In several recent decisions, two judges on the United States District Court for the Southern District of New York adopted an interpretation of the Trust Indenture Act of 1939 (the “TIA”) that can be expected to complicate future exchange offers and, in some cases, force bond restructurings that might otherwise have been completed out-of-court to be effectuated through a bankruptcy filing. These decisions have been appealed to the United States Court of Appeals for the Second Circuit, but given the approach taken by the Southern District courts in interpreting the TIA, reorganizing issuers would be well advised to pay close attention to this significant change in the financial restructuring landscape.
Education Management Corporation (“EDMC”) is a large for-profit provider of college and graduate education. Faced with deteriorating finances, EDMC sought to restructure approximately $1.522 billion in secured loans and unsecured notes, both issued by its subsidiary Education Management LLC and guaranteed by EDMC. Because EDMC would lose its entitlement to funds under federal student aid programs if it filed for bankruptcy, the restructuring had to be accomplished out-of-court.
To this end, EDMC negotiated a restructuring with its creditors that contemplated two possible transactions. If 100% of EDMC’s creditors consented, secured lenders would receive a combination of cash, new debt and preferred stock and noteholders would receive preferred stock. If 100% consent was not obtained, secured lenders would release EDMC’s guarantee of their loans (which under the indenture governing the unsecured notes would automatically release EDMC’s guarantee of the notes), foreclose on substantially all of EDMC’s assets and then sell the assets back to a new subsidiary of EDMC, in exchange for new debt and equity to be distributed only to consenting creditors. Non-consenting holders of unsecured notes would lose the benefit of the EDMC guarantee and would be left with claims against an entity that no longer held any assets.
While 99% of the secured lenders and over 90% of the noteholders consented to the first option, EDMC was forced to pursue the nonconsensual alternative. The plaintiffs were among the holdouts and sought a preliminary injunction to enjoin the restructuring (“Marblegate I”). The court denied the preliminary injunction and, later, following the provision of extensive supplemental briefing, it affirmed its earlier position that the proposed restructuring was prohibited by the TIA (“Marblegate II”).
Caesars Entertainment Corporation (“CEC”), along with its subsidiaries, including Caesars Entertainment Operating Company, Inc. (“CEOC”), owns and manages dozens of casinos in the United States. CEOC issued $750 million in senior unsecured notes due in 2016 and $750 million in senior unsecured notes due in 2017. The notes were guaranteed by CEC.
In August 2014, with a restructuring on the horizon, CEOC and CEC purchased a substantial portion of the notes at par plus accrued interest in a private transaction. In exchange, the holders of these notes agreed to support a future restructuring of CEOC, including the release of CEC’s guarantees. The plaintiffs were noteholders (and bond trustees suing on their behalf) that were not invited to participate in the deal. Due to the amount of CEOC’s secured debt, with the release of the guarantee by CEC, the plaintiffs faced losing the only source for repayment on the unsecured notes. The plaintiffs sued CEC and CEOC on the theory that the release of the parent guarantee violated the TIA and the TIA-qualified indentures. The court denied Caesars’ motion to dismiss noteholder claims, even though release of a parent guarantee was allegedly permitted under the indenture’s amendment provision (“Caesars I”). In a later opinion denying summary judgment to noteholders, the same court analyzed the appropriate evidentiary showing required to prove a TIA claim (“Caesars II”). In January 2015, CEOC and 172 of its subsidiaries (but not CEC) filed for chapter 11 bankruptcy protection.
District Court Decisions
As generally understood prior to these recent decisions, the TIA only protects a legal right to seek payment by protecting each holder against amendments of certain “core terms” not implicated in either decision, such as the indenture’s payment terms, that are consented to by a majority of holders. After a review of an unpublished district court decision and the TIA’s legislative history, the Marblegate I court reasoned that the TIA should be read as “a broad protection against nonconsensual debt restructurings,” protecting each noteholder’s “substantive right to actually obtain” payment and not merely the “legal entitlement to demand payment.”
