In the United States, bond workouts are a famously dysfunctional method of debt restructuring, ridden with opportunistic and coercive behavior by bondholders and bond issuers. Historically, they also have been prone to fail. The last decade has seen a change. Since the shock of the financial crisis in 2008, US bond workouts have quietly started to work. A cognizable portion of the restructuring market—around 20 percent—has shifted from bankruptcy court to out-of-court workouts by way of exchange offers made only to large institutional investors. But the rough and tumble continues—the new workouts feature a battery of strong-arm tactics by bond issuers. Aggrieved bondholders have complained in court, triggering a fracas in America’s leading courts on the law of bonds, the federal courts sitting in New York City. A new, broad reading of the primary law governing workouts, section 316(b) of the Trust Indenture Act of 1939 (‘TIA’), was adopted in a number of cases in the Southern District of New York only ultimately to be rejected by an appellate panel.
In an article called The New Bond Workouts, we exploit the bond market’s reaction to the recent volatility in the law to reassess a long-standing debate in corporate finance regarding the desirability of section 316(b). Section 316(b) prohibits majority-vote amendments of bond payment terms pursuant to collective action clauses. Unanimous bondholder consent being unattainable as a practical matter, bond issuers wishing to restructure out-of-court are forced to resort to unwieldy exchange offers. Critics call for section 316(b)’s amendment or repeal because of its untoward effects on the workout process and tendency to push restructuring into more costly bankruptcy processes. Section 316(b) has also been staunchly defended on the ground that small bondholders need protection against 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. First, we show that markets have learned to live with section 316(b)’s limitations, denuding the case for repeal of urgency. Workouts now 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. Second, we show that workout by majority amendment will not systematically disadvantage bondholders. Indeed, the recent turn in the US to secured creditor control of bankruptcy proceedings makes workouts all the more attractive to unsecured bondholders. Third, we show that bond workouts in some respects are more coercive than previously thought, but also less coercive in others. Fourth, drawing on a second original data set that collects the process terms of contracts governing bonds issued under the securities laws’ Rule 144A exemption and thus not subject to the TIA, we show that bond contracts reflect the process preferences of both bondholders and bond issuers, again upsetting settled assumptions. Contracts issued prior to the recent judicial opinions tend to adhere to the section 316(b) regime’s broad outlines, but do introduce some significant modifications. Contracts issued after the Southern District cases show a new pattern, one group carrying on as before, but with another group affirmatively rejecting the Southern District’s broad reading of the TIA. The contracts also take the surprising step of affirmatively sanctioning a coercive device, the exit consent, utilized in exchange offers. Finally, the process terms in the contracts, while more thoroughgoing than expected, nevertheless fall short of completeness. Some drafters omit common terms, and some distortionary possibilities are altogether unaddressed.
Based on this background, we cautiously argue for the repeal of section 316(b). Section 316(b) no longer does much protective 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. At the same time, based on our bond contract survey, we recognize that drafting pattern falls short of complete responsiveness 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 did the broad reading of section 316(b).
William W. Bratton is the Nicholas F. Gallicchio Professor of Law and Co-Director at the Institute for Law & Economics of the University of Pennsylvania Law School.
Adam J. Levitin is a Professor of Law at Georgetown University Law Center.