Corporate bond indentures – the agreements that contain most of the terms of corporate bonds – typically run 50 to 100 pages.  Most of the provisions in indentures can be freely varied by the parties, but a few are prescribed by the federal Trust Indenture Act of 1934 (‘TIA’).  One of the most notable, and most litigated, of these provisions derives from Section 316(b) of the TIA and provides:

‘[t]he right of any holder of any indenture security to receive payment of the principal of and interest on such indenture security, on or after the respective due dates expressed in such indenture security … shall not be impaired or affected without the consent of such holder[.]’[1]

Section 316(b) has generally been understood to prohibit amendments to the core payments terms by majority bondholder consent.[2] But in 1999, in Federated Strategic Income Fund v. Mechala Grp. Jamaica Ltd.,[3] a federal district court went further.  Mechala involved amendments stripping most protective covenants from an indenture and eliminating subsidiary guarantees, to be followed by a transfer of the asset from the obligor.  Bondholders would retain their legal right to payment from the obligor; but, because the obligor would have no assets left, that right would be worthless.

The court in Mechala held that the amendments together with the asset transfers ‘impaired’ the holders’ right to receive payment. As the court reasoned: ‘A holder who chooses to sue for payment at the date of maturity will no longer, as a practical matter, be able to seek recourse from either the assetless defendant or from the discharged guarantors.’[4]

Then, in 2015, the federal district court in Marblegate Asset Mgmt. v. Education Mgmt. Corp.[5], took the next step. Like Mechala, Marblegate involved transactions that would have rendered the obligor (Education Management LLC) unable to pay its bondholders. However, unlike Mechala, Marblegate entailed no amendments by majority bondholder consent. Rather, or so the court at least assumed, the transactions that divested the obligor of its funds would be permitted, but for Section 316(b) and its indenture counterpart.[6]

The district court’s opinion in Marblegate raised substantial concern. According to two leading commentators, Marblegate disrupted practice assumptions going back three-quarters of a century, made bond counsel more reluctant to issue opinion letters on the enforceability of trust indentures, and led to efforts to get Congress to retroactively overrule the court’s opinion.[7]

One issue posed by the opinion is how far it extends. If the right to receive payment includes the practical ability to obtain payment – as held in both Marblegate and Mechala – and if impairment of that right does not require any amendment – as held by Marblegate – then should not any transaction undertaken by the company that ‘impairs’ the practical ability to obtain payment – that is, makes it more likely that the obligor will not be able to pay – fall under Section 316(b) and hence require the consent of each holder?  And if not, where exactly should one draw the line?[8]

More broadly, one may wonder why we need Section 316(b) of the Trust Indenture Act at all. Why not leave it to the contractual choices of the bondholders and the company to determine which ‘rights’ may be ‘impaired’ and by what mechanism? The corporate bond market, after all, is dominated by sophisticated institutional investors that are hardly in need of ‘consumer protection’-type laws that shield them from their own mistakes.  To the extent that Section 316(b) merely prohibits majority amendments of core payment terms, it may have been harmless.  Almost all indentures contain a separate clause – one not mandated by Section 316(b) – that provides that specified core payment terms may not be amended by majority consent.[9] But Mechala and Marblegate extended the scope of Section 316(b) to transactions that, but for Section 316(b), would require only majority consent or not require any bondholder consent at all.  The interpretation of Section 316(b) in these cases clearly poses the issue of why Section 316(b) is needed to start with.

On appeal, the Second Circuit ended up overruling the district court.[10]  The Second Circuit opinion largely focused on the sparse legislative history of the Trust Indenture Act and only briefly touched on policy questions.  The court concluded that the Section 316(b) only limits the type of amendments that can be adopted through majority bondholder consent. While the Marblegate transaction thus clearly lies outside the scope of Section 316(b), it is less clear whether transactions such as those in Mechala, which involve amendment, but not to core terms, are outside its scope as well. [11]

In addition, the Marblegate opinion does not address another important issue: Do the core payment terms that cannot be amended by majority consent include the right to receive payment from a guarantor – and hence do amendments eliminating a guarantee require the consent of each affected holder?[12]  At least at first blush, nothing in Section 316(b) confines the right to payment that cannot be ‘impaired’ to the right to receive payment from the principal obligor. Curiously, the amendments in Mechala involved the elimination of a guarantee and Mechala could have been decided on the ground that this elimination impaired the legal right (not just the practical ability) to receive payment.  Oddly, however, the court in Mechala did not even raise this argument.

Marcel Kahan is the George T. Lowy Professor of Law at the New York University School of Law.

 

[1] 15 U.S.C. §77ppp(b).

[2] See, e.g., Mark J. Roe, The Voting Prohibition in Bond Workouts, 97 Yale L.J. 232 (1987)   (‘Fifty years ago, Congress prohibited all binding bondholder votes that would modify any core term—principal amount, interest rate, and maturity date—of a bond indenture.’)

[3] 1999 WL 993648 (S.D.N.Y. 1999).

[4] Id. at. *7 (emphasis added).

[5] 111 F.Supp. 542 (S.D.N.Y. 2015).

[6] Specifically, the transactions involved a release by secured creditor of a guarantee by the parent (EDMC), which automatically resulted in a release of a guarantee of the bonds at issue; a foreclosure by the secured creditors on Education Management LLC’s assets; and a sale of the foreclosed assets to a new subsidiary of EDMC. These transactions were meant to induce bondholders to agree to an out-of-bankruptcy restructuring pursuant to which the secured creditors and the bondholders would receive debt and equity securities of the new subsidiary. 

[7] Willian W. Bratton, Jr. & Adam J. Livitin, The New Bond Workouts (working paper 2017)

[8] To be sure, the court in Marblegate stressed that the purpose of the transactions at issue was to induce bondholders to consent to a ‘restructuring’ in which they would exchange their bonds for different securities.  But this would suggest, implausibly, that the same transactions would not have violated Section 316(b) if their purpose had merely been to take advantage of the bondholders.

[9] Marcel Kahan. The Qualified Case Against Mandatory Terms in Bonds, 89 Nw. U.L. Rev. 565, 607-608 (1995).

[10] Marblegate Asset Management v. Education Management Corp., 846 F.3d 1 (2d Cir., 2017).

[11] See id. at *9 (‘the relevant portions of the TIA's legislative history exclusively addressed formal amendments and indenture provisions like collective–action and no–action clauses.’); id. at *16 (‘The transaction did not amend any terms of the Indenture.’); but see id. (‘Limiting Section 316(b) to formal indenture amendments to core payment rights will not leave dissenting bondholders at the mercy of bondholder majorities.’) (emphasis added).

[12] Cf. Bratton & Levitin, supra note 7, at fn. 193.