Alliance Politics in Corporate Debt Restructurings

• Publication year: 2023
• Citation: Vol. 39 No. 2

Alliance Politics in Corporate Debt Restructurings

Diane Lourdes Dick

ALLIANCE POLITICS IN CORPORATE DEBT RESTRUCTURINGS Diane Lourdes Dick^* Abstract

Alliance politics have always been a complicating factor in corporate restructurings. Negotiations between and among large groups of corporate stakeholders naturally require that parties expend time and resources on building coalitions, overcoming holdouts, and fleshing out their collective action. But recent trends suggest that alliance politics—rather than sound financial and economic decisions—may be driving restructuring outcomes, introducing new risks and inefficiencies in the financial markets. For instance, restructuring proponents increasingly use wedge strategies and divide-and-conquer tactics to exacerbate the coordination problems that lenders in large syndicates already face, giving rise to hostile restructurings that have the potential to introduce dangerous ripple effects in the capital markets. These strategies succeed because they introduce new opportunities for lender defection from the syndicate, essentially recasting the high-stakes coordination game played by lenders and driving up strategic uncertainty. By design, these transactions siphon value away from senior creditors, ultimately causing capital market participants to behave in inefficient ways. They may also enable economically wasteful restructurings by overpowering senior lender groups that would have collectively (and rightfully) pushed a company to liquidate. These developments call for a renewed focus on the role of alliance politics in corporate debt restructuring. This Article contributes to these efforts, laying the conceptual groundwork for subsequent works that explore other dimensions of the complicated, high-stakes relationships that make up the modern firm's capital structure.

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Table of Contents

Introduction..........................................................................................287

I. Background: A Review of the Literature on Divide-and-Conquer and Wedge Strategies...........................292

A. Political Theory Foundations of Alliance Politics and Wedge Strategies.............................................................. 292
B. Negotiation, Management, and Organizational Strategy Literature on Divide-and-Conquer Tactics in the Transactional Setting.............................................................. 297
C. Economic and Game Theoretic Analyses of Wedge Strategies and Divide-and-Conquer Tactics ............................ 300
D. Emerging Behavioral and Cognitive Psychology Insights........ 305

II. Analysis: A Theory of Alliance Politics in Corporate Restructurings.......................................................307

A. Social Coordination Among Senior Lenders............................ 308
B. Opportunities for Defection by Senior Lenders........................ 312
C. Lender Vulnerability to Wedge Attacks ................................... 314
D. Debtor Wedge Strategies ........................................................ 317
E. Debtor Divide-and-Conquer Tactics ....................................... 319

III. Discussion: The Normative and Practical Considerations of Alliance Politics in Corporate Debt Restructurings..............................................320

Conclusion.............................................................................................327

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Introduction

Commercial law scholars have recently shed light on the rise of highly aggressive bankruptcy and out-of-court private loan restructurings.¹ These transactions—which have been referred to in the literature as "hostile restructurings"² or as debtor companies playing "bankruptcy hardball"³ —are distinguishable from normal debt restructurings by their use of aggressive tactics to overcome not only the traditional minority lender holdout problem,⁴ but also exploit or exacerbate latent collective-action dynamics in the senior lender group.⁵

Traditionally, senior lenders wield enormous control over bankruptcy and out-of-court restructurings.⁶ They usually hold liens on all or substantially all of the debtor's assets and enjoy payment priority over virtually all other claimants.⁷ Meanwhile, modern debt instruments often contain covenants that give lenders control over the debtor's business and financial decisions.⁸

