The Examiners: Rulings May Deter Companies from Registering Bonds

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

The Trust Indenture Act—a statute enacted in 1939 that until recently was relatively dormant—has been awakened and is coming back with a vengeance. In particular, section 316(b) of the TIA requires that for bonds registered with the U.S. Securities and Exchange Commission, a bondholder’s right to receive payment cannot be changed or impaired without consent. The TIA originally targeted abusive practices by large insider bondholders who used their majority vote to modify the terms of an indenture to the disadvantage of minority bondholders. This consent-before-impairment requirement empowers minority bondholders with the ability to single-handedly prevent a transaction that contemplates the impairment of their bonds, thwarting issuers attempting a nonconsensual out-of-court restructuring.

Out-of-court workouts are often an attractive option for a distressed entity hoping to avoid the negative connotation often associated with a bankruptcy filing, reduce costs, restrict judicial oversight and allow existing management to take the reins in the restructuring process and to negotiate with creditors to reach a voluntary agreement. However, where a minority bondholder feels slighted by the terms of an out-of court restructuring, the TIA provides ammunition to voice those concerns with teeth.

Recently, the question of whether a restructuring proposed by an issuer constitutes impairment in violation of the TIA has become a highly litigated and divisive issue. Interpreted narrowly, the TIA prohibits only those amendments to core indenture terms which impair a bondholder’s procedural right to seek payment, or sue—a prohibition which, in practice, has more bark than bite. The more broad interpretation, recently endorsed by the court in the Education Management Corp. case, provides stronger bondholder protections against restructurings which impair bondholders’ substantive right to actually receive payment, or really get paid.

Decisions holding that section 316(b) protects a bondholders’ substantive right to payment (as opposed to the narrower procedural right to sue) significantly limit the issuer’s ability to engage in routine restructuring transactions aimed to enhance the entity’s financial viability by extracting concessions from bondholders. Where issuers cannot impair or affect a bondholders’ practical right to payment, their hands are virtually tied with respect to selling assets or releasing corporate guarantees. Moreover, minority bondholders increasingly use section 316(b)’s consent requirement as a bargaining tool to gain leverage in out-of-court workouts often to reap the benefits of a stronger issuer from the concessions provided by majority bondholders, without taking those concessions, or by having their bond bought by other holders at higher values or even at par.

Minority bondholders’ use of the TIA works to push recapitalizations into bankruptcy court—a forum more equalizing than the out-of-court environment. The bankruptcy code’s plan of reorganization process contains more favorable voting requirements for the issuer—only 50% in number and two-thirds in dollar amount, as opposed to the holdup rights afforded under the broad interpretation of section 316(b).

It is not difficult to imagine how a provision creating the described incentive structure could significantly frustrate a company’s ability to complete an out-of-court workout. However, this may have been Congress’s precise goal in enacting the statute. Regardless, if this trend of broadly reading section 316(b) to receive payment as opposed to simply sue for perceived unfair treatment continues, companies may be deterred from registering their bonds with the SEC to avoid subjecting their bond indentures to the TIA on the front end and fighting over venue-to-be in jurisdictions narrowly reading section 316(b) on the back end when contemplating an out-of-court restructuring that could potentially impair bondholders’ right to payment.

Sharon Levine is vice chair of Lowenstein Sandler LLP’s national bankruptcy, financial reorganization and creditors’ rights practice. Follow her on Twitter at @LevineSharon