Earlier this year in Marblegate Asset Management LLC (“MAM”) v. Education Management Corp. (“EDMC”), the Second Circuit evaluated whether Section 316(b) of the Trust Indenture Act (“TIA”) was designed to protect a dissenting bondholder’s right to receive payment through an out-of-court restructuring, if the out-of-court restructuring had the effect of eliminating the ‘practicable ability’ to receive payment but did not change the ‘core terms’ of the bonds.
Background
EDMC’s out-of-court restructuring was effectuated through an exchange offer and consent solicitation whereby in exchange for the consent of the majority holders (the “Consenting Holders”) of notes (the “Old Notes”) issued by Education Management LLC and Education Management Finance Corp. (together, the “Old EDMC Subsidiaries”) to amendments to the indenture governing the Old Notes, which removed various covenants of the Old EDMC Subsidiaries, the Consenting Holders (i) foreclosed on all of the Old Subsidiaries’ assets securing the Old Notes, (ii) sold the foreclosed assets to Education Management II LLC and Education Management Finance III LLC, two new subsidiaries of EDMC (together, the “New EDMC Subsidiaries”) (the foreclosure and subsequent sale of such assets is hereafter referred to as the “Intercompany Sale”), and (iii) exchanged their Old Notes for debt and equity distributed by the New EDMC Subsidiaries which were collateralized by the New EDMC Subsidiaries’ newly acquired assets. MAM, as a holder of the Old Notes who did not participate in the exchange offer and consent solicitation, argued that the Intercompany Sale and related amendments to the existing bond indenture effectively left the Old EDMC Subsidiaries as asset-less shell companies arguably rendering the Old Notes held by those who did not participate essentially worthless.1
The Second Circuit ultimately ruled that Section 316(b) of the TIA had not been violated since MAM’s legal right to receive payment on the Notes was left intact following the amendments and the Intercompany Sale. While MAM was unable to successfully assert a claim based on a violation of Section 316(b) of the TIA, the court reminded the plaintiffs that the dissenting bondholders were not without recourse. The Second Circuit noted that its decision precluding a Section 316(b) of the TIA claim from going forward “will not leave dissenting bondholders at the mercy of bondholder majorities” as holders were free to pursue other remedies under federal or state law, such as successor liability and fraudulent conveyance.
State and Federal Law Claims
On June 19, 2017, perhaps taking the Second Circuit’s suggestion in Marblegate, The Bank of New York Mellon Trust Company, N.A., at the direction of Marblegate Special Opportunities Master Fund, L.P. (“MSOMF”), filed a complaint in the United States District Court for the Southern District of New York against the New EDMC Subsidiaries alleging that the Intercompany Sale subjected EDMC to the New York common law theory of successor liability.
Successor Liability and Fraudulent Conveyance
Under New York common law, there are four circumstances that create successor liability: (1) the Purchaser of a company’s assets expressly or impliedly assumes the seller’s liabilities; (2) the Purchaser of a company’s assets is a mere continuation of the seller (de facto merger); (3) the Purchaser of a company’s assets continues essentially the same operations or product line of the seller; or (4) the sale was an attempt to fraudulently evade creditors or escape obligations.
In the complaint, MSOMF alleges three theories of successor liability, namely that (i) the New EDMC Subsidiaries are mere continuations of the Old EDMC Subsidiaries, (ii) the New EDMC Subsidiaries continue essentially the same operations as the Old EDMC Subsidiaries, and (iii) the Intercompany Sale was an attempt to evade obligations to holders of Old Notes who did not participate in the exchange offer and consent solicitation.
The question at hand is whether a majority of noteholders can consent to strip the issuer of its assets in exchange for notes issued by a new entity that receives all of the issuer’s previously held assets, thereby leaving the non-participating noteholders without a practical means of recovering against such issuer in the event of a default. On the one hand, the Second Circuit has held that Section 316(b) of the TIA does not prohibit exchange offers that preserve non-participating noteholders’ legal right to receive payment, even if such exchange offer has the effect of eliminating the non-participating noteholders’ ‘practical ability’ to receive payment. On the other hand, there is considerable uncertainty as to whether commencing an action under a theory of successor liability is in fact an effective and practical remedy for non-participating bondholders.
The District Court’s decision in this case will provide much needed certainty on whether, and to what extent, (i) issuers of notes can utilize similar out-of-court restructuring tools to avoid bankruptcy, and (ii) non-participating noteholders can succeed on a theory of successor liability in the context of this type of an out-of-court restructuring.
______________________________________________________
1 A more detailed synopsis of the Intercompany Sale and the Second Circuit’s decision can be found in our January 23, 2017 memorandum titled “Second Circuit Overturns Marblegate Decision Regarding Violation of §316(b) of the Trust Indenture Act.”
