Intra-Creditor Class Warfare
We asked three of our expert panelists from our Symposium on Intra-Creditor Class Warfare to weigh in on these controversial tactics. Professor Ayotte hit the dilemma head on: “These transactions buy runway for distressed borrowers, but they also upset the expectations of parties who contracted for security.” Ayotte reflects the bait and switch well: “The [J.Crew] trap door carve-out was intended to enable overseas investment in a tax-efficient way, but it enabled a transfer of term lenders’ trademark collateral to refinance lower-priority debt.” It may all just come down to who is footing the bill with Ayotte concluding that the expertise to manage this complex environment doesn’t come for free. Ayotte’s full-length article on the topic is here.
But what’s wrong with getting hosed? Why fix something if it’s not broken? Professor Bucolla provides a sound argument that something is amiss. Kicking the can down the road can “destroy economic value.” Sometimes rationalizing a capital structure and operations through a formal proceeding produces a net surplus. But who is best situated to take on this dilemma? Joel Moss questions whether courts or the market will be up to the task. “It remains to be seen whether courts will be effective gatekeepers to limit any perceived mischief, particularly given that the letter of the debt documents likely permits many of the liability management transactions at issue and given many of the litigations on these issues settle.” We will see.
Professor Ken Ayotte, Berkeley
Academic economists like me that study contracting are trained to think of contracting as “optimal”. In reality, of course, even the most sophisticated parties are human: they cannot see ahead to correcting every possible exploitable flaw in their contracts. The intra-creditor warfare conference addressed the causes and consequences of these developments in the world of distressed debt. Elisabeth DeFontenay began our panel by helpfully framing the three regulators of behavior: norms, contracts, and courts. Norms in the world of debt have clearly deteriorated. Hardball tactics by borrowers give rise to liability management transactions that exploit weaknesses in credit documents as a refinancing tool. These transactions buy runway for distressed borrowers, but they also upset the expectations of parties who contracted for security.
Why do these problems arise in a world of sophisticated actors? Our cognitive limitations are no doubt part of the answer: real-world boundedly rational actors are better at looking backward to solve the problems they already know about than anticipating future ones. Contract complexity is the inevitable result: permissions and restrictions evolve to solve past problems, but new terms create scope for new problems. The famous J. Crew drop-down transaction is an obvious example. The trap door carve-out was intended to enable overseas investment in a tax-efficient way, but it enabled a transfer of term lenders’ trademark collateral to refinance lower-priority debt.
Speakers and audience members also noted the rise of the CLO as a driver of the lender-on-lender violence phenomenon. They are the largest investors in leveraged loans, constituting over 70% of non-bank primary leveraged lending. This may be one example of unintended consequences at work: CLOs have diversification requirements that are intended to reduce risk to their investors. But these same requirements reduce their flexibility to pick and choose loans and to push back on borrower-friendly terms. This, combined with too much money chasing too few deals, weakens market pressure from the lenders’ side of transactions.
Does this mean that contracting as a solution is ineffective? Not necessarily. Vince Buccola and Greg Nini’s empirical research highlighted that contracts respond to these threats, at least to block uptiering transactions. Lender pushback on dropdown blockers has been slower and more uneven, but perhaps this non-response is the market’s response to the borrower’s reasonable need for flexibility in financial distress.
What are the big picture concerns with all these developments? In an ideal world, lending decisions would be based on the fundamentals of the underlying credit, starting with the company’s operational health, its future cash flows, and the claim’s priority in the capital structure. In that ideal world, secured debt is a particularly valuable capital structure tool because of its information insensitivity: secured lenders need not know everything about the company; if operations go south, secured creditors are first in line, and can look to collateral of a reasonably known value to get paid. Under modern restructuring norms, information-insensitive secured debt is a thing of the past. The value of today’s distressed debt depends not just on fundamentals, but also on possessing an airtight-enough document, and the connectedness to avoid getting stuck in a minority group. At the very minimum, this means that lenders need more information to know what their paper is worth, and more sophistication to defend it. All these offensive and defensive strategies require costly professionals to structure on the front end and litigate on the back end. We should expect that these costs ultimately get passed on to borrowers. The expertise it takes to manage this complex environment doesn’t come for free.
