Partner Harald Halbhuber (New York-Capital Markets) authored an article titled "Forced Debt for Equity Exchange Outside Bankruptcy Impairs Bondholder Payment Rights," for Twenty Eagle, a publication that covers news about the New York Court of Appeals.

The article, published on November 9, provides an analysis of a recent New York Court of Appeals decision on debt restructurings.

Read "Forced Debt for Equity Exchange Outside Bankruptcy Impairs Bondholder Payment Rights."

The recent decision of the New York Court of Appeals in CNH Diversified Opportunities Master Account, L.P. v. Cleveland Unlimited, Inc. provides important guidance for bond markets, creditor rights and debt restructurings.  It applies the "non-impairment" provision in bond indentures in the context of a forced debt for equity exchange through a majority-directed strict foreclosure, further developing the case law on out-of-bankruptcy restructurings following the Second Circuit's 2017 landmark ruling in Marblegate

The Non-Impairment Provision in Bond Indentures.  The non-impairment provision in bond indentures protects the right of each bondholder to receive (and sue for) payment of principal and interest on the due dates stated in their bonds from being "impaired" without that bondholder's consent.  While other bondholder rights are subject to change by majority action, this one is not.  In bond issues that are registered with the SEC, the non-impairment provision is mandated by section 316(b) of the federal Trust Indenture Act, but it is also found in indentures for private placement bonds that are exempt from SEC registration, such as those in CNH.

Marblegate.  The Trust Indenture Act's non-impairment provision came to unexpected prominence in 2015, when the federal District Court for the Southern District of New York in a case known as Marblegate sided with minority bondholders that had relied on the provision to challenge a foreclosure-based debt restructuring.  In that case, secured bank lenders foreclosed on their pledge over the bond issuer's assets and transferred the business to a new company.  This left unsecured bondholders that did not want to participate in the restructuring with claims against an empty shell.  The district court found that this "impaired" their payment rights because it adversely affected their recovery.  The holding caused uncertainty because many common debt restructuring techniques, such as consent solicitations to amend or remove restrictive covenants, have the potential to adversely affect bondholders' recovery.

In 2017, the Court of Appeals for the Second Circuit reversed the district court's ruling in Marblegate in a 2:1 decision (846 F.3d 1).  It concluded that the Trust Indenture Act's non-impairment provision protected each bondholder's legal right to receive payment, but not their practical ability to recover on that right.  The court noted that foreclosures that transferred the bond issuer's business to a new company were a well-worn restructuring technique in the decades leading up to the statute's enactment in 1939 that Congress did not intend to outlaw.  The decision emphasized that this reading of the non-impairment provision did not leave dissenting bondholders in junior classes without recourse in foreclosure-based restructurings:  With their payment claims intact, they remained free to pursue those claims against the purchaser of the assets under theories of successor liability or fraudulent conveyance.

The Court of Appeals' Decision in CNH.  In CNH, Cleveland Unlimited, a company in financial distress, defaulted on its secured bonds which were guaranteed by its subsidiaries and its parent company.  It worked out an arrangement with holders of a majority of the bonds to exchange them for equity in the issuer.  Some holders did not like the deal and preferred to take their chances by seeking to collect on their bonds.  The majority holders then tried to force the debt for equity exchange on the minority over their objection.  They did this by directing the bond trustee to foreclose "strictly" on the equity pledged by the bond issuer's parent company as collateral for the bonds and distribute that equity ratably to all of the bondholders, consenting majority and dissenting minority alike.  (In a "strict foreclosure" under Article 9 of the UCC, the secured party does not sell the collateral, but takes possession of it in full or partial satisfaction of the secured debt.  This requires the post-default consent of the debtor.)

The minority bondholders protested and proceeded to sue the company and the guarantors for damages suffered through the termination of their bonds, claiming that the strict foreclosure had breached the indenture's non-impairment provision by taking away their payment rights. 

The Court of Appeals, in a 4:3 decision, reversed the courts below that had found for the defendants, who effectively made two arguments: that the minority bondholders' payment rights were not impaired or, if they were, that bondholders had consented to that impairment in the contract by granting the majority authority to direct the trustee in the exercise of remedies.

The "No Impairment" Argument.  In support of their argument that plaintiffs' payment rights in CNH had not in fact been impaired by the strict foreclosure, the defendants cited certain language in the Second Circuit's opinion in Marblegate that referred to the Trust Indenture Act's non-impairment provision as prohibiting only "formal amendments" of "core payment terms."  The foreclosure in their case, defendants argued, did not constitute such an amendment, but merely the exercise of the majority's express contractual authority to direct the trustee's exercise of remedies.

The Court of Appeals distinguished Marblegate on the basis that the foreclosure-based restructuring there had left the minority bondholder's legal payment claims intact and merely transferred the issuer's assets to a new company.  The transaction in CNH was exactly the reverse: it left the issuer's business intact with all of its operating assets (the foreclosure involved only the equity in the issuer held by its parent company), but cancelled the bonds, thereby terminating the minority bondholders' legal right to receive payment and relegating them to the status of equity holders of the issuer.

The court further thought it was significant that in the Trust Indenture Act the non-impairment provision is placed in a section that begins by authorizing holders of a majority of the bonds to direct the trustee in the exercise of remedies.  This suggested to the court that the provision constitutes an exception to the principle of majority control of remedies, and that the exercise of remedies can thus well constitute an impairment of the minority's payment rights. 

