The New Bond Workouts

Bond workouts are a famously dysfunctional method of debt restructuring. The process is so ridden with opportunistic and coercive behavior by both bondholders and bond issuers as to make success intrinsically unlikely. Yet since 2008 bond workouts have quietly started to work. A segment of the restructuring market has shifted from bankruptcy court to out-of-court workouts by way of exchange offers made only to large institutional investors. The new workouts feature a battery of strong-arm tactics by bond issuers, and aggrieved bondholders have complained in court. There resulted a new, broad reading of the primary law governing workouts, section 3 16(b) of the Trust Indenture Act of 1939 (TIA), which prohibits majority-vote amendments of bond payment terms and forces bond issuers seeking to restructure to resort to exchange offers. This Article exploits the bond market\u27s reaction to the shift in law to reassess a longstanding debate in corporate finance regarding the desirability of TIA section 3 16(b). Section 3 16(b) has attracted intense criticism, with calls for its amendment or repeal because of its untoward effects on the workout process and tendency to push restructuring into the costly bankruptcy process. Yet section 3 16(b) has also been staunchly defended on the ground that mom-and-pop bondholders need protection from sharp-elbowed issuer tactics. We draw on a pair of original, hand-collected data sets to show that many of the empirical assumptions made in the debate no longer hold true. We show that markets have learned to live with section 3 i6(b)s limitations, denuding the case for repeal of any urgency. Workouts generally succeed, so that there is no serious transaction cost problem stemming from the TIA; when a company goes straight into bankruptcy there tend to be independent motivations. We also show that workout by majority amendment would not systematically disadvantage bondholders. Indeed, the recent turn to secured creditor control of bankruptcy proceedings makes direct amendment all the more attractive to unsecured bondholders. Based on this empirical background, we cautiously argue for the repeal of section 316(b). Section 316(b) no longer does much work, even as it prevents bondholders and bond issuers from realizing their preferences regarding modes of restructuring and voting rules. We do not know what contracting equilibrium would obtain following repeal,but think that the matter is best left to the market. Still, we recognize that markets are imperfect and that a free-contracting regime may result in abuses. Accordingly, we argue that repeal of section 316(b) should be accompanied by the resuscitation of the long-forgotten doctrine of intercreditor good faith duties, which presents a more fact-sensitive and targeted tool for policing overreaching in bond workouts than the broad reading of section 316(b)

The New Bond Workouts

Bond workouts are a famously dysfunctional method of debt restructuring, ridden with opportunistic and coercive behavior by bondholders and bond issuers. Yet since 2008 bond workouts have quietly started to work. A cognizable portion of the restructuring market has shifted from bankruptcy court to out-of-court workouts by way of exchange offers made only to large institutional investors. The new workouts feature a battery of strong-arm tactics by bond issuers, and aggrieved bondholders have complained in court. The result has been a new, broad reading of the primary law governing workouts, section 316(b) of the Trust Indenture Act of 1939 (“TIA”), which prohibits majority-vote amendments of bond payment terms and forces bond issuers seeking to restructure to resort to exchange offers. This Article exploits the bond market’s reaction to the shift in law to reassess a long-standing debate in corporate finance regarding the desirability of TIA section 316(b). Section 316(b) has attracted intense criticism, with calls for its amendment or repeal because of its untoward effects on the workout process and tendency to push restructuring into the costly bankruptcy process. Yet section 316(b) has also been staunchly defended on the ground that mom-and-pop bondholders need protection sharp-elbowed issuer tactics. We draw on a pair of original, hand-collected data sets to show that many of the empirical assumptions made in the debate no longer hold true. We show that markets have learned to live with section 3169b)’s limitations, denuding the case for repeal of any urgency. Workouts generally succeed, so that there is no serious transaction cost problem stemming from the TIA; when a company goes straight into bankruptcy there tend to be independent motivations. We also show that workout by majority amendment will not systematically disadvantage bondholders. Indeed, the recent turn to secured creditor control of bankruptcy proceedings makes them all the more attractive to unsecured bondholders. Based on this empirical background, we cautiously argue for the repeal section 316(b). Section 316(b) no longer does much work, even as it prevents bondholders and bond issuers from realizing their preferences regarding modes of restructuring and voting rules. We do not know what contracting equilibrium would obtain following repeal, but think that the matter is best left to the market. Still, we recognize that markets are imperfect and that a free-contracting regime may result in abuses. Accordingly, we argue that repeal of section 316(b) should be accompanied by the resuscitation of the long forgotten doctrine of intercreditor good faith duties, which presents a more fact-sensitive and targeted tool for policing overreaching in bond workouts than the broad reading of section 316(b)

