The Importance of Being Bound: Bondholders’ Vote and Workouts in the U.S. and in Italy
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By Francesca Prenestini (Bocconi University, Milan)

Francesca Prenestini

Most legal systems follow one of two rules for regulating the capacity of an issuer to renegotiate the terms of the bond loan to avoid insolvency or to accommodate changing capital needs. The first rule requires the individual consent of every bondholder while the second one permits the proposed agreement to be approved upon a majority decision which also binds dissenting bondholders.

This article analyzes the desirability of adopting a regulatory approach that allows a binding vote of bondholders on amendments of the core terms of the loan and other restructuring measures, including the conversion of bonds into shares. In doing so, this article examines the drawbacks of the prohibitive approach, which requires consent from all bondholders, with particular regard to the judicial cases and business practices of two major legal systems (the U.S. and Italy).

In the U.S., the Marblegate and Caesars cases have reignited the debate on out-of-bankruptcy restructurings of bond issues. In 2015, the U.S. District Court for the Southern District of New York reaffirmed that coercive exit consent transactions which force bondholders into questionable restructurings are prohibited by § 316(b) of the Trust Indenture Act of 1939 (“TIA”). Then, in January 2017, the U.S. Court of Appeal for the Second Circuit adopted a narrower interpretation, holding that § 316(b) only prohibits formal non-consensual modifications of an indenture’s core payment terms.
The district court’s interpretation, though broad, is more coherent with the text, the legislative history, and the purpose of the TIA. Section 316(b) provides that the individual right of each bondholder to receive payment of the principal of and interest on their indenture security on the due dates cannot (with a few minor exceptions) be impaired without the bondholder’s consent. This section was enacted to protect bondholders from insider abuses by giving individual bondholders the power to veto proposed amendments in an out-of-court restructuring. However, this individual veto power often precludes even fair renegotiation agreements between the issuer and the bondholders.

Under Italian law, the meeting of bondholders may approve “amendments of the terms of the loan” by majority vote. Nevertheless, in the light of quite restrictive interpretations of such a rule, those modifications may not change the structural characteristics of the bond loan.

This article suggests that governments should adopt rules that allow a majority bondholders’ vote to accept out-of-bankruptcy restructurings of bond issues. Currently two different solutions may be implemented in the U.S. and Italy: in the U.S., until § 316(b) can be reformed, the Securities and Exchange Commission could exercise its power to grant exemptions to authorize transactions and agreements otherwise banned; and in Italy, in the absence of a statutory prohibition, the contract governing the loan could include a provision allowing the meeting of bondholders to vote upon amendments of the core terms of the loan and other restructuring measures, such as the conversion of bonds into shares.

This article first examines the two different approaches to bond loans restructuring in various legal systems and in the context of sovereign debt, and considers why allowing a binding vote of the bondholders in workouts is so important given the rationales for and against this rule. Then it focuses on the U.S. legal system, and discusses the statutory provision that bans the majority rule, how the jurisprudence and business practices have evolved, and recent proposals for reform. The article also considers the Italian system, its rules and business practices, and how to overcome its limits. In the end, this article suggests an alternative rule and proposes interim solutions to the problem while awaiting statutory reform.

The full article is available here.

For previous Roundtable posts on § 316(b) of the TIA and Marblegate, see William W. Bratton, The New Bond Workouts; Out-of-Court Restructurings After Marblegate: Trust Indenture Act Section 316(b) and Beyond; Benjamin Liu, Exit Consents in Debt Restructurings; Second Circuit Rules on § 316(b) in Marblegate; Mark Roe, The Trust Indenture Act of 1939 in Congress and the Courts in 2016: Bringing the SEC to the Table; National Bankruptcy Conference Proposed Amendments to Bankruptcy Code to Facilitate Restructuring of Bond and Credit Agreement Debt; David A. Brittenham, Matthew E. Kaplan, M. Natasha Labovitz, Peter J. Loughran, Jeffrey E. Ross, and My Chi To, 28 Law Firms Publish White Paper Addressing Trust Indenture Act Complications In Debt Restructurings; Carlos Berdejó, Revisiting the Voting Prohibition in Bond Workouts (providing evidence related to argument made in Mark Roe, The Voting Prohibition in Bond Workouts, 97 Yale L.J. 232 (1987)).

