Bond Trustees, and the Rising Challenge of Activist Investors

By Steven L. Schwarcz (Duke University School of Law)

Steven L. Schwarcz

Large financial institutions, such as U.S. Bank or Bank of NY Mellon, typically administer the governance of bond indentures—the contract under which bonds are issued—on behalf of the investors; in that role, they are called indenture trustees or, more colloquially, bond trustees. In Bond Trustees, and the Rising Challenge of Activist Investors, the 2020 TePoel Lecture at Creighton University School of Law, I examine how bond trustees should respond to this challenge.

Bondholders are the primary beneficiaries of indenture governance, just as shareholders are the primary beneficiaries of corporate governance. As beneficiaries, bondholders and shareholders have much different expectations. Indenture governance and corporate governance have evolved differently to meet those different expectations.

For example, because bondholders are only entitled to receive principal and accrued interest on their bonds, indenture governance has evolved to protect that recovery. In contrast, because shareholders, as residual claimants of the firm, are entitled to (and thus expect to receive) the firm’s surplus value, corporate governance has evolved to increase that value.

Most people would consider corporate governance as more important than indenture governance. In part, that’s because corporations and stock markets are highly visible to the average person. Also, a corporate manager’s job—to try to increase shareholder value—involves more judgment and discretion, and thus can be more interesting (and more desirable of scholarly study), than an indenture trustee’s job of merely protecting bondholder recovery.

Still, indenture governance is critically important. Domestically and worldwide, the amounts invested in bonds dwarfs the amounts invested in stock. Recent data show, for example, that global bond issuance is almost 30 times greater than global equity issuance.

An indenture trustee’s governance duties turn on whether the trustee is acting pre-default, or post-default. Once an indenture defaults, the law requires the indenture trustee to act on behalf of the bondholders as would a prudent person in similar circumstances regarding its own affairs. Many post-default decisions—such as whether to accelerate the maturity of the bonds or to liquidate collateral—involve difficult judgment calls. These decisions are made more difficult by what I have called a “protection gap”: when things go wrong, investors often blame parties with deep pockets, especially indenture trustees, for failing to protect them. Post-default indenture governance becomes even more complicated when the bondholders themselves have conflicting interests, caused, for example, by conflicting payment priorities or conflicting sources of payment.

Notwithstanding its complexities, post-default indenture governance is informed by case law. And perhaps because of its complexities, post-default indenture governance is also informed by legal scholarship. In contrast, pre-default indenture governance is not yet well informed by either case law or legal scholarship. The rising challenge of activist investors is now making it critical to also understand what an indenture trustee’s pre-default duties should be.

Historically, an indenture trustee’s pre-default duties have been seen as ministerial and limited to the specific terms of the indenture, such as selecting bonds for redemption and preparing and delivering certificates. Since the financial crisis, some investors argue that indenture trustees of securitized bond issues, in which investors are paid from collections on underlying financial assets such as mortgage loans, should have pre-default fiduciary duties. Indeed, complaints in recent lawsuits allege that those indenture trustees should “police the deal” for the investors.

These allegations are not compelling. Indenture trustees receive relatively tiny fees and don’t even negotiate the terms of the indentures. In contrast, the institutional investors in securitized bond issues, including activist investors, are highly sophisticated. Indenture trustees could not understand complex securitized bond issues better than those investors.

Furthermore, parties other than indenture trustees are assigned monitoring duties to protect the investors. Notably, securitized bond issues require a party, usually called a servicer, to service and collect payment on the underlying financial assets. In litigation following the financial crisis, which caused widespread defaults on residential mortgage loans, some investors argued that indenture trustees in mortgage securitization transactions should have monitored or supervised the performance of the mortgage-loan servicer.

Imposing such duties on the indenture trustee would be duplicative and expensive. Rather, an indenture trustee that actually becomes aware of servicing problems should act in a common sense and practical manner. For example, it might enter into conversations with the servicer about its performance and communicate the results of those conversations to the investors. It also might seek, or request the investors to provide, formal investor directions.

Typically, indentures allow investors with at least 25-50 percent of voting rights to direct the indenture trustee to act.

The full TePoel Lecture is available here:

For a related Roundtable post, see Steven L. Schwarcz, Indenture Trustee Duties: The Pre-Default Puzzle.

