The Importance of Being Bound: Bondholders' Vote and Workouts in the U.S. and in Italy.

• Author: Prenestini, Francesca

INTRODUCTION

Two recent American law cases, Marblegate and Caesars, (1) have refired the smoldering debate about the propriety of nonjudicial or nonbankruptcy law restructuring of bond issues. (2) In 2015, the U.S. District Court for the Southern District of New York reaffirmed that coercive exit consent transactions that force bondholders into questionable restructurings are prohibited by [section] 316(b) of the Trust Indenture Act of 1939 ("TIA"). After Marblegate and Caesars followed a series of proposals attempting to reform those parts of the Act that effectively prevented nearly every out-of-court workout. Then, in January of 2017, the U.S. Court of Appeals for the Second Circuit adopted a narrow interpretation, holding that [section] 316(b) only prohibits formal non-com sensual modifications of an indenture's core payment terms. (3)

The district courts' interpretation, though broad, more coherently aligns with the text, the legislative history, and the purpose of the TIA. Section 316(b) provides that the individual right of each bondholder to receive payment of the principal of and interest on her indenture security on the due dates cannot (with a few minor exceptions) be impaired without the bondholder's consent. This section was enacted to protect bondholders from insiders' abuses by giving individual bondholders each the power to veto proposed modifications to their bonds' terms and conditions in an out-of-court restructuring. This "protection" often precludes even fair renegotiation agreements between the issuer and the bondholders because a majority vote is not enough to give their approval. Modification of bond provisions by majority vote is also prohibited or discouraged in other countries, though, in recent years, some foreign jurisdictions adopted a more permissive approach.

The article analyzes the desirability of adopting a regulatory approach that permits bond modifications to be approved by a majority of the bondholders and that bind those holders who dissent. (4) Midterm modifications of debt are often required to avoid insolvency and turn around a corporation's affairs. Because it is often impossible or impractical to obtain unanimous consent--the individual consent of each and every bondholder, embracing a majority rule structure furthers the possibility of reaching an agreement. This paper asks whether the different regulatory approaches to consent strike a reasonable balance between the issuer's needs and interests and the investors' protection and how the applicable regime should be shaped. We compare various international legal systems and conclude that: (i) governments should adopt rules that allow a majority bondholders' vote to accept out-of-bankruptcy restructurings of bond issues; (ri) if the TIA cannot be changed in the United States, the Securities and Exchange Commission's power to grant exemptions could authorize transactions and agreements otherwise banned; and (in) in Italy (and other civil law jurisdictions), the contract or indenture binding the issuer and the bondholders may provide for modification of core terms of the loan by a majority vote at a bondholders' meeting.

Part I considers why allowing a binding vote of the bondholders in work outs is so important along with the rationales for prohibiting or allowing this opportunity. Part II focuses on the U.S. legal system, discusses the statutory provision that bans majority rule, how the jurisprudence and the business practices have evolved, and recent proposals for reform. Part III considers the Italian system, its rules and business practices, and how to overcome its limits. Part IV suggests an alternate rule and interim solutions to the problem while awaiting statutory reform.

1. AMENDING CORE TERMS OF THE BOND: THE INDIVIDUAL VETO POWER V. THE MAJORITY VOTE

   In "The Importance of Being Earnest", Oscar Wilde describes the irrevocable desire of a young lady to be engaged to a man named Ernest, because of the assonance between the male name ("Ernest") and the quality of being serious ("earnest"), as if a name could grant his own virtues. Bonds "bind" their issuer and their purchasers or holders, but does that "binding" require each bondholder to be granted veto power over the bonds' modification? Just as Ernest may not actually be earnest, a bondholder's individual veto power does not guarantee that her best interests are actually protected. Indeed just the opposite may be the case.

   During the twentieth century, the law protected the interests of bondholders by guaranteeing that fundamental characteristics of the debt they held could not be impaired without each holder's individual consent (the "Individual Veto" or "Unanimity" rule). This Part questions whether this model remains relevant light of the evolution of capital markets and sea changes in the sophistication, expertise, and broad dispersal of bondholders. These changes warrant considering protecting holders' rights by allowing them the ability to accept bond modifications by majority vote (the "Majority Vote" rule), provided that vote is free, informed, and unaffected by conflicts of interest.

