Holdout Panic.

• Author: Lubben, Stephen J.

The corporate restructuring community is in the grip of an unbridled fear of holdouts--bondholders who, in the face of an issuer's attempted restructuring, withhold their consent and retain their right to seek full repayment. (1) Outside of bankruptcy, this fear presents itself in a narrow reading of the already limited protections for minority bondholders. (2) In bankruptcy, the conception of objectors as holdouts is reflected in judicial acceptance of restructuring support agreements, or RSAs, offering accepting creditors far better treatment than dissenters. (3) But in indulging our fears of holdouts, we have lost the essential balance of the system. (4) Corporate creditors, perhaps like Americans generally, like to think of themselves as rugged individuals, even while they work within a communal system. The fundamental tension is clearest at the point of default: Too much individuality, and a small minority of creditors can block a useful deal that would get the debtor-firm back on track. On the other hand, too much collective process, and the majority can bulldoze the minority, forcing them to take outsized losses when the majority cuts a side deal with the firm and its managers.

The restructuring system--comprised of chapter 11 of the Bankruptcy Code, parts of the securities laws, and related contractual and equitable principles (5)-exists to mediate this tension. Thus, Bankruptcy Code section 1123(a)(4) provides that "a plan shall provide ... the same treatment for each claim or interest of a particular class." (6) Nevertheless, modern chapter 11 cases routinely involve plans in which certain bondholders (those who sign the RSA (7)) get a better recovery than those who do not. (8) For example, several recent chapter 11 cases have seen RSAs that feature a select group of creditors "backstopping" the offer of equity securities in the reorganized debtor. The backstop is simply the promise, in exchange for a fee, to purchase any remaining equity if the offering is undersubscribed. Because securities in these chapter 11 rights offerings are typically presented at a substantial discount to the value attributed to the reorganized debtor in the plan, there would seem to be minimal risk that the backstop will ever be used. (9)

The greater the discount to plan value being offered to rights-offering investors, the lower the backstop fee should be. A traditional backstop fee is to pay for the degree of risk a "backstopper" is taking, and a backstop fee makes no sense if not linked to the degree of risk (i.e., the magnitude of the plan value discount). Nevertheless, we frequently see modern chapter 11 cases paying an "industry standard" fee while offering substantial equity discounts relative to the debtor's purported value. The backstop fee in modern cases thus can be better understood as a way of distributing plan value under another guise. (10) When combined with aggressive milestones and other time limited payments frequently seen in an RSA, (11) which further limit the opportunities for outsiders to participate in full, the discounts and backstop fees can provide substantial recoveries to those in the "in crowd," while other creditors of equal rank are only provided with the basic treatment set forth in the plan. (12)

RSAs can also work with other pre-bankruptcy restructuring moves to give select groups of creditors special treatment, despite the Bankruptcy Code's stated preference for creditor equality. For example, in May 2020, Guitar Center contracted with a sub-group of its secured noteholders to have those noteholders make an interest payment on the notes. (13) That is, some of the secured noteholders paid the interest payment due to all the secured noteholders. In exchange, these distinctive noteholders received new "super-priority secured notes" secured by a lien that surpassed the old secured notes' liens, while also carrying a hefty 10% coupon. (14) When Guitar Center filed for chapter 11 later that same year, to implement its own RSA-driven plan, the new super-priority notes were paid in full, with interest and "make whole call" fees. (15) In short, the lenders made a small, six-month loan for a very high return.

Another way in which lenders under the "super-priority secured notes" received additional value was through the grant of exclusive rights to provide a term DIP loan to Guitar Center. (16) Under the RSA, that DIP loan was to be paid in full upon plan confirmation. The opportunity to provide new money is itself a valuable right, which in this case was conferred on a subset of the noteholder class, without any apparent market test. In short, by the time the debtor entered bankruptcy, the Code's equal treatment norm already had been violated. The common reply that the "extra" return to favored creditors comes not from their existing claim but from the provision of new money rings hollow when the chance to provide that new money was limited to the select class in the first instance. Similar trends are observable throughout the broader restructuring system. For example, the Trust Indenture Act--and particularly section 316(b) thereof--was designed to stop bondholders from teaming up with debtors to sell out their fellow bondholders. (17) Nevertheless, courts have recently approved exchange offers that squeeze out retail bondholders, (18) and section 316(b) itself has been read to be a paper-thin protection against appropriation. (19)

Part 1 of this essay develops the concept of corporate creditors as "collective individuals." That is, these creditors retain the rights to act as individual lenders to the debtor, while operating under collective structures like bond indentures or syndicated loan agreements.