The New Bond Workouts

Bond workouts are a famously dysfunctional method of debt restructuring. The process is so ridden with opportunistic and coercive behavior by both bondholders and bond issuers as to make success intrinsically unlikely. Yet since 2008 bond workouts have quietly started to work. A segment of the restructuring market has shifted from bankruptcy court to out-of-court workouts by way of exchange offers made only to large institutional investors. The new workouts feature a battery of strong-arm tactics by bond issuers, and aggrieved bondholders have complained in court. There resulted a new, broad reading of the primary law governing workouts, section 3 16(b) of the Trust Indenture Act of 1939 (TIA), which prohibits majority-vote amendments of bond payment terms and forces bond issuers seeking to restructure to resort to exchange offers. This Article exploits the bond market\u27s reaction to the shift in law to reassess a longstanding debate in corporate finance regarding the desirability of TIA section 3 16(b). Section 3 16(b) has attracted intense criticism, with calls for its amendment or repeal because of its untoward effects on the workout process and tendency to push restructuring into the costly bankruptcy process. Yet section 3 16(b) has also been staunchly defended on the ground that mom-and-pop bondholders need protection from sharp-elbowed issuer tactics. We draw on a pair of original, hand-collected data sets to show that many of the empirical assumptions made in the debate no longer hold true. We show that markets have learned to live with section 3 i6(b)s limitations, denuding the case for repeal of any urgency. Workouts generally succeed, so that there is no serious transaction cost problem stemming from the TIA; when a company goes straight into bankruptcy there tend to be independent motivations. We also show that workout by majority amendment would not systematically disadvantage bondholders. Indeed, the recent turn to secured creditor control of bankruptcy proceedings makes direct amendment all the more attractive to unsecured bondholders. Based on this empirical background, we cautiously argue for the repeal of section 316(b). Section 316(b) no longer does much work, even as it prevents bondholders and bond issuers from realizing their preferences regarding modes of restructuring and voting rules. We do not know what contracting equilibrium would obtain following repeal,but think that the matter is best left to the market. Still, we recognize that markets are imperfect and that a free-contracting regime may result in abuses. Accordingly, we argue that repeal of section 316(b) should be accompanied by the resuscitation of the long-forgotten doctrine of intercreditor good faith duties, which presents a more fact-sensitive and targeted tool for policing overreaching in bond workouts than the broad reading of section 316(b)

Corporate Distress, Credit Default Swaps, and Defaults: Information and Traditional, Contingent, and Empty Creditors

Federal securities law seeks to ensure the quality and quantity of information that corporations make publicly available. Informational asymmetries associated with companies in financial distress, but not in bankruptcy, have received little attention. This Article explores some important asymmetries in this context that are curious in their origin, nature, and impact. The asymmetries are especially curious because of the impact of a world with credit default swaps (CDS) and CDS-driven debt “decoupling.” The Article explores two categories of asymmetries. The first relates to information on the company itself. Here, the Article suggests there is fresh evidence for the belief that troubled companies may prove lax in securities law compliance and for the existing “final period” explanation for such laxity. The Article also offers two new explanations: one based on the requirements for class action certification in Rule 10b-5 litigation and the other based on uncertainties as to private enforceability of “Management’s Discussion and Analysis” disclosure requirements. Building on the existing analytical framework for decoupling, the Article also examines a less obvious category of asymmetries: “extra-company” informational asymmetries flowing from the CDS and CDS-driven debt decoupling activities of third parties. Such third-party activities can be determinative of a company’s prospects, but reliable public information on the presence, nature, and magnitude of such activities tends to be scant. Here, even the company itself, not just investors, may not have the requisite information, including information on the highly counterintuitive and unusually complex incentives that such third parties may have. Unlike traditional creditors, “empty creditors with a negative economic ownership” as well as certain other buyers of CDS protection can have strong incentives to intentionally cause corporations to go bankrupt even when bankruptcy would make little sense. Such third parties may profit not only from actual defaults on financial covenants—at just the right times—but also from artificially manufacturing “faux” defaults or seizing on real, but largely technical, defaults. The Article examines such CDS and “net short” creditor matters through the lens of four examples. The three most important and recent of these examples have not previously been considered in the academic literature: Norske Skog (a Norwegian lumber company) (involving Blue Crest and GSO Capital Partners), Hovnanian (an American home builder) (involving GSO Capital Partners), and Windstream Services (an American telecommunications company) (involving Aurelius)

National Anti-Vulture Funds Legislation: Belgium's Turn

Sovereign distressed debt investors can create holdout problems during sovereign restructurings. Scholars have suggested a wide-range of normative solutions to alleviate these holdout problems, including ad hoc deals, the creation of a multilateral international sovereign bankruptcy framework, the insertion of collective-action clauses into bonds, the expansion of judicial discretion, and the return of the doctrines of comity and sovereign immunity. However, national legislatures have increasingly begun to exhibit a preference for adopting national legislative solutions to this issue. In 2015, Belgium passed the broadest Anti-Vulture Funds Law to date, which is significant because the law impacts the Euroclear payment system. While this law has received high praise from the United Nations and from other nations also considering passing similar legislation, a careful analysis demonstrates it is not sensitive to the benefits that vulture funds bring, such as providing incentives to sovereigns to form more efficient capital structures, providing a moral hazard counterbalance, serving as liquidity providers on the secondary distressed-debt market, and providing information to the market. If adopted by other nations, Belgium’s law can eliminate the secondary distressed debt market by blocking liquidity-providers from the market. As a result, national legislatures should avoid using Belgium’s law as model law, but rather, enact legislation that enhances active settlement discussions without compromising the bargaining power or rights of either the sovereign or the vulture funds

