Accept the Worse Terms or Be Left Behind With Nothing

The Problem With Restructuring Bonds

A company that needs to reduce its debt can negotiate with lenders a loan agreement where most can usually bind the rest on many terms

Bonds are different. Contracts usually require the consent of each affected holder to change payment terms i.e. principal interest or maturity. That unanimity requirement exists to protect individual bondholders and makes consensual reduction of debt nearly impossible since any holder can refuse

The result is a resistance problem. Each bondholder prefers that others accept a reduction while being paid in full

Why Unanimity Produces the Holdout

That last sentence is the whole difficulty and the reasoning is worth following because the result is perverse in a specific and predictable way

Put yourself in the position of a holder. The company needs to reduce its debt. If enough other holders accept a small claim the balance sheet is repaired the business survives and the bonds of anyone who has refused are good for money. Therefore the best outcome available to any individual holder is for everyone else to accept and they themselves reject

All the possessors can see that and all the possessors come to the same conclusion. So no one accepts

The company then declares bankruptcy and everyone recovers less than the reduction they collectively refused to accept. Each acted rationally on their own and the group produced the result that none of them wanted

This is a free-rider problem in a fairly pure form. The benefit of a reduction in debt that is of a company that survives is shared by everyone including those who contributed nothing. The cost falls only on the holders who accepted. Whenever the benefits are collective and the costs are individual the contribution is insufficient

The uncomfortable observation is that the unanimity requirement causes this. It was written to protect the individual bondholder against having his payment rights taken away by a majority vote which is a genuine protection. What it also does is eliminate any mechanism for the group to act in its own interest so that a provision designed to protect bondholders reliably produces the result that is worse for them

The Exchange Offer

a exchange offer It asks holders to exchange existing bonds for new securities usually with a lower principal amount longer maturity or lower coupon sometimes with better security or seniority as compensation

As it is an exchange and not a modification of the payment conditions it does not require unanimous consent. Each holder decides individually if they wish to participate

If it were left there most holders would refuse preferring to maintain their existing claim and let others take the reduction

The Coercion

Therefore issuers structure the offering so that not participating is worse than participating and there are several techniques

the exit consent is the classic device. Participating holders upon exit vote to amend the old indenture eliminating clauses releasing collateral or eliminating cross-default provisions. These amendments only require a majority because they do not affect payment conditions

Therefore a refusing holder retains the original principal and interest and holds a bond stripped of almost all protection subordinated to any new debt that has been created

The Trick Inside the Exit Consent

Exit consent deserves a closer look because the asymmetry that makes it effective is easy to overlook on a first reading

Bidding and voting are bundled together. By handing over your bonuses to the exchange you also get their consent to modify the previous contract so they both occur as a single act and not as separate decisions

Now ask who casts those votes. It's the holders who leave. By the time the amendments go into effect the people who voted for them no longer own the damaged bonds. They have exchanged the new securities and the stripped instrument is someone else's problem

So the vote is carried out by parties that are not exposed to its consequences. Normally a majority vote is disciplined by the fact that the majority has to live with the result. Here the majority has decided not to do it

That's what makes the technique work and it's also the most compelling argument against it. The protection a contract offers a minority against a majority assumes that the majority shares its position. An exit consent breaks that assumption exactly when it matters

Note also how modest each individual step is. Eliminating a covenant requires only a majority and does not affect principal interest or maturity so no payment rights have been formally altered. The protection of unanimity is intact on its own terms at all times. It has simply been bypassed

The Clock as a Weapon

The last row of the table is the quietest device and may be the most effective because it attacks something that the other techniques leave alone

An early bid bonus pays better terms to holders who commit before a deadline long before the offer closes. At first glance it is a reward for deciding promptly which sounds administrative

Consider what this does to the decision. Without it a holder can wait watch how the issue responds talk to other holders and choose late with better information. Waiting premium prices. Deliberating now costs money and the cost is certain while the benefit of waiting is speculative

Now read it against the defenses at the end of this article. Forming an ad hoc group agreeing terms among the incumbents hiring advisors and forming a blocking position takes weeks. The initial deadline is usually shorter than that

So the premium is not really the speed of buying. It is buying the absence of a coalition by ensuring that the decision is made before one can be built. The incumbents most affected are the small and dispersed ones the ones who need more time to find themselves and have less reason to think that someone is organizing on their behalf

The Legal Boundary

The technique has been the subject of numerous litigation and the Central American case concerned whether an exchange that achieves what an amendment could not legally achieve violates the legal protection of payment rights