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Even in bankruptcy, where debtors can obtain court approval to cram down a plan on their creditors,⁹ senior secured creditors still have tremendous power. They typically have liens that extend to all of the debtor's cash proceeds; this means that for the company to advance through bankruptcy and propose a plan, it must work closely with senior lenders from the very beginning of the case and either gain their consent to use cash collateral or obtain new debtor-in-possession financing.¹⁰ Early agreements of this sort tend to lock up the entire restructuring by imposing stringent substantive and procedural limitations on subsequent decisions and negotiations.¹¹ These bankruptcy dynamics, in turn, have profound influence on out-of-court restructurings, which proceed against the backdrop of the threat of bankruptcy.¹²

in light of these practical realities, the conventional wisdom holds that senior lenders possess all of the power in bankruptcy and out-of-court restructurings.¹³ But in the modern commercial lending market, large senior debt facilities are extended by syndicates of lenders that must coordinate their responses to the debtor's financial distress.¹⁴ Hostile restructurings rely on certain strategies and tactics to exploit the potential for coordination problems within the syndicate. These dynamics allow debtors to achieve restructurings that advance the interests of some stakeholders, but that may not be in the interest of the senior creditors, collectively, or the firm as a whole. Envision Healthcare, for example,

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recently completed a hostile restructuring described by several commentators as "one of the most ambitious and complex financial maneuvers in corporate finance history."¹⁵ Relying on questionable interpretations of loosely drafted provisions in its senior secured loan agreements, the company boldly transferred the most valuable collateral to a subsidiary beyond the reach of its existing lenders.¹⁶ Then, it used threats of further subordination and impairment, on the one hand, and targeted offers to participate in a new superpriority debt facility,¹⁷ on the other, to push a majority of lenders to consent to the transaction on behalf of the entire group.¹⁸ Examples of similar conduct can be found across the capital markets. For instance, when mattress seller Serta restructured its senior debts in 2020, it negotiated with multiple lenders in tandem and in secret, requiring them to promise not to divulge information about the restructuring negotiations to their co-lenders.¹⁹

It is not always clear in these situations that the debtor is the one instigating the hostile restructuring. The debtor may simply be trying to restructure, and certain creditors use the occasion to extract value from their co-lenders. There are clearly incentives for lenders to anticipate potential fractures in the lender group and take steps to align themselves correctly: lenders that participate in a hostile restructuring receive some economic benefits in the form of new credit enhancements and new investment opportunities, while nonparticipating lenders pay the price by losing payment priority and lien rights.²⁰ But no matter who

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instigates a hostile restructuring, the lender group, as a whole, receives less than it would have received had it engaged in restructuring negotiations as a unified bloc.²¹ In this way, the restructuring drives a wedge through the senior lenders, effectively dividing and conquering the entire group.

These developments have major implications for commercial law and for the capital markets. As I explored in a prior work, they challenge the prevailing view that out-of-court restructurings are largely consensual.²² They also call into question the theoretical foundation of some of the most important creditor safeguards reflected in modern debt instruments and codified in bankruptcy law.²³ These and other protective mechanisms are considered necessary to prevent value-eroding hold-up behavior by minority lenders.²⁴ But hostile restructurings exploit these very same protective mechanisms in order to cram down a plan that the lender group, as a whole, would likely oppose.²⁵ More broadly, these transactions suggest that alliance politics—rather than sound financial and economic decisions—may be driving restructuring outcomes that have the potential to undermine investor confidence and threaten capital formation. Reflecting on these shifting sands in the market for corporate restructurings, Professor Douglas Baird recently highlighted the renewed importance of studying coalition-building tactics in chapter 11 bankruptcy and out-of-court restructurings.²⁶

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To be sure, Professor Daniel Bussel,²⁷ Judge Michelle Harner,²⁸ Professor stephen Lubben,²⁹ and other bankruptcy scholars have laid important groundwork. This Article builds on these prior studies and contributes to the conceptual refinement of a broader theory of alliance politics in corporate restructuring. Specifically, I explore the social science and game theoretic literature on wedge strategies and divide-and-conquer tactics. I then use these insights to describe and analyze techniques to prevent, break up, and weaken coalitions of senior lenders in order to achieve hostile restructurings.

The Article proceeds as follows. Part I engages with a rich body of literature on wedge strategies and divide-and-conquer tactics. Part II uses these multidisciplinary insights to develop a theory of wedge strategies and divide-and-conquer tactics that is specifically tailored to the unique world of corporate debt...