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Private Equity's Private Bill to Amend the Trust Indenture Act

posted by Adam Levitin

One of the many creatures attempting to crawl its way onto the back of the omnibus appropriations bill is an amendment to the Trust Indenture Act.  The Trust Indenture Act is the 1939 securities law that is the major protection for bondholders. Among other things, the Trust Indenture Act prohibits any action to "impair or affect" the right of bondholders to payment or to institute suit for nonpayment absent the individual bondholder's consent. This legislation was passed in the wake of extensive study by the SEC of the unfair and abusive practices in bond restructurings in the 1920s and '30s, when ma and pa retail bondholders were regularly fleeced in corporate reorganizations.

The amendment in question is being pushed by the private equity firms that own Caesar's Entertainment Corporation (CEC), which is attempting to unburden itself from the guaranty of $7 billion of bond debt issued by its (now bankrupt) subsidiary, Caesar's Entertainment Operating Company (CEOC)

There are several problems with the proposed Trust Indenture Act Amendment, ranging from political unseemliness to ineffective drafting to unintended consequences on capital markets. There might be good reason to amend the Trust Indenture Act, but not through a slapdash job intended to bail out some private equity firms from their own sharp dealings.  

Background

CEO is the parent of CEOC.  CEC is in turn owned by private equity firms Apollo and TGP, which purchased the Caesar's empire in a leveraged buyout in 2008.  In 2014 CEC undertook certain transactions that it claims released it from its $7 billion guaranty obligation on the CEOC bonds. First, CEC sold a small percentage of CEOC, which made it so that CEOC was no longer a "wholly-owned subsidiary," which CEC argues cancelled the guaranties. Second, and more importantly, CEC redeemed many of the CEOC bonds at par.  

The redemption offer, however, was not made to all bondholders, but only to certain institutional holders. Moreover, the redemption was paired with a requirement that the to-be-redeemed bondholders first vote for "exit consents"--that, among other things, agreed to the removal of the parent guaranty for the unredeemed bonds. (If this sounds a little like requiring someone to torch the ship they are on before they are allowed to jump into the lifeboat, well that's right.) The removal of the guaranty matters quite a bit because CEOC is in bankruptcy and the only real source of recovery for the bondholders is CEO.

Some of the CEOC's bondholders objected to the release of the guaranty (and sued over it).  First, they claimed that the release violated the Trust Indenture Act because it effectively impaired their right to payment by leaving them with only an empty shell company as an obligor.  Second, they claimed that even if the release were allowed under the Trust Indenture Act, it was not properly authorized because it was not approved by a sufficient percentage of bondholder unaffiliated with the obligor--many of the votes were cast by CEOC affiliates. (This is a really creative--and I think persuasive--empty voting argument, as the bondholders would never have voted for the exit consents, but for their position being bought out.  The fact that the consents technically preceded the redemption is irrelevant except to the silliest formalism.) Third, there's a bucket of contract language claims that the redemption violated the indenture provision about ratable sharing of any recovery and the requirement that selective redemption be "fair and appropriate" and that an unconditional guaranty cannot be released by a majority vote. And fourth, there's a good faith and fair dealing claim.

The US District Court for the Southern District of New York held that this release impaired or affected the bondholders' right to payment, meaning that CEC's is going to have pay full freight on the guaranty unless it gets the ruling overturned on appeal or gets a legislative bail out. The court has not yet ruled on whether the release of the guaranty was properly authorized, or on the contract claims or the good faith and fair dealing claims. The court denied CEC's motion to dismiss on everything except the release authorization claims, but allowed that claim to be amended and repleaded, which it was. The district court certified the impairment issue under the Trust Indenture Act for an interlocutory appeal to the Second Circuit, but did not stay trial on the other issues. The plaintiffs' summary judgment motion on the release authorization, contract, and good faith and fair dealing claims is pending.

The Proposed Amendment to the Trust Indenture Act

The Trust Indenture Act protects two things: the right to payment and the right to sue for nonpayment. Neither can be "impaired or affected" without the consent of the individual affected bondholder. The proposed amendment would defineimpairment of the right to payment narrowly, as a reduction in principal or interest rate or extension of maturity. In other words, stripping a guaranty would not be an impairment of the right to payment. The proposed amendment would also define impairment of the right to institute suit as being only an action that "prevents" suits against the "primary obligor (other than a guarantor) on such indenture security.") The amendment would clarify that nothing therein requires unanimous consent of all bondholders to amendments, and it provides that it applies retroactively to cases that had not reached a final judgment by December 1, 2015--i.e., to Caesar's. 

What's Wrong with the Proposed Amendment

There are several things wrong with the proposed amendment. 

