On January 17, 2017, a divided (2-1) panel of the U.S. Court of Appeals for the Second Circuit (Second Circuit) reversed the decision of the District Court for the Southern District of New York (Southern District) in the Marblegate litigation1 (Marblegate) with respect to the interpretation of Section 316(b) of the Trust Indenture Act of 1939 (TIA). Consistent with the narrower interpretation that was commonly followed prior to the Southern District’s decision, the Second Circuit found that “Section 316(b) prohibits only non-consensual amendments to [a TIA-qualified] indenture’s core payment terms, and does not extend to non-consensual amendments of other terms or corporate actions that would adversely impact the practical ability of a company to make timely payments on its debt securities. Because indentures for debt securities offered under Rule 144A, Regulations S or Section 4(a)(2) under the Securities Act of 1933 (Securities Act) often include a provision similar to Section 316(b), the Second Circuit’s ruling is also relevant for indentures that are not TIA-qualified.
When a company asks its law firm to provide an opinion that a proposed indenture amendment or corporate transaction complies with or does not contravene the indenture, the law firm must perform a Section 316(b) analysis if the indenture is TIA-qualified or contains a provision similar to Section 316(b). Prior to the Southern District’s decision, the analysis primarily involved confirming there were no changes to the core payment terms applicable to the debt securities issued under an indenture. By requiring the Section 316(b) analysis to also take into account the impact of an indenture amendment to other than core payment terms or a corporate transaction on a company’s practical ability to make payments on the debt securities, the Southern District’s ruling in Marblegate, together with a similar Southern District ruling in the Caesars litigation2 (Caesars), resulted in or contributed to considerable additional work. More importantly, it led to uncertainty, resulting in the following:
- For distressed companies (e.g., energy companies in 2016), resorting to bankruptcy rather than out-of-court restructurings to restructure their balance sheets, or not restructuring at all;
- For companies undertaking out-of-court restructurings, balance sheet management exercises, covenant stripping or other indenture amendments or other corporate transactions, particularly in a distressed industry or emerging market, more onerous procedures to enable companies and their law firms to conclude that the required indenture amendments or corporate transaction would not adversely affect the practical ability of the company to make payments on the company’s debt securities; and
- For companies structuring offerings of debt securities, efforts to avoid the statutory obligation to qualify an indenture under the TIA and excluding, or limiting the scope of, indenture provisions similar to Section 316(b) to avoid the impact of the Southern District’s decisions.
The Second Circuit’s decision in Marblegate has been appealed to the Second Circuit en banc3. Also, the Southern District’s decisions focused the attention of both companies and investors (in taking actions that impact outstanding debt securities, as well as in originating new debt securities) on a statute and a statutory provision that had previously enjoyed relative obscurity. For these and other reasons, it is important for companies and their lawyers to consider the issues that remain following the Second Circuit’s decision.
Section 316(b) and Its Application Prior to Marblegate
Debt securities issued and sold to investors in an offering registered under the Securities Act, as well as debt securities issued and sold in exempt transactions pursuant to Sections 3(a)(9) and 3(a)(10) of the Securities Act and Section 1145 of the Bankruptcy Code, must be issued pursuant to a TIA-qualified indenture that contains, or is deemed to include, specified TIA provisions relating to indenture trustee qualifications and obligations and debt securities holder rights, including Section 316(b). Section 316(b) provides as follows (italics added):
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, except as to a postponement of an interest payment consented to as provided in paragraph (2) of subsection (a) and except that such indenture may contain provisions limiting or denying the right of any such holder to institute any such suit, if and to the extent that the institution or prosecution thereof or the entry of judgment therein would, under applicable law, result in the surrender, impairment, waiver, or loss of the lien of such indenture upon any property subject to such lien.
Section 316(a)(2) permits, but does not require, an indenture to contain a provision that allows holders of 75 percent in principal amount of debt securities to authorize the postponement of an interest payment on all of the debt securities for up to three years.
The judicial interpretation of Section 316(b) is also relevant to many U.S. (primarily New York) law-governed indentures for Rule 144A, Regulation S and Section 4(a)(2) debt securities offerings because those indentures often include a provision similar to Section 316(b). Such a provision is typically included because the offering is made with Securities Act registration rights, or investors, particularly those in the United States, want the protections afforded by Section 316(b). This is particularly the case for companies that issue high-yield debt, including non-U.S. companies from emerging markets that are de facto high yield.
