Debt Restructurings and the Trust Indenture Act

In a case commonly referred to as Marblegate, a federal district court recently held that a debt restructuring by for-profit education provider EDMC violated a non-impairment provision in the Trust Indenture Act (TIA), a Depression-era statute governing bond indentures. The restructuring presented bondholders with a choice between exchanging their bonds for equity and being left with claims against an empty shell by virtue of a foreclosure by secured creditors. The decision, which is currently under review by the Court of Appeals for the Second Circuit, has attracted a lot of attention in bond markets and has affected debt restructurings across the country. According to the decision, the TIA prohibits debt restructurings outside bankruptcy that “impair” a dissenting bondholder’s recovery, even if they do not change payment terms or make the bonds payable in something other than cash. The decision relied heavily on the legislative history of the statute and concluded that transactions like the one in Marblegate were precisely what Congress intended to prohibit.

Debt Restructurings and the Trust Indenture Act, a new paper recently posted on SSRN, uses thorough historical analysis to make three main points about the application of the TIA to debt restructurings. First, it demonstrates that Congress cannot have intended the TIA to prohibit transactions like the one in Marblegate. Second, it shows that “impairing” a bondholder’s right to payment had a well-understood meaning at the time. Third, the paper explains how the TIA’s non-impairment provision, despite its seemingly narrow focus, fit with the SEC’s broader policy objectives regarding debt restructurings. It concludes that debt restructurings that do not change payment terms do not implicate the TIA.

The paper carefully reconstructs the lost context of debt restructuring practice in the 1920s and ‘30s. In the decades leading up to the TIA, foreclosure-based reorganizations like the one in Marblegate were not, as the court suggested in its recent decision, a perhaps unforeseen legal device. Quite the contrary: they represented a generally accepted debt restructuring technique. Without a reorganization chapter in the Bankruptcy Act, foreclosure sales were the only means available to businesses to reorganize and restructure their debts. Equity receivership stayed creditor enforcement, but it was the foreclosure sale that accomplished the reorganization. Reorganization in bankruptcy was eventually permitted in 1934, but the sale technique continued to be available. There is no indication that Congress intended to outlaw the sale technique with the TIA.

More importantly, the paper also shows that most bond indentures at the time already contained the non-impairment provision relied on by the court in Marblegate, well before it was mandated by the TIA. It happily co-existed with foreclosure-based reorganizations like the one in Marblegate, and it did not occur to anyone, let alone Congress, that the provision would have prohibited such transactions. The corresponding provision in the TIA was understood as merely making mandatory what had been standard indenture drafting.

In addition to demonstrating what the non-impairment provision in the TIA cannot have meant, the paper shows that the concept of “impairing” a bondholder’s right to payment had a very specific meaning. It referred to any attempt to extinguish the payment right with anything other than cash in the amounts and at the times specified in the bond. A foreclosure-based reorganization, in contrast, was viewed not as impairing, but as respecting that right, even though it offered bondholders a somewhat coercive choice. Bondholders in the foreclosing class could participate in the reorganization or take cash based on a hypothetical forced sale value of the business, representing a significant discount to their bonds’ trading price. Bondholders in junior classes had no cash-out claim, but had to choose between participating in the reorganization and being left with a claim against, as it was called at the time, an “empty shell.”

Finally, the paper explains why the TIA’s non-impairment provision, even though it merely codified standard indenture drafting, was not irrelevant boilerplate. The legal protections available to minority bondholders that did not want to participate in a reorganization were rooted in their right to receive payment. It was the right that entitled bondholders in the foreclosing class to be cashed out (albeit at a discount), and for bondholders in junior classes it preserved their fraudulent conveyance claims that ensured them a fair share in the reorganized company ahead of the stockholders. For companies, majority creditors and stockholders, the only way to avoid cash-out and fraudulent conveyance claims by minority bondholders was to file for bankruptcy.

The SEC in 1939 pushed Congress to make the traditional non-impairment provision mandatory because it had observed a worrying new trend in bond indenture drafting. Some deals were including provisions that permitted a majority of bondholders to force a dissenting minority to accept equity in a restructuring and effectively cut off their cash-out or fraudulent conveyance claims. These new powers for the majority were not available in indentures that included the non-impairment provision. Congress had just overhauled the bankruptcy reorganization process in 1938, imposing significant regulatory oversight by the SEC. The SEC thus saw a risk that companies would bypass that additional level of regulation if they could obtain the same legal protection against claims by minority bondholders outside bankruptcy. By making the non-impairment provision mandatory, the TIA closed that potential loophole.

This does not mean that debt restructurings outside bankruptcy are immune from legal attack by minority bondholders. They are subject to scrutiny under fraudulent conveyance and other laws protecting creditors generally, just as they would have been in the 1930s. The TIA ensures that minority bondholders continue to enjoy those protections.

As Professor Roe recently pointed out in this blog and a corresponding article, the recent decisions in Marblegate and other cases raise interesting policy questions regarding the ability of companies to restructure their debts outside bankruptcy. The historical analysis presented here does not take sides in the policy debate but focuses on the meaning of the TIA and the intent of its framers.

The full paper is available here.