OECD Report on Corporate Bond Markets in a Time of Unconventional Monetary Policy

By Ryan M. Rossner (Harvard Law School, J.D. 2019)

On February 25, the OECD published another report in its Capital Market Series, Corporate Bond Markets in a Time of Unconventional Monetary Policy, which noted both a significant increase of outstanding nonfinancial corporate debt and a simultaneous decrease in bond quality post-financial crisis. Authored by Mats Isaksson, Serdar Çelik, and Gul Demirtaş, the report drew upon a dataset of almost 85,000 unique corporate bond issues by nonfinancial companies from 114 countries between 2000 and 2018.

The report provides a detailed account of capital markets development post-financial crisis with comparisons among different jurisdictions.  The authors emphasize that levels of nonfinancial corporate bond issuances have reached record highs. Global outstanding debt in the form of corporate bonds issued by nonfinancial companies reached almost $13 trillion USD at the end of 2018, twice the amount in real terms than was outstanding in 2008.  The report links the expansion of corporate bond issuances to regulatory initiatives aimed at encouraging corporate bond issuances, expansionary monetary policy, and (particularly in the EU) quantitative easing.  The report also forecasted a record repayment period ahead with $2.9 trillion coming due for advanced economy issuers and $1.3 trillion for emerging economy issuers within 3 years.

The US remains the largest corporate bond market and US issuers raised the most funds over the period.  However, the authors found that the number of US nonfinancial issuers increased only modestly in the post-crisis era, suggesting increased issuer concentration in US primary corporate bond markets. Over the same period, Japan, the EU, Korea, and China all increased both their use of corporate bond issuances as a means of borrowing and their number of issuers. Most strikingly, the number of Chinese companies issuing bonds increased steeply from 68 issuers in 2007 to a peak of 1,451 in 2016.

Amidst the expansion, the authors found a marked decrease in bond quality. To support these conclusions, the authors pointed to a marked expansion of non-investment grade bonds, and the increase of BBB-rated bonds (the rating just above non-investment grade) as a percentage of investment grade debt (to 54% in 2018).

The report also noted a decrease in covenant protection for non-investment grade corporate bonds. The authors devised a “Covenant Protection Index” of US issuances, by looking at the presence or absence of 27 different types of covenants in bond indentures.  While the index is a rough measure of covenant protection, it demonstrated a downward trend for non-investment grade bonds.  The authors attribute the decrease in covenant protections to increased issuer bargaining power in a low interest rate environment, as investors have been willing to forgo certain protections in favor of higher yields.

The authors note that the combination of increased bond issuances, a “prolonged period of low issuer quality,” and “lower levels of covenant protection” for noninvestment grade bonds suggest that in an economic downturn the amount of expected future corporate bond defaults “may be considerably larger than that experienced in the financial crisis.” This report comes shortly after Federal Reserve Chairman Jay Powell, during the January FOMC meeting press conference, described the current state of corporate debt as a “macroeconomic risk,” which could “amplify” a negative downturn.

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For a previous Roundtable post on distressed debt, see Edward Altman & Robert Benhenni, “The Anatomy of Distressed Debt Markets.”

 

Rethinking “Too Big To Fail”

 By Saule T. Omarova (Cornell University)

“Too big to fail” – or “TBTF” – is a popular metaphor for a core dysfunction of today’s financial system: the recurrent pattern of government bailouts of large, systemically important financial institutions. The financial crisis of 2008 made TBTF a household term, a powerful symbol of the pernicious society-wide pattern of “privatizing gains and socializing losses.” It continues to frame much of the public policy debate on financial regulation even today, ten years after the crisis. Yet, the analytical content of this term remains remarkably unclear.

In a forthcoming article, I take a fresh look at the nature of the TBTF problem in finance and offer a coherent framework for understanding the cluster of closely related, but conceptually distinct, regulatory and policy challenges this label actually denotes. I begin by identifying the fundamental paradox at the heart of the TBTF concept: TBTF is an entity-centric, micro-level metaphor for a complex of interrelated systemic, macro-level problems. I argue that, while largely unacknowledged, this inherent tension between the micro and the macro, the entity and the system, critically shapes the design and implementation of the key post-2008 regulatory reforms in the financial sector.

