The Second Circuit handed down an opinion on the Trust Indenture Act that puts a cudgel in the hands of senior creditors to prevent a holdup by junior creditors. So long as the junior lenders’ right to sue is not impaired, senior lenders can use the threat of friendly foreclosure to force lower-ranked creditors into accepting something or receiving nothing at all from a company that otherwise would be in bankruptcy.
In a 2/1 opinion, the majority justified its conclusion by an exhaustive analysis of legislative history in an environment where using legislative history is no longer in vogue. The net effect of the Jan. 17 opinion is to make bankruptcy less often necessary for companies that can restructure without impairing general unsecured creditors.
The opinion is important and beneficial for companies in financial distress because forum selection clauses in trust indentures often require litigation in New York, where the Second Circuit sits.
Education Management’s Debt Structure
The appeal involved Education Management Inc., an operator of for-profit educational institutions. It was insolvent, with an enterprise value worth less than its $1.5 billion in debt.
The capital structure included $1.3 billion in senior secured debt with liens on all assets. Technically speaking, the debt was issued by a finance subsidiary and guaranteed by the parent.
The company had some $200 million in unsecured notes also issued by the finance subsidiary and guaranteed by the parent. The indenture provided that the parent’s guarantee would be released if senior secured lenders ever released their guarantees against the parent. Offering materials explicitly said that unsecured noteholders should not put any value on the parent’s guarantee.
As Education Management Inc. needed to reduce its debt, a chapter 11 reorganization was unpalatable because bankruptcy would make the company’s students ineligible to receive government guaranteed loans.
To recapitalize out of court without consent from all unsecured noteholders, the senior lenders foreclosed all the assets under the Uniform Commercial Code and released the parent’s guarantee, which had the effect of automatically releasing the guarantee held by the unsecured noteholders.
Next, the senior lenders “sold” the assets to a newly formed subsidiary of the parent. The newly formed subsidiary issued (1) new secured debt and most of the new stock to “old” secured lenders, and (2) a sliver of the new stock to unsecured noteholders who consented.
The nonconsenting unsecured noteholder, a hedge fund, got nothing, although its debt was not extinguished and it retained its right to sue, but could only sue the finance subsidiary, which had no assets, because the guarantee against the parent had been released.
The Decision in District Court
The hedge fund sued, claiming a violation of Section 316(b) of Trust Indenture Act of 1939, known as the TIA. The district judge declined to issue a preliminary injunction, although she did say the dissenting hedge fund might win after trial on the merits.
Following a bench trial, the district judge found a violation of the TIA and declared that the restructured company should be liable for the debt owing to the dissenter. The company and the senior lenders appealed and won, in an opinion for the majority written by Circuit Judge Raymond J. Lohier.
TIA § 316(b)
The appeal turned on Section 316(b) of the TIA, which provides, in relevant part, that the right of any security holder “to receive payment of the principal and interest . . . shall not be impaired or affected without the consent of such holder.”
District Judge Katherine Polk Failla held, in substance, that the language of the statute prohibits more than cutting off the right to payment or the right to sue. She said it bars an “involuntary debt restructuring.”
On appeal, the dissenting noteholder argued that the TIA bans nonconsensual transactions that result in the practical inability to collect.
The Majority Opinion
For himself and Circuit Judge José A. Cabranes, Circuit Judge Lohier held that the statute is ambiguous, thus justifying an extensive analysis of legislative history going back to the 1930s.
Judge Lohier said that the interpretation sought by the dissenting hedge fund would have “improbable results and interpretive problems.” He said the conclusion sought by the dissenter would turn a right to sue, guaranteed by the TIA, into a right to receive payment.
Judge Lohier rejected the notion that the result depends on “the subjective intent of the issuer or majority bondholders, not the transactional techniques used.” Were the dissenting bondholder to prevail, Judge Lohier said, in substance, that every friendly foreclosure would turn into a TIA violation.
At the end of his majority opinion, Judge Lohier pointed out potential flaws in the out-of-court restructuring as compared with a chapter 11 reorganization. Dissenting creditors could sue in state court to block the foreclosure and might try to hold the newly formed company liable on theories of successor liability or fraudulent transfer.
Judge Lohier said that the dissenting noteholder, a “sophisticated creditor,” had the best protection of all, ensuring that the indenture could not allow a transaction of this type in the first place. Logically also, an investor could decline to purchase debt in the secondary market where the governing agreements might obviate the ability to hold up a transaction promulgated by senior creditors.
In short, Judge Lohier said there was no violation of the TIA because the transaction did not amend any terms of the indenture, nor did it preclude the dissenter from suing.
The Dissent
Circuit Judge Chester J. Straub dissented. He said that the “plain language” of the TIA barred the transaction. Focusing on the words “right,” “impair” and “affect,” he said that an offer violates the TIA when it gives a bondholder the choice between accepting something or receiving nothing at all.
Judge Straub’s dissent goes to the heart of how a court ought to interpret a statute. Should a court focus on the mechanisms used by smart lawyers and investment bankers, or should the court focus on the result?
Judge Straub said that the “methodology used to accomplish an annihilation is of little interest when the end result is squarely at odds with the plain intent of Section 316(b).”
The split decision may be the end of road because the Second Circuit is disinclined toward rehearings en banc.