Corporate Restructuring under Relative and Absolute Priority Default Rules: A Comparative Assessment

By Jonathan Seymour, Steven L. Schwarcz (Duke University School of Law)

Jonathan Seymour
Prof. Jonathan Seymour
Steven L. Schwarcz
Prof. Steven L. Schwarcz

The European Union recently adopted a Restructuring Directive intended to facilitate the reorganization of insolvent and other financially troubled firms. Although the central goal of the Directive parallels that of Chapter 11 of U.S. bankruptcy law—to protect and maximize the value of financially distressed but economically viable enterprises by consensually reorganizing their capital structure—the Directive introduces an innovative but controversial option: that EU Member States can decree that reorganization negotiations should be subject to a relative priority default rule, as opposed to the type of absolute priority default rule used by Chapter 11.

The purpose of the default rule—whether relative or absolute priority—is to provide a mechanism whereby a plan of reorganization may be approved notwithstanding failure of the parties to reach a consensus. Such a “cram down” plan reflects that one or more classes of impaired creditors or shareholders dissents. In that case, the EU’s relative priority default rule would allow confirmation of the cram down plan so long as senior classes are treated more favorably than junior classes. In contrast, Chapter 11’s absolute priority default rule would require senior classes to be paid in full before junior classes receive any distribution under the cram down plan.

EU officials argue that relative priority would provide a fairer and more pragmatic default rule than absolute priority. We disagree. As explained below, we believe that a relative priority default rule would, perversely, make consensual reorganization plans less likely. We also illustrate why a relative priority default rule could produce unfair and economically undesirable outcomes.

A relative priority default rule would make consensual reorganization plans less likely because, unlike an absolute priority default rule, it would not function as a penalty default. Absolute priority functions as a penalty default because it would require a costly and contentious going-concern valuation of the debtor, in order to determine what share of the equity in the reorganized debtor is necessary to pay the claims of senior classes in full before any remaining value may be paid to junior classes. To avoid that cost and contention, the parties are motivated to negotiate a consensual plan, even if they would have to give up some value.

Relative priority, in contrast, would not operate effectively as a penalty default rule. A debtor could gain approval of a nonconsensual (i.e., cram down) plan without any valuation of the reorganized business. Even if a valuation is required, a simple and relatively inexpensive floor or ceiling valuation should suffice, rather than the precise valuation required under absolute priority. Parties therefore would have little incentive to compromise.

A relative priority default rule also would permit unfair outcomes. Our article shows how such a default rule would permit shareholders to retain much of the value in a reorganized business, while forcing creditors to accept significantly less than full payment. That could make debt investments less attractive in EU Member States that adopt a relative priority default rule. At the same time, relative priority would create incentives, as was the case in the early years of the U.S. bankruptcy laws, for senior and junior classes to collude to “squeeze” intermediate classes. Additionally, by reducing the risk of insolvency for shareholders and management, relative priority could operate as a subsidy for overleveraged businesses and encourage risky behavior.

For all of these reasons, we believe that EU Members States should avoid adopting a relative priority default rule. Our article also responds to potential defenses of that option. We demonstrate that relative priority is unnecessary to deter holdout creditors from obstructing the plan negotiation process. We additionally explain why relative priority is not needed to promote successful reorganizations of small and medium sized businesses. To the extent that traditional Chapter 11-style reorganization has not worked well for small businesses in the US, we suggest that the recent Small Business Reorganization Act provides a better restructuring model by permitting such businesses to reorganize on a “best efforts” basis.

The full article is available here.

Indenture Trustee Duties: The Pre-Default Puzzle

By Steven L. Schwarcz (Duke University School of Law)

Indenture trustees act for the benefit of the investors in a company’s bonds. They perform this role for virtually all companies that issue bonds, whether in the United States or abroad. The existing scholarship on their duties focuses on the post-default scenario. In many countries, including the United States, the law then imposes a ‘prudent person’ standard. This Article, in contrast, examines an indenture trustee’s “pre-default” duties.

It is critical to try to define those duties because activist investors, including hedge funds and so-called “vulture fund” investors that purchase defaulted bonds at deep discounts, increasingly are making pre-default demands on indenture trustees, who must know how to respond. Also, the manner in which they respond can have widespread economic consequences because the bond market is huge—in 2018, approximately $43 trillion in the United States and $103 trillion worldwide.

Activist investors are also suing indenture trustees for losses on their bonds, alleging they should have taken pre-default actions to protect the bonds. To avoid the risk of liability, indenture trustees should know how they should discharge their pre-default duties.

The indenture trustee’s pre-default duties have not been seriously re-examined since enactment of the Trust Indenture Act of 1939, although the bond market has changed dramatically since then. Institutional investors now dominate; there are few individual retail investors. By virtue of their sophistication and the size of their bondholding, institutional investors face less of a collective action problem than retail investors had faced. Also, as mentioned, certain activist investors increasingly are engaging in high-risk strategic investing.

