In lieu of proceeding through a chapter 11 bankruptcy, borrowers and their creditors usually prefer to restructure their debt agreements outside of court. Although they avoid the costs and delays of bankruptcy, out-of-court negotiations can be contentious, as the various parties may have divergent goals. For example, secured and unsecured creditors will likely differ with respect to the desired treatment of their respective types of debt. Even within classes of debt, creditors’ interests—and willingness to compromise—may differ significantly. Unanimous agreement is difficult to achieve.
Non-unanimity is problematic under Section 316(b) of the Trust Indenture Act (“TIA”), 15 U.S.C. § 77ppp(b), which forbids impairing “the right of any holder of any indenture security to receive payment” of principal and, with limited exceptions, interest, in an out-of-court agreement without that holder’s consent. In other words, for bonds that are governed by the TIA, a single “hold out” can prevent an out-of-court restructuring that is supported by the majority of other bondholders.
The TIA’s prohibition on the impairment of individual creditors’ legal right to payment is well-established. Less certain, however, has been the TIA’s application to out-of-court restructurings that may have the practical effect of preventing bondholders from receiving full payment of principal and interest. The Southern District recently addressed this issue in Marblegate Asset Mgmt. v. Educ. Mgmt. Corp., 2014 WL 7399041 (S.D.N.Y. Dec. 30, 2014) (“Marblegate I”), and Marblegate Asset Mgmt., LLC v. Educ. Mgmt. Corp., 2015 WL 3867643 (S.D.N.Y. June 23, 2015) (“Marblegate II”).
Education Management Corporation (“EDMC”), along with multiple subsidiaries including Education Management LLC (“EDLLC”) (together, “Defendants”), operates for-profit colleges in the United States. EDMC receives 80% of its revenue from federal funds; of critical importance, it loses eligibility for these funds if it files for bankruptcy. In 2014, it had outstanding over $1.5 billion in debt (issued by EDLLC), including roughly $1.3 billion in secured debt and $200 million in unsecured notes issued pursuant to an indenture governed by the TIA. EDMC guaranteed the notes.
In 2014, EDMC’s revenue dropped by 58%, its stock price dropped 95%, and it forecast additional financial problems. Because EDMC would have lost 80% of its revenue if it filed for bankruptcy, that was not an option. EDMC and the majority of its creditors instead negotiated a Restructuring Support Agreement (“RSA”). Under the RSA, unsecured noteholders were to receive roughly one-third value of their notes in the form of EDMC equity. The RSA also provided that any noteholders that did not consent to the deal would receive no payout at all. (Absent unanimous agreement, EDLLC would be divested of all assets, and EDMC would remove its guaranty over the notes, leaving nonconsenting noteholders with no avenue of recovery.) Although the holders of 90% of the notes agreed to the RSA, some holders did not, including hedge funds Marblegate Asset Management, LLC and Marblegate Special Opportunities Master Fund, L.P. (together “Marblegate”). Marblegate and another hedge fund (which eventually settled) sued Defendants, arguing that the RSA violated TIA Section 316(b), which reads:
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[.]
Marblegate first moved to enjoin the RSA. Judge Failla of the Southern District of New York denied the motion, primarily because Marblegate failed to show harm. The Court determined that Marblegate would have been worse off had the Court enjoined the RSA: Marblegate could recover little or nothing in bankruptcy, and absent any restructuring, could recover at most roughly $2.25 million of its $14.6 million in notes before EDMC became insolvent. The Court further found that any harm would not be irreparable because, even if the parties executed the RSA (which would divest EDLLC and remove the EDMC guaranty), “broad principles of veil-piercing would enable the Court to facilitate a demand for payment from EDMC wherever within its corporate structure assets happen to be located.” Marblegate I, 2015 WL 7399041, at *13. Finally, neither the balance of the equities nor the public interest favored enjoining a $1.5 billion restructuring based upon the objection of entities holding $20 million in notes. Id. at *14.
The ruling in Marblegate I, however, was by no means a defeat for Marblegate. To the contrary, although the Court denied Marblegate’s request for an injunction, the Court raised serious questions as to whether the RSA violated Marblegate’s rights under TIA Section 316. The Court held that the TIA’s purpose would be served by protecting individual holders’ rights when a majority agrees to modifications that “effect an involuntary debt restructuring.” Id. at *19. The court explained, “where a debt reorganization that seeks to involuntarily disinherit the dissenting minority is brought about by a majority vote, that violates the fundamental purpose of the Trust Indenture Act.” Id. Marblegate I was relied upon a few weeks later by Judge Scheindlin of the Southern District of New York, who denied a motion to dismiss claims challenging under TIA Section 316 the release of a parent guarantee. MeehanCombs Global Credit Opp. Funds, LP v. Caesars Entertainment Corp., 2015 WL 221055 (S.D.N.Y. Jan. 15, 2015).
EDMC then executed the RSA (modified to retain the guaranty of Marblegate’s notes pending the outcome of the Court’s ultimate ruling on the merits). On June 23, 2015, the Court issued its decision on whether the RSA had violated TIA Section 316(b). That decision hinged on the Court’s choice between the parties’ competing interpretations of TIA Section 316(b). Defendants had urged the Court to find that TIA Section 316(b) applies solely to the holder’s legal rights, and not the holder’s practical avenues of recovery. Under Defendants’ interpretation, the RSA could therefore remove Marblegate’s ability to recover from EDLLC (by divesting its assets) and EDMC (by removing its guarantee), as long as the RSA did not destroy Marblegate’s right to bring a (pointless) suit to recover principal and interest that EDLLC could not afford to pay.
The Court disagreed with Defendants’ position, finding that TIA Section 316(b) entitles bondholders not merely to the legal right to sue, but to the substantive, practical right to recover. In its prior order denying the preliminary injunction, addressing Marblegate’s likelihood of success on the merits, the Court had concluded that TIA Section 316(b) is “substantive rather than formalist” and “simply does not allow . . . a debt reorganization outside the bankruptcy process to effectively eliminate the rights of nonconsenting bondholders.” Marblegate I, 2015 WL 7399041 at *21. In its second opinion, which exhaustively detailed the TIA’s legislative history, the Court reiterated its earlier provisional holding: “[T]o interpret Section 316(b) as protecting merely the right to sue for payment, and not any substantive right to receive such payment, would be unfaithful to the text and the drafting history.” Marblegate II, 2015 WL 3867643 at *11. The Court found that because EDLLC was already fully divested of its assets, removing the EDMC guaranty would “sever the final avenue for Marblegate’s recovery” and thus “enfeeble the Trust Indenture Act.” Id. at *13. Refusing to do so, the Court ordered EDMC to “guarantee any past and future payments of principal and interest to Marblegate.” Id. at *14.
The ruling raises interesting issues. By refusing to consent, Marblegate obtained full value on its notes, more than was likely possible through either restructuring or bankruptcy. At first glance, therefore, the Southern District’s ruling might disincentive bondholders to consent to any out-of-court restructuring that offers less than 100% value. Indeed, the Court itself recognized “the potentially troubling implications of the Trust Indenture Act in rewarding holdouts [and] its arguable obsolescence given the expense and complexity of modern bankruptcy.” Id. at *13. However, the Court also recognized that “courts should give effect to the purpose of the [TIA], and not allow minority bondholders to be forced to relinquish claims outside of the formal mechanisms of debt restructuring.” Id. at *12.
How the Marblegate decisions will affect the ability of parties to reach unanimous agreement on out-of-court restructuring deals thus remains to be seen. Debtors and creditors alike will be well advised to keep an eye on the issue.