To trace these dynamics, I deconstruct the TBTF metaphor into its two basic components: (1) the “F” factor focused on the “failure” of individual financial firms; and (2) the “B” factor focused on their “bigness” (i.e., relative size and structural significance). Isolating and examining these conceptually distinct components helps to explain why the potential for failure (and bailout) of individual firms – or the “F” factor – continues to be the principal focus of the ongoing TBTF policy debate, while the more explicitly structural, relational issues associated with financial firms’ “bigness” – or the “B” factor – remain largely in the background of that debate.

Analyzing post-crisis legislative and regulatory efforts to solve the TBTF problem through this simplifying lens reveals critical gaps in that process, which consistently favors the inherently micro-level “F” factor solutions over the more explicitly macro-level “B” factor ones. It also suggests potential ways of rebalancing and expanding the TBTF policy toolkit to encompass a wider range of measures targeting the relevant systemic dynamics in a more direct and assertive manner. Admittedly, implementing such deliberately structural measures would require a qualitative shift in the way we think and talk about the financial system and its dysfunctions – not an easy precondition to meet in practice. Yet, as I argue in the article, this deep attitudinal shift is the necessary first step toward finally achieving the lofty – and persistently elusive – goal of eliminating the TBTF phenomenon in finance.

The complete article is available for download here.

 

Debt Restructuring and Notions of Fairness

By Sarah Paterson (London School of Economics & Political Science)

In a recent article, I argue that we have repeatedly failed to identify clearly our concerns for fairness in different types of debt restructuring situations, and that this has confused corporate bankruptcy policy debate.  To defend the article’s thesis, I build a theoretical frame by unpacking the principles and the procedural demands of fairness from diverse fields of scholarship such as moral and political philosophy, biological sciences, psychology, organisation theory, group theory and economics.  I apply this theoretical frame to three very different types of debt restructuring: a restructuring of a small or medium sized enterprise; a restructuring of a large corporate; and a restructuring of a financial institution in English law.  In each case, a fairly typical fact pattern is outlined to ground the analysis, and the quality and extent of the fairness concerns examined.

The analysis in the article concentrates exclusively on fairness.  It does not consider the trade-off between fairness and other objectives (such as cost reduction), or utilitarian objections (such as concern that a situation which differentiates between classes of stakeholder in its approach to the fairness of the case would make stakeholders worse off overall), or arguments that what we might consider to be questions of fairness should properly be reinterpreted as economic questions.  In short, its objective is not to argue that fairness should prevail over all other considerations, but rather to explore, as an initial question, the quality of fairness in each of the situations with which it is concerned.

S. Paterson, ‘Debt Restructuring and Notions of Fairness’ (2017) 80(4) Modern Law Review 600 available here.

Debt Recharacterization Under State Law

By James M. Wilton (Ropes & Gray, LLP)

The majority federal law test for recharacterization of insider debt in bankruptcy establishes a multi-factor test drawn from federal tax cases. The test is problematic and has been rejected by Fifth and Ninth Circuit Courts of Appeals in favor of a state law rule of decision. The U.S. Treasury, in fact, has moved away from use of multi-factor tests even in tax cases because they are unworkable and produce “inconsistent and unpredictable results.”

In an article published this month in The Business Lawyer, I predict that the U.S. Supreme Court will resolve the circuit split over debt recharacterization in favor of a state law rule of decision. The article is intended for transactional lawyers interested in structuring transactions to minimize debt recharacterization risk and for bankruptcy litigators interested in understanding the arguments both for and against application of a federal or a state law rule of decision. For the circuits that have endorsed a state law rule of decision for debt recharacterization, the article examines the appropriate test for determining choice of law and surveys the substantive state law of debt recharacterization in thirteen jurisdictions, including New York and Delaware.

The article concludes that debt recharacterization under state law allows equity sponsors and other corporate insiders to provide credit support to distressed businesses, with greater assurance that loans will be enforceable both under state law and in bankruptcy court.

The full article is available here.1


  1. ©2019. Published in The Business Lawyer, Vol. 74, Winter 2018-2019, by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association or the copyright holder.

