I love really good contrarian papers. They teach me things, and they don’t come along very often. Let’s face it, we academics tend to run in herds and our work tends to conform to our herd’s paradigm. Now, there may be more than one herd roaming in a given field—in corporate law we have at least three and maybe more—so that even the most argumentative, tendentious piece is less contrarian than it is directed at an opposing herd’s paradigm. The contrarian paper I have in mind works differently. It takes aim at a basic assumption shared amongst all members of all herds and tells us that that’s not what’s going on at all.
I also love really good papers about derivatives. There are certainly more than a few of these, but they don’t add up to very many given the importance of the subject matter and the concomitant need for investigation and learning. Corporate law professors for the most part don’t want to go there, preferring the comfier and less technically demanding precincts of corporate governance.
“The Myth of Creditor Sabotage,” forthcoming in the University of Chicago Law Review and co-written by Vincent S. J. Buccola, an Assistant Professor at Wharton, Jameson K. Mah, an Investment Analyst at Cyrus Capital Partners, and Tai Zhang, a member of the Wharton class of 2020, hits both of these buttons. It is a really good, deeply contrarian paper about credit derivatives. I knew it was going to be special when the sheer orneriness of the introduction gave me a pleasant jolt. My pleasure grew as the analysis unfolded.
So what sacred cow is being targeted by Buccola, Mah, and Zhang (BMZ)? I’ll describe it in herd terms. Corporate law professors of all stripes are constantly on the lookout for skewed incentives. This is most clearly true of law and economics types (“skewed incentives lead to suboptimal outcomes”) but is hardly their exclusive provenance (“self-dealing is unfair”). Find a skewed incentive and an unaccountable actor and you’ve got law review paydirt. Such papers often conclude with a call for law reform but need not do so. One can just as easily write a paper arguing against law reform on the ground that market controls assure backstop correction if not full accountability (whatever that is). CEOs, controlling shareholders, and plaintiffs’ lawyers are corporate law’s leading examples of unaccountable actors afflicted with skewed incentives. But the cast of nefarious characters grows all the time. We now hear about index funds, asset managers, investment bankers, proxy advisors, and, of course, hedge funds. I have written more than a few of these papers myself.
BMZ target the conventional wisdom surrounding the most recent development in the history of opportunistic hedge fund value destruction—the bankruptcy of Windstream, a large telecommunications provider, as a result of successful litigation by Aurelius, a net short vulture fund. The story is long and technical, so if anything confuses the reader of the brief summary that follows, the best palliative is to read BMZ. The thing to bear in mind is that the New York financial community (especially the corporate bar) was mesmerized as these events unfolded. Windstream-Aurelius was in 2017-2019 what Unocal, Revlon, and Paramount were in earlier decades.
Windstream did a complex asset partition to avail itself of REIT-based relief from double taxation. New legislation was closing the loophole, so Windstream needed to hustle. An internal sale-leaseback to and from a new shell subsidiary is the standard means to this particular end, but in this case it ran up against a sale-leaseback covenant in a trust indenture covering an issue of Windstream’s 6 3/8% Notes. To end-run the covenant, Windstream reconstituted itself with a new top-tier holding company and had the holding company take the lease back from the new sub asset transferee. Now, the property transferred continued to be used by the original asset transferor, the corporate obligor on the 6 3/8% Notes. But there was no lease to it from the holding company, which was now the nominal lessee. Instead, there was just a vaguely denominated arrangement under which payments flowed from the transferor-obligor using the assets to the holding company. (Are you still with me?) If the arrangement was not a “lease” within the meaning of the sale-leaseback covenant, there was no violation.
The bondholders let the deal go upon its completion in 2015. Nothing happened for the succeeding two years. Then Aurelius showed up as the holder of the majority of the 6 3/8% Notes, purchased at a discount. (An outright majority is necessary to assure an absolutely unimpeded right to enforce an event of default under the covenant and accelerate the entire bond issue.) Aurelius sued. Windstream defended with a literal read of the indenture and a backdoor attempt to upset Aurelius’s majority control of the bond issue. The indenture was openended, permitting the issue of more 6 3/8% Notes. Windstream set up an exchange offer of new 6 3/8% Notes to holders of its other bond issues, pursuant to which it minted enough new 6 3/8%s (and consents to waive the covenant) to undercut Aurelius’s lawsuit.
Windstream lost anyway. In U.S. Bank National Association v. Windstream Services, LLC, 2019 WL 948120 (S.D.N.Y.), Judge Furman rejected its reading of the sale-leaseback covenant, going with a substance over form interpretation. He also threw out the votes of the new 6 3/8% Notes, based on some highly technical limitations on new note issuance set out in the indenture. It is a well-executed, straightforward opinion, well within the ordinary interpretative parameters of bond cases decided over the past several decades.
