Yesterday, in the latest chapter in the ongoing debate over Section 316(b) of the Trust Indenture Act, the Second Circuit reversed the district court’s decision in Marblegate, concluding that the TIA does not prohibit out-of-court restructurings that deprive non-consenting noteholders of their substantive right to payment on account of their notes. There will be time for reflection in the weeks to come – reflection that will be fueled the Second Circuit’s own internal disagreement in its 2-1 decision, with a strong dissent from Judge Straub.  In the meantime, a brief summary follows.

Background

Section 316(b) of the Trust Indenture Act (which governs virtually all notes issuances) provides, in relevant part, as follows:

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[.]

Under a narrow reading, Section 316(b) protects against only involuntary modification of payment terms or a noteholders’ right to sue for payment. Some courts have specifically 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 –one that impairs the right to demand payment – would violate Section 316(b).

More recently, a broad reading has been in favor, fueled by recent decisions in the Marblegate and Caesars cases. That reading understands Section 316(b) to bar transactions in which the noteholders are to be paid less than that which was initially bargained for; in other words, Section 316(b) protects the substantive right to payment.  In that scenario, even an out-of-court restructuring that has the practical effect of impairing a dissenting bondholder would (or could) violate Section 316(b).

The articles discussing the various readings of the TIA are legion, and we won’t rehash all of those decisions here. But importantly, the recent decisions of the United States District Court for the Southern District of New York (in Marblegate and Caesars) found relief in a provision that had largely been ignored or taken for granted for seventy-odd years. In fact, an Opinion White Paper, signed by a number of leading law firms, recognized this “significant departure from the widely understood meaning of TIA Section 316(b) that has prevailed among practitioners for decades.” But a departure from prior practice doesn’t necessarily mean it’s wrong…. Or does it?  Let’s read.

Marblegate I and II

In Marblegate, Education Management Corporation had sought to accomplish a debt restructuring via an exchange offer. If (and when) 100 percent participation could not be achieved, the company proposed to undertake an alternative transaction (the “Intercompany Sale”), pursuant to which it would transfer assets from its notes-issuing subsidiary to another EDMC subsidiary via a foreclosure sale by the company’s secured lenders. EDMC’s guarantee would then be released, and the holdout noteholders would be left with claims against an entity with no assets. Except for Marblegate, all of EDMC’s creditors (representing 98 percent of its debt) eventually consented. But Marblegate challenged this treatment, arguing that, pursuant to (a broad reading of) the Section 316(b) of the TIA, EDMC and its subsidiaries could not effectively deprive non-consenting noteholders of their practical right to receive payment on account of their notes, even pursuant to the Intercompany Sale.

The district court, reading Section 316(b) broadly, concluded that TIA barred EDMC from releasing the parent guarantee because the Intercompany Sale and release of that guarantee stripped non-consenting noteholders of their “practical ability to collect payment” on account of the notes issued by certain Education Management subsidiaries. In other words, Section 316(b) does not allow companies “to effectively eliminate the rights of non-consenting bondholders.” Any other reading, argued the district court, could effectively gut the TIA’s protections simply by instituting a foreclosure sale, along the lines of the Intercompany Sale.  Consequently, the district court ordered EDMC to continue to guarantee the non-consenting noteholders’ notes and pay them in full.

EDMC appealed, arguing that it had never formally amended the notes or deprived noteholders of the right to sue for payment of any amounts actually owed, and that the Intercompany Sale therefore did not violate the TIA.

The Second Circuit

As the Second Circuit succinctly put it, the “core disagreement in this case is whether the phrase ‘right . . . to receive payment’ forecloses more than formal amendments to payment terms that eliminate the right to sue for payment.”

The Circuit Court agreed with the district court that the TIA was ambiguous. It did, however, seem sympathetic to a reading of the TIA that would not bar substantive right to receive payments, particularly given that a “right to sue” is entirely different from an underlying “right to payment.”  Regardless, because the provision was not certain, the Circuit Court noted that it must look to the legislative history for guidance.

