Getting to Yes: The Role of Coercion in Debt Renegotiations

How parties to a loan agreement or bond indenture can change the terms of their deal is an important, if frequently neglected, aspect of debt financing. Bonds and loans represent a company’s obligation to repay a debt, with interest, over time. But only a small fraction of what goes into an indenture or a loan agreement relates directly to the debtor’s financial obligations. Most of the material, by word count and complexity, consists of rules that bind the debtor while the debt is outstanding and which are designed to increase, relative to a naked promise to repay, the likelihood that the debtor will make good on its debt and that the investors will be able to recover otherwise if it doesn’t. The problems of incomplete contracting plague these supporting rules, however. Parties to a debt contract thus try to articulate sensible terms when they strike their agreement knowing full well that the world will change and might change in ways that undermine the initial terms’ commercial desirability. Sometimes it will make sense for the deal to change.

In recent years, long-settled understandings about how debtors pursue change have largely collapsed. Some of the world’s most elite law firms and financial advisors have made their marks devising novel approaches to consent solicitations. From the debtor’s perspective, the stimuli for these changes have been both “defensive” and “offensive.” On the defensive side, a seeming increase in activism by hedge funds specializing in distressed debt has induced companies to consider all available means to escape a threatened acceleration. On the offensive side, private equity-backed companies seeking to restructure unsustainable debt burdens without invoking Chapter 11 have proven willing to experiment with previously unthinkable techniques. The most talked-about development in leveraged finance and restructuring in recent years, sometimes described as “creditor-on-creditor violence,” is a story first and foremost of dashed expectations about how consent solicitations work. More than hyperbolic labels are at stake. The new methods have spurred numerous rounds of litigation, with disaffected debtholders challenging the validity of putative “majority” or “supermajority” results.

Yet despite consent solicitations having become a frequently contested matter, debates touching on the subject remain frustratingly atomistic. The courts lack a general analytical framework for assessing the validity of practices that can have substantial impact on investors and operating companies. Consequently litigation appears disordered and ad hoc. Academics, to the extent they have noticed the issue, have tended to focus on one or another practice rather than develop a general theory for assessing what is at stake.

We offer a comprehensive account of the methods (shy of bankruptcy) by which companies seek to persuade lenders and bondholders to accept a change to their rights as creditors. The pole star orienting our analysis is coercion: a structural property of some offers that can induce debtholders to give requisite consents even to a proposed alteration that will reduce the aggregate value of the affected debts. Coercion so understood is a useful starting point because its normative odor is unmistakable. Every plausible normative theory of contractual change regards a proposed change’s decrement to the affected debtholders’ wealth as, at minimum, important. Making sense of debtholders’ (and the law’s) tolerance of coercive methods turns out to be the central task in giving an account of contract alteration.

We offer four principal contributions. First, we identify and analyze, from a game-theoretic perspective, the key dimensions of coercion. Specifically, we show that coercion can result from (1) the ranking of an altered instrument relative to the pre-alteration ranking; (2) the conditioning of an offer of payment or eligibility to participate in an exchange on the debtholder having consented to an alteration; (3) the exclusivity of an offer of inducement; or (4) manipulation of the amount of debt eligible to consent. In theory, a debtor’s combinatory options along these dimensions are quite numerous. As we explain, however, three combinations dominate recent market practice. These include traditional solicitations, where a debtor solicits all holders but pays a consent fee only to consenting holders (or, in an exchange,  all holders are invited to participate but providing an exit consent is a condition of participation); exclusive uptiers, where a debtor invites a select group of holders to exchange their securities for higher-ranked debt; and ballot stuffing, where a debtor issues new securities to a buyer who agrees to vote them alongside previously outstanding securities either to waive an alleged default or relax a covenant.

Second, we document debtors’ persistent ability under standard loan and bond contracts to employ coercive solicitation methods. The only coercive technique systematically addressed by standard contracts relates to offers to exchange a lower ranked instrument for a higher ranked one. Even though parties in some contracts, in some submarkets, have from time to time adopted provisions that could shut down coercive solicitation altogether, most bond and loan contracts are silent as to whether and when the other techniques may be employed. Courts, in turn, have been reluctant to use open-ended doctrines such as the implied covenant of good faith and fair dealing to announce a general, judicial aversion to coercive techniques.

Third, we show that efficiency-based considerations may explain some of the observed, contractual tolerance for coercive solicitation methods. For example, debtors’ typical freedom to pursue traditional solicitations, which are mildly coercive, could be explained by a desire to reward active creditors or by the availability of substitute techniques in a hypothetical Chapter 11 proceeding, especially if, as seems plausible, creditors can coordinate relatively cheaply to thwart negative-value alterations.

Finally, we conclude that the more coercive prevailing techniques, in particular exclusive uptiers and ballot stuffing, cannot be so easily justified and propose an approach to construing debt contracts that would restrain what are likely the most value-destructive solicitation methods without condemning longstanding and plausibly value-enhancing techniques. Modesty about one’s ability to weigh the costs and benefits of even highly coercive solicitation methods counsels against an approach that would rule out practices on which market participants might settle. In our view, however, judges should not hesitate to look through or unwind alterations achieved through exclusive offers of inducement or ballot stuffing when the relevant contractual provisions are ambiguous or when the contract as a whole does not clearly anticipate the method. Debtors, who can propose changes to standard contractual language more easily than dispersed investors can, should bear the burden of specification.

The article can be found here.