Whether or not due to these market changes, there are at least two views today of the indenture trustee’s pre-default role. By far the dominant view—and the view that comports with existing law and the plain language of indentures—is that indenture trustees have no pre-default fiduciary duties to investors. Rather, their duties are ministerial and limited to the usually administrative functions specified in the indenture. Since the 2007-08 financial crisis, however, some investors argue that indenture trustees—especially those of securitized bond issues, who act for the benefit of investors whose right to payment is limited to collections on specified financial assets (such as mortgage loans)—should have some pre-default fiduciary duties.

My Article analyzes what an indenture trustee’s pre-default duties should be, starting by considering the possible normative frameworks for legally imposing duties in a business context. I consider two potentially overlapping frameworks: to correct market failures, and to maximize efficiency. I also consider a formalistic rationale for legally imposing duties—because securitized bond issues involve purchased financial assets, they more closely resemble a traditional trust; and trustees of a traditional trust have fiduciary duties.

Based on its analysis, the Article concludes (among other things) that, pre-default, the indenture trustee’s duties should only be those specified in the indenture. The Article also applies that standard to the types of issues that may arise in lawsuits against indenture trustees.

For example, even prior to a formal default, one or more investors may demand that the indenture trustee take some enforcement or other remedial action to try to correct a problem. Compliance with that demand could be expensive, reducing the value of the estate for investors generally. Taking remedial action could therefore create a conflict if it would disproportionately benefit only certain investors. Absent instructions from the requisite investor threshold contractually required to direct the indenture trustee, the trustee should have the right to refuse to take a demanded action. In case of doubt, an indenture trustee could itself seek instructions. The Article also examines practical issues—and practical ways to resolve those issues—that might sometimes impair formation of the requisite investor threshold to direct the indenture trustee.

The full article is available here.

Secured Transactions and Financial Stability: Regulatory Challenges

By Steven L. Schwarcz (Duke University School of Law)

Secured transactions traditionally are regulated to protect transacting parties and to increase transactional efficiency. This essay argues they should also be regulated to protect the stability of the financial system. This raises numerous challenges.

In our increasingly complex financial system, for example, regulation to control moral hazard in the originate-to-distribute model of secured loan origination faces the challenge that the relevant market failure is less likely to be asymmetric information than mutual misinformation—neither the originator (i.e., seller) of the loans nor the buyer may fully understand the risks. Non-traditional secured transactions, including securitization and other forms of structured finance, exacerbate the challenges of complexity and the limits of disclosure.

The regulation of collateralization levels and interconnectedness faces fundamentally different challenges than those underlying the (technically) analogous post-Depression regulation of “margin” lending to acquire publicly traded stock. The Fed’s Regulation U then required that stock pledged as collateral be worth at least twice the loan amount. Requiring overcollateralization of home-mortgage lending, however, could be highly regressive.

The potential for the widening gap between the rich and the poor to undermine stability also raises the challenge of whether to recognize de facto rights, in order to enable the poor to use their homes as collateral to raise capital. This challenge is itself partly informed by the Uniform Commercial Code’s innovative disentanglement of commercial and property law, which articulates the former to reflect commercial realities rather than the arbitrary shifting of rights based on property. Innovating secured transactions law to recognize those de facto rights could help to unlock a worldwide entrepreneurial potential.

The full paper can be found here.

Derivatives and Collateral: Balancing Remedies and Systemic Risk

By Steven L. Schwarcz, Duke University School of Law

schwarczProfessor Schwarcz examines whether the bankruptcy “safe harbor” for derivatives is necessary or even appropriate to protect against systemic risk—such protection being the safe harbor’s articulated justification. The article examines the most important function of the safe harbor: allowing derivatives counterparties to exercise their contractual enforcement remedies against a debtor or its property notwithstanding bankruptcy law’s stay of enforcement actions. A threshold question is whether there is anything inherently risky about derivatives that might cause a systemic failure.

The standard answer is volatility. But, the article observes, regulation could reduce that potential for systemic risk in a more limited fashion. The article next addresses the safe harbor from the standpoint of its impact on avoiding contagion. The safe harbor is supposed to enable large derivatives dealers to enforce their remedies against a failed counterparty, thereby minimizing the dealer’s losses and reducing its chance of collapse. There are, however, several flaws in the safe harbor’s design to accomplish that. First, the safe harbor incentivizes systemically risky market concentration by enabling dealers and other parties to virtually ignore counterparty risk. Second, the safe harbor operates independently of the size of the counterparty or its portfolio. The article then examines how the Lehman bankruptcy might inform the safe harbor debate. The article offers a final caution: To the extent the safe harbor might amplify, rather than protect against, systemic risk, its negative impact would transcend the traditional derivatives market.

