The Situation: In a sharply divided 4-3 decision, CNH Diversified Opportunities Master Account, L.P., et al. v. Cleveland Unlimited, Inc. et al., Case No. 42 (Oct. 22, 2020), the New York Court of Appeals reversed the courts below to rule that the actions of the majority noteholders and Trustee to foreclose on collateral, as expressly authorized under the Indenture and Collateral Trust Agreement ("CTA"), did not override the individual noteholder’s legal right to payment or suit under the "consent" provision of the Indenture based on Section 316(b) of the Trustee Indenture Act of 1939 ("TIA").
The Result: For indentures governed by New York law, CNH breathes new life into the standard indenture provision—prevalent in corporate bonds and structured finance transactions—requiring that, notwithstanding remedy provisions that permit actions against collateral at the direction of a majority of noteholders, an individual noteholder’s rights to receive “payment of principal . . . and interest and . . . on or after the respective due dates expressed in such Note, or to bring 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.” (CNH Slip Op. at 2)
Looking Ahead: Whether this decision "needlessly injects uncertainty into a multi-trillion-dollar corporate debt market" as the dissent claims is yet to be seen, but it is fair to say that the pendulum has swung back in favor of dissenting noteholders and a broader interpretation of Section 316(b) of the TIA. Minority noteholders will likely be emboldened to take actions seeking to preserve their rights to demand payment or the right to sue in connection with out-of-court collateral dispositions, even when the Trustee’s actions are contractually authorized and implemented at the direction of the majority of noteholders.
In 2005, Cleveland Unlimited, Inc. ("CU") issued $150 million of five-year senior secured notes ("Notes") guaranteed by subsidiaries under an indenture. Although the indenture was not qualified under the TIA, it included provisions tracking Sections 316(a) (Section 6.05 Control by Majority) and 316(b) (Section 6.07 Rights of Holders To Receive Payment) of the TIA, and expressly incorporated by reference "[a]ny provision of the TIA which is required to be included in a qualified indenture."
When CU defaulted on the Notes’December 15, 2010, maturity date, the parties entered a forbearance agreement pursuant to which CUI Holdings, LLC ("CUI Holdings"), an affiliate of CU that owned 100% of CU’s stock, became a guarantor and pledged 100% of CU’s stock. After a plan to have the noteholders purchase 100% of CU equity in exchange for a release under the Notes was rejected by holders of 3% of the Notes ("plaintiffs"), the holders of 97% of the Notes directed the Trustee to commence a "strict foreclosure" on the CU equity, pursuant to which the Notes were cancelled, and the Trustee complied. Plaintiffs brought breach of contract and breach of guaranty actions against CU and the guarantors (including CUI Holdings).
The Supreme Court entered summary judgment for the defendants, and the Appellate Division affirmed, ruling that the strict foreclosure did not violate Section 316(b) of the TIA—or the equivalent language of Section 6.07 of the indenture—because the transaction neither formally "amend[ed] any terms of the Indenture" nor "prevent[ed the Minority Noteholders] from bringing an action to collect payments due on the dates indicated in the Indenture." The lower courts relied on the Court of Appeals’ prior decision in Beal Sav. Bank v Sommer, 8 N.Y.3d 318 (2007) and the Second Circuit’s decision in Marblegate Asset Mgt., LLC v Education Mgt. Fin. Corp., 846 F.3d 1 (2d Cir. 2017).
Court of Appeals Decision
In the Court of Appeals, the majority reversed the grant of summary judgment to the defendants and granted partial summary judgment to the plaintiffs. Although plaintiffs argued they were entitled to an award equal to the face value of the Notes plus unpaid interest, the Court determined the amount of damages and other factual issues preserved by the parties should be addressed in the first instance by Supreme Court upon remittal. On the key legal issue presented, the majority determined that the dissenting noteholders’ right to sue, and right to payment, survived the purported cancellation of the Notes under the strict foreclosure.
Unlike in Beal, where the agreements as a whole bound all holders to "collective" action in the event of a default, "the Indenture in this case contained a specific provision, section 6.07, that affords each individual Noteholder the absolute legal right to bring suit on its own behalf for payment of principal or interest, despite any 'no-action clause' to the contrary." The majority was careful to distinguish the rights of the dissenting senior secured noteholders here from the minority junior unsecured noteholders in the Second Circuit’s Marblegate decision (whose right to sue was not extinguished). They noted that while the TIA provides a simple majority in the principal amount of the securities to authorize the Trustee to pursue an available remedy, "the same section of the TIA [protects] certain core rights of minority bondholders" (citing Marblegate, 846 F3d at 15 n.15 ("while the 1938 version of the bill vested discretion in the SEC to regulate indenture provisions, the 1939 version of the bill was altered to mandate that all qualified indenture contain certain provisions")). The majority also found that the after-market noteholders were not parties to the CTA, and thus rejected the dissent’s argument construing the CTA to provide the requisite consent.
The dissenting opinion concluded that the majority ignored the CTA and mistakenly applied (and misapplied) the TIA in what should have been a contractual analysis reading all the indenture documents as a whole. Viewing this case as controlled by the reasoning in the Second Circuit’s Marblegate decision, the dissent argued that the foreclosure did not violate Section 316(b) of the TIA because it did not amend an indenture’s "core payment terms" and, reading the Indenture together with the CTA, the noteholders consented to the remedy chosen by the controlling noteholders to have the Trustee foreclose on the collateral. Warning that the "decision needlessly disconnects the law of the two courts most relevant to the markets in which these securities are traded" and that "[c]onfusion will surely follow," the dissent concludes that the majority’s recognition that dissenting noteholders’ rights survive an authorized foreclosure "needlessly injects uncertainty into a multi-trillion-dollar corporate debt market …[and] ultimately strikes a chord of disharmony in undermining what should be the prevailing rule in both this Court and the Second Circuit that agreements of collective design should be read as one."
The majority opinion disputed the dissent’s assertion that this decision conflicts with Marblegate, noting that the transaction in question in that case interfered only with the dissenting noteholders "practical ability" to recover payment, while CU’s note cancellation eliminated the dissenting noteholders legal rights to payment in full, and to sue the issuer and guarantors after default.
Three Key Takeaways
- Following a string of district court decisions regarding the scope of Section 316(b) of the TIA, the Second Circuit’s 2017 Marblegate decision was viewed to have provided financial markets with judicial certainty on the subject. Time will tell whether the rationale behind the CNH decision will be embraced by the Second Circuit or whether the dissent’s dire predictions of discord and confusion will prove accurate.
- The Marblegate decision was widely viewed as substantially narrowing the grounds for dissenting noteholders to attack out-of-court restructurings based on Section 316(b) of the TIA in the absence of an amendment to an indenture’s "core payment terms." The CNH decision now provides leverage to minority noteholders protected by Section 316(b) in the context of out-of-court restructurings. Those seeking certainty in restructuring debt governed by New York law may need to resort to the bankruptcy process to bind an objecting minority.
- Although the CNH decision is likely to embolden minority noteholders, the distinction drawn by the majority between impairment of (i) the practical ability; and (ii) the legal right to recover payment should not be overlooked. If anything has been made clear by the series of non-pro rata refinancing transactions implemented recently, it is that there are countless ways to impair a party’s practical ability to be repaid without eliminating its legal right to repayment.