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November 16, 2020

New York Court of Appeals Upholds Holdout Noteholders’ Rights to Payment Under an Indenture Following Foreclosure Directed by Majority Noteholders


The New York Court of Appeals issued a ruling in CNH Diversified Opportunities Master Account LP v. Cleveland Unlimited Inc. (CNH)1 on October 22, 2020, holding that a majority noteholder group's and the indenture trustee's purported cancellation of notes through a strict foreclosure of equity (without minority noteholders' consent) both constituted a breach of the applicable indenture agreement and violated the Trust Indenture Act of 1939, 15 USC § 77ppp(b) (TIA), and thus did not extinguish the minority noteholders' right to payment under the applicable indenture.

The rights of holdout noteholders under the TIA in connection with out-of-court restructurings has been a critical subject of contention in several prominent cases including Caesars Entertainment and Education Management, with particular focus on the application of section 316(b) of the TIA. That TIA provision provides that core payment terms of an indenture cannot be amended without the express consent of the affected noteholder and further provides that this restriction cannot be modified by the indenture terms. The dispute in Education Management was litigated to the Second Circuit Court of Appeals, Marblegate Asset Management, et al. vEducation Management Corp., et al. (Marblegate).2 In Marblegate, the Second Circuit held that section 316(b) applied only to "formal amendments" of the indenture which affected a noteholder's "legal right" to payment (in contrast to a practical right to payment). In CNH, the Court of Appeals, applying and purportedly following Marblegate, upheld the minority noteholders' right to payment notwithstanding the majority noteholder's strict foreclosure on the issuer's equity and accompanying cancellation of the notes, effectively determining that the cancellation of the notes constituted a formal amendment affecting the minority noteholders' legal rights to payment.

The CNH decision gives holdout noteholders greater leverage in out-of-court restructuring negotiations, and is likely to increase restructuring costs and lead to more in-court restructurings.

CNH Factual Background

In December 2005, defendant Cleveland Unlimited Inc. (Cleveland Unlimited or Issuer) issued $150 million of senior secured debt in the form of notes (Notes) pursuant to a New York-law governed indenture agreement (Indenture) among the Indenture's trustee (Indenture Trustee), the Issuer, and certain of the Issuer's subsidiaries and affiliates as guarantors (Guarantors). In April 2010, the plaintiffs purchased approximately $5 million of the Notes from the secondary market. The Notes were governed by three agreements: the Indenture, a collateral trust agreement (Collateral Trust Agreement) and a security agreement. The Collateral Trust Agreement contained a provision that permitted the Indenture Trustee to foreclose at the direction of a majority of the holders of the Notes (Noteholders).

In December 2010, Cleveland Unlimited concluded it would not be able to meet the interest and principal obligations coming due under the Notes. To avoid defaulting, Cleveland Unlimited entered into negotiations with the Noteholders regarding a potential workout. Despite those efforts, on December 15, 2010, Cleveland Unlimited defaulted on its payment obligations under the Notes. Several weeks later, Noteholders owning 99% of the outstanding Notes executed a forbearance agreement (Forbearance Agreement) with Cleveland Unlimited, the Guarantors, the Indenture Trustee, and CUI Holdings LLC (CUI Holdings), the parent of Cleveland Unlimited. Pursuant to the Forbearance Agreement, CUI Holdings became a Guarantor on the Notes, pledging the Cleveland Unlimited stock as collateral. In return, the consenting Noteholders and the Indenture Trustee agreed to refrain from exercising any rights or remedies available to them through April 2011.

On the date of the Forbearance Agreement, CUI Holdings and a new entity owned by a majority of the Noteholders (Majority Noteholders), CUI Acquisition Corp. (CUI Acquisition), negotiated a Purchase and Sale Agreement whereby CUI Holdings would transfer all outstanding stock in Cleveland Unlimited to CUI Acquisition for the benefit of the Noteholders (Purchase and Sale Agreement). In return, the Noteholders would forfeit their rights as secured creditors and instead become equity holders in Cleveland Unlimited. Several months later in April 2011, a minority group of Noteholders (Minority Noteholders" informed the Majority Noteholders of their opposition to the Purchase and Sale Agreement and unwillingness to convert their Notes to equity.

