Recently, in a split (2-1) decision, the United States Court of Appeals for the Second Circuit overturned the United States District Court for the Southern District of New York’s decision in Marblegate Asset Management, LLC v. Education Management Finance Corp., 111 F. Supp.3d 542 (S.D.N.Y. 2015) (“Marblegate II”). The Second Circuit held in Marblegate Asset Management, LLC v. Education Management Finance Corp., No. 15-2124, 2017 U.S. App. LEXIS 782 (2d Cir. Jan. 17, 2017) that the District Court erred in ruling that an out-of-court plan to restructure $1.5 billion in debt over the objection of minority noteholders violated Section 316(b) of the Trust Indenture Act of 1939, 15 U.S.C. § 77ppp(b) (the “TIA”). In the decision overturned by the Second Circuit, the District Court had significantly departed from the traditional reading of Section 316(b) of the TIA, in finding that an out-of-court restructuring violated it by impairing a bondholder’s “practical ability” to receive payment under an indenture despite the absence of any formal modifications to the indenture’s payment terms. In reversing the District Court, the Second Circuit restored the narrow reading of Section 316(b) as prohibiting “only non-consensual amendments to an indenture’s core payment terms.”
In 2014, Education Management Corporation (“EDMC”), a for-profit educational company, faced severe financial distress, with nearly $1.5 billion in outstanding debt and a valuation far less than that. EDMC relied heavily on federal funding under Title IV of the Higher Education Act of 1965, 20 U.S.C. §§ 1070-1099 (“Title IV”). As such, bankruptcy was not a viable option because EDMC could not file without jeopardizing its eligibility for that funding. Accordingly, EDMC sought to pursue an out-of-court financial restructuring.
Roughly $1.3 billion of EDMC’s debt consisted of secured debt (the “Secured Debt”) owed by an EDMC subsidiary (the “EDM Issuer”) and issued under a 2010 credit agreement. The Secured Debt was secured by virtually all of EDMC’s assets and gave the holders of the Secured Debt the full and absolute right to dispose of the collateral upon default. The remaining roughly $217 million in unsecured debt (the “Notes”) owed by the EDM Issuer was governed by a 2013 indenture also qualified under the TIA (the “Indenture”). The Notes were guaranteed by EDMC as parent to the EDM Issuer (the “Parent Guarantee”), although the Indenture provided that the Parent Guarantee could be released upon a release by the secured creditors of any later guarantee by EDMC of the Secured Debt.
In consideration for EDMC’s agreement to guarantee the Secured Debt (the “Secured Guarantee”), EDMC negotiated certain changes to the 2010 credit agreement with its secured creditors, which were memorialized in a 2014 credit agreement. At the same time, EDMC proposed to swap the outstanding Secured Debt for $400 million in new secured loans and roughly 77 percent of EDMC’s common stock, and to swap the unsecured Notes for 19 percent of EDMC’s common stock. If the proposed swap did not receive the requisite unanimous creditor consent, EDMC’s secured creditors would instead exercise their rights to foreclose on their collateral and release the Secured Guarantee, which would, in turn, release the Parent Guarantee. The foreclosed assets would then be transferred to a new EDMC subsidiary that would distribute debt and equity to the consenting creditors (the “Intercompany Sale”).
Marblegate, an unsecured holder of Notes with a face value of approximately $14 million, objected to the proposed out-of-court restructuring and sued to enjoin the Intercompany Sale. Marblegate asserted that it violated Section 316(b) of the TIA, which provides that “the right of any holder of any indenture security to receive payment of the principal 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[.]” 15 U.S.C. § 77 ppp(b). Marblegate contended that the Intercompany Sale violated Section 316(b) because the practical effect was to render the EDM Issuer an empty shell and impair the non-consenting noteholders’ ability to receive payment on the Notes or to collect via the released Parent Guarantee.
EDMC, on the other hand, argued that, in accordance with the traditional reading of Section 316(b) and the TIA, there had been no formal amendments to the core payment terms of the Indenture and, therefore, the Intercompany Sale did not violate Section 316(b).