Applying this expansive interpretation of the TIA, the Marblegate I court found that the nonconsensual restructuring would “effect a complete impairment of dissenters’ right to receive payment” and therefore likely would be illegal under the TIA. The court further stated that Section 316(b) of the TIA “was intended to force bond restructurings into bankruptcy where unanimous consent could not be obtained.” Relying on this reasoning, the Caesars I court held that, as alleged, the removal of the parent guarantee was “an impermissible out-of-court debt restructuring achieved through collective action. This is exactly what TIA Section 316(b) is designed to prevent.”
Addressing the TIA issue, the Marblegate II court framed the question, “[D]oes a debt restructuring violate Section 316(b) of the Trust Indenture Act when it does not modify any indenture term explicitly governing the right to receive interest or principal on a certain date, yet leaves bondholders no choice but to accept a modification of the terms of their bonds?” The court answered in the affirmative and even though TIA Section 316(b) is silent as to the precise kinds of restructurings that are prohibited, the court had no trouble holding that the Marblegate restructuring did so by offering holdouts no choice but to take the deal or to get nothing.
Building on Marblegate II, the Caesars II court rejected the argument that the bondholders should be required to show an offensive restructuring of their particular tranche of debt, because such a requirement would ignore the fact that “an impairment may also occur where a company restructures debt arising under other notes.” It also determined that connected transactions should be reviewed collectively in concluding whether, as a whole, they made up an impermissible out-of-court restructuring. Finally, the court held that impairment must be shown when payment is due under the notes, which is the point at which a noteholder’s right can be said to be affected by an issuer’s or guarantor’s actions.
While these decisions have been appealed to the Second Circuit, their implications are significant. The facts of these cases are extreme, involving involuntary releases of guarantees and attempts to strip a borrower of assets without requiring the new owner to assume liability for the notes. Nevertheless, the stated rationale of these decisions is extraordinarily broad and could reach transactions involving far less dramatic modifications to noteholder rights. Although the decisions do not clearly define what constitutes a debt restructuring for these purposes, and Caesars II indicated that this is a question of fact to be determined on a case-by-case basis, they suggest that any modifications of an indenture – and even automatic guarantee releases and other actions provided for or permitted under an indenture – that actually impair a dissenter’s ability to obtain payment are prohibited. Exchange offers, however, commonly involve exit consents whereby exchanging noteholders consent to indenture amendments stripping certain covenants and events of default under typical majority-rule amendment provisions. These alterations of debt terms are designed to discourage noteholders from holding out in order to free ride on concessions made by majority holders. While the Marblegate I court stated that exit consents will be permissible in some cases, Marblegate II and Caesars II call into question the continued viability of this restructuring tool, at least if coupled with other steps such as guarantee releases and transfers of assets out of the reach of dissenting bondholders. In so doing, these decisions may force more companies into bankruptcy or, at a minimum, increase the execution risk and related costs of out-of-court bond restructurings.
In addition, there is anecdotal evidence that these decisions are having an impact on the terms of new bond issuances. Given the breadth of the rationale in these cases and the resulting uncertainty with respect to the feasibility of out-of-court restructurings, issuers have another disincentive to register their bonds with the Securities and Exchange Commission and thereby subject their indentures to the TIA. Further, and unsurprisingly, references to TIA Section 316(b) and any language that approximates that section’s text are being meticulously modified or removed from 144A-for-life indentures. Finally, some issuers and their counsel have taken a straightforward step to address the underlying concern of a small holdout minority being able to block a restructuring otherwise supported by a large majority of bondholders: some recent indentures require only 90% (instead of 100%) support to modify certain fundamental terms like payment obligations and maturity dates. These provisions, modeled on similar provisions commonly seen in the European market, currently represent a minority position in the U.S. market. However, this trend may gain momentum, particularly given that these provisions benefit both issuers and bondholders by removing a holdout’s ability to force a consensual financial restructuring into a bankruptcy proceeding that may be lengthy, destroy value and reduce recovery for bondholders (and, ultimately, other constituencies).