The Court of Appeals' recent decision in CNH Diversified Opportunities Master Account, L.P. v. Cleveland Unlimited, Inc., 2020 WL 6163305 (NY Oct. 22, 2020), is likely reverberating through the corporate debt markets right now. It represents a significant development in the area of law concerning when minority holders of a note issuance have the right to hold up an out-of-court, majority-approved debt restructuring of the note issuer. The ruling also potentially introduces uncertainty with respect to a now-common tool for raising financing senior to the issuer's note obligations.
The Court's decision focused on boilerplate indenture language derived from section 316(b) of the Trust Indenture Act (or TIA) and typically incorporated into non-TIA qualified indentures as well. That provision states that "notwithstanding" any other indenture provision, the right of a holder to "receive payment" on its notes or to "institute suit for the enforcement" of payment "shall not be impaired" without the consent of the holder. In Marblegate Asset Management, LLC v. Education Management Finance Corp., 846 F.3d 1 (2d Cir. 2017), a seminal 2017 case successfully litigated by one of the authors, the Second Circuit held that this language has a narrow and specialized meaning: it prohibits only "non-consensual amendments to an indenture's core payment terms" (those stating how much is owed and when) and does not forbid transactions that do not amend these terms and do not prevent dissenting noteholders from initiating suit to collect payment on the notes when due. In other words, the provision protects the formal legal right to receive payment, but not the practical ability to realize a recovery. Thus, in Marblegate, section 316(b) was held not to bar a foreclosure by secured lenders that removed all the issuer's assets, automatically released a guarantee in accordance with the indenture, but left the payment terms of the notes unchanged.
A divided New York Court of Appeals, in a 4-3 decision, ruled in Cleveland Unlimited that the language of section 316(b) applied to a majority-directed strict foreclosure on the stock of the issuer, which had been pledged as collateral in favor of the notes, that resulted in a cancellation of all holders' notes and replacement of those securities with a pro rata portion of the issuer's equity. The Court ruled that the minority holders that did not assent to the transaction could not be stripped of their rights to sue on the now-cancelled notes, and instead were permitted to obtain judgment for the full amount of their notes from the issuer and guarantors, which had been substantially de-leveraged following the equitization of the majority's notes.
This ruling expands Marblegate's interpretation of section 316(b) in at least two significant respects. First, the Court held that the language at issue bars not only formal amendments of indentures, but also an exercise of remedies by the trustee that has the effect of eliminating non-consenting holders' legal right to receive payment or bring a collection suit. In the United States, where foreclosures are not frequently used to effectuate restructurings, this aspect of the Cleveland Unlimited ruling may have limited consequences. But it could give rise to concerns for non-U.S. issuers of New York law notes, which often rely on out of court restructuring mechanisms akin to foreclosure, such as share-pledge enforcements, combined with the release provisions in intercreditor agreements applicable to primary liabilities and guarantee obligations.
Second, and perhaps of greater consequence, the Cleveland Unlimited decision precluded reliance on other indenture provisions to argue that noteholders gave advance consent to the challenged transaction. The indenture, as well as related documentation, contained numerous terms that authorized the indenture trustee to exercise remedies, including by conducting foreclosures, at the direction of a noteholder majority in default scenarios. Under the logic of Marblegate, these other contractual terms might have been dispositive, pointing to the conclusion that there was no section 316(b) issue: following the indenture as written, without amending it, honors the holders' rights to receive payment and sue for enforcement; it does not impairthose rights. Nevertheless, the Court of Appeals held that the language of section 316(b) overrode whatever authority the trustee had to effectuate the strict foreclosure under these other contractual terms, since it applied "notwithstanding" any other indenture provision. A vigorous dissent, which would have enforced the plain contractual terms rather than interpreting them as being in conflict with and trumping each other, warned that the Court's ruling "needlessly injects uncertainty into a multi-trillion-dollar corporate debt market."