As a result, rather than proceeding with the Purchase and Sale Agreement, the Majority Noteholders directed the Indenture Trustee to (i) "foreclose strictly" on the Cleveland Unlimited stock and, thereafter, (ii) distribute Cleveland Unlimited's stock on a pro-rata basis to the Noteholders. In furtherance of the strict foreclosure, the Notes were cancelled and Cleveland Unlimited's and the Guarantors' obligations under the Indenture ceased. In response, the Minority Noteholders informed Cleveland Unlimited, the Majority Noteholders and the Indenture Trustee that they did not "join or in any way consent to the [strict foreclosure]," and that such foreclosure violated, among other things, the Indenture provision which tracked section 316(b) of the TIA. In other words, the Minority Noteholders did not "consent to any impairment or effect on their rights to receive payment of principal or interest" on their Notes, "on or after the respective due dates, or to bring suit for the enforcement of any such payment on or after such respective dates." Over the Minority Noteholders' objection, the strict foreclosure went forward. This suit by the Minority Noteholders to enforce their right to payment of the Notes followed.

As the Court of Appeals did in CNH, we begin by reviewing the TIA and the Second Circuit's decision in Marblegate.

Marblegate Background

In Marblegate, the Second Circuit clarified the applicability of section 316(b) of the TIA in the context of out-of-court debt restructurings. Section 316(b) of the TIA provides:

Notwithstanding any other provision of the indenture to be qualified, the right of any holder of any indenture security to receive payment of the principal of and interest on such indenture security, on or after the respective due dates expressed in such indenture security, or to institute suit for the enforcement of any such payment on or after such respective dates, shall not be impaired or affected without the consent of such holder, except as to a postponement of an interest payment consented to as provided in paragraph (2) of subsection (a), and except that such indenture may contain provisions limiting or denying the right of any such holder to institute any such suit, if and to the extent that the institution or prosecution thereof or the entry of judgment therein would, under applicable law, result in the surrender, impairment, waiver, or loss of the lien of such indenture upon any property subject to such lien.

Faced with financial difficulties and because a bankruptcy filing would have caused Education Management Corporation and certain of its subsidiaries (collectively, "EDMC") to lose significant federal funding, EDMC sought to restructure their debt outside of bankruptcy. EDMC had $1.3 billion in secured debt and $217 million in unsecured notes governed by a TIA-qualified indenture. To restructure its debt, EDMC negotiated a restructuring transaction with the majority of its secured lenders and noteholders whereby EDMC would effectuate an intercompany sale.

Several steps were required to fully effectuate the intercompany sale. First, consenting secured creditors would exercise their pre-existing rights under the applicable credit agreement and Article 9 of the Uniform Commercial Code to foreclose on EDMC's assets. Second, EDMC would be released from its obligations under certain guarantees. Third, with consent from the secured creditors (but without needing the consent of the unsecured noteholders), the collateral agent would then sell the foreclosed assets to a newly constituted EDMC subsidiary (NewCo) for purposes of the intercompany sale. Finally, NewCo would distribute debt and equity only to consenting creditors and continue the business. In effect, nonconsenting secured creditors would receive NewCo debt junior to the debt of consenting secured creditors and nonconsenting noteholders would receive nothing from NewCo.

Although the intercompany sale did not formally amend the terms of the unsecured notes, it effectively precluded nonconsenting unsecured noteholders from receiving payments because the applicable guarantee was extinguished. All of EDMC's creditors, save Marblegate Asset Management LLC and Marblegate Special Opportunity Master Fund LP (both noteholders), consented to the intercompany sale. The district court ruled that EDMC's out-of-court restructuring violated section 316(b) of the TIA because the transaction's effects stripped nonconsenting noteholders of their "practical ability" to collect payment on the notes and violated the TIA.

