On January 17, 2017, in a long-awaited and highly anticipated decision, the United States Court of Appeals for the Second Circuit (the "Second Circuit"), overturned the controversial District Court decision in Marblegate Asset Management v. Education Management Corp. (S.D.N.Y. 2014) ("Marblegate") that construed the $1.5 billion out-of-court restructuring plan, proposed by the distressed company Education Management Corp. ("EDMC"), as a violation of §316(b) of the Trust Indenture Act ("TIA").
The question presented in Marblegate was whether the contemplated restructuring impaired the right of a minority bondholder, Marblegate Asset Management ("MAM"), to receive principal and interest on its bond in violation of §316(b) of the TIA. EDMC, in an attempt to avoid a bankruptcy filing, devised a series of transactions aimed at restructuring and reorganizing its debt through an exchange offer and consent solicitation (the "Intercompany Sale") whereby (i) the majority secured bondholders foreclosed on all of EDMC's assets securing the bonds, (ii) these majority bondholders sold the foreclosed assets to a subsidiary of EDMC (the "EDMC Subsidiary"), and (iii) the EDMC Subsidiary issued new debt to consenting bondholders collateralized by the EDMC Subsidiary's newly acquired assets. In connection with the Intercompany Sale, consenting bondholders also provided consents that amended the existing bond indenture to remove various covenants of EDMC, effectively leaving EDMC as an asset-less shell company.
The District Court ruled in favor of MAM and held that §316(b) of the TIA not only protects a bondholders' "legal right" to payment, but also protects a bondholder's "practical ability" to receive such payment, especially in cases "where an out-of-court restructuring renders repayment a practical impossibility". The District Court reasoned that EDMC, by effectively giving the bondholder no choice but to accept a change in payment terms, the Intercompany Sale and the related amendments, violated the TIA's "prohibition of impairment of holder's right to payment", and could not proceed without the consent of such holder. The District Court's decision resulted in significant ambiguity and uncertainty surrounding the viability of certain types of traditional out-of-court restructurings that did not have the unanimous support of bondholders.
EDMC appealed the District Court decision to the Second Circuit which in a 2-1 ruling reversed the District Court. While acknowledging that "the text of §316(b) is ambiguous insofar as it lends itself to multiple interpretations that arguably favor either side on that issue," the Second Circuit nonetheless, disagreed with the District Court's reasoning and ruled that §316(b) does not guarantee "absolute and unconditional rights to payment", but rather protects minority bondholders against alteration of their "legal right to payment" under the indenture without their consent. The Second Circuit's decision made clear that a noteholder's legal right to receive payment would only have been impaired if there had been an express modification of the document's "core payment terms".
In response to MAM's assertion that, outside prohibiting the Intercompany Sale from occurring, there was no relief available to holdout bondholders, the Second Circuit suggested that MAM (and any other similarly situated non-consenting bondholders) could pursue (i) the payment from EDMC under state and federal law, and (ii) state law theories of successor liability or fraudulent conveyance against the EDMC Subsidiary if the facts supported such claims. Additionally, one recommendation of the Second Circuit was to negotiate better terms when drafting agreements. The Second Circuit noted that "sophisticated creditors, like [MAM], can insist on credit agreements that forbid transactions like the Intercompany Sale".
The Second Circuit's decision will help alleviate many of the concerns and uncertainties that have plagued restructuring professionals and bond issuers resulting from the District Court decision in Marblegate. Based on this holding, it now appears that, at least in courts in the Second Circuit, absent an express violation of the indenture or a modification of the indenture's core payment terms, out of court restructurings designed to put pressure on bondholders to consent to, and participate in, such restructurings by amending or removing non-core payment terms and/or selling or transferring the collateral securing the bonds, should not violate §316(b) of the TIA.
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