Second Circuit Holds That Minority Bondholders Cannot Avail Themselves of the Trust Indenture Act


While out-of-court restructurings can help companies in need, they can negatively impact minority bondholders. Minority bondholders displeased with out-of-court restructurings looked to a 2015 decision interpreting the Trust Indenture Act (the Act). In Marblegate Asset Management LLC v. Education Management Finance Corp., the District Court for the Southern District of New York found that an out-of-court restructuring negatively impacted the rights of minority bondholders under Section 316(b) of the Act by affecting bondholders’ practical ability to recover principal and interest. This decision, and a similar decision in the Caesars hotel bankruptcy case, provided minority bondholders with a potential tool for leverage in restructurings that affected their investments. But a Jan. 17, 2017, decision from the Second Circuit Court of Appeals has limited the scope of the Act. Hearing the appeal from the Marblegate decision, the Second Circuit held that the Act does not guarantee an unconditional right to payment, and would not bar an out-of-court restructuring that precluded a noteholder ‘s practical ability to receive payment from the issuer. Any shareholder in a financially distressed company should monitor the developing legal landscape of the Act in the aftermath of Marblegate.

In Marblegate, Education Management Corporation (EDMC), a for-profit higher education company, faced financial distress and the potential loss of federal funding if it filed for bankruptcy. EDMC thus sought an out-of-court restructuring of its debt obligations with its creditors. One of those creditors, Marblegate Asset Management LLC, held $14 million in unsecured debt issued by two of EDMC’s subsidiaries, which was guaranteed by EDMC. Under the proposed restructuring, the EDMC subsidiaries’ assets would be foreclosed on by its secured creditors and sold to a newly created subsidiary of EDMC, which would continue the business. However, this series of transactions would result in the issuers becoming shell companies and rendering Marblegate’s right to recover against the issuers virtually worthless. Pursuant to certain provisions of the notes, the structure of the transaction also released EDMC from its guarantee on Marblegate’s debt. On a motion from Marblegate to enjoin the restructuring, the District Court for the Southern District of New York determined that Section 316(b) of the Act protected the “ability” of the noteholders to receive payment, and that if a transaction resulted in an “involuntary debt restructuring,” it violated the Act even though it did not formally affect rights under the bond indentures.

On appeal, the Second Circuit reversed. The Second Circuit held that the Act was intended to protect bondholders only against formal, nonconsensual amendments to indenture provisions and to preserve their ability to bring suit to collect on their principal and interest. The Second Circuit held that Congress did not intend for the law to preclude other “well-known forms of reorganization like foreclosures” or guarantee payments to creditors. The Second Circuit also noted that there were other remedies available to minority bondholders like Marblegate. The Second Circuit recognized that bondholders could pursue state and federal remedies at law, such as a breach of contract action or the commencement of an involuntary bankruptcy petition against the issuer; could negotiate to change conventional indentures to preserve their rights during out-of-court restructurings; or could bring a successor liability or a fraudulent conveyance litigation against the new entity.

The Second Circuit’s decision in Marblegate may reduce bondholder litigation based on a broad interpretation of the Act. The decision could result in similar decisions from courts in other jurisdictions, and presages the result in the Caesars matter as it moves forward. So where does that leave minority bondholders? Conventional bond indenture language may evolve to protect their rights in restructurings. Under Marblegate, bondholders can proceed with state and federal legal actions and bring successor liability or fraudulent conveyance actions against a newly formed company. Meanwhile, parties involved with out-of-court restructurings should track new legal developments in this area.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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