Indenture Trustee Duties: The Pre-Default Puzzle
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates, Fiduciary Duties | 0

By Steven L. Schwarcz (Duke University School of Law)

Indenture trustees act for the benefit of the investors in a company’s bonds. They perform this role for virtually all companies that issue bonds, whether in the United States or abroad. The existing scholarship on their duties focuses on the post-default scenario. In many countries, including the United States, the law then imposes a ‘prudent person’ standard. This Article, in contrast, examines an indenture trustee’s “pre-default” duties.

It is critical to try to define those duties because activist investors, including hedge funds and so-called “vulture fund” investors that purchase defaulted bonds at deep discounts, increasingly are making pre-default demands on indenture trustees, who must know how to respond. Also, the manner in which they respond can have widespread economic consequences because the bond market is huge—in 2018, approximately $43 trillion in the United States and $103 trillion worldwide.

Activist investors are also suing indenture trustees for losses on their bonds, alleging they should have taken pre-default actions to protect the bonds. To avoid the risk of liability, indenture trustees should know how they should discharge their pre-default duties.

The indenture trustee’s pre-default duties have not been seriously re-examined since enactment of the Trust Indenture Act of 1939, although the bond market has changed dramatically since then. Institutional investors now dominate; there are few individual retail investors. By virtue of their sophistication and the size of their bondholding, institutional investors face less of a collective action problem than retail investors had faced. Also, as mentioned, certain activist investors increasingly are engaging in high-risk strategic investing.

Whether or not due to these market changes, there are at least two views today of the indenture trustee’s pre-default role. By far the dominant view—and the view that comports with existing law and the plain language of indentures—is that indenture trustees have no pre-default fiduciary duties to investors. Rather, their duties are ministerial and limited to the usually administrative functions specified in the indenture. Since the 2007-08 financial crisis, however, some investors argue that indenture trustees—especially those of securitized bond issues, who act for the benefit of investors whose right to payment is limited to collections on specified financial assets (such as mortgage loans)—should have some pre-default fiduciary duties.

My Article analyzes what an indenture trustee’s pre-default duties should be, starting by considering the possible normative frameworks for legally imposing duties in a business context. I consider two potentially overlapping frameworks: to correct market failures, and to maximize efficiency. I also consider a formalistic rationale for legally imposing duties—because securitized bond issues involve purchased financial assets, they more closely resemble a traditional trust; and trustees of a traditional trust have fiduciary duties.

Based on its analysis, the Article concludes (among other things) that, pre-default, the indenture trustee’s duties should only be those specified in the indenture. The Article also applies that standard to the types of issues that may arise in lawsuits against indenture trustees.

For example, even prior to a formal default, one or more investors may demand that the indenture trustee take some enforcement or other remedial action to try to correct a problem. Compliance with that demand could be expensive, reducing the value of the estate for investors generally. Taking remedial action could therefore create a conflict if it would disproportionately benefit only certain investors. Absent instructions from the requisite investor threshold contractually required to direct the indenture trustee, the trustee should have the right to refuse to take a demanded action. In case of doubt, an indenture trustee could itself seek instructions. The Article also examines practical issues—and practical ways to resolve those issues—that might sometimes impair formation of the requisite investor threshold to direct the indenture trustee.

The full article is available here.

Out-of-Court Restructurings After Marblegate: Trust Indenture Act Section 316(b) and Beyond
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Lawyers from Davis Polk, Drinker Biddle, and Wilmer Hale recently held a panel discussion entitled “Out-of-Court Restructurings After Marblegate: Trust Indenture Act Section 316(b) and Beyond.” Jude Gorman of Reorg Research moderated.

The panelists considered the future of out-of-court restructurings and refinancings in light of the Second Circuit’s recent Marblegate decision, the latest development in the litigation between Marblegate Asset Management and Education Management Corp. The panelists discussed several issues surrounding section 316(b) of the Trust Indenture Act (“TIA”), including its underlying policy rationale, how the statute might serve capital markets most effectively, the practical application of 316(b) after the Second Circuit’s decision, and the likelihood of near-term changes to the legal context for out-of-court restructurings. Of particular note, James Millar, of Drinker Biddle, discussed how guarantees of bonds may be treated independently from the underlying bond under the TIA and, hence, subject to 316(b). George Shuster, of WilmerHale, noted that the decision could lead unhappy bondholders to pursue involuntary chapter 11 cases or fraudulent transfer actions. Byron Rooney, of Davis Polk, discussed how the lower court decision in Marblegate had disrupted opinion practice. Finally, Mark Roe emphasized that the SEC has broad authority to issue exemptions, presumably prospectively and generally, as well as on a case-by-case basis; although the SEC has used this authority only occasionally, in theory, bond market players unhappy with the impact of 316(b) could seek conditional exemptions.