In a 2-1 decision, the Second Circuit reversed the district court and held that it was unclear from the plain text of the TIA whether section 316(b) was meant only to protect against formal amendments to payment terms or more broadly protect noteholders' "practical ability" to collect payment. Following a thorough examination of the TIA's legislative history, the Second Circuit held that the TIA did not prohibit involuntary debt restructurings that could be implemented without altering principal, interest, tenor, or payment terms. Instead, the Second Circuit held that the TIA prohibits only formal amendments to core payment terms without the consent of all noteholders and determined that the Marblegate transaction did not involve a formal amendment of the noteholders' right to seek payment from the issuer.

The Court of Appeals' CNH Decision

Granting the Majority Noteholders' request for summary judgment on the Minority Noteholders' complaint, the New York Supreme Court (New York's trial court) held the Majority Noteholders were authorized to direct the Indenture Trustee to act for all the Noteholders (including the Minority Noteholders) in the event of a default. Further, the trial court applied Marblegate and held that the strict foreclosure did not violate TIA section 316(b)—or the equivalent language in the Indenture —because that transaction neither formally "amend[ed] any terms of the Indenture" nor "prevent[ed the Minority Noteholders] from bringing an action to collect payments due on the dates indicated in the Indenture." The Supreme Court, Appellate Division (First Department) affirmed based on much of the same reasoning, holding that "[a] fair reading of the [Indenture Documents] demonstrates that the [Trustee] was authorized to pursue default remedies, including the strict foreclosure at issue here, if so directed by a majority of noteholders." The Appellate Division further held that debt-for-equity restructuring at issue did not amend the Indenture's "core payment terms."

In a 4-3 decision, the Court of Appeals reversed the trial court and the Appellate Division.           

The Majority Opinion

At the outset, the majority opinion focused its analysis on a provision in the Indenture that mirrored TIA section 316(b). The Indenture provision at issue provided, "[n]otwithstanding any other provision of this Indenture, the right of any Holder to receive payment of principal . . . and interest . . . on a Note . . . or to bring suit for the enforcement of any such payment . . . shall not be impaired or affected without the consent of such Holder" (Consent Clause). The Consent Clause prompted two questions: (i) whether the Minority Noteholders consented to the strict foreclosure and (ii) whether the strict foreclosure affected the Minority Noteholders' right to payment.

To the first question, the Majority Noteholders argued the Minority Noteholders implicitly consented to the restructuring transaction, i.e., strictly foreclosing on the Issuer's equity, via the Collateral Trust Agreement. The Majority Noteholders posited that the Collateral Trust Agreement modified the Indenture Trustee's powers under the Indenture, thereby allowing the Indenture Trustee to act as directed by the Majority Noteholders to realize and foreclose upon the collateral following the Issuer's default. According to the Majority Noteholders, when the Indenture's Consent Clause and the Collateral Trust Agreement are read together, the Indenture Trustee could strictly foreclose at the Majority Noteholders' direction (over the Minority Noteholders' objection) while still satisfying the Consent Clause. Unpersuaded by the Majority Noteholders' argument, the majority opinion held the Minority Noteholders were not party to the Collateral Trust Agreement and their consent to the strict foreclosure could not be implicitly construed from the foreclosure provision of the Collateral Trust Agreement.

To the second question, the Court of Appeals held there was "no question that, here, the [Indenture] Trustee was authorized to act" at the Majority Noteholders' direction but that focusing on that inquiry alone was inappropriate. Instead, the court focused on whether the Minority Noteholders' rights "were extinguished . . . by the purported cancellation of the Notes." The defendants argued Marblegate controlled and, under Marblegate, the Majority Noteholders were prohibited only from making "formal amendments to "core payment terms," which, they argued, had not occurred as a result of the strict foreclosure.

The majority opinion disagreed and held the Majority Noteholders' purported cancellation of the Notes in connection with the strict foreclosure, without the Minority Noteholders' consent, terminated the Minority Noteholders' legal right (in contrast to a practical ability) to receive payment on the Notes, a key distinction recognized by Marblegate. The majority opinion did not clearly identify what constituted a "formal amendment" of the Indenture—as required by Marblegate, which the majority opinion purported to follow—but seems to have viewed the cancellation of the Notes as effecting a formal amendment of the Indenture.

