The Trust Indenture Act of 1939, 15 U.S.C. §§ 77aaa-77bbbb (the “Act”) basically provides that holders of notes subject to the Act shall not have their right to receive payment of principal, premium and interest impaired without the holders consent.  In the recent opinion in Marblegate Asset Management v. Education Management Corp., civil case in New York (the “Case”), the Court held (arguably in dicta), that the Act will allow a small minority of noteholders to block an out of court restructuring because the proposed intercompany sale via foreclosure (of substantially all assets) prevented the noteholders from receiving any real recovery from the maker.

chicken-game

In the Case, the Plaintiffs are dissenting unsecured noteholders subject to an indenture agreement (the “Indenture”) made by the operating subsidiaries (the “EDMC Subs”) of Education Management Corp. (“EDMC”).  The Plaintiffs hold ~$20MM of the ~$1.553BB in secured and unsecured debt owed by the EDMC Subs and guaranteed by EDMC.

Importantly, EMDC and the EDMC Subs operate one of the largest for-profit college systems in the United States.  As such, EDMC derived 78.6% of its net revenue from federal student aid programs under the Higher Education Act and overseen by the Department of Education.  One of the many regulatory requirements imposed on EDMC to permit it to receive the federal funds is that EDMC and the EDMC Subs may not file bankruptcy.  Thus, for practical purposes, if EMDC wants to continue to operate and receive funds it cannot file bankruptcy to restructure.

In 2014, EDMC began to suffer significant financial problems and its EBITA dropped from $662MM to $276MM in one year.  To address the situation, EMDC proposed an out-of-court restructuring that could proceed along one of two paths.

  • First Path: everyone agrees to an intercompany sale and creditors receive new notes and equity in the NewCo entity to be owned by EDMC and EDMC guarantee would be released.
  • Second Path: not everyone agrees and the secured creditors foreclose on substantially all of the assets of the EDMC Subs, release EDMC guarantee as to all creditors (permitted because of Indenture terms) and then re-sell the assets to NewCo owned by EDMC.  The consenting creditors would get new notes and equity in/from NewCo.  The non-consenting creditors would get nothing.

At the deadline for consent/non-consent to the first option 99% of the secured creditors consented and 90% of the unsecured consented.  Thus, the secured creditors indicated they would proceed with the second path.

Faced with the practical reality of receiving nothing because of the transfer of the assets from the EDMC Subs to NewCo, the Plaintiffs brought suit to enjoin the intercompany sale.  (The Court noted that even if the borrower/maker had no assets following the intercompany sale, there was potentially causes of action such as fraudulent transfer which might serve as recovery, even if speculative).

At the heart of the Case is whether the Act provides note holders with only the procedural right to pursue their note claim or the actual right to not have their payment impaired.  The Court held that the notes subject to the Act receive the actual right to not have their payment impaired by the maker (without their consent), and thus EDMC’s restructuring proposal (and related agreements) would violate the protection afforded the Plaintiffs under the Act.  Stated simply, the Court stated that depriving the maker/borrower of any meaningful means to pay the Plaintiffs (ie, the assets) violated the terms of the Act which require that repayment not be impaired by the maker/borrower.

In reviewing the legislative history, the Court indicates that the Act protects dissenting note holders (even this small minority of them) from this type of restructure by the borrower and encourages bankruptcy filing instead if the borrower seeks to restructure.

Notably, the Act does not prevent the secured creditor from simply foreclosing and being done with it.  So, as a practical matter, bankruptcy may be the only avenue for debtors seeking to restructure with multiple creditor constituencies who are subject to the protections of the Act if agreement is not immediately forthcoming.  However, the game of chicken remains the same.  Ultimately, if there is no money except from operations, if operations shut down the unsecured creditors face a difficult road to any meaningful recovery.

Marblegate Asset Management, et. al., v. Education Management Corp., et al., Cause 1:14-cv-08584, pending in the United States District Court for the Southern District of New York.