   1. The Need for Renegotiation in Bond Issues

      The duration of the issuer-holder contractual relationship requires establishing mechanisms, agreed at the time of the issue, that facilitate renegotiating the terms of the debt so that the issuer and the holders can address the issuer's changing financial position or other conditions. Often, amending the original agreement may be desirable in order to prevent default. Default and insolvency costs may sometimes be unavoidable when there are no prospects of recovery for the company. (5) Even so, before bankruptcy, the bondholders can play a key role in helping the company to recover and defend their invest' ment by renegotiating the terms of the debt. (6) When the company is dealing with financial difficulties, only a renegotiation of the terms of the debt can prevent the risk of bankruptcy. (7) Not only defaulting companies need restructuring. (8) Companies in good standing may find renegotiation advisable to ac' commodate further capital expansion needed to expand into new markets, for example. It may be well worth an issuer's offer of a future interest rate in' crease in exchange for the holders agreeing to reschedule the due date for payment or relieve guarantors of the debt. (9)

      In either case, the renegotiation of the originally agreed terms implies an increased need for protection of the bondholders. An issuer might, for example, propose to convert the debt into equity to liberate itself from an excessively costly obligation and propose unfair or unsupported treatment to the bondholders as part of that effort. (10) Bondholders desperate to preserve some chance of recovery might fall prey to these proposals. This is the major reason why policymakers in many different countries address this concern with specific and prohibitive rules.

   2. Comparing the Individual Veto and Majority Vote Models

      Most jurisdictions follow one of two rules for regulating the ability of an issuer to avoid insolvency or accommodate changing capital needs by renegotiating the debt. One requires the creditors' unanimous consent ("unanimity rule") while the other permits certain modifications to be approved upon a majority vote of the bondholders ("majority rule"). (11)

      1. Unanimity and the "Holdout Problem"

         In several countries, and notably, the United States, unanimous bondholder consent to a modification of payment terms is required. Thus, all of the bondholders must support the proposed renegotiation, otherwise the restructuring will not be approved. Because obtaining unanimity is so difficult, even the mere consideration of a proposed restructure may be rendered impractical.

         This approach creates a menu of disadvantages. A single bondholder, who may even be a competitor of the company, can frustrate the efforts to reach an agreement. An issuer may have great difficulty and expense incurred in giving notice to all bondholders and collecting evidence of their consent. The company may lack the necessary financial resources and may not even know who some of the bondholders are or where they can be reached. These circumstances effectively preclude bondholders and the company reaching an advantageous agreement. (12) Faced with holdouts, an issuer might propose to renegotiate, but agree that only the consenting bondholders would be affected by the restructure terms while dissenters would be granted the full repayment of their investment. (13)

         While that approach might give bondholders the broadest freedom of choice, whether it actually works is another matter. With little or no incentive to opt for the lessTavorable treatment, what rational holder would opt for a future possibility (and not certainty) of being repaid instead of the sure and immediate reimbursement? (14) Moreover, should enough bondholders refuse the offer, the restructuring plan would fail. (15)

      2. Majority Vote

         In the second model, the agreed-to restructuring terms are submitted to the bondholders for a vote. The decision of the majority binds the minority. In a system free from distortions like conflicts of interest, (16) this approach should be beneficial. (17) Bondholders would be stripped of their incentive to hold out. (18) Instead, they could freely evaluate if the proposed plan really is a better option, compared with the perspective of a bankruptcy.

         Likewise, a solvent issuer could seek a change of terms to gain a capital or other competitive advantage. For instance, the issuer might desire to make an investment that will cash flow in five years. It may ask the bondholders to renounce their coupon interest due for the next three years, offering in return an increased interest return when the investment becomes profitable. Though each bondholder has an incentive to refuse in order to receive their current interest without betting on the successful outcome of the...