Part 2 examines how the restructuring system--both pre- and post-bankruptcy-works to maintain balance between creditors' individual and collective rights. Some of the balance comes from the agreements that create the creditor relationship or duties related to those agreements; however, other aspects of balance are external and come from outside structures like the Bankruptcy Code or the Trust Indenture Act. In general, the basic challenge is to find the point at which the illegitimate power of holdouts is reduced without trampling on the legitimate rights of minority creditors. It is very easy to avoid holdouts if the majority always wins.

Part 3 explores the ways in which modern restructuring practice has moved toward that "majority always wins" extreme. This change was not part of some grand plan, but rather the result of a series of incremental decisions, each reacting to perceived abuses by holdouts. The end result has been to move the American restructuring system to the point where a debtor and a majority of its lenders can inflict serious harm on minority creditors. At some point, this reality is bound to have consequences. (20)

I conclude by arguing that the idea of debtors attempting coercive restructuring plans in order to advance the interests of certain favored creditors or allies--DIP lenders, asset purchasers, RSA signatories, or equity-holders --is not new, and standing on its own is not a problem. However, the reorganization system is designed to put a meaningful check on debtor (and creditor) overreach, and in recent years that check has been eroded. That is, majority groups are now able to operate without meaningful restrictions on abuse of their powers--and thus modern restructuring faces a tyranny of the majority problem. (21)

1. CREDITORS AS COLLECTIVE INDIVIDUALS

   Corporate creditors--at least voluntary corporate creditors--typically take one of two forms: bondholders or syndicated loan lenders. (22) Within each broad category, subdivisions are possible and common. For example, senior bonds and subordinated bonds frequently coexist within the capital structure, but the basic form remains the same.

   1. BONDS

      At a basic level, a bond involves the loan of a sum of money--typically $1,000--to a corporation by an investor. The debtor-firm promises to pay interest on that $1,000 every six months--"coupons" (23)--and return the principal at maturity. Thus, when a firm issues $100 million in bonds, in theory it could be borrowing from 100,000 distinct lenders (although it rarely happens that the bondholder group is quite that fractured). Bonds are often said to have a "bullet" repayment structure, since all the principal comes due at the specified maturity date. (24) Bonds are typically issued under an indenture. That is, while the promise to pay is a relatively simple document, it incorporates tremendous substance from the terms set forth in the indenture, which often exceeds one hundred pages of dense text. (25) The indenture also appoints an indenture trustee.

      The Trust Indenture Act of 1939 (the "TIA") (26) governs bond offerings in public securities markets in the United States, and provides that an indenture for debt securities must be "qualified" under section 305 of the TIA or must meet the requirements for an exemption from qualification under section 304 of the Act. (27) Sections 310 through 317 of the TIA are automatically deemed part of any qualified indenture, and under 310(a)(1), every qualified indenture must utilize a qualified indenture trustee, who may not be the debtor or an affiliate.

      Before 1939, indentures commonly included an exculpatory clause to immunize the trustee from liability for any negligent action (or failure to act) on behalf of the bondholders. Although the New Dealers talked a good game about making indenture trustees "true" fiduciaries for bondholders, the actual terms of the Trust Indenture Act of 1939 fell somewhat short of that lofty standard. (28) And after the TIA was substantially revised in 1990, it is plain that indenture trustees are not quite like the other trustees one studies in law school. (29) As a result, the trustee's duties are mainly ministerial; (30) Notwithstanding, when a default occurs, such as when the issuer...