Marblegate and a Dose of Reality for the Trust Indenture Act

The Second Circuit on Tuesday released its long-awaited opinion on the Trust Indenture Act, Marblegate v. EDMC. Several of us Slipsters have been discussing the case behind the scenes, and others will have (more intelligent) things to say about the opinion than I, but I thought I'd introduce the blockbuster case to get us rolling.

Long story short, the TIA essentially prohibits out-of-court workouts over the objection of any noteholder whose notes (debt securities) are part of the issuance qualified under the TIA. Section 316(b) says "the right of any holder of an indenture security to receive payment ... or to institute suit for the enforcement of any such payment ... shall not be impaired or affected without the consent of such holder." (emphasis added). The case was about what it means to "impair or affect" the "right" to get paid under indentured notes. The creative argument advanced by Marblegate was that lots of activities having nothing to do with changing the notes or their terms can "impair or affect" its right to get paid, and EDMC crossed the line. EDMC had done a creative end-run around the TIA by suffering its secured creditors to foreclose their (undisputed) security interests in all of its assets and then resell those assets to a newly created subsidiary of EDMC, scrubbing the former unsecured claims from those assets and leaving Marblegate and other noteholders with a claim against an empty shell. This was the second option in a Hobson's choice presented to noteholders; the first was to accept a 67% haircut and participate in a global workout with the secured creditors. Nearly 100% of the noteholders chose this option; Marblegate chose to play chicken and see if the courts would allow EDMC and its secured creditors to wipe out Marblegate's practical ability to enforce its claim by leaving an empty shell as the only obligor on Marblegate's unsecured debt after senior secured claimants exercised their superior rights in every scrap of available value. The contractual terms of Marblegate's right to collect were unchanged, but the practical ability of Marblegate to make anything of this right was clearly "impaired and affected," Marblegate argued.

I like this case because it demonstrates that sophisticated investors, like law students, are apt to make way too much of the Latin maxim ubi jus ibi remedium (where there is a right, there is a remedy). If I have a right to payment, I must have an effective remedy to get paid, right? Of course not. A decidedly un-Latin maxim explains why: you can't squeeze blood from a turnip (or stone). The remedy is the ability to sue and get a legally enforceable judgment. Then reality takes over. The practical ability to find value against which to enforce that claim is not guaranteed ... and never has been in the history of law. Planning for such an eventuality is the very reason for secured debt, a contractual way to reserve a superior interest in property of value against which a future right can be effectively enforced. Marblegate and other unsecured investors take a risk--and get compensated for that risk by a higher interest rate--that the debtor will become insolvent, including by having all its value wiped out by senior secured creditors. That Marblegate's argument had any legs seems to have been a function of an ambiguity in the law that one has to really squint to see.

The District Court squinted. It accepted Marblegate's argument that the TIA prohibits not only modification of Marblegate's notes themselves, but also any action that impairs Marblegate's effective remedy for breach of those notes ... if that action is part of a covert reorganization involving secured creditors and their superior rights. The TIA says nothing about prohibiting any covert reorganization, but the language quoted above was regarded as sufficiently ambiguous to allow for this expansive interpretation.

Too expansive, the Second Circuit held. After a brilliant exploration of the language and history of the TIA, the Second Circuit concluded that section 316(b) prohibits only "amendments to an indenture's core payment terms"; that is, changes in the legal rights of noteholders. It does not prohibit any number of actions not involving changing the contractual terms of an indenture that have a direct or indirect effect on the practical ability of noteholders to monetize their rights. That's a problem that unsecured noteholders need to anticipate and contract around, such as by prohibiting asset sales, etc. But the bottom line here is beautifully sensible and a needed reminder to out-of-the-money claimants: It is certainly not illegal, and perhaps not even unfair, for senior claimants to exercise their rights, leaving nothing for unsecured claimants. The fact that this might be part of a negotiated arrangement to help the debtor rehabilitate its business operations does not change the answer. 

Hyenas have no room to complain when the lions eat the entire carcass. Luckily for Marblegate and similar creditors, whether you're a hyena or a lion is not a matter of immutable genetics when it comes to creditor priorities.

Comments

[Jay Westbrook]

A rare instance when I disagree with you. The cherry picked discussion of Douglas’ views missed the substance of his well-informed and passionate desire to protect public bondholders and other investors from the financiers and their lawyers who had so mistreated them in the Twenties and Thirties. Form over substance sends a signal to investors that the American bond market is now wide open to manipulation. Can bondholders' lawyers stay ahead of issuers and their lenders in the sport of covenant versus maneuver? The district court ruling would have required some difficult line drawing, but fairness often imposes that burden. Douglas must be spinning in his grave.