New York Court of Appeals Distinguishes Marblegate, Holds Majority-Directed Strict Foreclosure Violates Indenture and Minority Noteholders’ Absolute Legal Right to Payment

The Bottom Line

On October 22, 2020, in a 4-3 opinion, the Court of Appeals for the State of New York held that the right of certain dissenting minority noteholders to sue for nonpayment following a default survived a strict foreclosure, undertaken by the indenture trustee at the direction of the majority that purported to cancel the notes. In doing so, the Court of Appeals reversed the decisions of the state Supreme Court and the Appellate Division below, which had relied on the Second Circuit’s 2017 decision in Marblegate Asset Management LLC v. Education Management Corp., and upheld the minority noteholders’ action on the grounds that the strict foreclosure had “impermissibly terminated” the right to payment without their consent. See CNH Diversified Opportunities Master Account, L.P. v. Cleveland Unlimited, Inc., No. 42, 2020 WL 6163305 (N.Y. Oct. 22, 2020) (the Opinion).

What Happened?

Background and the Indenture Provisions

In December 2005, Cleveland Unlimited, Inc., a telecommunications company, issued $150 million of senior secured debt (the Notes) pursuant to an indenture agreement (the Indenture). In addition to the Indenture, a Collateral Trust Agreement and a Security Agreement were also executed (collectively, the Indenture Documents). At issue in this case were certain provisions in the Indenture Documents governing “the rights of the Noteholders to receive payment, the remedies available in the event of default, and the power of a majority of Noteholders to direct the Trustee’s choice of remedy.”^[1] See Opinion at 3.

In April 2010, the plaintiffs purchased $5 million of Notes in the secondary market, amounting to 3.33% of the outstanding principal value (the Minority Noteholders). Interest payments on the Notes were made until September 2010. However, in December 2010, due to the deterioration of its financial situation, Cleveland Unlimited defaulted. During this time, Cleveland Unlimited engaged in discussions regarding potential restructuring transactions with the Trustee and a committee of Noteholders, which included the Minority Noteholders and a separate group that owned 96.3% (the Majority Noteholders). In June 2011, the Majority Noteholders announced that they had been working with the Trustee on a “strict foreclosure,” pursuant to which, instead of reaching an agreement among all the Noteholders, the Trustee, at the direction of the Majority Noteholders, would “foreclose strictly” on the “collateral … pledged against the Notes … and distribute the stock … to the Noteholders,” thereby canceling the Notes and ending the defendants’ obligations under the Indenture. See Opinion at 6.  

In a letter addressed to Cleveland Unlimited, the Majority Noteholders and the Trustee, the Minority Noteholders asserted that they did not “join or in any way consent to the [strict foreclosure]” and, pursuant to section 6.07 of the Indenture and the relevant sections of the TIA, the Minority Noteholders did not consent to any “impairment or effect on their rights to receive payment of principal or interest [on the Notes] … or to bring suit for the enforcement of any such payment.” See Opinion at 6. Despite the Minority Noteholders’ objection, the strict foreclosure proceeded, extinguishing the indebtedness evidenced by the Notes.

Following the strict foreclosure, the Minority Noteholders filed suit, asserting that because they had not consented to the transaction, their right to payment and interest and their right to bring suit to enforce those payment rights had been “impermissibly terminated.” See Opinion at 8. The defendants countered that the plaintiffs’ rights under the Notes had been extinguished by the strict foreclosure, which was expressly authorized by the terms of the Indenture Documents. Both parties moved for summary judgment.

Finding that the strict foreclosure was permissible under the parties’ agreement, the Supreme Court held that the Minority Noteholders technically retained the legal right to obtain payment by suing Cleveland Unlimited as the issuer of the original Notes. The Appellate Division affirmed, concluding that the strict foreclosure “did not amend the core payment terms in violation of section 6.07 of the Indenture, even if it had a similar effect.” See Opinion at 9. The Court of Appeals granted plaintiffs leave to appeal. 

The Court of Appeals’ Decision

In determining whether the plaintiffs could proceed in their action to recover outstanding principal and interest on the Notes, the Court of Appeals focused on whether the Minority Noteholders’ payment rights had been “extinguished by the strict foreclosure, which purportedly cancelled their Notes.” See Opinion at 10. Judge Garcia, writing for the majority, began his analysis by interpreting sections 6.05 and 6.07 of the Indenture “as a matter of basic contract law.” See Opinion at 10. Although the Indenture was not “qualified under the TIA,” the majority noted that sections 6.05 and 6.07 incorporate language from subsections 316(a) and 316(b) of the TIA, respectively. As such, the Court of Appeals would look to the TIA for “guidance as to the intended application of those Indenture Provisions.” See Opinion at 11.

In his review of the TIA, Judge Garcia noted the “interplay” between subsections 316(a) and 316(b), the provisions governing the Noteholders’ rights and remedies. Where subsection (a) permits a qualified indenture to contain certain “majority action” or “collective action” clauses, subsection (b), mandatory in all indentures governed by the TIA, “serves as a limitation on the majority action authorized in subsection (a).” See Opinion at 12. The majority action permitted by subsection (a), “namely the authority to excuse a default and to direct trustee action in the event of a default, are constrained by subsection (b).” Id. Analyzing the structure of the TIA, Judge Garcia noted “[the structure] demonstrates an intent to protect bondholders’ legal rights to payment and to bring suit from the effects of collective action.” See Opinion at 13. While the Majority Noteholders were entitled to act, without the consent of all Noteholders, in directing a specific remedy [the strict foreclosure] and the Trustee was authorized to follow that directive, Judge Garcia clarified that the “purported cancellation of the Notes cannot extinguish the rights protected by section 6.07 of the Indenture.” As such, the issue was “whether the Minority Noteholders’ rights were extinguished by the purported cancellation of the Notes.” Id.