Professor Vince Buccola, Wharton
Change is hard, and no one likes getting hosed. These hard truths are sufficient to explain why lenders who have been on the short end of a surprising new breed of class-splitting liquidity transactions feel aggrieved.
It’s tempting to let customary norms drive a reform agenda—to leap from righteous indignation at the counter-normativity of some recent transactions to the conclusion that something systematic needs to change. But it’s a mistake to try to fix something if one isn’t sure it’s broken. In business, as we all know, some innovations leave casualties at first but turn out to be “disruptions” that make everyone better off in a new equilibrium. In my view, class-splitting liquidity transactions are a problem. But it’s important to be able to say why, because plausible responses may depend on market participants (and judges?) being able to articulate a distinction between abusive and defensible transactional forms.
Forget for a moment whether it’s fair to the left-out lenders to suffer unequal treatment. The problem, as I see it, is that deals to secure liquidity for a distressed business in which inducement is offered only to a fraction of lenders are apt to destroy economic value. The reason for uptiers and the like is that a borrower wants liquidity without having to use chapter 11. That can be, but is not always, a sensible goal. But why does a borrower make a non-pro rata offer (rather than propose a super-senior facility to all on a pro rata basis)? There are two generic possibilities corresponding to two economic scenarios.
In one scenario, avoiding chapter 11 can be expected to create a net surplus. In this case there is by tautology a hypothetical deal to be struck between the borrower and all lenders on a pro rata basis. So, the choice to split the class is purely distributional. The borrower (read: the borrower’s sponsor) wants to keep more of the surplus attributable to the deal than it could in a pro rata deal. That’s not the end of the world. A fight over spoils can bleed value, but for the most part lenders can adjust.
In the other scenario, avoiding chapter 11 does not produce a net surplus. Instead, investors as a group would be better off with a realization event that allows the borrower to rationalize its capital structure and perhaps operations. In this case a deal to extend runway may be viable only if the borrower can exclude a subset of lenders from sharing the spoils. From a social perspective, one wants the deal to fall through and the restructuring to take another form.
A sensible economic norm bars class splitting because it’s hard to tell the scenarios apart.
What exactly the right response is—and crucially who is best situated to respond—is not obvious. Contract drafters might be able to develop a pro rata principle that is sufficiently general to rule out new iterations of class splitting but not so vague as to put sensible flexibility in doubt. Courts, aided by perceptive argument, might be able to articulate a pro rata interpretive principle sufficiently clearly that there is no money in trying to flout it. We shall see.
Joel Moss, Shearman & Sterling
I was honored to participate in the recent Creditors’ Rights Coalition Symposium on Creditor on Intra-Creditor Warfare. I was struck by the divergent views on what type of actions by market participants is or is not permissible and how far parties can go without ultimately running afoul of concepts like the implied covenant of good faith and fair dealing, which is generally reserved for situations where no contractual provision addresses a given issue, and also how concepts like open market purchases (which is generally an exception to the pro rata treatment requirement in credit agreements) will be interpreted by courts.
At the end of the day, I don’t believe the term creditor on creditor warfare has much utility. Intercreditor skirmishes are as old as time and now just playing out outside of a formal court process due to lax covenants and flexible debt documents. Parties are merely using the architecture in very flexible documentation created by Sponsors in a manner to either protect their existing position in debt or make large returns as an offensive matter. In the end, parties will do what is in the best interests of their investors as a fiduciary matter, and Sponsors will use the leverage in debt documents to extend their optionality and runway, sometimes pitting creditors with divergent interests against one another. It remains to be seen whether courts will be effective gatekeepers to limit any perceived mischief, particularly given that the letter of the debt documents likely permits many of the liability management transactions at issue and given many of the litigations on these issues settle. So far, the trend has been for sponsors and creditors to do the transaction first and settle later if there is litigation. If there is no definitive guidance from courts, it will be up to market participants to push back in syndication on provisions in debt documents that could lay the foundation for intercreditor skirmishes down the line.