The Bondholder Consent Argument.  The defendants in CNH also argued that the plaintiff bondholders could not complain about being forced to give up their bonds and take equity instead because they had already consented to the transaction.  The consent was said to be baked into the indenture provision authorizing holders of a majority of the bonds to direct the trustee in the exercise of remedies.  The Court of Appeals' opinion made short shrift of that argument, pointing out that the indenture's non-impairment provision necessarily trumped any potentially conflicting provision elsewhere because it included the "notwithstanding any other provision in this [i]ndenture" formulation that establishes such primacy.

The dissent reasoned that the indenture accorded the non-impairment provision primacy only over other provisions in the indenture and was therefore capable of being overridden in turn by the separate collateral trust agreement.  That agreement empowered only the trustee, to the exclusion of any individual bondholder, to enforce the security interest in the collateral at the direction of the majority bondholders.

Analysis.  The Court of Appeals' conclusion that the non-impairment provision prohibited the strict foreclosure transaction in CNH seems reasonable.  Indeed, a prohibition against impairing bondholders' payment rights by majority action might be perceived as toothless if it could be circumvented by the majority's instructing the trustee to seize equity pledged as collateral, thereby extinguishing those payment rights and replacing them with equity, all without the consent of the affected bondholders.  Even the dissent in CNH acknowledged as much when it conceded that "standing alone, [the non-impairment provision] would prohibit the trustee from pursuing the strict foreclosure in question here."

A historical perspective can help identify the types of transactions reached by the Trust Indenture Act's non-impairment provision.  It supports the court's holding.  Based on a rich body of contemporary case law and commentary, I have argued elsewhere that, at the time the statute was written, "the right to receive payment was viewed as impaired if a creditor was forced to accept, in full extinguishment of its claim, something other than the cash payments stipulated in the contract" (Debt Restructurings and the Trust Indenture Act, 25 Am. Bankr. Inst. L. Rev. 1 (2017)).

While it is true that foreclosure was then a standard restructuring technique, it operated as a sale of the bond issuer's business to a new company owned by the majority bondholders.  Importantly, the foreclosure did not extinguish the payment claims of dissenting minority holders, it merely cut off their lien against the collateral.  Minority holders in the foreclosing class had the "inviolate right" to be paid their portion of the foreclosure proceeds in cash and retained a deficiency claim for the shortfall from the face amount.  In an oft-cited opinion, legendary New York federal judge Learned Hand rejected "the idea that an interest in property may be forcibly imposed upon" debt holders whose claims are "measured by, and collectible in, money," and emphasized that they always had the right to have the debtor's assets "converted into money . . . and nothing can invade or impair that right." (In re Prudential Outfitting Co. of Delaware, 205 F. 504, 506 (S.D.N.Y. 1918)). 

To be sure, using foreclosure to exchange bondholder payment claims for equity at the direction of the majority was sometimes possible if authorized by the indenture (Sage v. Central R. R., 99 U. S. 334 (1878)), but such a contractually enabled forced exchange was likely viewed as just another example of the "reorganization by contract" (see the reference to Sage under that heading on page 143 in note 13 of Part VI of the SEC report cited by the Second Circuit in Marblegate) that the Trust Indenture Act's non-impairment provision was designed to prevent.

The dissent's argument in CNH that bondholders had consented to having their payment claims impaired via a foreclosure due to provisions contained in the collateral trust agreement suffers from an inherent tension.  It requires the dissent to treat the indenture and the collateral trust agreement as one integrated whole so that bondholders, while not parties to the collateral trust agreement, hold their payment claims subject to it.  At the same time, however, the dissent must emphasize that the two documents are quite separate, so that the trustee's majority-directed enforcement powers under the collateral trust agreement are not subject to the primacy of the non-impairment provision within the indenture.

Taken to its logical conclusion, the argument that minority bondholders in CNH validly consented to what happened to them would make the Trust Indenture Act's non-impairment provision largely optional.  Yes, every indenture for SEC-registered bonds would need to include it, but it could easily be disapplied as long as that disapplication was contained in a separate agreement rather than in the indenture itself.  This seems difficult to square with the statute.

Practical Implications for Out-of-Bankruptcy Restructurings.  Overall, the distinction the Court of Appeals draws between the restructuring technique used in Marblegate and that employed in CNH seems convincing.  The former left the minority bondholders' payment claims intact, enabling them to pursue those against the transferee of the assets.  The latter purported to extinguish those payment claims and forced minority bondholders to accept equity instead without a bankruptcy process if the majority so decided, which is exactly what the Trust Indenture Act sought to forestall.  This holds an important lesson for restructuring planners seeking to modify the capital structures of bond issuers outside of bankruptcy.  Transactions that do not seek to extinguish bondholders' payment claims are likely to continue to pass muster under the non-impairment provision mandated by, or modeled on, the Trust Indenture Act even if they are "coercive" in the sense that they remove assets, eliminate covenants or otherwise create incentives for bondholders to participate.  Conversely, attempts to forcibly exchange the dissenting minority's bonds for equity or other non-cash consideration, whether through strict foreclosure or other legal structures, may be subject to challenge for interfering with their payment rights.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.