By Dennis Hranitzky, Richard East, Liesl Fichardt, Epaminontas Triantafilou, Yasseen Gailani, and Rupert Goodway (Quinn Emmanuel Urquhart & Sullivan, LLP)
The article summarizes the likelihood and implications of a sovereign bond default by the Russian Federation. It first discusses the economic sanctions imposed on the Russian Federation, their impact on Russia’s ability to access gold and foreign currency reserves and the consequences of sanctions on Russia’s ability to satisfy its obligations under the approximately $40 billion in UK law bonds. Noting that a payment default will likely lead to litigation arbitration, the article analyzes key provisions of the bonds, noting that atypical of sovereign bonds, they include no choice of law or venue provisions or waiver of sovereign immunity. The article explores anticipated litigation hurdles in both the US and the UK, with a focus on sovereign immunity and forum non conveniens defenses that may be available to Russia, including the particular difficulties that may be faced by litigants in enforcing a judgment from a US or UK court in the absence of a sovereign immunity waiver. The analysis of sovereign immunity necessarily includes consideration of the commercial activity exception and the article analyzes the US and UK interpretation of this exception. The availability of judgment enforcement discovery is also addressed, noting that broad written and sworn deposition discovery of both the debtor and third parties is the norm in the US and also potentially available in the UK. The article concludes with a recommendation that holders of Russian bonds organize themselves and seek advice on their options prior to the occurrence of a default.
By Kenneth Ayotte (University of California – Berkeley School of Law) and Christina Scullly (University of California – Berkeley School of Law)
The Nobel laureate Herbert Simon describes a complex system as one “made up of a large number of parts that interact in a nonsimple way.” The modern large Chapter 11 fits this definition quite well. Debt contracts with overlapping provisions lie within capital structures with multiple classes of claims, layered across numerous legal entities. Distressed restructuring transactions give rise to complex litigation over entitlements to the firm’s value. Bankruptcy case governance strategies are driven by intercreditor and restructuring support agreements that are constantly evolving.
Traditional law and economics theory of bankruptcy has little to say about this complexity, except to assume that rational, forward-looking “sophisticated parties” have anticipated it and managed it optimally. Taken to its logical conclusions, this perspective leaves no useful role for bankruptcy law. After all, if some feature of the Bankruptcy Code were useful, sophisticated parties would find a way to put it in their contracts. Mandatory features, even bedrock ones like the automatic stay, become no more than harmful interferences with contractual freedom.
Simplified models that assume omnisciently rational actors are useful tools in corporate finance: they isolate the forces that drive capital structure decisions and generate testable empirical predictions. But as normative models of bankruptcy law design, they are fundamentally flawed. We provide two case studies, one involving a complex contract (J. Crew), and another involving a complex capital structure (Nine West). Taken together, they suggest that it is time for law and economics scholars to take the uncomfortable but necessary step to acknowledge bounded rationality. Bankruptcy law must function not just for the optimal contracts a theorist derives, but also for the “good enough” contracts parties actually write, and the unpredictable interactions these imperfect contracts can generate.
Our first case study recounts the narrative behind the J. Crew restructuring, the most well-known of many “liability management transactions” that have become part of the distressed borrower’s playbook. The J. Crew case illustrates how a complex loan agreement with numerous interacting terms gives rise to loopholes that sophisticated parties can exploit. We describe the two-step transaction by which J. Crew combined multiple provisions in a term loan agreement to transfer the lenders’ collateral to an unrestricted subsidiary to refinance other debt. Though one particular “trap door” provision received the most public attention, our study reveals that other contractual weaknesses, such as the administrative agent’s low-powered incentives as a lender representative, also enabled the collateral transfer.
The growing importance of liability management strategies suggests that the true effect of greater sophistication is not optimal debt contracts, but instead, a magnification of their inevitable flaws. To understand these trends, we first need a model of contracting where such weaknesses can exist. Acknowledging bounded rationality in contracting is a necessary first step toward an agenda that understands the imperfect ways complex contracts evolve. This agenda can help scholars gain an understanding what drives contractual change, why loopholes form and close, and the costs and benefits of contractual complexity.
