Revisiting the Voting Prohibition in Bond Workouts

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Author: Carlos Berdejó, Loyola Law School, Los Angeles

Economic theory suggests that corporate law should enable parties to contract freely in order to promote their best interests, leading to socially optimal arrangements.  This is particularly true for corporate bonds, which are governed by detailed indentures and held by large, sophisticated investors.  However, the Trust Indenture Act, which for 75 years has regulated the terms of U.S. public corporate debt, contains numerous mandatory rules, including a prohibition on collective action clauses (CACs).  A CAC allows a qualifying majority of bondholders to modify the interest rate, maturity and principal of an outstanding bond issue in a manner that binds all bondholders, including those who may prefer to hold-out to extract a larger payment.  This longstanding prohibition limits the ability of firms to restructure their debt via private workouts and can exacerbate the costs of financial distress by unnecessarily forcing issuers into bankruptcy.  Most countries other than the U.S. do not prohibit CACs and afford parties flexibility in choosing the qualifying majority that may amend the core terms of a bond issue.

My article, Revisiting the Voting Prohibition in Bond Workouts, examines contracting choices in Brazil, Chile and Germany, countries that have recently enacted reforms affecting their bond markets, including changes in restrictions on CACs.  I find that not only do market participants embrace increased flexibility with respect to CACs, but that interest rates decrease as a result, lowering the cost of capital for issuers.

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[Related Work Note: The work in Revisiting the Voting Prohibition in Bond Workouts provides evidence relating to the argument made in Mark Roe, The Voting Prohibition in Bond Workouts, 97 Yale L.J. 232 (1987), that the prohibition unwisely impeded out-of-bankruptcy recapitalizations and channeled some parties’ incentives towards coercive restructurings that would not have been needed if straight-forward votes were allowed.  That article can be found here.  More generally, academic bankruptcy theory has focused on the extent to which contract terms should be respected by law, inside and outside of bankruptcy.  See Alan Schwartz, Bankruptcy Workouts and Debt Contracts, 36 J. of L. & Econ. 595 (1993), available here.  –Stephen Adams, Editor]

Bankruptcy and Economic Recovery

Authors: Thomas Jackson & David Skeel

A striking feature of the recent economic crisis was the long period of subpar economic growth that continued even after the crisis had officially ended.  Although discussion about how to spur economic recovery has focused on the efficacy of Keynesian stimulus spending, this is only one of many factors that might plausibly encourage growth.  For a book entitled “Financial Restructuring to Sustain Recovery,” published by the Brookings Institution, we were asked to discuss the role that bankruptcy policy plays, or might play, in economic recovery.

After summarizing how bankruptcy posits a collective solution to a common pool problem of individual creditors and thereby improves the efficient use of assets, we consider two obstacles to its effectiveness.  The first is that bankruptcy proceedings often seem to begin too late.  The increased influence of debtors’ principal lenders probably counteracts this problem in part, but we suspect not fully.  We consider a wide range of strategies that lawmakers might use to encourage timely filing, some of which are fairly simple, while others are more speculative.

The second major issue is the relationship between bankruptcy and jobs.  The question whether bankruptcy should be used to protect jobs is a recurring theme that came to the fore most recently when the government used bankruptcy to bail out Chrysler, justifying its intervention as preserving jobs.  We caution that distorting the standard bankruptcy rules—focused on efficient use of assets—to save jobs in the short run may have more problematic effects overall.

The full-length article can be found here.

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