Reorg Research’s summary of the session is available here.

(This post comes from Paavani Garg, J.D. ’18.)

 

Exit Consents in Debt Restructurings
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By Benjamin Liu (University of Auckland Business School)

The exit consent technique refers to an offer by a bond issuer to all the bondholders to exchange the existing bonds for new bonds or other types of securities, on the condition that the tendering bondholders consent to a resolution to amend the terms of the existing bonds to make them less valuable.

In Marblegate and Caesars, the U.S. District Court for the Southern District of New York held that the relevant exit consent in each case violated Section 316(b) of the Trust Indenture Act of 1939, reasoning that Section 316(b) prohibits not only impairment of a dissenting bondholder’s formal right to payment, but also “practical impairment” of such right. This article argues that there is no sufficient justification for giving Section 316(b) a broader interpretation than its plain language suggests. Such an interpretation is inconsistent with the legislative history of Section 316(b) and how the term “impairment of a right” is used in other contexts. In January 2017, in a 2–1 decision, the Second Circuit reversed the district court’s ruling in Marblegate, holding that Section 316(b) prohibits only non-consensual amendments to an indenture’s core payment terms.

In Assenagon, the U.K. High Court held that the exit consent arrangement in that case was unlawful because it breached the abuse principle under English law. This article argues that the application of the abuse principle in exit consent cases should be considered in light of the facts and the parties’ presumed intention. A consenting bondholder does not abuse its power when it is simply making a rational choice. Furthermore, it cannot possibly be the parties’ presumed intention that, when the issuer has made an exchange offer coupled with an exit consent, the consenting bondholder is required to prioritize the interests of the dissenting bondholders over its own interest.

The full article is available here.

For past Roundtable posts on exit consents and related issues, see the Roundtable’s round up of reactions to the recent Marblegate decision; our post covering a white paper by twenty-eight law firms on debt restructurings and the TIA; and Roe, “Fixing the Trust Indenture Act to Allow Restructuring Votes.”

Second Circuit Rules on § 316(b) in Marblegate
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Last week, the Second Circuit decided Marblegate Asset Management, LLC v. Education Management Corp., holding that § 316(b) of the Trust Indenture Act (“TIA”) protects only bondholders’ formal, legal right to repayment, not their practical ability to recover. The Second Circuit’s 2–1 decision thus resolves uncertainty surrounding out-of-court bond workouts and returns to the pre-Marblegate practice.

The majority viewed the statute’s text as ambiguous and consulted the legislative history; it emphasized legislative history supporting the idea that § 316(b) protects only against the formality of a bondholder vote altering payment terms and discarded legislative history to the contrary as shards. The dissent concluded that the transaction “annihilated” a bondholder’s right to payment and, hence, ran afoul of statute’s plain language — which requires that a bondholder’s right to payment cannot be affected or impaired without the affected bondholder’s consent.

Law firms reacted rapidly to the decision. Wachtell Lipton, which represented the winning appellant, and Weil Gotshal both extoll the opinion. Paul, Weiss and Morgan Lewis see in the decision a clear rule that bars only express changes to core terms. Several firms, such as Shearman & Sterling and White & Case, emphasized that the decision will facilitate out-of-bankruptcy restructurings.

Squire Patton Boggs highlights limitations, arguing that the law remains “neither clear nor predictable” on when an out-of-court restructuring goes so far as to impair bondholders’ right to repayment. They caution against assuming that any action short of a direct alteration of core repayment terms is now permissible.

In his American Bankruptcy Institute column, Bill Rochelle notes that the decision’s focus on legislative history, including views contemporaneous with the statute’s passage, was unusual and, by implication, indicates that the dissent’s textual decision-making mode fits better with current Code interpretation. Seyfarth Shaw notes the decision’s limited practical effect because of the widespread use of binding votes in pre-packaged Code restructurings, which avoid § 316(b)’s restrictions.

The Roundtable has posted previously on Marblegate and § 316(b). In one post, Mark Roe argued that bondholders should not be barred by statute from choosing in their indenture whether to be allowed to reposition their bonds via a fair vote. Other posts include a summary of the National Bankruptcy Conference’s proposed amendments to the Bankruptcy Code to facilitate bond restructuring; a 28-law firm legal opinion white paper on transactional complications arising from the Marblegate district court decision; and an international perspective on the TIA’s prohibition on collective action clauses.