(1) First, there's just the yuckiness of a bailout of private equity firms through what is essentially a private bill. (Of course it's being done in the backroom deal setting of riders to an omnibus appropriations bill...) That a couple of private equity firms might be able to change the federal securities laws through a private bill speaks to just how utterly broken the politics of financial regulation is. 

(2) Second, the bill is terribly drafted, such that it is likely to result in more litigation. Indeed, the drafting is so bad that it isn't clear that it will ultimately have any affect on CEC's liability to bondholders. The problem is that the bill defines impairment of the right to institute suit as being only actions that "prevent" suits against the "primary obligor (other than a guarantor) on such indenture security." That's a drafting disaster. The Trust Indenture Act has a definition for "obligor" that includes "guarantor".  It does not recognize the term "primary obligor", and in practice that term isn't meaningful either. Most guaranties on bonds are guaranties of payment, not guaranties of collection. A guaranty of payment makes the guarantor co-liable, not secondarily liable. In other words, the guarantor on a guaranty of payment is also a primary obligor. So this language could well be read to allow releases of guaranties of collection, but not of guaranties of payment.  CEC's guaranty was an “unconditional[] guarantee[] [of] . . . full and punctual payment when due"--that is a guaranty of payment, which means that this language might not help CEC at all.  Moreover, even if this language were to help CEC, CEC could still lose on the unauthorized release grounds, the contract language grounds, or the good faith and fair dealing grounds.  

Are we really going to mess with a long-standing major federal securities law without even so much as a single legislative hearing to achieve what might be an ineffective bailout for some private equity funds?  If we're going to do bail outs, let's just own it and be obvious about it ... and effective.  

(3) Third, there's a real possibility of unintended consequences.  To "prevent" suit is a very narrow term. It would seem to allow all sorts of things that would make suit difficult, but not actually impossible. A 99% collective action threshold for a suit for nonpayment? A requirement of posting a huge indemnity bond before suing? A fee-shifting requirement making the bondholders pay the costs of litigation (even if they win)? An indemnification provision requiring bondholders to pay any of the obligor's liability on the suit (i.e., bondholders pay themselves if they win)? A lopsided jurisdictional provision making all suits subject to arbitration by appointees of the obligor? This bill opens the door to really nasty exits consents such that even if the right to payment is not impaired, there will be effectively no ability to sue for that nonpayment. And that is pretty much tantamount to allowing the right to payment to be impaired. (Query if there's a takings issue here for existing indentures...) 

Given all the mischief that the language about impairment of the right to institute suit causes, why is it in the bill at all? That's not really clear to me. I assume it is the product of overly cautious lawyering, but I have trouble seeing how the right to institute suit for nonpayment could be broader than the right to payment...unless it covers a right to sue for a guaranty of payment, which this language doesn't fix. Defining the right to payment narrowly necessarily has the effect of narrowing the right to institute suit for nonpayment from any party directly liable on the obligation. Thus, it's probably best if the whole language about the right to institute suit were dropped. 

The point here is that even if courts have been getting it wrong in their interpretations of the Trust Indenture Act, the right way to proceed is with caution. First, let the Second Circuit Court of Appeals have a chance to set things right.  Second, if the Second Circuit fumbles, then go through the normal procedural route that protects against the problems of legislation drafted on the fly:  having hearings, let the legislative language circulate publicly, and let folks with some background in the area kick the tires. It may well make sense eventually to legislatively amend the Trust Indenture Act. There might well be bipartisan support for that. Don't do it on the fly as a bailout for some private equity funds. It's both unseemly and has the potential to have real unintended consequences for capital markets. 

p.s. #1 These days one assumes that debt restructuring fights are all squabbles between sophisticated institutional investors. There are certainly sophisticated institutional investors on both sides in the Caesar's matter, but it seems there are also a surprising number of retail investors holding the bonds, which are from before Caesar's 2008 LBO by Apollo and TGP. The redemption offer was not made to all investors, but only to a subset that excluded these retail investors. The Trust Indenture Act was written with an eye to protecting retail investors, but it only applies to registered debt securities.  In other words, if a business doesn't want to deal with the Trust Indenture Act, it has a lot of options. It can sell unregistered bonds under Reg 144A (sales to Qualified Institutional Buyers) or Reg S (sales outside of the US) or it can borrow in the form of syndicated loans, rather than debt securities. That suggests that to the extent there are registered bonds around, they might be more likely to have retail investors involved than one might suppose, making the Trust Indenture Act's protections all the more important.

p.s. #2 There's a whole 'nother ugly story about the action (or inaction) of the indenture trustee in this matter.  The indenture trustee is supposed to be acting as a fiduciary for the bondholders and protecting their interests.  The original indenture trustee--U.S. Bank--resigned its trusteeship. The current trustee--Law Debenture Co.--claims that pursuant to the transactions there is no guaranty, so it hasn't brought action against CEC.

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