Bankruptcy Hardball

By Jared A. Ellias (University of California, Hastings) & Robert Stark (Brown Rudnick LLP)

On the eve of the financial crisis, a series of Delaware court decisions added up to a radical change in law: Creditors would no longer have the kind of common law protections from opportunism that helped protect their bargain for the better part of two centuries. In this Article, we argue that Delaware’s shift materially altered the way large firms approach financial distress, which is now characterized by a level of chaos and rent-seeking unchecked by norms that formerly restrained managerial opportunism. We refer to the new status quo as “bankruptcy hardball.” It is now routine for distressed firms to engage in tactics that harm some creditors for the benefit of other stakeholders, often in violation of contractual promises and basic principles of corporate finance. The fundamental problem is that Delaware’s change in law was predicated on the faulty assumption that creditors are fully capable of protecting their bargain during periods of distress with contracts and bankruptcy law. We show through a series of case studies how the creditor’s bargain is, contrary to that undergirding assumption, often an easy target for opportunistic repudiation and, in turn, dashed expectations once distress sets in. We further argue that the Delaware courts paved the way for scorched earth distressed governance, but also that judges can help fix the problem.

The full article is available here.

Taking Control Rights Seriously

By Robert K. Rasmussen (University of Southern California Gould School of Law)

It is common to observe that investors receive both cash flow rights and control rights against a borrower. The crucial differences between these two “rights” are rarely focused on. Cash flow rights are legal entitlements. Outside of bankruptcy, failure to pay entitles a lender to resort to a legal remedy against the borrower. Inside of bankruptcy, the Bankruptcy Code structures the way in which these legal entitlements will be adjusted. Control rights are different. They do not confer direct power over the business, nor do they provide lenders with a judicial remedy that allows them to assert control. Rather, they work indirectly. The Bankruptcy Code, in turn, pays scant attention to a lender’s control rights.

This disparate treatment stems from the lending contract. That agreement provides enforceable rights to cash and as we have seen in recent years – there is little limit to the creativity in dividing up cash flow rights. The same contract, however, does not place control in the hands of a lender, even on a contingent basis because legal doctrines threaten creditors who put their hands on the levers of power. Outside of bankruptcy, the lingering shadow of lender liability doctrine leads lawyers to counsel clients to avoid contracting for control upon a borrower’s default. Inside of bankruptcy, lenders that exercise what a court finds to be excessive control face the threat of having their claims equitably subordinated. In addition to these threats, it is far from clear that a bankruptcy court would enforce a contract that gave direct control to the debtor’s lenders should the debtor default. These restrictions on contracting, however, are questionable. Opening up the contract space for direct contracting on control could increase contracting surplus.

The full article is available here.

Debt Restructuring: When Do Loan and Bond Prepayments Pay Off?

By Edwin Fischer and Ines Wöckl (University of Graz)

Many debtholders, whether private households, companies, or states, are caught up in high-interest long-term loans. At the same time, economic developments in the Eurozone over the past few years have created a low-interest environment in which prepaying an existing loan and simultaneously refinancing into a new loan can be advantageous from the borrower’s point of view. By redeeming an existing loan before maturity and refinancing into a loan with a lower interest rate, the amount of interest owed to the lender can be reduced significantly. Intuitively debt restructuring seems advantageous whenever the nominal interest rate of the new loan is lower than that of the old loan. However, prepayment considerations are more complex since debt restructuring entails transaction costs. These include a possible penalty for the early redemption of the existing loan, called a prepayment penalty, as well as credit charges and a possible loan disbursement fee for taking out a new loan. We use the method of differential investment to analyze under which circumstances loan and bond prepayments make sense for debtholders. We provide an exact solution concept as well as an easy-to-use approximation for calculating the critical upper limits for the nominal interest rate of the new loan up to which prepayment and subsequent refinancing is optimal. The calculations address both fixed and variable rate loans and consider whether the debt agreement is repaid at maturity or in annuities.

The full article is available here.

Insider Trading: Are Insolvent Firms Different?

By Andrew Verstein (Wake Forest University School of Law)

Are insolvent firms different from solvent firms with respect to insider trading law and policy? One difference is the level of regulation of trading in the residual claims of the firm. In solvent firms, the residual claims are equity securities, and equity securities are subject to the full ambit of trading restrictions. In insolvent firms, non-equity claims are typically residual claims that are subject to less stringent regulation precisely because they are not equity and they may not even be securities. As a result, insider trading regulations apply with lesser force to the most economically significant and informationally-sensitive interests in an insolvent company. Insolvency is therefore deregulatory.

