Professor Vince Buccola (Wharton) Speaks on Intra-Creditor Warfare

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.