Marblegate Asset Management v. Education Management Finance Corp., the U.S. Court of Appeals for the Second Circuit reversed a 2014 U.S.
District Court decision, narrowing the court’s interpretation of
Section 316(b) of the Trust Indenture Act of 1939 (TIA). The Court of
Appeals held that an out-of-court debt restructuring that impaired the
practical ability of noteholders to be repaid did
not violate Section 316(b) since it did not amend an indenture’s core
payment terms. By ruling that only non-consensual amendments would violate
Section 316(b) of TIA, the Court of Appeals clarified its broad interpretation
of out-of-court restructurings when they involve public bonds.
The purpose of enacting TIA was to provide protections to holders of debt
securities whose bonds qualified under the statute. Section 316(b) provides that:
“The right of any holder of any indenture security to receive payment
of the principal of and interest on such indenture security, on or after
the respective due dates expressed in such indenture security, or to institute
suit for the enforcement of any such payment on or after such respective
dates, shall not be impaired or affected without the consent of such holder.”
Section 316(b) shields minority bondholders by requiring the consent of
each minority bondholder, rather than a majority, to amend a bondholder’s
right to receive payment. However, in
Marblegate Asset Management, LLC v. Education Management Corp., the U.S. District Court for the Southern District of New York broadened
the interpretation of Section 316(b) to not only prohibit transactions
that impair a non-consenting bondholder’s legal ability, but also
their practical ability to receive principal and interest payments, including
transactions that do not specifically modify any of the indenture’s
payment terms. Before
Marblegate, the interpretation of Section 316(b) of TIA protected the legal right,
but not the practical right, for a bondholder to recover payment under a bond.
In 2014, Education Management Corporation (“EDMC”), an education
provider that profits from federal student aid programs, reorganized approximately
$217 million in unsecured notes and $1.3 billion in secured debt issued
by EDMC’s subsidiaries through an out-of-court exchange offer that
was guaranteed by EDMC. Under the restructuring, secured creditors of
EDMC’s subsidiaries foreclosed and transferred those assets to a
newly formed subsidiary of EDMC.
Moreover, the secured creditors released the guaranty of their debt by
EDMC, putting into motion a series of EDMC’s guaranty releases of
the unsecured notes, which was permissible under the terms of the indenture.
Despite no amendments to the payment terms, dissenting noteholders had
no recourse except against the smaller EDMC subsidiaries. Unfortunately,
those affiliates were left with no assets.
In the U.S. District Court case, two funds collectively known as “Marblegate”
holding a combined $20.3 million sued to order the exchange offer, alleging
that it violated Section 316(b) by depriving them of the practical ability
to collect on the notes. The District Court ruled in Marblegate’s
favor, thereby broadening the interpretation of Section 316(b) as it practically
left non-consenting noteholders with worthless claims. The District Court
confirmed that Section 316(b) of TIA was meant to force bond restructuring
into bankruptcy when the holders of notes could not reach a unanimous decision.
After the decision, EDMC went ahead with the intercompany sale, but protecting
Marblegate’s rights in the process. The EDMC also filed an answer
with the District Court concerning the counterclaim of declaratory relief
on the parent guarantee so that the Court could make a final determination.
The Second Circuit Decision
EDMC appealed the District Court decision, asserting its actions complied
with Section 316(b) by agreeing to a foreclosure sale and release of the
parent guarantee. However, in January 2017, the Second Circuit held that
Section 316(b) of TIA “prohibits only nonconsensual amendments to
an indenture’s core payment terms.” Although the Court of
Appeals was divided, the majority wrote that “[a]bsent changes to
the indenture’s core payment terms… Marblegate cannot invoke
section 316(b) to retain an ‘absolute and unconditional’ right
to payment of its notes.” The Court of Appeals held that the transaction
did not amend terms of the indenture nor prevent any holders from suing
to collect, and therefore did not violate TIA.
The Second Circuit’s decision not to uphold the District Court's
ruling prevents noteholders from pursuing out-of-court restructuring in
cases where public bonds are at stake. By reversing the decision of the
lower court, the Second Circuit ensures that endless litigation delays
will not prevent an entity from negotiating satisfactory terms outside
Marblegate still has the right to petition for a writ of certiorari (i.e.
rehearing) to the U.S. Supreme Court. However, until then, the Second
Circuit Court of Appeal’s ruling will give clarity to an otherwise
uncertain interpretation of Section 316(b), and will provide greater flexibility
for restructuring negotiations. The Second Circuit has ensured that both
issuers and holders of U.S. bonds can now act with greater confidence
and clarity in regards to the protections provided under Section 316(b).