United States: The Trust Indenture Act’s New Relevance To Out-Of-Court Restructurings

Two recent decisions of the United States District Court for the Southern District of New York in Marblegate Asset Mgmt., et al. v. Education Mgmt. Corp., et al.¹ and Meehancombs Global Credit Opportunities Fund, L.P. et al. v. Caesars Entertainment Corp., et al.,² raise new hurdles for out-of-court restructurings of notes qualified under the Trust Indenture Act of 1939 (the "TIA") where the obligor fails to obtain the consent of all holders of such debt. In both those cases, the court gave an expansive reading of section 316(b) of the TIA³ , indicating that the elimination of parent company guarantees and amendment of covenants designed to insure that the obligor would have assets from which to pay the debt in the future, constituted an impairment of the nonconsenting noteholders' rights to receive payment of principal and interest on their notes in violation of TIA section 316(b) and in breach of the indenture covenants mandated by that section.⁴

Education Management Corporation ("EDMC") and its affiliates facing financial distress pursued an out-of-court restructuring (and not a bankruptcy filing) because EDMC and its affiliated entities would lose their eligibility for education funding from the federal government under Title IV of the Higher Education Act of 1965 if they were to file for bankruptcy or have an order for relief filed against them. In the Education Management case, the restructuring involved both secured debt and unsecured notes issued by Education Management LLC (the "Notes"). The Notes indenture was guaranteed by the obligor's parent, EDMC, and had a covenant that if the secured lenders were to release a guarantor of the secured debt from its guarantee then that guarantor's guarantee of the Notes would be automatically released. While there was no guarantee of the secured debt when the Notes were issued, a guarantee by the parent company was added to the secured debt as part of restructuring negotiations with the secured lenders earlier in 2014. This addition made it possible for the indenture covenant providing for automatic release of a guarantee to apply upon the release of such guarantee by the secured lenders. As part of the Restructuring Support Agreement ("RSA") signed by the secured lenders and holders of a majority in principal amount of the Notes, if the obligor did not obtain consent of 100% of the Noteholders to the terms of the restructuring, the signatories to the RSA would be obligated to effect an "Intercompany Sale". In connection with the Intercompany Sale, the secured lenders would release the obligor's parent from its guarantee of the secured loans (resulting in a release of the parent company's guarantee of the Notes), the secured lenders would exercise their rights under their 2014 Credit Agreement and Article 9 of the UCC to foreclose on substantially all of the assets of the obligor and other defendants and the secured lenders would immediately sell those assets back to a new subsidiary of EDMC, which would distribute debt and equity to creditors who had consented to the restructuring.

The nonconsenting Noteholders sought a preliminary injunction of the out-of-court restructuring, maintaining that the restructuring violated the nonconsenting holders' rights under TIA section 316(b). The Education Management court denied the nonconsenting Noteholders' request for injunctive relief because the Noteholders failed to prove, among other things, that they would be irreparably harmed, since if the nonconsenting Noteholders prevailed in their suit they would have the opportunity to collect monetary damages against the parent guarantor or whatever subsidiary the assets were conveyed to through the Intercompany Sale. However, the court, in dicta, in considering the other factors for issuing the injunction, including the likelihood of success on the merits, concluded that the Intercompany Sale likely violates the TIA. The court in reaching that conclusion considered the legislative history of TIA section 316(b) and determined that the section provides a broad protection against nonconsensual debt restructurings.⁵ The court observed that the record "[left] little question that the Intercompany Sale is precisely the type of debt reorganization that [section 316(b) of] the Trust Indenture Act is designed to preclude"⁶ because it would ensure that the dissenting Noteholders would not receive payment on account of their Notes. The court viewed the Intercompany Sale as operating "to effect a complete impairment of dissenters' right to receive payment."⁷ The court concluded that "the Trust Indenture Act simply does not allow the company to precipitate a debt reorganization outside the bankruptcy process to effectively eliminate the rights of nonconsenting bondholders."⁸ The case is a departure from prior decisions that interpreted TIA section 316(b) as requiring a payment default or change in payment terms before that section would come into play.

