‘Revolutionary’ Distressed-Debt Case Argued in NYC Appeals Court

  • Borrowers fight ruling they say makes restructurings harder
  • Caesars in similar dispute that it says could force bankruptcy

A dispute that critics say threatens to upend the $225 billion distressed-debt market reached a federal appeals court, where three judges were asked to weigh how much corporate borrowers can alter terms before they run afoul of a Depression-era law designed to protect bondholders.

Last year, a lower-court judge set new, tougher standards on corporate borrowers that opponents say would force more companies into bankruptcy by limiting their restructuring options. The case involves just $14 million but could entangle billions more in bonds.

The hearing Thursday in Manhattan appeals court lasted about an hour -- twice as long as scheduled -- as one judge interrupted the lawyers fighting the new standard, while another questioned the other side more closely. The appellate panel will issue its decision later.

Emil Kleinhaus, an attorney for the company seeking to overturn last year’s ruling, said that “out-of-court restructurings have ground to a halt” since the decision came down.

Sean E. O’Donnell, defending the new standard, said its impact should be limited to companies that try to impose bond restructurings designed to avoid paying debt. He also said it would involve only those bonds subject to the Trust Indenture Act, or TIA, the 77-year-old law at the heart of the dispute.

“I don’t think there’s going to be an army of cases before you,” said O’Donnell, whose clients are bondholders that rejected a restructuring offer by Education Management Corp., the for-profit college company.

Creditor Choice

In June, U.S. District Judge Katherine Polk Failla ruled in favor of O’Donnell’s clients, Marblegate Asset Management, holding that Education Management violated the TIA by forcing unsecured creditors to choose between accepting stock in a reorganized company or standing aside as assets that could have covered their debts were transferred out of reach. The restructuring was backed by 99 percent of senior lenders owed $1.3 billion and 90 percent of bondholders owed $217 million. 

On Thursday, U.S. Circuit Judge Chester J. Straub asked Kleinhaus if his interpretation of the TIA meant “anything goes” in an out-of-court restructuring as long as the bond contract doesn’t let a majority of bondholder votes to change the interest and principal.

Kleinhaus said investors assume whatever risks are contained in the contract.

‘Means Something’

If the appeals court upholds that decision, “people are going to have to learn that the Trust Indenture Act act means something,” said Marshall Sonenshine, founder of the financial advisory firm Sonenshine Partners LLC. “You’ll have to take into account the possibility that small bondholders may have hold-up value.”

Caesars Entertainment Corp. is embroiled in similar creditor disputes and has said it risks bankruptcy if the new interpretation stands. The gambling giant, which put its main operating unit into Chapter 11 last year, faces five lawsuits by bondholders, or their trustees, who are owed $11 billion and say the company violated the TIA.

Failla sided with holdout Education Management bondholders who said the restructuring made it impossible for lower-ranking creditors to collect on their debts. She ruled that the changes violated the TIA. She said that, in passing the 1939 law, Congress sought to prevent the kind of “nonconsensual majoritarian debt restructuring” that Education Management undertook. 

Steps Contemplated?

U.S. Circuit Judge Raymond Lohier questioned whether the rights of the holdouts were actually violated, since their bond contract, or indenture, included a clause allowing the company’s repayment guarantee to be withdrawn under certain circumstances.

“Weren’t these steps contemplated in the indenture?” he asked.

Kleinhaus, who represents Education Management, and a lawyer for lenders that supported the reorganization, said the restructuring may hurt Marblegate but doesn’t deprive the unsecured noteholders of any of rights under the bond contract or the TIA.

‘Revolutionary’ Ruling

Education Management’s position has found support with the Loan Syndications & Trading Association and the Chamber of Commerce, which called Failla’s ruling “revolutionary” and said it could affect the entire $8 trillion loan market. 

The decision “risks driving companies that might otherwise have restructured their debt successfully out of court into bankruptcy or foreclosure,” the two groups said in a brief submitted to the appeals court.

Caesars faces lawsuits in New York and Delaware over out-of-court restructurings from 2014, including the decision to abandon a debt guarantee. In preliminary rulings, another New York judge employed reasoning similar to Failla’s but didn’t issue a definitive decision in the case, which is still pending.

The TIA says a bondholder’s right to collect principal and interest “shall not be impaired or affected without the consent of such holder.” For decades, courts interpreted this provision as allowing companies to write indentures under which bondholder rights could be changed down the road, usually with a simple majority vote. An indenture that allowed a company to modify the collateral backing a debt would most likely be allowed, but a clause that reduced a bondholder’s right to principal and interest would not.

Caesars and Education Management argue that if an indenture allows changes to a bond deal, they should be free to impose those changes, as long as the interest and principal aren’t altered. Bondholders say any change that makes it impossible for them to collect violates the TIA, even if a change is allowed by the original contract.

Caesars’ main shareholders, Apollo Global Management LLC and TPG Capital, have lobbied Congress to amend the TIA to restore what the casino company claims is the original interpretation of the law.

The trustee for the Caesars bondholders said overturning Failla’s ruling would render “worthless the protections embodied in the statute for nearly 80 years.”

The appeal is Marblegate Asset Management LLC v. Education Management Corp., 15-2124, U.S. Court of Appeals for the Second Circuit. The main Caesars lawsuit is BOKF NA v. Caesars Entertainment Corp., 15-cv-01561, U.S. District Court, Southern District of New York (Manhattan).

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