What Marblegate Can Teach Us About the Protections Available to Minority Noteholders in an Out-of-Court Restructuring

Two recent decisions from the District Court for the Southern District of New York have renewed interest in the Trust Indenture Act and the ability of minority bondholders to use it as a shield to protect its rights in an out-of-court nonconsensual restructuring:  Marblegate Asset Management, LLC v. Education Management Corp. and MeehanCombs Global Credit Opportunities Funds, LP v. Caesars Entm’t Corp.  Today, we focus on Marblegate, under which the court concluded that the Trust Indenture Act, when read broadly, is intended to protect minority bondholders against out-of-court restructurings designed to impair their practical rights to payment of principal and interest 
Education Management Corporation, a for-profit education company, and its affiliated entities (“EDMC”) sought to restructure approximately $1.5 billion of debt.  EDMC was effectively precluded from filing for bankruptcy because doing so would have rendered EDMC ineligible for federal funding under Title IV of the Higher Education Act of 1965, depriving it of 80% of its revenue.
EDMC had $1.553 billion of debt outstanding, comprised of: (i) $1.305 billion in secured debt, of which $220 million was revolver debt and $1.085 billion was term loan debt, and (ii) $217 million in unsecured notes.  The unsecured notes, which were issued by a subsidiary, Education Management LLC, and guaranteed by the parent company, were qualified under the Trust Indenture Act.  Under the terms of the parent guarantee for the unsecured notes, the guarantee could be released either by majority vote of the unsecured noteholders or by a corresponding release of the separate parent guarantee in favor of the secured lenders.  For this reason, the offering circular for the notes warned investors not to assign any value to the parent guarantee.
Restructuring Support Agreement
The committee of the secured term loan lenders representing 80.6% of EDMC’s secured debt and 80.7% of the unsecured notes negotiated with EDMC a proposed out-of-court restructuring under which the secured lenders would receive debt and equity of EDMC representing approximately a 55% recovery and unsecured noteholders would receive equity representing approximately a 33% recovery.  If 100% of the creditors did not consent to the proposed restructuring, however, then the company would implement an alternative transaction (the “Intercompany Sale”), under which: (i) the secured lenders would release the EDMC parent guarantee of their loans, triggering the automatic release of EDMC’s parent guarantee of the unsecured notes, (ii) the secured lenders would foreclose on substantially all of the assets of EDMC, (iii) the secured lenders would sell the assets back to a new subsidiary of EDMC, and (iv) the new subsidiary would distribute debt and equity to the consenting creditors in accordance with the restructuring support agreement, and the dissenting creditors would receive no payment on their unsecured notes.  While the transaction did not amend the actual terms of the unsecured notes, it was designed to ensure that any noteholder who dissented from the out-of-court restructuring would receive no payment on its notes.  The unsecured noteholders would be left with only claims against a worthless subsidiary.
Events Leading Up to the Court’s Decision
Marblegate Asset Management, L.L.C. and Marblegate Special Opportunities Master Fund, L.P. (“Marblegate”), which held $14 million of the unsecured notes, declined to participate in the exchange offer.  On October 28, 2014, it filed a motion for a temporary restraining order and a preliminary injunction seeking to enjoin EDMC from violating its duty under the Trust Indenture Act through participation in the Intercompany Sale transaction, which motion the court denied on December 15, 2014.  The court’s decision, however, also opined in dicta that Marblegate would be likely to succeed on the merits of its Trust Indenture Act claims.  Subsequently, the parties moved forward with the Intercompany Sale with a few adjustments designed to protect Marblegate’s rights in the event the court issued a final ruling in its favor.  EDMC did not remove the parent guarantee on Marblegate’s notes and amended the indenture governing the notes to clarify that the new subsidiary would guarantee Marblegate’s notes until such time as the parent guarantee was released.
The Court’s Decision
The issue before the court was whether an out-of-court debt restructuring that did not amend the terms of an indenture governing a noteholder’s right to receive interest or principal on a certain date, but that effectively precluded the noteholder’s ability to receive such amounts, violated Section 316(b) of the Trust Indenture Act.  The court concluded yes.
Section 316(b) of the Trust Indenture Act reads in relevant part:

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[.]

