Why would a 75 year old statute that has been rarely cited garner so much attention in the last two years? That statute, the Trust Indenture Act of 1939 or “TIA”, 15 U.S.C. § 77aaa et seq., prohibits any person from selling a note, bond or debenture in a public offering unless it has been issued under an indenture and is qualified under the TIA. Importantly, the TIA specifically mandates that the right of a bondholder to receive payment on such security cannot be impaired without the bondholder’s consent. While no one appears to dispute that an impairment of that right would include, for example, revising the terms of an indenture to delay payment of principal, what is less clear is whether impairment also includes the cancellation of a parent guaranty or the stripping of covenants such as those restricting the transfer of valuable company assets such that the bondholders’ ability to recover on the bond is severely undercut, whether on the due dates or otherwise. That question has recently been raised in a number of 2014 and 2015 cases.
The recent cases of Marblegate and Caesars, each of which is described in detail below, highlight the different views regarding the scope of the TIA provision prohibiting the impairment of a noteholder’s right to payment. Parties in these litigations have articulated what are essentially two different interpretations of the “right” protected by the TIA, each of which has its foundation in existing case law. This article will review the history of the TIA, the bases for the two different views of the “right” protected by the TIA, and then finally examine the most recent TIA decisions, one of which has been appealed to the Court of Appeals for the Second Circuit.
The Creation of the Trust Indenture Act
In the 1930s, the public bond market was identified by the Securities and Exchange Commission (or “SEC”) as one of the financial markets ripe for change. A 1936 Report to Congress created by a team headed by SEC commissioner and future Supreme Court Justice William O. Douglas focused on the actions of indenture trustees in that market. See Report on the Study and Investigation of the Work, Activities, Personnel and Functions of Protective and Reorganization Committees, Part VI: Trustees Under Indentures (June 18, 1936).
The 1936 Report concluded that while indenture trustees were given broad discretionary powers to protect beneficiaries of the trust, they rarely invoked those powers. Individual bondholders could theoretically force action but often only if they could identify other bondholders who would act collectively with them. However, identifying a given percentage of geographically scattered bondholders was often impractical, if not impossible. Without such a percentage, certain indentures would not permit individual holders to bring suit. The 1936 Report proposed that Congress take a number of steps to, among other things, make indenture trustees more proactive. Proposed bills were circulated by Congress in 1937, 1938 and 1939, all of which proposed a more involved oversight role for the SEC with respect to indentures. The final 1939 proposal, however, took a somewhat different approach. The Trust Indenture Act of 1939 put some obligations directly on the trustees (such as various reporting requirements) but also gave investors more substantive rights, requiring indentures to include provisions that, among other things, gave individual holders the independent right to bring certain legal actions and to be paid.
Introduction to TIA Section 316
Section 316 of the TIA was intended to provide a balance between the rights of a majority of investors to take certain actions in the event of a default under the indenture and the rights of individual investors who may not side with the majority position. For example, section 316(a) provides that noteholders holding a majority in principal amount may direct the time, method and place of conducting any proceeding for any available remedy and may also waive any past default and its consequences. Section 316(a) also provides that an indenture may include a provision permitting holders of 75 percent of outstanding securities to agree to postpone interest due under an indenture for up to three years, notwithstanding
Section 316(b), in contrast, is designed to protect the minority. It provides:
Notwithstanding any other provision of the indenture to be qualified, 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) of the TIA cannot be waived or excluded from any indenture governed by the TIA. Accordingly, outside of bankruptcy, a majority of noteholders cannot affect an individual noteholders’ right to payment of principal or interest. End of story. Or, is it?
Early TIA Section 316 Cases
Before the 2014 and 2015 TIA cases, only a small number of published cases addressed the required section 316 provisions that were incorporated into every qualified indenture. For example, one early case, In re Continental Bank & Trust Co. v. First National Petroleum Trust, 67 F.Supp. 859, 871 (D.R.I. 1946), concluded that an interest forbearance greater than three years agreed to by a majority of holders and otherwise consistent with section 316(a) could not trump the explicit language in section 316(b) that required payment be made when due unless otherwise agreed by a holder. According to the district court, the right of a holder to interest when due is absolute. In the 1999 case of Federated Strategic Income Fund v. Mechala Group, 1999 WL 993648 (S.D.N.Y.), the court focused on the more-global “right to payment” requirement of section 316(b). There, the court was asked whether a tender offer which included a proverbial “carrot” accepted by 77% of the noteholders but left the remaining noteholders with “stripped” covenants and no guaranty was acceptable under the TIA. The court concluded that in that situation, bondholders would no longer be practically able to “seek recourse from either the assetless defendant or from the discharged guarantors.” As such, the court found that section 316(b) of the TIA was violated. This interpretation of the TIA was not universally accepted.