A second case study, Nine West, illustrates a “butterfly effect” of complex capital structures: small changes can have large and unanticipated effects when a bankruptcy occurs. Sycamore Capital Partners acquired Nine West and related fashion brands in a leveraged buyout in 2014. It reorganized its corporate structure in the process, leaving most of the debt with Nine West and spinning out other brands to itself, free of debt. An eleventh-hour decision to add more debt to the deal, and to make this debt senior through subsidiary guarantees, gave rise to a dizzyingly complex array of entitlement disputes between parent and subsidiary creditors about the uncertain ownership of assets and responsibility for debts across the entities in the Nine West corporate group. These disputes contributed to the exorbitant professional fees incurred in the bankruptcy case that consumed over 20% of the company’s enterprise value.
Insights from the study of complex systems can more realistically inform our models of bankruptcy law design. For example, an important feature of complex systems design is robustness: the system must be able to function effectively under suboptimal conditions. Features like the automatic stay and judicial oversight play a valuable role in preventing imperfections and gaps from propagating. Because interactions across contracts are most likely to lead to unanticipated effects, a perspective based in bounded rationality is also consistent with bankruptcy’s special role as a tool for addressing multiple creditor problems. Overall, we believe there is significant insight to be gained from the recognition that even sophisticated parties are imperfect.
By Mike Harmon (Gaviota Advisors, LLC) and Claudia Robles-Garcia (Stanford Graduate School of Business)
Corporate leveraged finance cycles have followed a predictable pattern in the forty years that have ensued since the invention of the junk bond in the late 1970s. They expand as investors’ risk appetites grow and recede as default rates rise. The recession of credit cycles has historically facilitated a healthy “creative destruction” in the form of restructuring transactions which have enabled over-leveraged companies to fix their burdened balance sheets. While the current credit cycle is positioned to share some of the characteristics of past cycles, it is also shaping up to differentiate itself in some meaningful ways. First, companies entered the current crisis with significantly more debt, and with that debt bearing a much higher blended risk profile, than in past cycles. Second, the restructuring “fix” has required much more additional financing than previous cycles, due to the economic nature of the crisis. Third, companies have had much more contractual leeway to avoid default, and to solve their liquidity problems with more leverage, than they have in previous cycles. Fourth, many investors have been aligned with borrowers on their desire to maintain elevated leverage levels. And finally, and probably most importantly, the Fed’s actions have facilitated, and even encouraged, the raising of more leverage. As a result of all of these factors, we believe that this restructuring cycle is more likely to see companies emerge with significantly more debt than we have seen in previous cycles. This will exacerbate the highly publicized “zombie” problem (where companies that are technically insolvent have no real catalyst to restructure), which could impact economic growth, and will increase the likelihood of a more protracted restructuring cycle in the years to come.
By Mitchell Mengden (Law Clerk, Delaware Court of Chancery)
In the past decade, private equity sponsors have taken a more aggressive stance against creditors of their portfolio companies, the most recent iteration of which has come in the form of collateral stripping. Sponsors have been using creative lawyering to transfer valuable collateral out of the reach of creditors. This Article delves deeper into the issue by examining the contract terms and litigation claims raised by these transactions.
The lack of protective covenants and ease of manipulating EBITDA and asset valuations are key conditions that permit collateral stripping. Each of these conditions were present in the past decade, primarily due to the protracted expansionary stage of the credit cycle. Lenders, however, can protect themselves from collateral stripping by negotiating stricter covenants and tighter EBITDA definitions, as well as pursuing ex post litigation for fraudulent transfers, illegal distributions, and claims for breach of fiduciary duty.
Contractual opportunism and creative lawyering will almost certainly continue to pervade credit markets. This Article provides a roadmap of ways that lenders can protect themselves from opportunism during contracting and throughout the course of the loan. As this Article concludes, ex post litigation claims are often an inadequate remedy, so lenders should seek to tighten EBITDA definitions and broaden protective covenants—even if to do so requires other concessions—to avoid litigation.