Before the Southern District’s decision in Marblegate, Section 316(b) and similar indenture provisions were commonly understood to prohibit indenture amendments that affect holders’ contractual rights to receive payments unless the consent of each affected holder was obtained. In some cases, primarily debt securities issued in some European high-yield transactions, debt securities issued in unregistered offerings provide that the rights to receive payments can be changed with the consent of holders of a supermajority principal amount of the debt securities, following Euro market convention. Core payment provisions subject to Section 316(b) and similar provisions include those that specify the amounts of interest and principal payable, and the times for payment. A law firm asked to opine on a transaction’s compliance or non-contravention with an indenture would only focus on whether the core payment terms were being changed. The Section 316(b) analysis did not consider whether an action otherwise permitted by the underlying indenture would practically impair a company’s ability to make payments in accordance with the express terms of its debt securities.
The Southern District’s Decisions and Subsequent Actions to Address Uncertainty
As noted above and in an earlier Sidley Update, the Southern District’s decisions in Marblegate and Caesars extended Section 316(b) to prohibit indenture amendments or corporate actions that would practically impair the ability of the company to make the payments required by the debt securities. In those cases, the actions included the release of guarantees and collateral and the transfer of income-producing assets to entities that were not obligors or guarantors under the indenture and the debt securities. The practical effect of the decisions was to require law firms and others involved in transactions to analyze whether changes to any indenture provision (not just core payment provisions) or any corporate actions otherwise permitted by the terms of an indenture, such as non-core payment indenture covenant changes made or actions taken in connection with a debt restructuring, an asset sale or another corporate transaction, would negatively affect the likelihood that holders of affected debt securities would actually receive the required payments when due. Under the Southern District’s reasoning, the question of whether an amendment or other action passes muster under Section 316(b) or a similar indenture provision, previously a purely legal question, also required a potentially difficult factual analysis concerning a company’s capacity to make payments that falls outside a law firm’s professional expertise. The factual support such an analysis requires depends on the circumstances, but may include all or a combination of a solvency opinion from a financial advisor, a company officer’s certificate, company representations, assumptions in the legal opinion and other factual assurances.
To assist companies, financial advisers, trustees, law firms and others in addressing the uncertainty created by the Southern District’s decisions in Marblegate and Caesars, on April 25, 2016, a group of national law firms, including Sidley, published a White Paper (White Paper), available here, that provides guidelines for rendering legal opinions to indenture trustees and others in connection with a debt restructuring or in circumstances where the company may be in financial distress. Our earlier article discusses the guidance provided in the White Paper.
The White Paper provided helpful guidance in the wake of the Southern District’s Marblegate and Caesars decisions; however, an increased level of scrutiny was still required for indenture amendments to non-payment terms and other corporate actions that, as part of debt restructurings, other balance sheet management exercises or other corporate transactions, actually or potentially impacted the likelihood that debt security investors would receive payments when due. That scrutiny included obtaining factual support to ensure that the company involved was not in distress and that the actions involved did not have the effect of impairing the company’s ability to actually make timely payments on the debt securities. Unfortunately, even following publication of the White Paper, the uncertainty that followed the Southern District’s decisions made it costly and difficult for companies to proceed with certain transactions and, given the Southern District’s expressed public policy preference for restructuring corporate debt under the supervision of a bankruptcy court, often narrowed the array of alternatives to voluntary bankruptcy for companies in distressed industries.
The Second Circuit’s Decision
In its review of the Marblegate decision, the Second Circuit determined that the Southern District had misinterpreted Section 316(b). It found that the Marblegate plaintiff’s “broad reading of the term ‘right’ as including the practical ability to collect payment leads to both improbable results and interpretive problems.” The Second Circuit noted that such a reading would require “a subjective intent of the issuer or majority bondholders, not the transactional techniques used.” The uncertainty and resulting disruptions in the market following the Southern District’s decisions are persuasive in that regard. Nevertheless, the Second Circuit agreed with the Southern District that Section 316(b) “is ultimately ambiguous,” found that the TIA’s structure fails to remove the ambiguity and therefore, like the Southern District, turned to the legislative history of the TIA to reach its conclusion.