The defendants argued that, despite the language of the statute, cancellation of the Notes by majority action authorized in 316(a) of the TIA did not violate the rights protected by subsection 316(b). Relying on Marblegate Asset Management LLC v. Education Management Corp., in which the Second Circuit adopted a narrow interpretation of the TIA holding that subsection 316(b) prohibits “only non-consensual amendments to an indenture’s core payment terms,” see Marblegate Asset Mgt., LLC v. Education Mgt. Fin. Corp.. 846 F.3d 1 (2d Cir. 2017) (the Marblegate Opinion), the defendants contended that the language in Marblegate limits the scope of 316(b) to protection against “formal amendments” of “core payment terms.” See Marblegate Opinion at 7, 14-15. The defendants argued that the strict foreclosure did not effectuate such an amendment, and thus was not prohibited by subsection 316(b).

In Marblegate, the plaintiffs, a group of minority noteholders, sued to enjoin an intercompany sale on the ground that it violated 316(b) of the TIA “because it impaired the [Minority Noteholder’s] practical ability to recover on the debt.” See Marblegate Opinion at 5. The Second Circuit held that 316(b) was not violated because the plaintiff “retained its legal right to obtain payment by suing [the issuer], among others.” See Marblegate Opinion at 17. The plaintiff’s unimpaired right to bring suit in Marblegate was crucial to the Second Circuit’s finding that there was no violation of 316(b). So long as a bondholder “retains the legal right to obtain payment by suing … the holder cannot invoke section 316(b) to retain an absolute and unconditional right to payment of its notes.” See Marblegate Opinion at 16-17. With the plaintiff’s right to bring suit unaffected by the out-of-court reorganization, the Second Circuit held that section 316(b) had not been violated as the plaintiff could still pursue claims against the issuer and others.

However, Judge Garcia rejected the defendants’ reliance on Marblegate noting “the facts [in Marblegate] are very different. The debt levels are different. The action that was taken is very different.” See Oral Argument Transcript at 2. Unlike the plaintiffs in Marblegate, the Minority Noteholders did not merely lose the “practical ability to collect payment” but rather, at the direction of the Majority Noteholders, the Trustee initiated a strict foreclosure “terminating the Minority Noteholders’ legal right to receive payment … on the Notes,” which Judge Garcia noted had been preserved in the transaction at issue in Marblegate. See Opinion at 18. The defendants also argued that the Minority Noteholders’ rights were not violated as the transaction was authorized by section 6.05 of the Indenture. However, Judge Garcia noted that “the powers conferred upon the Majority Noteholders by 6.05 are subject to the limitations in section 6.07 and cannot be used to extinguish the legal right to sue or the legal right to payment of non-consenting Noteholders protected in section 6.07.” See Opinion at 19. Based on the foregoing, the Court of Appeals held that section 6.07 in the Indenture, which affords “each individual Noteholder the absolute legal right to bring suit on its own behalf for payment of principal or interest” had been violated by the “purported cancellation of the Notes without the dissenting Minority Noteholders’ consent.” See Opinion at 21. Finding the Minority Noteholders were entitled to partial summary judgment on the right-to-payment issue, Judge Garcia remitted the case to the lower court. ^[2]

Why This Decision Is Important

In reversing the lower courts’ decisions that relied on Marblegate, Judge Garcia held that the strict foreclosure — the purported cancellation of the Notes without the Minority Noteholders’ consent — violated section 6.07 of the Indenture by extinguishing the Noteholders’ absolute legal right to recovery. Although the facts of the case are at least superficially similar to Marblegate, the Court of Appeals’ decision raises the prospect that litigation outcomes might differ depending on the facts presented in future cases, most specifically whether the legal right of minority noteholders’ to receive payment has been truly extinguished. Whether and to what extent the two decisions can be reconciled will undoubtedly be the subject of future litigation.

^[1] _{The two main provisions at issue are sections 6.05 and 6.07 of the Indenture. Section 6.05 (Control by Majority) provides “the Holders of a majority in principal amount of the outstanding Notes may direct the time, method and place of conducting any proceeding for exercising any remedy available to the Trustee.” Section 6.05 is substantially similar to section 3.16(a) of the Trust Indenture Act of 1939 (TIA). Section 6.07 (Rights of Holders to Receive Payment) provides “Notwithstanding any other provision of this Indenture, the right of any Holder to receive payment of principal of, premium, if any, and interest and Additional Interest, if any, on a Note, on or after the respective due dates expressed in such Note, or to bring 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.” Section 6.07 is substantially similar to section 3.16(b) of the TIA.}

^[2] _{As noted above, three judges dissented, with Judge Fahey’s dissenting opinion noting that the majority opinion “needlessly disconnects the law of the two courts [the Second Circuit and the Court of Appeals] most relevant to the markets in which these securities are traded.” See Dissent at 1.}