The Myth of Creditor Sabotage

Since credit derivatives began to substantially influence financial markets a decade ago, rumors have circulated about so-called “net-short” creditors who seek to damage promising, albeit financially distressed, companies. A recent episode pitting the hedge fund Aurelius against broadband provider Windstream is widely supposed to be a case in point and has at once fueled calls for law reform and yielded an effigy of ostensible Wall Street predation. This Article argues that creditor sabotage is a myth. Net-short strategies work, if at all, by in effect burning money. When an activist creditor shows its cards, as all activists must eventually do, it also reveals an opportunity for others to profit by thwarting the activist’s plans and saving threatened surplus. We discuss three sources of liquidity that targeted firms could tap to block a saboteur—“net-long” derivatives speculators, the target’s own investors, and bankruptcy. We conclude that it is exceedingly difficult for creditors to make money hobbling debtors and that there is little reason to believe anyone tries. We then examine the Windstream case and find, consistent with our theory, that the strongest reason for thinking Aurelius aimed at sabotage—namely that everyone says so—is weak indeed. Our analysis suggests that calls for law reform are addressed to a nonexistent or, at worst, self-correcting problem. Precisely for this reason, however, the persistent appeal of the sabotage myth is a lesson in political rhetoric. A story needn’t be true for some to find it useful

The Case for a Market in Debt Governance

Scholars have long lamented that the growth of modern finance has given way to a decline in debt governance. According to current theory, the expansive use of derivatives that enable lenders to trade away the default risk of their loans has made these lenders uninterested, even reckless, when it comes to exercising creditor discipline. In contrast to current theory, this Article argues that such derivatives can prove a positive and powerful influence in debt governance. Theory has overlooked those who sell credit protection to lenders and assume default risk on the borrower. These protection sellers are left holding the economic risk of a loan without any legal control rights to safeguard their exposure. This Article demonstrates that the interests of lenders and protection sellers are not necessarily adversarial, as theory conventionally assumes. Rather, each side has considerable incentive to cooperate as a way to reduce its own costs of participating in the debt market and to preserve reputational capital. Recognizing this potential for cooperation, this Article proposes a market for creditor control as a cure to the crisis in debt governance. Such a market would allow lenders and protection sellers to trade control rights in debt to ensure that they are held by those with real economic skin in the game. This market aims to offer a fix to an otherwise difficult and costly problem: the misalignment seen in modern markets between those who bear the economic risk in debt and those best able to control it

The Case for a Market in Debt Goverance

Scholars have long lamented that the growth of modern finance has given way to a decline in debt governance. According to current theory, the expansive use of derivatives that enable lenders to trade away the default risk of their loans has made these lenders uninterested, even reckless, when it comes to exercising creditor discipline. In contrast to current theory, this Article argues that such derivatives can prove a positive and powerful influence in debt governance. Theory has overlooked those who sell credit protection to lenders and assume default risk on the borrower. These protection sellers are left holding the economic risk of a loan without any legal control rights to safeguard their exposure. This Article demonstrates that the interests of lenders and protection sellers are not necessarily adversarial, as theory conventionally assumes. Rather, each side has considerable incentive to cooperate as a way to reduce its own costs of participating in the debt market and to preserve reputational capital. Recognizing this potential for cooperation, this Article proposes a market for creditor control as a cure to the crisis in debt governance. Such a market would allow lenders and protection sellers to trade control rights in debt to ensure that they are held by those with real economic skin in the game. This market aims to offer a fix to an otherwise difficult and costly problem: the misalignment seen in modern markets between those who bear the economic risk in debt and those best able to control it

Sovereign Debt: Now What?

The sovereign debt restructuring regime looks like it is coming apart. Changing patterns of capital flows, old creditors’ weakening commitment to past practices, and other stakeholders’ inability to take over, or coalesce behind a viable alternative, have challenged the regime from the moment it took shape in the mid-1990s. By 2016, its survival cannot be taken for granted. Crises in Argentina, Greece, and Ukraine since 2010 exposed the regime’s perennial failures and new shortcomings. Until an alternative emerges, there may be messier, more protracted restructurings, more demands on public resources, and more pressure on national courts to intervene in disputes that they are ill-suited to resolve. Initiatives emanating from wildly different actors — the United Nations General Assembly, the International Monetary Fund, the International Capital Market Association and the Jubilee coalition, among others — reflect broad-based demand for reform. Now is the time to reconsider the institutional architecture of sovereign debt restructuring, along with the norms and alliances that underpin it. In this symposium essay, I suggest broad criteria for evaluating a successor regime, and offer a package of incremental measures to advance sustainability, fairness, and accountability