Based on its review of the TIA’s legislative history, the Second Circuit concluded that Congress “did not intend the broad reading … that the [Southern District] embraced.” It pointed to legislative history stating that Section 316(b) prohibits “only formal changes to an indenture’s core payment terms” and that the purpose of provisions similar to Section 316(b) is to “preserv[e] the right to the individual bondholders to enforce the payment of principal and interest at their respective due dates.” The Second Circuit also cited Congressional reports stating that Section 316(b) does not “prevent the majority from binding dissenters by other changes in the indenture or by a waiver of past defaults.”
By interpreting Section 316(b) as it had commonly been interpreted prior to the Southern District’s decisions in Marblegate and Caesars, the Second Circuit’s decision provides more certainty to companies, financial advisers, trustees and others by not requiring them to evaluate a company’s solvency or ability to pay when they interpret and apply Section 316(b) and similar indenture provisions.
The Second Circuit’s decision could be overturned. As noted above, the Second Circuit’s decision in Marblegate has been appealed to the Second Circuit en banc and ultimately remains subject to appeal to the U.S. Supreme Court.
The Second Circuit’s decision is binding only in the U.S. district courts under the Second Circuit and is persuasive but not binding in the 11 other federal judicial circuits. Because of the prominence of the Second Circuit on securities law matters and the limited body of case law under the TIA, it is likely (although not certain) that federal courts in the other circuits will follow the Second Circuit’s decision, so long as it is not overturned, regarding the scope of Section 316(b). Recently, notwithstanding the appeal of the Second Circuit’s decision to the Second Circuit en banc, a federal district court in the Western District of Oklahoma dismissed a claim based on an expansive reading of Section 316(b), citing the Second Circuit’s decision and stating that “the weight of authority thus appears to support the narrow view of Section 316(b).”4
The Second Circuit’s decision is not binding on state courts, but it may be strongly persuasive for similar reasons. The courts have traditionally stressed the need for consistent interpretation of commonly used indenture terms, and the sharp distinction the Second Circuit drew between direct impairments of the legal right to enforce payment and other, broader challenges to the company’s financial structure is one with roots in long-standing doctrines in New York and other states about the special status of suits for failure to pay principal and interest when due.
As Caesars was also decided by the Southern District, albeit on facts that differ from those in Marblegate, given the basis for the Second Circuit’s decision in Marblegate, any Second Circuit decision in Caesars is unlikely to significantly modify its interpretation of Section 316(b) in Marblegate.
Under the current judicial circumstances, law firms may wish to consider including in their indenture compliance and non-contravention opinions an assumption that any action to enforce an indenture or debt securities will be brought in a U.S. district court under the Second Circuit.
The Second Circuit’s decision should relieve the pressure to change indentures not qualified under the TIA to avoid the implications of the Southern District’s decisions in Marblegate and Caesars. However, if there are concerns about the extent to which the Second Circuit’s decision will be followed, upheld on appeal, enforced or applied, companies may consider including in non-TIA-qualified indentures a statement to the effect that the provision similar to Section 316(b) shall be interpreted in accordance with the Second Circuit’s decision.
While the Second Circuit’s decision has dispelled much of the uncertainty concerning the interpretation of Section 316(b), there are other potential causes of action (primarily under state laws) that companies and their lawyers should consider when a company undertakes to amend or strip indenture covenants, restructure its debt, engage in other liability management exercises or engage in any other corporate transaction that could impair the ability of its debt securities holders to receive payment. These include fraudulent conveyance claims (under applicable state law and Section 548 of the Bankruptcy Code), commercial tort claims, laws that provide collection remedies for creditors, commercial reasonableness requirements of Article 9 of the Uniform Commercial Code, and successor liability laws where a transfer of assets is involved, as well as various other claims that creditors may have if the company enters into bankruptcy. In some narrow situations, an insolvent company may even owe fiduciary duties to its bondholders. While claims advanced under these theories have long been possible, the attention that the Marblegate and Caesars decisions have drawn to transactions that could impair the ability of a company to make payment on its debt securities should lead companies, particularly those in distressed situations, to consider and prepare for other legal theories of liability by dissenting debt security holders.
Finally, as was the case before the Southern District’s decisions in Marblegate, Section 316(b) and similar indenture provisions can present interpretative issues when considering whether amending or stripping redemption, change of control and similar provisions will be considered changes to core payment terms.