William W. Bratton, Adam J. Levitin
Professor of Law and Co-Director, Institute for Law & Economics, University of Pennsylvania Law School
Agnew N. Williams Research Professor and Professor of Law, Georgetown University Law Center
The new bond workouts
Bond workouts are a famously dysfunctional method of debt restructuring. The process is so ridden with opportunistic and coercive behavior by both bondholders and bond issuers as to make success intrinsically unlikely. Yet since 2008 bond workouts have quietly started to work. A segment of the restructuring market has shifted from bankruptcy court to out-of-court workouts by way of exchange offers made only to large institutional investors. The new workouts feature a battery of strong-arm tactics by bond issuers, and aggrieved bondholders have complained in court. There resulted a new, broad reading of the primary law governing workouts, section 316(b) of the Trust Indenture Act of 1939 (TIA), which prohibits majority-vote amendments of bond payment terms and forces bond issuers seeking to restructure to resort to exchange offers.
This Article exploits the bond market’s reaction to the shift in law to reassess a longstanding debate in corporate finance regarding the desirability of TIA section 316(b). Section 316(b) has attracted intense criticism, with calls for its amendment or repeal because of its untoward effects on the workout process and tendency to push restructuring into the costly bankruptcy process. Yet section 316(b) has also been staunchly defended on the ground that mom-and-pop bondholders need protection from 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. We show that markets have learned to live with section 316(b)’s limitations, denuding the case for repeal of any urgency. Workouts 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. We also show that workout by majority amendment would not systematically disadvantage bondholders. Indeed, the recent turn to secured creditor control of bankruptcy proceedings makes direct amendment all the more attractive to unsecured bondholders.
Based on this empirical background, we cautiously argue for the repeal of section 316(b). Section 316(b) no longer does much 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. Still, we recognize that markets are imperfect 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 the broad reading of section 316(b).
Bond workouts are famously dysfunctional.
When a company is in financial distress, its stockholders and bondholders have every reason to negotiate a restructuring (or “workout”) of its obligations to produce a sustainable capital structure and avoid the costs of a bankruptcy. The reality is different. Bondholders hold out and free ride in response to restructuring offers from distressed debtors. Debtors respond with coercive inducements and procedural maneuvers. The result is a destabilizing and potentially toxic mix of creditor opportunism and debtor coercion that can derail the workout process, forcing a bankruptcy restructuring.