Professor Ken Ayotte (Berkeley) Speaks on Intra-Creditor Warfare

Academic economists like me that study contracting are trained to think of contracting as “optimalâ€. 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.