By Jared A. Ellias (University of California Hastings College of the Law)
When commentators describe American bankruptcy law as “the model to which European restructuring laws should aspire,” they are really speaking about an ‘American bankruptcy ecosystem’ of which law is only a significant part. The American bankruptcy ecosystem is best understood as a complex system inhabited by bankruptcy judges, law firms, investment bankers and activist investors. In this Report, I focus on one of the major components of this ecosystem: specialized investors that participate in the ‘bankruptcy claims trade.’ As I discuss, American bankruptcy courts today are best understood not as a place of shame and failure but rather as an integrated part of the capital markets, similar to the private equity firms of New York and the venture capital investors of Palo Alto. As this view of bankruptcy law took hold, investors, typically hedge funds, began to raise a large stock of capital to deploy in it. Importantly, while these investors were born of the bankruptcy bar’s development of institutions that situated bankruptcy courts within the capital markets, they have deployed their capital to accelerate it. This Report chronicles the rise of claims trading and the state of the academic literature on activist investing. In sum, the best interpretation of the available empirical evidence is that claims trading and activist investing have, at the very least, not harmed Chapter 11 or distressed corporations, and may have actually improved the capacity of the American bankruptcy system to reorganize distressed assets.
By Efraim Benmelech (Northwestern University – Kellogg School of Managemen, Nitish Kumar (University of Florida), and Raghuram Rajan (University of Chicago – Booth School of Business)
Is collateral at all valuable to creditors in corporate lending? At one level, it is clear why collateral should be important for lenders: it consists of hard assets that are not subject to asymmetric valuations in markets and that the borrower cannot alter easily. Collateral gives comfort to a lender that, even if the lender does little to monitor the borrower’s activity and the borrower’s cash flows prove inadequate to service the debt, the lender’s claim is protected by underlying value.
Yet even if assets are important to lending, why does debt need to be secured by them? After all, in a bankruptcy filing the firm’s assets will all be there to support the lender’s claim. Why protect the lender further through claims on specific collateral? In a related work (The Decline of Secured Debt), we find that firms tend to issue more secured debt when their credit quality is low or at times when average credit spreads across firms are higher or economic growth is slower. These are times when firms may find access to credit more difficult, creditors may fear greater stockholder-debtholder conflicts, and borrowers may need to collateralize debt issuances in order to regain access to funding. Moreover, with new lenders unwilling to lend without the comfort of collateral, existing lenders might rush to secure their claims so as not to be diluted. Indeed, negative pledge clauses (whereby the borrower commits to a lender that it will not issue secured debt to any other lender, failing which the debt payment will be accelerated) allow creditors to large companies to stay unsecured until they sense a greater likelihood of borrower distress, at which point they will move to secure their claims.
If collateral matters to creditors for the enforcement of debt claims, even in the case of large, mature companies but in a more contingent way, we should see it reflected in the pricing of secured claims vis-à-vis unsecured claims, especially in how that pricing moves with the state of the firm and the economy. Security should be of little value to lenders when a firm is far from distress or the economy is healthy, and it should become much more valuable (and hence secured debt should promise lower interest rates than unsecured debt) as a firm nears distress or the economy deteriorates.
The difficulty in identifying the effects of security on debt pricing derives from the circumstances under which it is offered. Since riskier firms will offer security at riskier times, a comparison of rates offered by secured debt issuances against rates offered by unsecured debt issuances across firms, or by the same firm over time, will tend to be biased toward suggesting higher rates for secured debt issuances.
In this paper, we use multiple data sets to get at the true pricing of secured debt, stripped as best as possible of the selection bias. Our identification strategy compares spreads on secured and unsecured credit of the same firm and at the same point in time.
We conclude from all these ways of obtaining the value of security that the selection bias is important, and correcting for it suggests that security is valuable to creditors – creditors typically require a lower spread when their claim is secured. Most important, however, we show that creditors value security differently for different firms and at different times.
For highly rated firms, creditors pay almost nothing for the added protection afforded by security, whereas for low-rated firms, they pay a lot. Yields on bonds issued by investment grade firms (those with an S&P rating of BBB− or better) are 20 basis points lower when secured, whereas this yield differential (unsecured versus secured) jumps to 112 basis points for a firm having a non-investment grade rating. Similarly, implied yields from bond trades in secondary market suggest that investors are willing to give up almost 161 basis points in spread for the added protection of security for non-investment grade issuers, whereas they are not willing to reduce spread at all for the added protection of security in the case of investment grade issuers.
Equally important, as a firm’s credit quality deteriorates, we see the valuation of secured claims improve relative to unsecured claims, suggesting that security becomes more valuable. We also find that secured spreads decline relative to unsecured spreads as the economy’s health – as reflected in GDP growth or the economywide Baa–Aaa spread – deteriorates.