This aspect of the Court's decision may have further-reaching implications, both for U.S. issuers and foreign issuers of New York law notes. It potentially calls into question the viability of a now commonly used financing tool that depends on indenture-mandated releases of guarantees.
Indentures frequently include guarantees by the issuer's subsidiaries. Those entities that are guarantors are subject to the same restrictive covenants in the indenture as the issuer and are called "Restricted Subsidiaries." The issuer is usually given the authority to remove a subsidiary from the list of "Restricted Subsidiaries (a so called "de-restriction") if it has sufficient capacity in its covenants to make investments in entities that are not restricted (so-called "Permitted Investments"). So, for example, if the covenants permit the issuer to make $150 million of Permitted Investments, the issuer can "de-restrict" a subsidiary or group of subsidiaries worth up to that amount. Under the terms of most indentures, proper de-restriction expressly has the effect of automatically releasing the subsidiary of all obligations under the indenture, including its guarantee of the notes. This, in turn, makes the subsidiary's assets or stock newly available to support financing. An enterprise may raise new capital by borrowing against the newly de-restricted subsidiary, through debt obligations that are structurally senior to the issuer's note obligations.
Does a de-restriction, and the resulting automatic release of a guarantee in accordance with the indenture's express terms, impermissibly "impair" the noteholders' legal rights to receive or sue for payment in contravention of section 316(b)? After Marblegate, the answer was understood to be no. That case itself involved a release of a guarantee (albeit through a mechanism other than a de-restriction) that was accomplished in accordance with the express terms of the indenture. Yet Cleveland Unlimited placed such weight on the "notwithstanding" clause of section 316(b) that it might be read as precluding non-consensual guarantee releases upon a contractually authorized de-restriction. After all, such releases – despite being clearly authorized by the indenture's language and bargained for by the noteholders – expunge a legal right to receive payment from the guarantor, as well as a noteholder's right to sue the guarantor for enforcement.
The Court of Appeals surely did not have de-restriction-based financings in mind when it reached its decision, and it remains to be seen whether section 316(b) will be applied in a case involving such a mechanism. There are reasons to believe that courts will be reluctant to give Cleveland Unlimited such a broad reading, however. For one thing, the facts of the case were extreme: the issuer's notes were cancelled upon the strict foreclosure, and the holders ceased to be creditors entirely of any entity in the corporate enterprise. This may be viewed in future cases as different in both degree and kind from a transaction, like the one in Marblegate or a de-restriction, where the issuer's primary liability on the notes remains in place and only a contingent guarantee obligation is released. The Marblegate court did not explicitly rule on whether a guarantee constitutes one of the "core payment terms" of an indenture.
A court applying Cleveland Unlimited to a de-restriction transaction also will have to confront the rule of contract construction that terms are not to be rendered meaningless. If a provision expressly saying a guarantee is to be released upon a de-restriction can never be enforced without consent because it is trumped by section 316(b), it is difficult to see how it would be anything but surplusage. The release provision would be reduced to saying that guarantee obligations can be extinguished upon consent, which is a truism. This rule of construction was not implicated in Cleveland Unlimited because the remedy and enforcement provisions at issue authorized the trustee to do a wide variety of things short of cancelling notes; they were not rendered meaningless by a conclusion that just one remedy among innumerable others was impermissible. Finally, any reading of section 316(b) must be understood against the backdrop of the legislative history, which is outlined in detail in Marblegate. As described there, the purpose of section 316(b) was to prevent indentures from containing clauses that allow noteholder majorities to force minorities to accept the results of out-of-court debt-readjustment plans. De-restrictions of subsidiaries are undertaken by the issuer, without necessarily involving majoritarian action by noteholders, and may be accomplished completely independent of any financial reorganization of the issuer. Section 316(b), which was intended to regulate relationships among noteholders in the context of restructurings, arguably has no application to the issuer's exercise of rights, conferred upon it in the indenture, to raise new financing.
Originally Published by Twenty Eagle
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