Marblegate Asset Management v. Education Management: Second Circuit Reverses SDNY and Clarifies Right to Payment Under Section 316(b) of the Trust Indenture Act

Practical Law Legal Update w-005-5852 (Approx. 7 pages)

Marblegate Asset Management v. Education Management: Second Circuit Reverses SDNY and Clarifies Right to Payment Under Section 316(b) of the Trust Indenture Act

by Practical Law Bankruptcy & Restructuring

Background

Education Management Corporation (EDMC), Education Management L.L.C. (EDM LLC), and Education Management Finance Corporation (collectively, EDM) is one of the largest for-profit education companies in the US. In 2014, EDMC held $1.3 billion in outstanding secured loans and $217 million in unsecured notes. The loans were secured by liens on substantially all the assets of EDMC while the notes were issued by EDM LLC with a parent guaranty by EDMC. Since EDMC received a significant portion of its revenue through Title IV of the Higher Education Act of 1965 (20 U.S.C. §§ 1079-1099), under Title IV rules, filing for bankruptcy would have resulted in the loss of these funds (approximately 80% of EDMC's revenue).

EDMC therefore entered into a restructuring support agreement which anticipated 100% participation by creditors and, by those terms, would have provided the secured term-loan lenders with debt and equity amounting to a 55% recovery, and noteholders a 33% recovery. The exchange offer provided that, if the participation was not 100%, a multi-step process would be triggered ultimately resulting in formation of a new subsidiary of EDMC to which EDM LLC's assets would be transferred, with EDM LLC remaining a shell for the non-consenting bondholders to recover against.

Marblegate Asset Management, L.L.C. and Marblegate Special Opportunities Master Fund, L.P. (collectively, Marblegate), owners of approximately $14 million of the notes, declined to participate in the exchange and filed a motion in the SDNY District Court for a temporary restraining order and preliminary injunction in an attempt to prevent the restructuring on grounds that it violated Section 316(b) of the TIA.

The SDNY District Court denied Marblegate's motion due to failure to demonstrate a likelihood of irreparable harm but found a likelihood of success on the merits of its TIA claim (Marblegate Asset Mgmt. v. Education Mgmt. Corp., 75 F.Supp.3d 592 (S.D.N.Y. 2014) (Marblegate I), see Legal Update, Marblegate Asset Management v. Education Management Corp: SDNY Broadly Interprets Trust Indenture Act to Limit Non-consensual Out-of-Court Restructurings).

In January 2015, EDMC proceeded with the multi-step intercompany sale described above, with certain modifications made to secure Marblegate's rights. EDMC then petitioned the SDNY District Court to release it from its parental guarantee on the notes. The SDNY District Court ruled that the release would violate the Section 316(b) of TIA and held that TIA Section 316(b) protects a bondholder even when a debt restructuring does not specifically modify the indenture's terms on the right to receive interest or principal on a given date, but essentially leaves the bondholder no choice but to accept the modification (Marblegate Asset Mgmt., LLC v. Education Mgmt. Corp., 111 F.Supp.3d 542 (S.D.N.Y. 2015) (Marblegate II), see Legal Update, Marblegate Asset Management v. EDMC: TIA Provision Read Broadly to Protect Bondholder in Restructuring). EDMC appealed the SDNY District Court's Marblegate II decision.

Outcome

The Second Circuit, in a majority opinion, reversed the SDNY's decision in Marblegate II, and held that the payment protection provision in Section 316(b) of the TIA only applies to formal amendments to an indenture's core payment terms and that the release of EDMC's guarantee did not violate that protection.

In reaching this decision, the Second Circuit analyzed:

The plain text and the competing interpretations of the statutory structure of Section 316(b) of the TIA (see The TIA Plain Text ).
The legislative purpose and history of Section 316(b) of the TIA (see The Legislative History and Other Government Reports).
The available remedies to bondholders (see Dissenting Bondholder Remedies).

The TIA Plain Text

The Second Circuit agreed with the SDNY District Court and determined that the text of Section 316(b) of the TIA is ambiguous. Section 316(b) of the TIA states:

[T]he 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 …

(15 U.S.C. § 77ppp(b)).