While insolvency deregulates, it also expands the reach of other aspects of federal insider trading law. That is because bankruptcy law creates new roles and new duties. Since insider trading law hinges on duties, these new relationships expand the coverage of insider trading restrictions.

I consider these tradeoffs in a forthcoming article, and I offer two tentative conclusions.  

First, we should not rush to close the “loopholes” in insider trading law that open with regards to the residual claims. Deregulating insider trading is a Faustian bargain—greater price accuracy at the risk of lesser liquidity, fairness, and managerial integrity—but we should be more willing to accept the bargain with respect to insolvent firms than solvent ones.

Second, we should be solicitous of efforts to shield members of creditors’ committees from extensive insider trading regulation because these creditors occupy a position without analogue in the solvent firm: they both receive and contribute material, nonpublic information. Traditional insider trading law theory may not have the resources to manage a two-way flow of information, requiring new and accommodating thought.

The full article is available here.

Transplanting Chapter 11 of the US Bankruptcy Code into Singapore’s Restructuring and Insolvency Laws: Opportunities and Challenges

By Gerard McCormack (University of Leeds) and Wai Yee Wan (Singapore Management University – School of Law)

In 2017, Singapore introduced wide-ranging reforms to its insolvency and restructuring laws with a view to enhancing its attractiveness as an international centre for debt restructuring. A key theme of the reforms is the transplantation (with modification) of certain provisions from Chapter 11 of the US Bankruptcy Code including the automatic moratorium, cross-creditor cram-down, rescue financing and pre-packs. These provisions are engrafted into the existing scheme of arrangement framework, which in turn has its roots in the United Kingdom (UK).

In our paper, relying on the US experience and the reactions to similar reform proposals in the European Union (including the UK), we critically evaluate the effectiveness of the legal transplantation and discuss the possible unintended consequences of such transplantation.

We raise three issues. First, the new cross-class cram-down provisions could lead to valuation disputes and satellite litigation, such as whether the directors and scheme managers have properly discharged their duties. Second, the 2017 reforms shift power from the creditors to the management of the debtor company. This may prove to be disadvantageous to creditors in Singapore (and many other Asian countries) where the majority of the companies, including publicly listed companies, have concentrated shareholdings, and managers owe their existence to those who are in control. Finally, there remains the question whether the Singapore schemes will be recognised overseas, which will be important if the scheme proposes to modify debt obligations that are governed by non-Singapore law.

The full article is available here. The article is recently published in Journal of Corporate Law Studies.

 

How Specialized Courts Changed the Chinese Bankruptcy System

By Bo Li (Tsinghua University – PBC School of Finance) and Jacopo Ponticelli (Kellogg School of Management – Department of Finance)

In the last decade, China experienced a massive increase in corporate debt and, more recently, in corporate bankruptcies. Despite the mounting pressure on its insolvency resolution system, little is known about how bankruptcy works in China and the role played by the government.

China’s bankruptcy system experienced two recent changes: the reform of the bankruptcy code in 2007, and the introduction of specialized courts between 2007 and 2017. Before the introduction of specialized courts, bankruptcy cases were filed in local civil courts. Characterized by limited expertise and long delays, local courts tend to operate under the influence of local politicians, who have strong incentives to keep financially distressed state-owned companies alive to reduce unemployment and boost their political career. Thus, even though  the 2007 reform aligned Chinese bankruptcy law with those in the US and Europe, timely resolution of state-owned firms in financial distress remains a problem due to the influence of local governments.

Recently, China’s central government promoted the introduction of courts specialized in bankruptcy, which are modeled on US courts and run by insolvency professionals. In this paper, we study the impact of the introduction of specialized courts across Chinese provinces a on bankruptcy resolution and credit markets. The introduction of specialized courts led to an increase in the share of liquidations of state-owned firms and a faster speed of processing in court. In addition, state-owned firms operating in jurisdictions with specialized courts experienced a decrease in the size of new bank loans, lower access to new loans, and lower investment in physical capital relative to privately-owned firms.

The full article is available here.

 

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