Courts have interpreted Section 316(b) differently.  Under a narrow reading, Section 316(b) protects against only involuntary modification of payment terms or a noteholders’ right to sue for payment.  At least two courts have distinguished between the legal right to demand payment, and the practical right to receive payment, holding that Section 316(b) only protects the former.  Under this interpretation, only an explicit modification of the indenture that impairs the right to demand payment would violate Section 316(b).
Under a broad reading, Section 316(b) protects against lesser payment than originally bargained outside of a bankruptcy restructuring.  At least two courts, both in the Southern District of New York, have interpreted Section 316(b) as protecting the broader substantive right to payment.  Thus, an out-of-court transaction structured to deprive a dissenting bondholder of assets against which it can recover would violate Section 316(b).
In adopting the broader reading, the court analyzed the legislative history of the Trust Indenture Act and determined that the language of Section 316(b) evolved to impose mandatory indenture terms that were intended to address potential abuses related to restructurings that involved foreclosures or the substitution of worthless collateral for collateral on which a bondholder had relied.  Examining the Senate report, testimony and debate surrounding the proposition of the Trust Indenture Act of 1938 (a prior iteration of the current version of the Trust Indenture Act), the court found that Section 316(b)’s precursor was meant to prevent exactly what happened to Marblegate: a majority forcing a non-assenting security holder to accept a reduction or postponement of the minority’s claim for principal.
Moreover, comparisons of the final text of Section 316(b) with the prior versions proposed in the Trust Indenture Act of 1939 revealed that (i) the indenture provisions became mandatory, rather than reliant on the SEC to designate them as such, and (ii) the “right” evolved from a narrow “right to bring action” to a broader substantive “right to receive payment,” which right could not be impaired or affected without consent.
The court held that the text and drafting history of Section 316(b) reflected an intentional expansion of protections available to bondholders to achieve its purpose: protecting nonconsenting minority bondholders from being forced to relinquish claims outside of judicial supervision under the formal mechanisms of a debt restructuring.  Furthermore, a fair reading of the text and the purpose of the legislation did not suggest that that the Trust Indenture Act was targeted at only one method of restructuring, a straightforward amendment, as opposed to an undesirable restructuring outcome.  The court ultimately held that the Intercompany Sale was “precisely the type of debt reorganization that the Trust Indenture Act was designed to preclude,” and denied the defendant’s request to remove the parent guarantee.
Marblegate’s successful use of the Trust Indenture Act to defend their right to payment in the Marblegate case should provide minority bondholders some comfort in a nonconsensual debt restructuring, but it also stokes fears of “troubling implications,” which the court acknowledged.  A broader reading of the Trust Indenture Act provides leverage for minority holdouts to extract additional value in an out-of-court transaction.  In effect, such holders can free-ride off an exchange implemented by the majority, leaving the minority in a position to collect their claims in full against a newly solvent issuer, while the claims of the majority have been impaired.  In the rare circumstances where bankruptcy is not a viable option, like in the instance of EDMC where a bankruptcy filing would have caused EDMC to lose federal funding, this leverage may increase the transaction risks, and therefore costs, of an out-of-court transaction.  And, if enough holdouts exist, it may ultimately limit a company’s restructuring options.
For most issuers where bankruptcy can be a viable restructuring option, however, a broad reading of the Trust Indenture Act may indirectly encourage companies to file for chapter 11 relief, which has its own transaction costs, to find a way to bind minority noteholders to a transaction supported by the majority.  Some might argue, however, that the latter result – a debt restructuring pursuant to a court-supervised process – is exactly what Section 316(b) of the Trust Indenture Act was originally designed to accomplish (some proponents hoped that it would prevent the evasion of judicial scrutiny in debt readjustment plans).
Ultimately, the Marblegate decision does not mean that nonconsensual out of court restructurings are impossible.  Most exchange offers involve some coercive element, like the stripping of liens and covenants from an indenture without the unanimous consent of all bondholders.  The court’s decision in Marblegate, however, does teach us that there is a point when such coercive actions cross the line into an impermissible impairment of a bondholder’s substantive right to payment of principal and interest.