The Second Circuit noted that the phrase "right…to receive payment" lends itself to multiple interpretations because it could refer to:

A broad protection from non-consensual amendments that limit a creditor's practical right to payment.
A narrow protection from non-consensual amendments that limit core payment terms, which are the amount of principal and interest owed, and the date of maturity.

The Second Circuit noted that no party seriously contended that the structure of the TIA provided a clear answer to the ambiguity, except the dissent opinion. The Second Circuit, relying on Bank of New York v. First Millennium, Inc., stated that "at best" the TIA does not require that noteholders be afforded absolute and unconditional rights to payment (607 F.3d 905, 917 (2d Cir. 2010)).

The Legislative History and Other Government Reports

Because the Second Circuit found that the plain text of Section 316(b) is ambiguous, the Second Circuit devoted more than half of its opinion to an examination of the TIA's legislative history. The Court determined that the legislative history evidenced that the TIA sought to prohibit non-consensual formal amendments to indentures but did not prohibit foreclosures, a well-known form of reorganization, even when the foreclosure affects a creditor's ability to receive full payment.

The Second Circuit disagreed with the Marblegate II decision that, under the legislative history of the TIA, Congress did not consider foreclosures as a method of reorganization. The Court, rejecting Marblegate II's broad reading of the TIA, adopted a narrow construction of the provision. The Second Circuit analyzed a 1936 comprehensive report of the SEC, the 1938 testimony of an SEC commissioner, the 1939 testimony of a future SEC commissioner, the 1939 House and Senate Reports, and a 1940 SEC report and concluded that Congress was aware of foreclosures as a form of reorganization and did not intend that Section 316(b), or the TIA in general, prohibit other forms of reorganization.

Based on its reading of the legislative history, the Second Circuit concluded that Congress had not intended to create a "broad right to actual payment" and that instead, Section 316(b) provides "merely a right to sue for payment under fixed indenture terms."

Dissenting Bondholder Remedies

The Second Circuit rejected Marblegate's interpretation of Section 316(b) because it would require a court to determine in each case whether the out-of-court reorganization was designed to eliminate a noteholder's ability to receive payment, and the subjective intent of the issuer or majority noteholders. Relying on Sharron Steel Corp., the Second Circuit noted it had a particular distaste for interpreting boilerplate indenture provisions based on the intention of the parties (691 F.2d 1039, 1048 (2d Cir. 1982)).

Last, the Second Circuit rejected concerns that limiting Section 316(b) to formal amendments of core payment rights would put non-consenting noteholders at the mercy of noteholder majorities. The Second Circuit noted that Marblegate, and similarly situated noteholders, had alternative options which included the right to pursue available state and federal law remedies, and the ability to insist on credit agreements that prohibit transactions like the one consummated by EDMC.

The Dissenting Opinion

The dissenting judge explained that, based on the plain text of the TIA, an out-of-court restructuring "impairs" or "affects" a non-consenting bondholder's right to receive payment when it is designed to eliminate the non-consenting noteholder's ability to receive payment, and when it leaves bondholders with no choice but to accept the modified terms of their bonds. As a result, the dissent concluded that Section 316(b) is not ambiguous and compels the broad interpretation adopted by the SDNY District Court in Marblegate II.

Practical Implications

The Second Circuit's decision creates more certainty for out-of-court restructurings taking place in that Circuit. By protecting bondholders only against changes to the core indenture payment terms affecting their legal right to receive payment, issuers may have greater confidence in implementing out-of-court financial restructurings involving US bonds without the threat of Section 316(b) challenges by dissenting minority bondholders. However, noteholders seeking to protect against the type of out-of-court restructuring that took place in Marblegate should consider including specific language in indentures protecting their rights, including the right to receive payment.

It is worth noting that Marblegate may still petition for a rehearing en banc in the Second Circuit or for certiorari to the US Supreme Court, and it remains to be seen how other Circuits will hold on this issue.

Marblegate Asset Management v. Education Management: Second Circuit Reverses SDNY and Clarifies Right to Payment Under Section 316(b) of the Trust Indenture Act | Practical Law