In the 2004 case of YRC Worldwide, Inc. v. Deutsche Bank Trust Co., 2010 WL 2680336 (D.Ct. Kan.), the indenture trustee asked the court to determine whether the deletion of certain purchase rights violated section 316(b) of the TIA. The court found that such deletions were improper under the TIA because they involved the loss of an absolute right to receive payments on specific due dates. However, the court also concluded that section 316(b) was not violated by the elimination of merger or transfer covenants, which was agreed to by 90% of the company’s creditors. The court noted that no evidence was presented that such an elimination would practically result in the loss of recourse to the remaining bondholders – as was the case in Federated – but suggested that this fact was not ultimately determinative to the analysis. In language culled from earlier TIA cases, the court made a distinction between a bondholder’s “legal rights” and its “practical rights” under the TIA. Only legal rights to receive payment or institute a lawsuit are protected under the TIA said the court. In contrast, while modifications affecting practical rights may make it difficult for a bondholder to receive payment on its notes, such changes do not violate the TIA. This ruling, along with similar other rulings undoubtedly led to the more recent TIA disputes, which are addressed below in chronological order.
The Marblegate Decision
In 2014, Education Management Corporation and certain of its affiliates (“EDMC”), for-profit education companies, negotiated an out-of-court restructuring with the majority of its debt holders. (An out-of-court restructuring was particularly important for EDMC because 80% of its revenues were obtained from Title IV Higher Education Act funds; EDMC would have become ineligible to receive Title IV funds had it filed for bankruptcy.) Prior to the proposed restructuring, EDMC had $1.305 billion in secured debt and $216 million in unsecured notes. Relevant here, the unsecured notes were qualified under the TIA. The notes were issued by an EDMC subsidiary, with the EDMC parent guaranteeing the subsidiary’s obligations to the noteholders. The notes’ indentures provided that the guarantee could be released either by a majority vote of the noteholders or by a corresponding release of the guarantee by the
The EDMC restructuring provided the secured term lenders with new debt and equity in a new EDMC subsidiary (for a 55% recovery of value), while holders of the unsecured notes received equity amounting to approximately a 33% recovery of value. The mechanics for providing the new debt and equity were as follows: the secured lenders agreed to release the EDMC guarantee, which had the effect of releasing the unsecured noteholders’ guarantee. The lenders would then foreclose on the assets of the EDMC entities and sell the assets back to a new subsidiary of EDMC. The new subsidiary would issue the new debt and make the proposed equity distributions, but only to those creditors who consented to the terms of the restructuring. Non-consenting creditors would be left to assert their claims against the original EDMC obligors who, after the sale, would no longer have any assets to satisfy the claims. As summarized by the district court, “although the Intercompany Sale would not formally alter the dissenting Noteholders’ right to payment on their Notes, it was unequivocally designed to ensure that they would receive no payment if they dissented from the
Marblegate Asset Management, a holder of the unsecured notes, first filed a motion seeking to enjoin the proposed restructuring, arguing that it violated section 316(b) of the TIA because it impaired, without Marblegate’s express consent, its right to payment. The court denied the motion for a preliminary injunction on the basis that Marblegate had adequate remedies at law, but the court also found that Marblegate would likely succeed on the merits of its claims under the TIA.
EDMC proceeded with the restructuring in 2015, and Marblegate sought declaratory and monetary relief based on its continued assertions of violations under the TIA. In its June 2015 decision, see Marblegate Asset Management, LLC v. Education Management Corp., 2015 WL 3867643 (S.D.N.Y. June 23, 2015), the court agreed with Marblegate, finding that section 316(a) of the TIA was to be interpreted broadly, consistent with the legislative history. The purpose of the TIA, stated the court, was to ensure that minority bondholders would not “be forced to relinquish claims outside of the formal mechanisms of debt restructuring.” As such, while EDMC’s proposal did not directly amend any term explicitly governing any individual bondholder’s right to receive payment, it did give “dissenting bondholders a Hobson’s choice: take the common stock, or take nothing.” The threat of total deprivation was “without resort to the reorganization machinery provided by law.” As such, and while recognizing the potentially troubling implications of rewarding holdouts, the court concluded that it was “beyond peradventure” that section 316 of the TIA was violated by EDMC’s actions.
