenting noteholders such as Marblegate would receive nothing under this second option and would lose the parent guarantee, but they retained their right to sue for payment against the EDMC subsidiary that originally issued the notes. That entity, however, would merely be an empty shell after the foreclosure. Marblegate, as a holder of approximately $14 million of notes, was the only hold-out -- 98% of EDMC’s creditors consented to the foreclosure sale transaction. Marblegate first sought to enjoin the transaction in the District Court as a violation of Section 316(b). While the District Court did not enjoin the transaction, it did indicate that Marblegate had demonstrated a likelihood of success on the merits. On that basis, the other parties agreed to leave both parent guarantees (of the bank debt and the notes) in place pending the full trial. Ultimately, the District Court entered a decision and judgment in favor of Marblegate and held that the transaction, particularly the release of the EDMC guarantee of the notes, effectively impaired Marblegate’s ability to collect and thus, violated Section 316(b) of the TIA.

The Second Circuit Reverses

After admitting that the express terms of Section 316(b) were somewhat vague, the majority of the Second Circuit panel nevertheless reversed the District Court by analyzing the Trust Indenture Act as a whole, by reviewing its legislative history in detail, and then by considering the practical, prospective effects of the District Court’s decision if it stood. Specifically, the Second Circuit concluded first that “no other provision in the TIA purports to regulate an issuer’s business transactions, which would be a likely result of Marblegate’s broad reading of Section 316(b).” Second, after conducting what amounted to an exegetical analysis of the legislative history of the Section 316(b), the TIA as a whole, and restructuring methods and techniques employed at the time the law was enacted, the Second Circuit found that nothing in the testimony and reports delivered before or after the enactment of the TIA suggested that Section 316(b) was intended to encompass the practical ability to collect payment in addition to the legal right to sue for payment under the notes. Foreclosures like that proposed in EDMC’s restructuring were long recognized as potential restructuring alternatives and nothing in the TIA was intended to limit those transactions. Third, the Second Circuit went further and also pointed out the practical difficulty in the application of Marblegate’s interpretation of Section 316(b) as well. Specifically, the Court found that Marblegate’s interpretation would elevate subjective intent (i.e., whether the transaction is designed to eliminate a non-consenting holder’s ability to receive payment) over the objective analysis of the transactional technique used. This would lead, in the majority’s view, to a lack of “uniformity of interpretation” in different transactions, a hardly desirable result.

Where the Second Circuit Decision Leaves the Market

The Second Circuit’s decision effectively restores the investing market and creditors’ rights to where both had stood before the Marblegate and Caesars decisions were issued in 2014 and 2015: Section 316(b) of the TIA protects certain core contractual payment rights of noteholders, including the right to sue to enforce payment rights, under TIA qualified indentures. It is not a tool for a broad interpretation and the creation of extra-contractual rights for noteholders to protect noteholders’ practical ability to recover in any workout scenario or to give such minority noteholders voting rights greater than the contractually agreed voting provisions of an indenture. Noteholders such as Marblegate had, and continue to have, other remedies under state and federal law, including fraudulent transfer and successor liability claims, to redress their grievances. The Second Circuit reinforced the notion previously raised in its decision in Bank of New York v. First Millenium, Inc.5, that “[n]othing in Section 316(b), or the TIA in general, requires that bondholders be afforded ‘absolute and unconditional’ rights to payment.” The Marblegate decision probably puts to rest the broad use of Section 316(b) of the TIA to oppose certain non-consensual, out-of-court restructurings for the foreseeable future.