Here, Judge Lahier, joined by Judge Cabranes, departed from the district court. The district court had concluded that the drafters of the TIA had not anticipated the use of a foreclosure sale to skirt the TIA’s protections, and would have intended to protect noteholders from this “end-run” around the TIA. The Circuit Court rejected that reading. After undertaking an extensive review of contemporaneous reports and statements from the 1930s (including from William O. Douglas and Edmund Burke, Jr.), the Circuit Court concluded that the drafters of the TIA were “well aware of the range of possible forms of reorganization available to issuers, up to and including foreclosures like the one that occurred in this case but that the district court concluded violated Section 316(b).” Yet they chose this language in Section 316(b) to protect only against contractual restructurings, and not against foreclosures or other mechanisms for restructuring debt.

The Circuit Court also acknowledged a problem with the “workability” of Marblegate’s (and the district court’s) proposed interpretation of Section 316(b). The Circuit Court observed that such an interpretation would require courts in each case to determine whether a challenged transaction constitutes an “out‐of‐court debt restructuring . . . designed to eliminate a non‐consenting holder’s ability to receive payment.”  To make such a determination, each court would have to ascertain “the subjective intent of the issuer or majority bondholders, not the transactional techniques used.” The Circuit Court was particularly averse to such a regime given its stated distaste for interpreting boilerplate indenture provisions based on the “relationship of particular borrowers and lenders” or the “particularized intentions of the parties to an indenture,” both of which undermine “uniformity in interpretation.”

[Interestingly, the Circuit Court omits any reference to Judge Sweet’s December 2016 decision in Waxman v. Cliffs Natural Resources Inc., in which the district court observed, among other things, that his brother and sister courts’ decisions in Marblegate and Caesars could be limited to situations in which the non-consenting noteholders were prejudiced by virtue of a “an involuntary, out-of-court pseudo-bankruptcy.” Perhaps this was done due to the Circuit Court’s rejection of the “workability” of this subjective and case-dependent solution.]

Finally, the Circuit Court concluded by observing that its holding would not leave dissenting noteholders without any relief (“at the mercy of bondholder majorities”). Because the non-consenting noteholders would still have a legal right to receive payment, they could pursue available remedies under state and federal law. They could also, ex ante, bargain for provisions in credit agreements that would forbid transactions like the Intercompany Sale. And without a discharge in bankruptcy, the foreclosure could be challenged by other creditors under New York law. Or there could be claims for successor liability or fraudulent conveyance.  The Circuit Court did not weigh in on the likelihood of success of these claims, but it recognized that noteholders would not necessarily be left entirely in the cold without recourse to Section 316(b) of the TIA.

Dissent

Judge Straub, on the other hand, parted ways with his two colleagues. In dissent, Judge Straub principally observed that the plain meaning of the statute compelled an affirmance of the district court. He looked to the plain meaning of “impair” and “affect,” noting that they include any diminution of value, “effect on,” or influence regarding the right to payment. He argued:

Even defined as a “legal entitlement” or “claim,” it is unquestionable that the “right” to receive payment can be “diminished” or “affected” without actual modification of the payment terms of the indenture. By making it impossible for a company to pay the amount due on its notes, for example, the “right” to receive payment is “diminished” because it literally has been made worthless. Surely, a bondholder’s right or “legal entitlement” to receive payment is impaired when actions are taken to ensure that the bondholder either consents to a change in his payment terms or receives no payment on his notes at all.

Because the TIA does not specifically limit itself to amendment of the underlying indenture, any modification or impairment of the practical right to payment must be included in Section 316(b). At a minimum, Judge Straub observed, Section 316(b) of the TIA must apply to a transaction such as the Intercompany Sale because EDMC’s proposals presented Marblegate with a “Hobson’s choice” – namely, that it must accept a modification of the payment terms of its notes or receive no payment at all. As Judge Straub observed, “[t]his scheme did not simply ‘impair’ or ‘affect’ Marblegate’s right to receive payment—it annihilated it.” Consequently, Judge Straub would have affirmed the district court on the basis of pure statutory interpretation.

Conclusion

The TIA debate is far from over, particularly given the 2-1 decision in the Second Circuit.  Section 316(b) will undoubtedly continue to be litigated and subject to creative interpretation. In the meantime, debt issuers and investors will await greater certainty and will explore ways of mitigating the risks inherent in matters that continue to be litigated. It remains to be seen whether issuers will capitalize on this decision and use it to justify debt modifications or restructurings that have been avoided in the wake of Caesars and Marblegate.  A risk? To be sure.  But therein lies the excitement.