On December 30, 2014, the US District Court for the Southern District of New York, in Marblegate Asset Management v. Education Management Corp., broadly interpreted Section 316(b) of the Trust Indenture Act of 1939 (TIA) (15 U.S.C. § 77ppp(b)) to protect nonconsenting noteholders against out-of-court debt restructurings that impair their practical rights to receive payment, and not just their legal rights to demand payment, even if the issuer's actions are permitted under the indenture (No. 14 Civ. 8584 (KPF), (S.D.N.Y. Dec. 30, 2014)).

Education Management Corporation (EDMC), together with its subsidiaries Education Management LLC (EDM LLC) and Education Management Finance Corporation (collectively, Defendants), is one of the country's largest for-profit providers of college and graduate education. In 2014, EDMC derived 78.6% of its net revenues from federal student aid programs under Title IV of the Higher Education Act of 1965. Of critical importance, an institution loses its eligibility for Title IV funds if it, or a controlling affiliate, files for bankruptcy or has an order for bankruptcy relief filed against it.

Marblegate Asset Management, LLC and Marblegate Special Opportunities Master Fund, L.P. (collectively, Marblegate) are investment management firms that focus in part on "event-driven distressed corporate credit restructuring." Like Marblegate, Magnolia Road Capital LP and Magnolia Road Global Credit Master Fund LP (collectively, Magnolia) are event-driven credit hedge funds that also invest primarily in corporate debt. Marblegate and Magnolia (collectively, Plaintiffs) held unsecured debt in EDMC.

At the time of litigation, EDMC had outstanding debt of $1.553 billion, consisting of:

The TIA-qualified indenture contained two provisions by which the Parent Guarantee could be removed from the Notes:

In May 2014, EDMC informed its investors and creditors that it was experiencing significant financial distress and that it would soon no longer be in compliance with certain financial covenants under the secured credit facility. Rather than file for bankruptcy, EDMC and the secured lenders entered into an amended credit agreement (2014 Credit Agreement), under which EDMC agreed to guarantee the Secured Debt.

At the same time EDMC was negotiating the 2014 Credit Agreement, it began to seek a longer-term balance sheet restructuring. The Restructuring Support Agreement (RSA) provided two potential paths to accomplishing the proposed restructuring. The first path, which would have required 100% creditor consent, would have left the secured lenders with a recovery of about 54.6%, and the unsecured creditors with a recovery of about 32.7%. In October 2014, to effectuate this voluntary restructuring, the Defendants commenced an exchange offer. However, the Plaintiffs, holding less than 10% of the Notes, did not consent.

Because unanimous creditor consent was not obtained, the RSA obligated the parties to undertake an intercompany sale, under which the secured lenders would:

Although the second path was permitted under the plain language of the Notes indenture, it would deprive non-consenting unsecured creditors of the Parent Guarantee and leave them only with claims against an entity which would no longer hold any assets. Therefore, unsecured creditors who declined to participate in the exchange offer would not receive payment on account of their Notes.

The Plaintiffs filed a motion for a temporary restraining order and a preliminary injunction to bar the company from taking the second restructuring path, arguing that it violated the TIA and the terms of the Notes indenture.

The Court denied the Plaintiffs' motion for a preliminary injunction on the grounds that they failed to demonstrate a likelihood of irreparable harm and because the balance of the equities and the public interest weighed against granting the injunction. However, in dicta, the Court set forth a broad interpretation of the protections provided by Section 316(b) of the TIA in finding that the Plaintiffs demonstrated a likelihood of success on the merits. The Court interpreted the TIA as offering "broad protection against nonconsensual debt restructurings" and rejected the view that the TIA offers only a "narrow protection against majority amendment of certain 'core terms'."

Under Section 316(b) of the TIA, "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[.]" The Court framed the issue as a question as to whether the "right . . . to receive payment" should be read narrowly, as a legal entitlement to demand payment, or broadly, as a substantive right to actually obtain such payment.

The Court first provided an overview of conflicting interpretations of the statute among courts. Some courts have held that the TIA is not violated by actions permitted or required under the terms of an indenture, even if those actions result in a loss of payments. In UPIC & Co. v. Kinder-Care Learning Centers, Inc., the court concluded that "although section 316(b) may guarantee a Securityholder's 'procedural' right to commence an action for nonpayment, Section 316(b) does not [affect] or alter the substance of a noteholder's right to payment of principal and interest under the Indenture and, in particular, cannot 'override' the indenture's subordination provisions" (793 F. Supp. 448, 456-57 (S.D.N.Y. 1992)). Two courts took this logic a step further by holding that Section 316(b) "applies to the holder's legal rights and not the holder's practical rights to the principal and interest itself . . . there is no guarantee against default" (In re Northwestern Corp., 313 B.R. 595, 600 (Bankr. D. Del. 2004); see also YRC Worldwide Inc. v. Deutsche Bank Trust Co. Am., No. 10 Civ. 2106 (JWL), at *7 (D. Kan. July 1, 2010)).

Other courts have interpreted the TIA as protecting the ability, and not merely the formal right, to receive payment in some circumstances (see Federated Strategic Income Fund v. Mechala Grp. Jam. Ltd., No. 99 Civ. 10517 (HB), , at *7 (S.D.N.Y. Nov. 2, 1999)).

The Court rejected three primary arguments offered by the Defendants to persuade the Court to side with the Northwestern Corp. and YRC Worldwide decisions rather than the Mechala decision.

First, the Defendants argued that courts have restricted the protections of Section 316(b) to "core term[s]," which are defined as "one[s] affecting a securityholder's right to receive payment of the principal of or interest on the indenture security on the due dates for such payments." While the Court conceded that this statement was correct, it held that those restrictions did not answer the underlying question of what the "right" consists of, or when an action "affect[s]" that right. If the Plaintiffs were correct that the right is substantive rather than formalist, then they were correct to consider the impact on such rights in the context of the overall transaction.

Second, the Defendants argued that the TIA protects only those rights provided for in the indenture, subject to the limitations contained therein. Therefore, because the Notes indenture permitted the actions contemplated by the second restructuring path, the TIA was not implicated. The Court found that this reading would render the TIA superfluous, and concluded that the TIA "must protect some rights against at least some ex ante constraints."

Third, the Defendants argued that if the Court were to adopt the Plaintiffs' position, this would permit any noteholder to attack any transaction based on a "standardless 'ability to receive payment test.'" The Court rejected this argument, concluding that it would be "equally unsatisfying to accept the notion that Section 316(b) protects only against formal, explicit modifications of the legal right to receive payment, and allows a sufficiently clever issuer to gut the Act's protections through a transaction such as the one at issue here."

In this case, the Court broadly construed the protections granted to creditors under the TIA. If this view is adopted by other courts, it may be more difficult to implement an out-of-court restructuring without unanimous consent, even if the actions taken are permitted by the indenture. In fact, the Court recently relied on this decision to protect holdout noteholders in MeehanCombs Global Credit Opportunities Funds, LP v. Caesars Entertainment Corp. (see No. 14-CV-7091 SAS, (S.D.N.Y. Jan. 15, 2015)). Giving more leverage to minority noteholders to block a restructuring may result in more bankruptcy filings and could increase costs as more litigation ensues. In addition, this ruling may further disincentivize some companies to issue notes in a registered securities offering, or to grant registration rights, which would subject their notes to the TIA.

For more information on out-of-court restructurings, see Practice Note, Out-of-Court Restructurings: Overview.

For more information on the TIA, see Practice Note, Indenture and Indenture Trustee: Governing Laws.