The Examiners: Rulings Could Prompt More Prepacks

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

When a company needs to restructure its balance sheet, it may look to a variety of legal mechanisms including exchange offers, tender offers, prepackaged plans of reorganization and traditional chapter 11 cases. While each situation is sui generis, it is important that all options be available. In many cases, companies will want to restructure through an out-of-court bond exchange offer in order to avoid the costs and other issues associated with a chapter 11 filing. Two recent Southern District of New York decisions threaten to severely limit the use of this restructuring technique: Marblegate Asset Management LLC v. Education Management Corp. and BOKF N.A. v. Caesars Entertainment Corp.

Specifically, these cases focused on the meaning of section 316(b) of the Trust Indenture Act. This section provides that “the right of any holder of an indenture security to receive payment of the principal of and interest on such indenture security…shall not be impaired or affected without the consent of such holder.” Prior to these two decisions, it was generally accepted that this section protected a holder’s legal rights to payment under the indenture, not the holder’s practical ability to recover. The Marblegate court disagreed with this position, instead finding that the TIA is meant to protect noteholders from out-of-court restructurings that are designed to impair their practical ability to recover the principal and interest on their notes. Similarly, the Caesars court found that section 316(b) protects not only the legal right, but the practical ability as well, to receive payment. Regardless of whether one agrees with this position, these opinions, if followed, will make completion of out-of-court bond exchange offers more difficult.

Parties that disagree with these decisions note that the TIA does not provide a guarantee against the issuer’s default. Instead, noteholders have many tools at their disposal to protect themselves. For instance, parties to indentures may negotiate “restrictive covenants.” Restrictive covenants may limit an issuer’s ability to engage in actions that could increase the risk of default. An indenture might include, for example, a covenant prohibiting the issuer from declaring dividends, selling assets, or incurring additional debt without bondholder approval. As such, noteholders can negotiate express contractual provisions to protect their practical ability to recover without incorporating such protections into section 316(b) of the TIA.

The practical effect of these two recent court decisions is to allow minority noteholders, who sometimes purchase their bonds in the secondary market, to block out-of-court exchange offers to which the majority of bondholders agree. This result discourages parties from participating in consensual out-of-court restructurings. Now, of course, companies can still bind holdouts through prepackaged bankruptcy filings. If these decisions stand, the end result will likely be more prepacks and fewer exchange offers. While prepacks offer various advantages, removing restructuring tools generally is not a positive development for companies in need.

Jay Goffman is the global leader of Skadden, Arps, Slate, Meagher & Flom’s corporate restructuring practice. He is based in New York.