A Difference in Interpretation: Section 316(b) and Legislative History
After reviewing the legislative history of Section 316(b), the District Court was persuaded by Marblegate’s argument and departed from the traditional interpretation of the Act in its decision. Finding the text of Section 316(b) to be ambiguous as to whether it protected against “formal, explicit modification of the legal right to receive payment” or a much broader practical “ability” of a bondholder to receive payment, the District Court engaged in an investigation of the TIA’s legislative history, beginning with its initial drafting in the mid-1930s through its evolution and enactment in 1939. The District Court determined that the fundamental purpose of the Act was to prohibit “a debt reorganization that seeks to involuntarily disinherit the dissenting minority . . . by a majority vote[,]” and concluded that the Intercompany Sale was “precisely the type of debt reorganization that the [Act] is designed to preclude.” Marblegate Asset Management, et al. v. Education Management Corp., et al., 75 F. Supp. 3d 592, 615 (S.D.N.Y. 2014) (“Marblegate I”).
EDMC appealed the District Court’s decision. The Second Circuit agreed with the District Court that the text of Section 316(b) is ambiguous and, therefore, engaged in its own review of the legislative history and reached a far different conclusion. The Second Circuit found that the District Court had erred in interpreting the legislative history to Section 316(b) and concluded that, in enacting Section 316(b), “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 reorganization like foreclosures.” Marblegate, 2017 U.S. App. LEXIS 782, *30. The Second Circuit held that the prohibitions set forth in Section 316(b) are limited “to formal indenture amendments to core payment rights,” and reversed and remanded the issue back to the District Court.
In so holding, the Second Circuit noted that Marblegate’s reading of Section 316(b) was unworkable, in that it would require courts to determine the subjective intent of the majority bondholders in every challenged out-of-court restructuring. The Court of Appeals further noted that dissenting bondholders were not left without recourse, recognizing that preservation of the legal right to payment allowed creditors to pursue other available remedies under state and federal law.
There was, however, a dissenting Second Circuit opinion. The dissent rejected both the District Court’s and the majority’s view that Section 316(b) was ambiguous, finding that “the plain text of the statute” prohibits a “collusively engineered” out-of-court restructuring designed to eliminate a non-consenting bondholder’s ability to receive payment. The dissent focused on the use of the terms “impair” and “affect” in the language of the statute, noting that the ordinary meaning of “impair” is “to diminish the value of” and the ordinary meaning of “affect” is “to produce an effect on” or “to influence in some way.” The dissent reasoned that it was entirely possible for a “right to receive . . . payment” to be diminished or affected without formal modification of the indenture’s payment terms, as illustrated by the total “annihilation” of Marblegate’s right to receive payment by the Intercompany Sale, and further reasoned that, if Congress had intended Section 316(b) only to prohibit formal modifications of an indenture’s payment terms, it could have drafted it that way.
Practical Implications of the Second Circuit’s Decision
In the wake of the District Court’s decision, restructuring advisors were left with uncertainty as to what protections were actually afforded by Section 316(b) to non-consenting bondholders. The traditional view—now reinstated by the Second Circuit’s reversal—had been that Section 316(b) protects non-consenting bondholders against modifications of the “core terms” of an indenture. The Second Circuit’s decision restores this narrow reading of Section 316(b), as well as a sense of confidence to restructuring advisors seeking to pursue more creative restructurings—short of express modifications to core indenture terms—without fear of violating Section 316(b) of the TIA.
While it is worth noting that EDMC’s status as a federally funded higher education provider was unique in that it raised the stakes for EDMC to ensure the success of an out-of-court restructuring, given the absence of bankruptcy as a viable option, the Second Circuit’s decision has broad implications on the limitations imposed by Section 316(b) on out-of-court restructurings. As the majority noted in its decision, the traditional view does “not leave dissenting bondholders at the mercy of bondholder majorities.” In addition to the legal remedies outlined by the Second Circuit in its decision, noteholders should require specific protective indenture covenants that will avoid an out-of-court restructuring like the one in Marblegate. Furthermore, indenture trustees should evaluate the actions necessary to protect and preserve such legal remedies to collect payment of outstanding principal and interest.
En Banc Rehearing Requested
On February 8, 2017, Marblegate petitioned for rehearing en banc on the grounds that the Second Circuit’s split decision raises a question of “exceptional importance” as to whether an out-of-court restructuring impairs or affects a non-consenting bondholder’s right to receive payment under Section 316(b) when it is engineered to make it impossible for a non-consenting bondholder to receive payment or when left with no choice but to accept a modification of the terms of the indenture.
The Second Circuit’s record of very rarely granting requests for en banc rehearing suggests that Marblegate’s petition is likely to be denied. Additionally, given the absence of a circuit split on the issue, it is also unlikely that the United States Supreme Court would grant a petition for certiorari.