Decisions in the Southern District of New York around 2014 held that the safe harbor reaches to the practical ability to receive payments and not simply the formal terms calling into question out-of-court restructurings that left non-participating holders with impaired recoveries. Subsequent appellate treatment considerably narrowed that interpretation restoring the more formal interpretation that the safe harbor refers to express payment terms

The practical position is that exit consents and dispossession covenants remain generally available and the line is drawn by contractual interpretation rather than by an anti-coercion doctrine as such

English law has developed differently with schemes of arrangement allowing for a court-sanctioned restructuring binding all holders with a supermajority completely eliminating the need for coercion. That difference is a major reason why jurisdiction-option issuers have used English schemes

Why the English Route Needs No Coercion

That contrast deserves attention because the two systems reach similar economic results through opposite routes and the comparison is not flattering with the one that more strictly protects its holders

A scheme of arrangement is a judicial process. The company proposes terms creditors are divided into classes with very similar interests and each class votes. If the required majorities are reached the company goes back to court and asks a judge to sanction the plan. Once sanctioned it binds all holders of that class including those who voted against and those who did not vote at all and can bind them directly in terms of payment

The consequences follow immediately. There is no reason to impose a penalty for refusing because refusing accomplishes nothing. An incumbent who votes against and is defeated is bound anyway. No one should be afraid to participate

The court also delivers a check that does not contain any exchange offer. A judge examines whether the classes were fairly composed whether creditors received the information necessary to vote sensibly and whether the result is one that a reasonable creditor could accept. A plan may be rejected

Put the two philosophies side by side. American contract law treats the individual's right to payment as almost inviolable which sounds like the strongest protection and pushes every real restructuring toward structures that achieve the same result indirectly without any court evaluating fairness. English law allows a majority to bind a minority in terms of payment which sounds weaker and delivers the result openly by vote under judicial supervision

Therefore the regime that most absolutely protects the individual holder is the one that produced the most coercive market practice which is a good example of a rule being ignored rather than obeyed when the underlying economics demand a different response

Why It Is Not Simply Abusive

The uncomfortable defense of these structures is that they solve a genuine collective action problem

If unanimity were truly necessary a company that could survive with less debt would declare bankruptcy destroying value through professional fees operational disruptions and flight of customers and suppliers. Each creditor would recover less

Coercive exchanges allow a restructuring to take place outside of court preserving the value that a filing would consume. Holders who lose relative to a hypothetical world where everyone cooperates are on the whole better off than if they were bankrupt

The objection is that the mechanism transfers value from the holding companies to the company and also from smaller less organized holders to larger ones who can negotiate directly and receive better terms in the same transaction

Who Actually Ends Up Paying

It is worth dwelling on that final objection because the classification it produces has nothing to do with the classification of the claims involved

Each holder of a single bond issue has an identical legal right. Same seniority same security same terms. Nothing in the documents distinguishes them

What sets them apart in practice is size and organization. A large holder is contacted before the offering is launched joins the deal and helps define the terms. He may agree to back the transaction and receive a fee for doing so or receive an allocation in the new instruments that is not generally available. When the offering is public that holder has already received payment for his cooperation

A small holder learns of the transaction when the offering document arrives and chooses from options that were settled before learning of it

So identical statements produce different economics and the variable is whether you were in the room. That's a real criticism and it's separate from the collective action defense which addresses whether the total recovery is greater and says nothing about how the total is divided

It also explains why the following defenses have more to do with organizing than arguing. The mechanism does not respond to a headline being right. It responds to a headline being coordinated

How Holders Defend Themselves

Defenses are collective rather than individual. Bondholder Form ad hoc groups and sign cooperation agreements committing not to accept an offer individually which restores the bargaining power that fragmentation destroys

The practical objective is a blocking position that is a problem sufficient to prevent the majority necessary for exit consent and the limitation is to build one quickly enough

At origination holders negotiate higher consent thresholds for amendments to covenants and provisions that restrict the issuer's ability to create senior debt which are the same drafted responses that followed liability management exercises in the lending markets

The Bottom Line

A coercive exchange offer restructures the bonds without the unanimous consent that the contract nominally requires making rejection worse than acceptance rather than asking someone to accept less. It exists because the alternative to solving the holdout problem is to declare bankruptcy which would leave everyone with less and it works by fragmenting a group of creditors who would have been better off acting together. The defense on both sides is the same: organize early or face an election designed to have an answer