In the Caesars case, certain minority holders of two issues of notes ("CEOC Notes") issued by Caesars Entertainment Operating Company, Inc. ("CEOC") brought suit against CEOC and CEOC's parent, Caesars Entertainment Corporation ("CEC") (a guarantor of the CEOC Notes) seeking, among other things, to enforce their rights under TIA section 316(b) and section 6.8 and 508 respectively, of two CEOC unsecured note indentures, mandated by section 316(b). The complaint alleged that prior to the execution of supplemental indentures in August 2014 the CEOC Notes were guaranteed by CEC, the asset rich parent of CEOC. The complaint also asserted that the removal of the parent guarantees and the amendment of the indenture covenants precluding divestiture of assets to measure future asset sales based on CEOC's assets as of the date of the amendment in August 2014, constituted a breach of section 6.8 and 508 of the respective indentures and a violation of the TIA. The amendments, which effectively left CEC free to transfer CEOC's assets without any obligation to back CEOC's debt, were consented to by holders of a majority in principal amount of the CEOC Notes. The majority noteholders were contacted by CEOC and paid par plus accrued interest (a more than 100% premium over market) for the majority noteholders' debt in connection with the noteholders' promise to support the future restructuring of CEOC and their consent to the removal of the CEC guaranty and the modification of the covenant restricting disposition of CEOC's assets. The complaint alleged that the amendments facilitated CEC's plan to put CEOC into bankruptcy while protecting CEC's owners from CEOC's creditors. ⁹

The Caesars court denied the defendants' motion to dismiss the complaint and found that "the [c]omplaint's plausible allegations that the August 2014 Transaction stripped the plaintiffs of the valuable CEC [g]uarantees leaving them with an empty right to assert a payment default from an insolvent issuer"¹⁰ were sufficient to state a claim under TIA section 316(b). The court held that the removal of the CEC guarantees was "an impermissible out-of-court debt restructuring achieved through collective action" which "is exactly what TIA section 316(b) is designed to prevent."¹¹ The court rejected defendants' arguments that the "no action" provision of the indentures (permitted by section 316(a) of the TIA) precluded the suit because no default in payment of principal of or interest on the CEOC Notes had occurred. The court also found no merit in defendants' argument that the language in section 316(b) and the corresponding mandated indenture provisions required an actual nonpayment of the CEOC Notes for the Noteholders to bring suit for breach of sections 6.8 and 508 of the indentures and the covenant of good faith and fair dealing. In fact, section 6.8 and 508 of the indentures lacked language contained in section 316(b) referring to "payment on or after... [the] respective [due] dates [for payment of principal and interest]." The court concluded that the removal of the CEC guarantee impaired the rights of the nonconsenting Noteholders to payment without their consent and was sufficient to defeat the motion to dismiss the complaint as to the claims under section 316(b) of the TIA and under state law for breach of section 6.8 and 508 of the respective indentures and the covenant of good faith and fair dealing against CEC.¹²

Potential Ramifications for Issuers and Noteholders

The Education Management and Caesars decisions provide new leverage for nonconsenting minority holders of public debt subject to the TIA in out-of-court restructurings. However, the decisions may prove in certain cases to be a double-edged sword because obligors who cannot obtain the consent of holders of 100% of their TIA debt may be forced to reorganize under chapter 11 of the Bankruptcy Code in order to achieve the same result with potentially less value left to pay noteholders. These decisions may also lead issuers in the future to avoid issuing notes in registered offerings or granting registrations rights that would cause the notes to be subject to the TIA. Moreover, it is likely that indenture trustees may require before entering into such supplemental indentures under similar circumstances receipt of an opinion of counsel to the obligor that the amendment does not violate section 316(b) of the TIA.

Footnotes

[1] 2014 U.S. Dist. Lexis 178707 (S.D.N.Y Dec. 30, 2014).

[2] 2015 U.S. Dist. Lexis 5111 (S.D.N.Y. Jan. 15, 2015).

[3] 15 U.S.C. § 77ppp(b). TIA Section 316(b) provides in pertinent part "...the right of any holder of any indenture security to receive payment of principal of and interest on such indenture security, on or after the respective due dates...or to institute suit for the enforcement of such payment on or after such respective dates shall not be impared or affected without the consent of such holder...."

[4] Although the court's expansive reading of section 316(b) in Education Management was by way of dicta, it serves as a basis for the court's holding in Caesars.

[5] The court also followed the decision in Federated Strategic Income Fund v. Mechala Grp. Jam. Ltd., 1999 U.S. Dist. Lexis 16996 (S.D.N.Y. Nov. 2, 1999) which found that the TIA protects the ability, and not merely the formal right to receive payment.

[6] 2014 U.S. Dist. Lexis 178707 at *59.

[7] 2014 U.S. Dist. Lexis 178707 at *60.

[8] 2014 U.S. Dist. Lexis 178707 at *65.

[9] 2015 U.S. Dist. Lexis 5111 at *5.

[10] 2015 U.S. Dist. Lexis 5111 at *17.

[11] 2015 U.S. Dist. Lexis 5111 at *18.

[12] The court made no ruling with respect to CEOC because at the time of the court's decision the automatic stay applied to litigation against CEOC as the result of the then pending involuntary chapter 11 case against CEOC.

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