Hilco Global Executive Vice President Jack Butler authored the below article as part of a series for the Wall Street Journal
When feasible, companies 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.
While companies seek broad-based consensus in out-of-court transactions, it is understood that a deal can be struck with “required lenders.” Depending upon 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), the Trust Indenture Act of 1939 or TIA must also be complied with which, among other matters, 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 at and often substantially above the “required lenders” threshold since companies seek to minimize the “stub” number of non-consenting creditors that have to be dealt with in some manner. While these restructuring tools often include coercive provisions to actively discourage dissenting hold-outs, 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 on a post-restructured basis without guaranteeing the holder’s practical right to the principal and interest itself.
The stable foundation of the out-of-court restructuring market experienced a serious crack beginning with the Education Management Corp. decision handed down last winter. Although the federal district court in the Southern District of New York denied an injunction sought by non-consenting holders to block a restructuring transaction that had garnered the support of 90 percent of the bondholders and 99 percent 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 the Mechala Group Jamaica decision rendered by the same bench some 25 years earlier but widely disregarded until now – a newly reasserted minority position that is in conflict within the Southern District of New York as well as with courts in Delaware and Kansas and a federal appellate circuit court. This new 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 rationale it may be. The rule will also likely lead to fewer out-of-court restructurings since 100% consensus is rarely achievable and therefore will not likely be pursued by companies as a feasible strategy.
These concerns notwithstanding, another judge on the same district court bench recently adopted this new minority view in the pending litigation over the “parent guarantee” in the Caesars bankruptcy case. (She had previously declined to dismiss the litigation concluding that the dissenting hold-out plaintiffs had sufficiently stated a claim about both their practical and procedural rights under the TIA.) While the Court concluded that the TIA prohibits nonconsensual impairment of a non-consenting creditor’s right to payment and right to bring suit if the amendments are to core terms of the regulated debt instrument or constitute non-bankruptcy debt reorganizations, the court decided to certify questions regarding the interpretation of the TIA to the Second Circuit, which remain pending. 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 use self-help where they can by ensuring that other bonds they issue that are not subject to the TIA (such as bonds issued to qualified institutional investors under Rule 144A) 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 hold-outs 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. The new minority rule, if followed and expanded, may force companies to abandon out-of-court restructurings involving registered securities that implicate 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.