The Bondholder's Dilemma
The Trust Indenture Act is a depression era law aimed at protecting the owners of debt of corporations. Just how much protection was the subject of recent decisions in New York federal courts, MeehanCombs Global Credit Opportunities Fund, LP v. Caesars Entertainment Corp.1 and Marblegate Asset Management v. Education Management Corp.2
Caesars Entertainment Corp. owns and operates casinos throughout the United States. The plaintiffs in the case against Caesars, mainly private funds, were holders of Notes issued by Caesars Entertaining Operating Company, the Caesars subsidiary which operated the casinos. These Noteholders owned a relatively small amount of the $1.5 billion of the Notes issued in 2005 and 2006.
In January 2008, Caesars was acquired in a leveraged buyout by two private equity funds. Years later, in financial distress, Caesars entered into a series of transactions aimed at transferring assets away from the operating company to affiliates, leaving the operating company holding debt, and releasing Caesars’s unconditional guarantee, which was memorialized in the governing indenture of the operating company’s debt.
In exchange for agreeing to the release of the parent‘s guarantee and the transfer of assets, Noteholders who approved the transaction received payments of double the market price of the Notes, albeit for less than the face amount otherwise due. The plaintiffs dissented and would not approve the transaction. They preferred to gamble on recovering the full value of the bonds through their lawsuit.
The second case involved Education Management Corporation (EMC), a for-profit provider of college and graduate education. EMC also had outstanding debt of approximately $1.5 billion, consisting of Secured Debt and Notes of operating subsidiaries, all unconditionally guaranteed under an indenture by the parent, EMC. In May 2014, EMC advised creditors that it was experiencing significant financial problems and needed to restructure its balance sheet.
Negotiations with creditors followed. The result was a Restructuring Support Agreement, which provided that, if EMC could not obtain unanimous consent for the its proposal, there would nevertheless be a restructuring through an “intercompany sale transaction,” under which: (i) EMC’s guarantee would be released; (ii) the Secured Lenders would exercise their right to foreclose on the assets of both EMC and the operating subsidiaries; and (iii) the Secured Lenders would then immediately sell those assets back to a new subsidiary of EMC. The subsidiary would then distribute its equity to the creditors who approved.
Creditors who did not approve, including the plaintiffs in the suit against EMC and its subsidiaries, the owners of a relatively small amount of the issues, would be left, like the dissenting creditors of Caesars, with claims against assetless subsidiaries and without the guarantee of the parent. They too gambled on their suit.
Section 316(b) of the Trust Indenture Act provides that holders of an indenture security have the right to receive payment of principal and interest that “shall not be impaired or affected without the[ir] consent.” The question in these cases was whether that provision afforded the owners of debt merely the narrow right to demand payment or the broader one to actually get paid. The dissenting holders of Caesars and EMC debt relied on the broad reading of Section 316(b), because they would otherwise be left holding an essentially worthless right to collect principal and interest from the issuers.
The answer to the question projected turned largely on the purpose of the Trust Indenture Act. Its authors were concerned that insiders would take advantage of out-of-court restructurings to harm a corporation’s bondholders. In cases where bondholders did not approve of a consensual out-of-court workout unanimously, those authors preferred bankruptcy, where courts would treat all bondholders in a class identically.
Thus, both the New York courts rejected the prevailing interpretation of the Act and found that the dissenting bondholders had the right to hold out for full payment of principal and interest. This did not necessarily give them the ability to block the restructurings. So long as enough holders of the debt were willing to make the sacrifice offered them, the issuer still had the option of going forward with its restructuring.
That is the likely outcome for Caesars and EMC. The owners of the securities who withheld their support in both cases held relatively small amounts of $1.5 million debt of each.
Certainly, Section 316(b) can be a potent weapon for an investor resisting a restructuring. However, it may not provide an unalloyed benefit to dissenting bondholders. As one critic of the Trust Indenture Act has argued, minority bondholders may get a free ride by withholding their consent to a restructuring, and realize the full value of the bonds of the newly solvent issuer. But that won’t be the result in all cases. Where some or most of the bondholders decline to approve, and thus frustrate, the corporation’s workout plans, all bondholders would be left with what a bankruptcy court gives them. The bondholders would be “locked in game theory’s prisoner’s dilemma.”3
The prisoner’s dilemma is an example of a problem analyzed in game theory that shows why two perfectly rational individuals might not cooperate, even if it appears to be in their best interest to do so. Here’s how it works: two suspected criminals are imprisoned in solitary confinement. The police admit they don’t have enough evidence to convict either for the principal offense and plan to charge both with the lesser offense, for which they would receive one year in prison. Each prisoner is then given the opportunity to betray the other, by testifying that the other committed the crime, or to cooperate with the other by remaining silent.
The possible outcomes are as follows: (1) if A and B each betray the other, both receive two years in prison; (2) if A betrays B but B remains silent, A will be set free and B will serve three years in prison (and vice versa); and (3) if A and B both remain silent, both will serve one year in prison (on the lesser charge). Fearing the outcome in (2), if one prisoner turns on the other, each of A and B might actually rationally opt for (1), despite the optimal outcome in (3), if each could be assured of his co-conspirator’s intentions.
In other words, if all bondholders pursued their own self-interest and withheld approval of the restructuring, the result almost certainly would be bankruptcy, an outcome which presumably leaves all of them–as well as the company, its shareholders and employees–worse off in the short term, and perhaps over the long term too.
Game theory aside, do we really need to keep on the books today a law which makes bankruptcy more likely, encourages speculation in bonds and does little to help ordinary bondholders? A corporate bankruptcy may have been the preferred outcome in 1939, when Congress adopted the Trust Indenture Act. It may not be in today’s marketplace, in which an out-of-court restructuring is likely a more satisfactory outcome for both the bondholders and the issuer over both the short and long term.
1 Docket Nos. 14-cv-7091(SAS) and 14-cv-7973 (SAS) (S.D.N.Y. Jan. 15, 2015).
2 Docket No. 14-cv-8584 (KPF) (S.D.N.Y. Dec. 30, 2014).
3 Roe, The Voting Prohibition in Bond Workouts, 97 Yale L.J. 232, 236-37 (1987).