Awaiting the Second Circuit’s Decision in Marblegate
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We anxiously await the Second Circuit’s decision in Marblegate, which was argued earlier this year. John Bessonette of Kramer Levin briefly summarizes the stakes:

“Section 316(b) of the Trust Indenture Act provides that ‘the right of any holder of any indenture security to receive payment of the principal of an interest on such indenture security . . . shall not be impaired or affected without the consent of such holder . . . .’ Various plaintiffs used this provision this past year to successfully challenge out-of-court restructurings in Marblegate and Caesars. In both cases, the Federal District Court for the Southern District of New York held that § 316(b) not only protects the formal legal right to receive payment under an indenture, but also restricts non-consensual out of court debt reorganizations, even where no express terms of the indenture are violated.

“However, neither case provided a limiting principle for when out-of-court restructurings violate § 316(b), and plaintiff firms are now taking advantage of this murkiness. In the last year, three lawsuits challenging distressed exchange offers have been filed by retail holders of unsecured bonds. Each lawsuit involves an exchange offer made to qualified institutional buyers by a distressed energy company, and retail bondholders who object to their bonds being subordinated to the secured bonds issued to QIBs as part of the exchange.

“The cases are still pending and it remains to be seen whether the courts will clarify the ambiguity around § 316(b). Meanwhile, this obscure provision of the TIA will occupy a more prominent role in out-of-court debt restructurings and serve as a new weapon for plaintiffs challenging such restructurings.”

His full memo is available here.

The Roundtable has issued multiple posts on the Marblegate litigation and the Trust Indenture Act. Mark Roe wrote what the appropriate limiting principle should be for courts when invalidating exit consent transactions under section 316(b) of the Act. He further argued that courts alone cannot solve the fundamental problems: The SEC must also act. The Roundtable also covered the 28-law-firm white paper on how courts should handle that section. See our archives for more.

28 Law Firms Publish White Paper Addressing Trust Indenture Act Complications In Debt Restructurings
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By David A. Brittenham, Matthew E. Kaplan, M. Natasha Labovitz, Peter J. Loughran, Jeffrey E. Ross, and My Chi To of Debevoise & Plimpton LLP

On April 25, 2016, 28 leading U.S. law firms published a legal opinion white paper (the “Opinion White Paper”) addressing recent decisions of the United States District Court for the Southern District of New York interpreting Section 316(b) of the Trust Indenture Act of 1939 (the “TIA”) in the Marblegate and Caesars Entertainment cases. These decisions contain language that suggests a significant departure from the widely understood meaning of TIA § 316(b) that had prevailed for decades among practitioners. They have introduced interpretive issues that have disrupted established legal opinion practice and created new obstacles for out-of-court debt restructurings.

Section 316(b) of the TIA generally provides that the right of any holder of an indenture security to receive payment of principal and interest when due may not be impaired or affected without the consent of that holder. These recent decisions suggest that TIA § 316(b) protects more than the legal right to receive payment of principal and interest in the context of a debt restructuring.

The Opinion White Paper presents general principles that can guide opinion givers until the interpretive questions raised by these recent cases are resolved through future judicial opinions or legislative action.

The Opinion White Paper and further discussion of these cases are available here: Opinion White Paper.

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The Bankruptcy Roundtable has previously posted on the Trust Indenture Act as well as the Marblegate and Caesars Entertainment cases. Most recently, Mark Roe posted an article on the underlying policy behind 316(b) and suggested regulatory and legislative changes to address the problems of bondholder holdouts and coercive exit consents: The Trust Indenture Act of 1939 in Congress and the Courts in 2016: Bringing the SEC to the Table. Additionally, the Roundtable posted the National Bankruptcy Conference Proposed Amendments to Bankruptcy Code to Facilitate Restructuring of Bond and Credit Agreement Debt.

 

The Trust Indenture Act of 1939 in Congress and the Courts in 2016: Bringing the SEC to the Table
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By Mark J. Roe, Harvard Law School

The Trust Indenture Act’s ban on restructuring payment terms via a vote has come to the fore in recent litigation. This memo examines broad aspects of the recent controversies to outline a path forward for a sensible legal structure governing out-of-bankruptcy restructurings.