The Dissenting Opinion

Broadly, the dissenting opinion takes issue with three aspects of the majority opinion. To start, the dissent observed that CNH involved two agreements "that, when properly read as one, govern that review: the indenture, for which the majority accounts, and the collateral trust agreement, which the majority does not meaningfully consider." The dissent asserted that such agreements, "when read together, . . . support the strict foreclosure course chosen by the trustee following the default of defendant Cleveland Unlimited Inc. (Cleveland Unlimited) with respect to the notes in question." In criticizing what it observed as the majority's decision to "brush[] the collateral trust agreement aside" and "elevate[] the importance of [the TIA] to a place of undue prominence in determining this case," the dissent asserted the majority opinion comes "[a]t the expense of both our rules of contract interpretation and the symmetry of such principles with those of the Second Circuit."

Second, and as a corollary to the first point, there was "no need for unanimity of noteholder opinion" because, by entering into a transaction under which the Indenture Trustee was permitted to foreclose at less-than-unanimous holder direction, all holders—including Minority Noteholders—consented to Indenture Trustee action on the basis of the Majority Noteholders' consent. According to the dissent, the Indenture "left open" the possibility that "a codicillary agreement—such as the collateral trust agreement—would modify the indenture," explaining that this was "precisely what occurred here." The dissenting opinion points out that "the adjustment of the indenture by operation of the collateral trust agreement provided the consent of the minority noteholders required in the indenture to allow the majority noteholders to authorize the foreclosure in question here." In other words, the dissent concluded applying ordinary contractual interpretation principles to the Indenture and the Collateral Trust Agreement meant the Minority Noteholders consented to the strict foreclosure.

Finally, to create certainty in financial dealings among parties, the dissent urged "[t]he prudent, common-sense approach here would be to maintain that sureness [by following Marblegate] and to avoid creating space between the rules of this Court and the rules of the Second Circuit governing the interpretation of indenture agreements." As a result, the dissent reasons that the Court of Appeals should conclude that its "steady rules of contract interpretation applied to the plain language of the contract in question authorize the strict foreclosure here at issue."

Implications of the Decision

The Court of Appeals' decision in CNH could significantly impact the rights and strategies of distressed companies/issuers, noteholders and indenture trustees in out-of-court restructurings. At the outset, it is important to note CNH does not affect bank debt and other debt not governed by the TIA or which does not otherwise incorporate section 316 of the TIA.

In addition, it appears that the CNH outcome could have been avoided had the Indenture Trustee foreclosed on the Issuer's underlying assets rather than the equity in the Issuer. In such event, the foreclosed assets would have been moved into a new ownership entity and the underlying notes against the Issuer could have remained in place, albeit with no practical remedy since the Issuer would have no remaining assets. This approach is one possible solution to CNH, although there may be a variety of reasons why foreclosure on the equity pledge would otherwise be preferable to a foreclosure on the underlying assets.3

Alternatively, restructuring can be accomplished under the Bankruptcy Code. While more costly and time-consuming, this approach would allow the implementation of a foreclosure-type transaction binding upon the minority noteholders notwithstanding the TIA and the CNH holding. Thus, in a bankruptcy, the Majority Noteholders could have implemented a debt-for-equity exchange, thereby effecting the strict-foreclosure transaction and binding the Minority Noteholders to that transaction.

Nonetheless, the CNH decision provides holdout noteholders (to the extent the notes are governed by, or parallel, the TIA) with greater leverage in the context of out-of-court restructuring negotiations because these alternatives may be otherwise more costly, uncertain and time-consuming.

© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.

  1. No. 42, 2020 WL 6163305, at *1 (NY. Oct. 22, 2020).

  2. 846 F.3d 1 (2d Cir. 2017).

  3. For example, if the underlying assets include real property, foreclosure on those assets may require judicial foreclosure—which would take much longer than a UCC foreclosure on equity.