The upshot is that collateral does not seem to matter for debt enforcement in normal times for a healthy firm, since debt linked to specific assets do not seem to enjoy better prices. Indeed, given the negligible pricing benefit, firms may want to avoid any loss in financial slack and operational flexibility at such times by not issuing secured debt. However, in tougher times, creditors do seem to value security, and firms do issue secured debt, either because creditors demand it or because of the better pricing.
By Bo Becker (Stockholm School of Economics) and Victoria Ivashina (Harvard Business School)
Corporate bond defaults have been on a long and powerful upward trajectory in the past few decades. The default rate of U.S. corporate bonds rose from 0.12 percent to 0.46 percent between the first and second halves of the period from 1970 to 2016—an increase of almost four times. The rating agency Moody’s reports that, of the ten years with the highest default rates since 1960, six occurred in the new millennium and none before 1990. In a recent working paper, we investigate the role of disruption in explaining this trend.
By disruption, we refer to the process whereby new firms replace old firms using innovations in their business models, operations, or new technology. This process causes incumbent firms to lose market share, suffer reduced profitability, and, as we demonstrate, default on debt obligations. Just to name a few of the many recent examples: single-location bookstores were disrupted by chain stores, which were in turn disrupted by online bookstores, and off-line travel agents were disrupted by online services.
In our study, we compare industries with high rates of arrival of new firms, measured as either venture capital investments in the sector over the last five years or as the fraction of public firms in the industry with an IPO date in the past five years. The two variables capture different stages of disruptors’ ascent. While one can easily think of several broad forces that have increased innovation and disruption over the past few decades, different industries have been affected at different speed and different depth. We exploit this variation to draw the connection between disruption and defaults.
Our measures of disruption positively predict future defaults on corporate bonds, controlling for a host of other factors (including time, industry, bond characteristics such as seniority and callability, and issuer characteristics such as credit rating). These bonds are largely issued by mature firms (startups rarely access the bond market). Not only are future defaults higher in industries with high rates of disruption, but the bond market prices this in: newly issued bonds in high-disruption industries have higher yields. These findings are surprising, as a reasonable expectation might be that firms in the same industry would generally suffer similar fates. We would then expect to see high rates of new firm creation coupled with low defaults on the debt (of incumbents). Instead, we find the opposite.
An active IPO market and elevated venture capital investment may help the inception and advancement of potential disruptors, but underlying causes may be found in technological shifts (information technology, mobile, and ,in an earlier era, perhaps electricity), deregulation (think airlines), and globalization (in our data, industries directly exposed to off-shoring are no more likely to see defaults; however, global markets may have an important role in scaling up the opportunities available for disruptive businesses).
The importance of disruption probably extends beyond creditors to other stakeholders of incumbent firms. The corporate bond market is useful for studying disruption because bonds are liquid securities with detailed, high-quality data. Furthermore, losses on corporate bonds are important because bonds are widely held. This is in contrast with the gains from disruption, which tend to be concentrated with entrepreneurs and venture capital investors.
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.
By Edward I. Altman (New York University) & Robert Benhenni (Pole Universitaire Leonard de Vinci)
The market for investing in distressed securities, the so-called “vulture” markets, has captured the interest of increasing numbers of investors and analysts. These investors, sometimes categorized as “alternative asset” institutions, mainly hedge funds, now can convincingly argue that the market has matured into a genuine asset class, with a reasonably long history of data on return and risk attributes.
In earlier works, Professor Altman has helped to classify this market into two distinct categories: (1) “Distressed” debt, meaning bonds or loans whose yield to maturity (later amended to option-adjusted yield) was equal to or greater than 10% above the 10-year U.S. government bond rate (later amended to be the U.S. government bonds with comparable duration), and (2) “Defaulted” debt, referring to bonds or loans of firms who have defaulted on their debt obligations and were in their restructuring (usually Chapter 11) phase.
The purpose of this article is to document the descriptive anatomy of the distressed debt markets size, growth, major strategies, characteristics, and participants, and then to explore its performance attributes, reviewing the relevant 30-year period from 1987-2017. The article notes a number of unique aspects which make this asset class attractive, especially to hedge fund managers who can move in and out of the securities depending upon the credit cycle.