There are four points to be made:

  1. The recent Southern District of New York decisions striking down exit consent transactions are justified under the Trust Indenture Act.
  2. The Act impedes out-of-bankruptcy restructurings because it clearly but mistakenly bars votes that restructure bond payment terms. Restructurings outside bankruptcy cannot succeed when widespread consent is needed. But in an institutionalized bond market, there is little reason to bar restructuring by vote.
  3. The Act’s ban on votes creates the potential for holdouts (or earnest dissenters) to destroy a good deal that most bondholders sincerely want. But to combat the Act’s voting ban (and sometimes to force an unsound restructuring), issuers use exit consent offers, which can impair bondholders’ indenture rights so severely that they reluctantly accept an offer whose terms they dislike. Courts cannot resolve both of these distortions; other lawmakers need to come to the table.
  4. Legislative solutions are possible. While awaiting wise legislation, there is another way to construct sensible rules for bond workouts — one that has previously not been recognized. The Securities and Exchange Commission has broad authority to exempt indentures and transactions from the full force of the ban on voting.

SEC exemptive rulemaking provides a viable path to facilitate out-of-bankruptcy restructurings of public bond issues going forward. The appellate courts can and should affirm the lower court decisions that the Trust Indenture Act bans exit consent degradation, and the SEC can and should then use its exemptive power to carve out uncoerced votes on payment terms from the Act’s voting ban.

The full memo is available here.

For some of our most recent previous posts on the Trust Indenture Act see here, here, and here.

WSJ The Examiners — Trust Indenture Act
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In light of recent court developments in Marblegate and Caesars, in which courts interpreted Section 316(b) of the Trust Indenture Act (“TIA”) as barring bond exchange offers at issue, the Wall Street Journal’s Bankruptcy Beat this month posted responses to this question: how does bondholders’ use of the Trust Indenture Act affect companies’ ability to complete out-of-court restructurings?

Mark Roe sees the recent decisions as properly interpreting the TIA (see The Voting Prohibition in Bond Workouts for further analysis). But he sees the TIA to be a poor statute for today’s institutionalized market and urges the SEC to use its power to exempt transactions from the TIA, so as to allow binding votes in non-coercive out-of-court restructurings.

Adam Levitin and Sharon Levine predict that more companies will hesitate to register their debts to keep them out from the TIA. Levitin also sees the TIA’s voting ban as outmoded.

Jay Goffman discusses negative consequences of broad minority bondholder power and predicts that companies will limit their use of out-of-court exchange offers. J. Scott Victor also predicts that more companies will file for Chapter 11 bankruptcy when minority bondholders hold out and prevent out-of-court restructurings.

Jack Butler concludes that the TIA’s legislative intent was not to grant bondholders more than the legal right to sue the debtor, even if an exit consent transaction ousted them of the practical capacity to be paid.

On the other hand, Richard Chesley argues that recent decisions should not affect the use of out-of-court restructurings, while Brett Miller expects further judicial opinions on the scope and reach of the Trust Indenture Act.

For previous Bankruptcy Roundtable posts discussing the Trust Indenture Act’s scope, see here, here, and here.

(This post was drafted by Jenny Choi, J.D. ’16.)

Fixing the Trust Indenture Act to Allow Restructuring Votes
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By Mark J. Roe, Harvard Law School

Roe 124

The Trust Indenture Act of 1939 bars binding bondholder votes on core payment terms. The inability of deal proponents to get a binding vote can lead the debtor to file for an otherwise unnecessary bankruptcy. To get a deal done when there are economically-important holdouts, deal proponents often seek exit consents to induce enough holdout bondholders to reluctantly tender into a deal they don’t otherwise like, by stripping the bond indenture of those covenants on which bondholders can vote.
Exit consent transactions have generally been upheld, despite that in analogous corporate settings such distortions induce doctrinal and deal structure issues. Recent decisions indicate that exit consents that oust the bondholders from an effective individual choice ran afoul of the Trust Indenture Act, which may well have been the intent of the 1930’s drafters of the law.
Regardless, the anti-voting provision is anachronistic. It was passed when bankruptcy law did not respect bondholder votes without a judge’s substantive approval of the deal, but the Code was updated in 1978 to allow binding votes. Bondholders should also be free to agree in advance to a binding vote in an out-of-court workout. More restructurings will succeed and avoid bankruptcy. And proponents will have less reason to resort to arm-twisting with exit consents. Similar individualized consent difficulties and holdout issues have hobbled sovereign debt restructurings, with sovereign debt issues moving in recent years to include majority vote provisions.
For my analysis of the incentives and structure of bond restructurings in light of the TIA, see 97 Yale L.J. 232 (1987).

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