The full version of this article is forthcoming from the University of Illinois Law Review and is available in draft form here.

Practitioners, Academics, and a Judge Testify about Safe Harbors before Congress

Author: Stephen D. Adams

The House Judiciary Subcommittee on Regulatory Reform, Commercial, and Antitrust Law has held two sets of hearings in recent months on the bankruptcy safe harbors for repos and derivatives from the automatic stay, from preference and fraudulent conveyance law, and from the limitations on ipso facto clauses.

This past Wednesday, March 26, Judge Christopher Sontchi, Seth Grosshandler, Jane Vris, Thomas Jackson, and Michelle Harner testified. Last December, Jeffrey Lacker, Donald Bernstein, and Mark Roe testified.

Judge Sontchi argued that the 546(e)’s exception for all settlement transactions is too broad and also urged Congress to narrow the safe harbors for repos. Seth Grosshandler, of Cleary Gottlieb, reported on the work of the ABI safe harbors advisory committee (which includes both Judge Sontchi and Prof. Roe) and warned that the safe harbors are complex and potentially costly to alter.  Jane Vris, representing the National Bankruptcy Conference (NBC), and Thomas Jackson, professor at the University of Rochester, testified on bankruptcy of SIFIs as an alternative to Dodd Frank resolution of bail-out.  Michelle Harner, professor at University of Maryland School of Law, testified in her role as the Reporter to the ABI Commission on Bankruptcy Reform about the Commission.

Mark Roe, professor at Harvard Law School, testified that the safe harbors facilitate excessive short-term funding of financial institutions and impede effective resolution of large financial failures, like that of Lehman in 2008.  Donald Bernstein, of Davis Polk, a member of the ABI bankruptcy commission, testified about the bankruptcy adjustments needed to adapt bankruptcy law to the FDIC’s Single Point of Entry resolution mechanisms.  Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, testified about the importance of bankruptcy reform to reduce the problem of too-big-to-fail and reduce reliance on short-term debt.

The written testimonies are linked above, and the video of the oral testimonies for the March 26th hearing will be found here once it has been posted, and is here for the December 3rd hearing.

For more on the bankruptcy safe harbors for derivatives and repurchase agreements, please see the post by Steven L. Schwarcz and Ori Sharon summarizing their recent paper, The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis, and the post by Kathryn Borgeson, Mark Ellenberg, Lary Stromfeld, and John Thompson, entitled Lehman Bankruptcy Court Issues Safe Harbor Decision, summarizing a recent Lehman case decision on the safe harbors, both published Tuesday.

The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis

Authors: Steven L. Schwarcz and Ori Sharon

Bankruptcy law gives creditors in derivatives transactions a “safe harbor” in the form of special rights and immunities. In The Bankruptcy-Law Safe Harbor for Derivatives: A Path-Dependence Analysis, available on SSRN here, we argue that this safe harbor grew incrementally from industry lobbying, without a rigorous vetting of its consequences. This type of legislative accretion is path dependent, in that its outcome is shaped by its historical path.

Path-dependent legislation is not necessarily bad; but if it’s not fully vetted, its significance and utility should not be taken for granted. For example, advocates of the safe harbor contend that the collapse of a highly connected derivatives counterparty might systemically disrupt the derivatives market, impacting the broader financial system. But there’s little evidence to support this.

Scholars also seriously question the safe harbor, estimating that the net exposure of the major derivatives dealers to their counterparties is small. They also argue that the safe harbor may not be focused on the right parties because it operates independently of the size of the counterparty and applies to non-financial firms. Thus a bank that makes a secured loan cannot enforce its collateral against a bankrupt borrower, but an ordinary company can enforce its collateral against a bankrupt derivatives counterparty. The safe harbor is also overly broad, tempting parties to try to document ordinary financial transactions as derivatives transactions.

Because the derivatives safe harbor has important consequences for systemic risk, there should be a more fully informed discussion of its merits.

[Editor’s note: Please stay tuned for a special post later this week on hearings on bankruptcy reform, financial institution insolvency, and derivatives in front of the U.S. House of Representatives Subcommittee on Regulatory Reform, Commercial, and Antitrust Law.]