Thursday, January 19, 2017

Court OK’s end-run around Trust Indenture Act protections

By Anne Sherry, J.D.

A restructuring maneuver that forced bondholders to accept reduced payment or get nothing at all did not violate the Trust Indenture Act, the Second Circuit held. The decision vacates the Southern District’s holding that, even if no indenture term is modified, an involuntary debt restructuring violates TIA Section 316(b). Over one judge’s dissent, the appellate panel held that the Act prohibits only nonconsensual amendments to an indenture’s core payment terms (Marblegate Asset Management, LLC. v. Education Management Finance Corp., January 17, 2017, Lohier, R.).

Restructuring. Education Management Corporation (EDMC), a for-profit education company, sought to restructure $1.5 billion in debt, including about $217 million in unsecured notes governed by an indenture. Because the bankruptcy route would have deprived EDMC of Title IV funds, the company negotiated an out-of-court restructuring with its largest creditors. The resulting agreement incentivized noteholders to go along: unless creditors unanimously approved the deal, an intercompany sale would transfer substantially all of EDMC’s assets to a new subsidiary, which would distribute debt and equity only to consenting creditors and continue the business.

District court proceedings. All of EDMC’s creditors approved the plan except for Marblegate Asset Management, which sued to enjoin the intercompany sale on the basis that it violated Section 316(b). That section provides that “the right of any holder of any indenture security to receive payment” of principal and interest “shall not be impaired or affected without the consent of such holder.” The Southern District allowed the sale to proceed but required alterations to protect Marblegate’s rights, finding that the creditor was likely to succeed on the merits. The court fulfilled its prophecy a few months later, ordering EDMC to continue to guarantee the notes and pay them in full. Even when a transaction does not explicitly modify an indenture’s payment terms, the district court held, it violates Section 316(b) whenever it effects an “involuntary debt restructuring.”

Appeals court reversal. The appellate majority agreed with the district court that Section 316(b) is ambiguous, but it interpreted the legislative history differently. The majority concluded that Congress did not intend the broad reading of the Trust Indenture Act that the district court embraced. For one, the TIA’s drafters appear to have been well aware of the forms of reorganization available to issuers, including foreclosures.

For example, the relevant portions of the TIA’s legislative history exclusively addressed formal amendments and indenture provisions; the history shows that Section 316(b) does not prohibit foreclosures even when they affect a bondholder’s ability to receive full payment. A 1940 SEC report recognized that junior creditors who refuse to participate in a foreclosure plan will be thrown back to the pool of assets as to which there are no prior claims—a pool which was “at best nominal.” There was also little if any textual support for Marblegate’s proposition that the final version of Section 316(b) included a new substantive right to receive payment.

Finally, the majority addressed potential workability concerns with Marblegate’s argument and with the panel’s holding. To accept Marblegate’s interpretation of Section 316(b) would require courts to determine in each case whether a challenged transaction was designed to eliminate a non-consenting holder’s ability to receive payment. That interpretation would turn on the subjective intent of the issuer or majority bondholders, not the transactional techniques in play. Interpreting boilerplate indenture provisions based on subjective criteria undermines uniformity in interpretation, the majority wrote.

Marblegate also argued that the right to receive payment is impaired when assets are deliberately placed out of dissenting noteholders’ reach. This description could apply to every foreclosure in which the assets are insufficient to pay creditors in full, and neither the text nor the legislative history of the TIA provision supports a distinction between adversarial and friendly foreclosures. The majority also reassured that its holding does not leave dissenting bondholders at the mercy of the majority. By preserving the legal right to receive payment, the court permits creditors to pursue available remedies, and the absence of a bankruptcy discharge means the foreclosure can be challenged by other creditors under state law.

Dissent. Judge Straub dissented on the basis that the plain text of the statute prohibits the “collusively engineered” restructuring at issue. To read the statute as EDMC does—as preserving only the ability to legally claim a right to payment—nearly eliminates the import of the terms “impair” and “affect” and imposes qualifications in Section 316(b) that do not exist. According to Judge Straub, the district court correctly identified EDMC’s restructuring plan as presenting bondholders a Hobson’s choice: either accept modification of the payment terms of the notes, or get no payment at all. “This scheme did not simply ‘impair’ or ‘affect’ Marblegate’s right to receive payment—it annihilated it.”

The case is No. 15-2124-cv.

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