Now for the twist in the wrist of the story. The Southern District’s judgment vested the acceleration of the 6 3/8%s, causing the cross-default clauses in Windstream’s other bond issues to go off like firecrackers. Windstream filed in chapter 11 two weeks after the Southern District’s opinion came down, at great cost not only to its shareholders but to its bondholders. It was a loss that was not shared by Aurelius, provided that Aurelius was net short as a credit default swap (CDS) protection buyer. And, as Bloomberg’s Matt Levine told us, everybody in the financial community assumed that to have been the case. The bankruptcy filing was a CDS credit event, leading to payout to the CDS protection buyer of the difference between face value and the post-bankruptcy value of the bond. On this read, Aurelius, a financial predator, successfully had inflicted suffering on all other Windstream constituents as it pursued a jackpot payoff conditioned on the company’s destruction. Much wailing and teeth-gnashing followed in the financial press and in the blogsphere. Creditor sabotage—covenant enforcement by a net short hedge fund—was corporate America’s Big New Problem. Indeed: Has there ever been a less accountable, more incentive incompatible player than Aurelius?
Now to BMZ, who do a deep dive into complex mechanics of bondholding, credit protection, and solvency to rebut the Big New Problem diagnosis. The net short play, they say, makes sense only to the extent that bankruptcy is the probable result, and that critical chapter 11 filing follows only to the extent the target runs out of liquidity. BMZ show that these days even distressed companies have places to turn to stay afloat. In fact, the proliferation of CDS has expanded the set of liquidity sources—in recent years protection sellers have been seen extending credit to distressed issuers of reference securities (if only to tide the securities’ issuer over until the CDS contracts’ expiration dates).
BMZ’s theoretical framework is Coasian. They show us a long cast of interested parties with stakes in keeping the target out of chapter 11 and the means to effect that result by mutual agreement. A beneficial trade, they say, can be expected. Happily, this is not a Cartoon Coasian solution where a Chicago Wizard waves a magic market wand and makes everybody better off. The authors acknowledge and confront numerous frictions. It is worth noting that such an account would not have been credible three decades ago, when everyone assumed that incentive skews and bondholder unaccountability made it impossible to solve problems of distressed issuers outside of bankruptcy. Things have changed since 2008, as the practitioners have developed a new spaces for successful contractual composition. In this new environment, BMZ’s Coasian move is quite plausible.
BMZ, having gotten this far, still have a problem. How can creditor sabotage not be the Big New Problem when we just saw a net short saboteur bring down a big company and make a killing? In the paper’s second part, BMZ meet this objection with a case study of Windstream-Aurelius. It makes for gripping reading. They run the numbers, reconstructing Aurelius’s position and laying out the stakes and returns and appraising the risks. The incentive take is that Aurelius went into the engagement to enforce the trust indenture and pick up the difference between the bond’s accelerated face value and the discounted value of the bonds at purchase (or such lesser amount as agreed to in a settlement); Aurelius, viewed ex ante, had no incentive to pursue the objective of pushing Windstream into bankruptcy and collecting on CDS. Per the terminology of Marcel Kahan & Edward Rock, Hedge Fund Activism in the Enforcement of Bondholder Rights, 103 Nw. U. L. Rev. 281 (2009), Aurelius sought to levy a “breach tax” and not to destroy the company. The ultimate negative result stemmed mostly from bad decisions made by Windstream’s managers, who misjudged the risks and stonewalled when they should have settled. The account is very, very well done, and teaches volumes about investments in distressed bonds and CDS.
The authors close with a succinct discussion of policy implications. They brief current positive law and contractual solutions to the Big New Problem with equanimity. No policy axes are ground even as caution is counselled. They also address implications “for rhetoric:” If creditor sabotage is a nothingburger, why all the brouhaha? A myth is being spun, say BMZ, (1) because it suits the interests of corporate managers, (2) because vulture funds “revel in a Machiavellian ethos,” and (3) because of “general anxiety about financialization.” Fair enough. I would add a fourth explanation, though. When managers transfer value from bondholders to their shareholders with tricked up asset partitions and stilted, literal readings of language in indentures, the bondholders are not supposed to win even as they’ve just been screwed. The managers after all are just doing their fiduciary duty to maximize shareholder value and the bondholders have skewed incentives (true) and are unaccountable (also true). The skewed incentive-unaccountability glove does fit. But not well. I prefer a different characterization, viewing the fact pattern not as “corporate governance” but as a case of contract performance, breach, and enforcement. Performance and breach is a world of tradeoffs where optimality has little to do with the present matters for decision. The value implications have to be left over for the future. And, if a contractual allocation has turned out to be dysfunctional—and this happens all the time in debt contracting—the term in question needs to be redrafted in the next generation of bond contracts. This too happens all the time, with the Big New Problem being solved as new money gets loaned. Finally, when a clever asset partitioning ploy goes sideways, managers shouldn’t stonewall. They should follow BMZ to stop posturing, consult Coase, and settle.