The Trust Indenture Act (TIA) is a depression-era statute that was passed to protect retail investors and minority bondholders from majority bondholders and insiders who occasionally operated in collusion with the issuer to the detriment of minority bondholders and outsiders.
This is the purpose or spirit of the TIA: protecting the little guy. Minority bondholders, however, are not always “little guys” in today’s financial markets. Far from it. Sometimes they are specialized distressed-debt funds or event-driven funds which buy minority positions—sometimes at a deep discount—to exert pressure on an anticipated debt restructuring, hoping to drive the price of the minority position up, and thus turn a profit on the investment.
More specifically, section 316(b) of the TIA provides that majority bondholders cannot impair the payment rights of minority bondholders without their consent. For instance, if you bought into a 5% bond due 2022, a majority vote cannot transform it into a 2% bond due 2035, even if the contract governing the bond so provides. Simply put, the payment terms on the bonds (principal, interest, and maturity) are protected from majoritarian action. It is not that simple, however. There are two ways of construing the prohibition contained in §316(b):
(1) It protects dissenting bondholders only from textual (or formal) changes to the payment terms on their bonds (the narrow construction), e.g., changing the interest rate; or (2) it also protects from non-textual (or practical) changes to the payment terms (the broad construction), e.g., removing all of the issuer’s assets and sources of payment, which leaves the payment terms on the bonds textually (and formally) unchanged, but makes actual payments less likely.
The markets have been operating under the narrow construction since the passing of the TIA. Two judges from the U.S. District Court for the Southern District of New York, however, concluded that the statute also protects against practical changes to the right to payment. This is a significant expansion of the scope of §316(b) which threatens to disrupt countless financial restructurings and to revolutionize the distressed-debt market.
More concretely, in Marblegate and Caesars, Judges Katherine Polk Failla and Shira A. Scheindlin (respectively) concluded that the bondholders’ majority decision to release the parent guarantee on the bonds and to transfer all of the issuer’s assets out of the dissenting (minority) bondholders’ reach impaired the dissenting bondholders’ right to payment under §316(b), even though the payment terms on the bonds remained formally unchanged after the release of the guarantee and simultaneous migration of assets.
The judges distinguished between the formal right to payment and the practical right to payment, and concluded, based on the spirit of the law (as evidenced in its legislative history) and an unpublished decision from the Southern District of New York, that the right to payment protected by §316(b) of the TIA covers both aspects of the right to payment. The spirit of the TIA supports this conclusion; its plain text and legislative history, in my opinion, do not.
As noted in an Opinion White Paper recently published in response to these decisions, twenty-eight prominent law firms hold the view that the statute protects only against textual changes of the payment terms—and they have been holding that view for decades now, giving legal opinions to issuers and majority bondholders that assumed the narrow construction was good law.
Some firms find the implications of these decisions to be significant; others contend a deeper analysis shows that the decisions are highly fact-specific and their implications less troubling.
It is unclear whether the decisions will be upheld, but the Second Circuit judges in Marblegate seem to be concerned with limiting this expansive construction of §316(b) and, more generally, with making the resulting rule, if any, predictable.
* Santiago Herrera is a second year student in the two-year Juris Doctor for international lawyers at Wake Forest University School of Law. He holds a Juris Doctor-equivalent from University of Buenos Aires (Argentina) and a Master of Laws from Northwestern University School of Law. He is licensed to practice law in Buenos Aires, Argentina and New York. He recently accepted an offer to join Haynes and Boone’s New York office after graduation.