EDMC appealed the district court’s ruling to the Second Circuit. It is hoped that the Second Circuit will provide clarity on the scope of noteholders’ rights under TIA section 316(b). The Second Circuit’s views on Section 316(b) will also have immediate implications for another large bankruptcy case currently pending—that of Caesars Entertainment Operating Corp.
The Caesars Decision
In early 2014, Caesars Entertainment Operating Company, Inc. (also known as “CEOC”), the owner of a substantial part of Caesars’s gambling properties, had $12.6 billion in bond debt governed by at least eight separate indentures. The majority of the bond debt was secured by first or second liens on CEOC assets, with only approximately $1 billion of the bond debt unsecured. Importantly, both the secured and unsecured bond debt had the benefit of a guarantee (when issued) from CEOC’s parent, Caesars Entertainment Corporation (also known as “CEC”).
In May 2014, in connection with the refinancing of certain debt maturing in 2015, CEC sold 5% of CEOC common stock to certain institutional investors. Several weeks later, CEC allocated another 6% of CEOC common stock to certain of its officers and directors as part of a performance incentive plan. As the indentures for both the secured and unsecured notes provided that CEC’s guarantee could be released if CEOC were no longer a “wholly owned subsidiary” of CEC, CEC asserted that its guarantee of CEOC’s obligations under the notes was released after the May/June 2014 transactions.
A group of CEOC unsecured noteholders disagreed with CEC, taking the position that the guarantee remained in place after the two stock transfers. After negotiations, CEC and CEOC announced that CEOC had agreed to the repurchase of the complaining noteholders’ notes at par plus interest (and certain transactional fees/costs). In return, the noteholders had agreed to the amendment of the unsecured note indentures to remove CEC’s guarantee (and make certain other changes). While CEC asserted that CEOC’s repurchase of notes was part of a bigger scheme to keep the Caesars companies afloat, other noteholders who were not invited to participate in the repurchase transaction have taken the position that the repurchase of notes was prompted by the ad hoc noteholder group’s initial opposition to the alleged stripping of the CEC guarantee.
In January 2015, CEOC and certain of its affiliates (but not CEC) filed for bankruptcy. The bankruptcy filing resulted in the acceleration of principal and interest on CEOC’s various notes. CEC immediately took the position that its guarantee of amounts owing under the notes had been terminated before the bankruptcy filing. The result was multiple lawsuit
Four lawsuits were filed in the District Court for the Southern District of New York asserting violations of the TIA, two by unsecured noteholders and the other two by the trustee for the first lien notes and the trustee for the second lien notes. Trial is set to begin with respect to the lawsuits relating to the secured notes on March 26, 2016 and the unsecured noteholders’ lawsuits are scheduled for trial on May 9, 2016. All of the lawsuits will require a determination of when (or if) the CEC guarantee was released under the respective indentures. Once that determination is made, the question will be whether the release of the guarantee (if it was released) violated the TIA.
The Caesars district court has already stated in ruling on earlier summary judgement motions and motions to dismiss that it agrees with the Marblegate court that “when a company takes steps to preclude any recovery by noteholders for payment of principal coupled with the elimination of the guarantors for its debt, such action constitutes an impairment” under section 316(b) of the TIA. See BOKF, N.A. v. Caesars Entertainment Corp., 2015 WL 5076785, at *4 (S.D.N.Y. Aug. 27, 2015) (denying summary judgment motion filed by first and second lien trustees); see also MeehanCombs Global Credit Opportunities Funds, LP v. Caesars Entertainment Corp., 80 F.Supp.3d 507, 516 (S.D.N.Y. 2015) (denying Caesars’s motion to dismiss, finding that the unsecured noteholders’ allegations that the August 2014 transaction stripped them of valuable guarantees and leaving them with an “empty right” to assert a payment default against an insolvent insurer were sufficient to state a claim under section 316(b) of the TIA).
Second Circuit Predictions?
The recent decisions in the Caesars and Marblegate litigations clearly interpret section 316(b) of the TIA to preclude issuers from cancelling a guarantee such that non-consenting noteholders will not receive payment. Whether these courts reflect a more general view in the market and the judiciary that minority investors are entitled to broad TIA protections in out-of-court restructurings is unclear. It is hard to predict what the Second Circuit will decide. Until then, issuers, indenture trustees and investors need to keep these cases in mind when faced with proposed
Marian Baldwin Fuerst is a partner in Chadbourne & Parke’s New York Office in the firm’s finance group. Christy Rivera is counsel in Chadbourne & Parke’s New York Office in the firm’s bankruptcy and financial restructuring group. Douglas Deutsch is a partner in Chadbourne & Parke’s New York Office in the firm’s bankruptcy and financial restructuring group.