The Examiners: It’s Bad Public Policy to Empower Holdout Bondholders...

How does bondholders’ use of the Trust Indenture Act affect companies’ ability to complete out-of-court restructurings?

When feasible, companies (and most of their stakeholders) strongly prefer pursuing and consummating out-of-court restructurings that avoid the uncertainty, expense, delay and loss of control inherent in chapter 11 reorganizations. However, effective out-of-court restructuring strategies are premised on a company being able to rely on the collective action of the required lenders under its credit agreements and trust indentures to approve debt modifications including debt forgiveness and debt-to-equity conversions.

While companies aim to achieve consensus in out-of-court transactions, it’s understood that a deal can be struck with “required lenders.” Depending on the intercreditor acknowledgments and consents included in the company’s debt instruments or in separate intercreditor agreements, the minimum threshold of “required lenders” may consist of a minority, majority or super-majority of debt holders. That said, throughout the entire modern restructuring era, when companies issue notes in registered securities offering (or grant registration rights), they must also comply with the Trust Indenture Act of 1939. Among other matters, the TIA prescribes that the right of a holder to receive payments of principal, premium and interest and to bring suit for the enforcement of such payment “shall not be impaired or affected without consent of such holder.”

Exchange offers, consent solicitations, restructuring support agreements and other restructuring tools are designed to achieve support thresholds substantially above the “required lenders” threshold. While these restructuring tools often include coercive provisions to actively discourage dissenting holdouts, the tools have been effective and considered compliant with the TIA because they are structured to guarantee each individual holder’s procedural (or legal) right to receive payments and commence actions for nonpayment without guaranteeing the holder’s practical right to actual payment of the principal and interest itself.

This stable foundation for the out-of-court restructuring market has weathered a serious crack beginning with the Education Management Corp. decision from the U.S. District Court for the Southern District of New York. Although the court denied an injunction sought by non-consenting holders to block a restructuring transaction that had garnered the support of 90% of the bondholders and 99% of the secured lenders, the court nevertheless broadly interpreted the TIA to prohibit companies from restructuring debt outside of bankruptcy court that would have the effect of impairing the practical rights of non-consenting bondholders irrespective of the continuing safeguarding of their procedural rights.

In reaching this conclusion, the court essentially reconfirmed a decision handed down by the same court some 25 years earlier but widely disregarded until now. This revival of the Mechala Group Jamaica decision is controversial among judges within the Southern District of New York and conflicts with courts in Delaware and Kansas as well as a federal appellate circuit court. This reasserted minority rule ignores the collective action of the majority of bondholders and disregards as irrelevant the underlying business judgment supporting the company’s proposed restructuring plan or the collateral consequences of preventing an out-of-court business solution no matter how sensible it may be. The rule may also lead to fewer out-of-court restructurings since consensus with every holder is rarely achievable and therefore will not likely be pursued by companies as a feasible strategy.

These concerns notwithstanding, another district-court judge in New York recently followed the Mechala and Education Management courts when deciding pending litigation over the parent guarantee in the Caesars bankruptcy case. While the court concluded that the TIA prohibits nonconsensual impairment of a dissenting hold-out creditor’s right to payment and to bring suit if the amendments are to core terms of the regulated debt instrument or involve non-bankruptcy debt reorganizations, the court decided to certify questions regarding the interpretation of the TIA to the federal appellate circuit court for the Second Circuit.

If the Second Circuit rejects the minority view, then it will have applied some much-needed adhesive to the shredding fabric of out-of-court restructurings. If the Second Circuit adopts the new minority rule, it will create a conflict among federal appellate circuit courts that should lead to Supreme Court review—unless Congress puts the statutory misinterpretation to rest first by amending the TIA to explicitly recognize and defer to collective action by a simple majority of bondholders. In the meantime, issuers should ensure other bonds they issue that aren’t subject to the TIA (such as bonds issued to qualified institutional investors under so-called “Rule 144A” transactions) explicitly reject the new minority rule.

It is bad public policy and a tortured interpretation of Congressional intent to conclude that the plain meaning of the 1939 statute is intended to provide minority holdouts with veto rights and control over the majority of creditors who want to support an out-of-court transaction that preserves jobs and creates value as a source of repayment for them. If the Mechala and Education Management principles are adopted and expanded, companies may be forced to abandon out-of-court restructurings involving registered securities controlled by the TIA. This will leave bondholders to navigate the current chapter 11 environment where assets are sold much more often than companies are reorganized and where unsecured creditors often receive less value than they could have obtained in a consensual out-of-court deal.

Jack Butler is executive vice president with Hilco Global, where he works with healthy and distressed companies, their creditors and investors on a broad range of strategic transactions.