THE NEW BOND WORKOUTS.

• Author: Bratton, William W.
• Position: Symposium on the Fortieth Anniversary of the 1978 Bankruptcy Code

INTRODUCTION 1600 I. THE PROBLEM OF DISTORTED CHOICE IN BOND WORKOUTS 1604 A. Distortion From Other Bondholders 1606 1. Voting Distortions: Self-interest, Holding Out, and Misjudgment 1606 2. Free Riding 1607 B. Distortion from Issuers 1608 1. Sticks: Exit Consents 1609 2. Sticks: Differential Consideration 1610 3. Carrots: Terms of the New Bonds 1610 4. Carrots: Consent Fees and Vote-Buying 1610 C. Implications and Correctives 1611 II. REGULATORY CONSTRAINTS 1611 A. Stockholders 1612 B. Bondholders--Federal Law 1614 1. Amendment: TIA Section 316 1615 2. Exchange Offers 1619 C. Bondholders--Contract Law 1620 D. Commentary 1621 III. THE NEW RESTRUCTURING 1625 A. The Dysfunctional Workout 1627 1. Holdouts 1628 2. Business Frictions 1629 B. Workouts Versus Bankruptcy: Comparative Costs 1630 C. The Shift to Workouts 1634 1. Volume 1634 2. The Empty Creditor Problem 1635 D. The New Practice 1636 1. New Data: Distressed Exchange Offers, 2010-2016 1637 2. Institutional and Household Bondholders 1640 E. Explaining the Changes 1641 1. Registration Exemption 1641 2. Creditor Control in Chapter 11 1642 F. Summary 1645 IV. RETAIN OR REPEAL? 1646 A. The Rise and Fall of the Broad Reading of Section 316(b) 1649 B. The Case for Outright Repeal of Section 316(b) 1655 1. Federal Mandate 1655 2. Contracting Practice 1656 a. Drafting Out from Under Marblegate 1657 b. Unanimous Action Expanded & Exit Consents Permitted 1659 3. Conclusion 1663 C. CACs--the Worst Case 1663 1. The Drafting Task in the Wake of Repeal 1663 2. The Worst Case 1664 D. Backstop Policing: An Intercreditor Duty of Good Faith 1665 1. Intercreditor Good Faith Cases 1665 2. The Disappearance of Intercreditor Good Faith Cases in the United States 1668 3. Scope 1671 4. Conclusion 1673 V CONCLUSION 1673 INTRODUCTION

Bond workouts are famously dysfunctional. When a company is in financial distress, its stockholders and bondholders have every reason to negotiate a restructuring (or "workout") of its obligations to produce a sustainable capital structure and avoid the costs of a bankruptcy. The reality is different. Bondholders hold out and free ride in response to restructuring offers from distressed debtors. Debtors respond with coercive inducements and procedural maneuvers. The result is a destabilizing and potentially toxic mix of creditor opportunism and debtor coercion that can derail the workout process, forcing a bankruptcy restructuring.

Bond workouts occupy a space governed by neither corporate law nor bankruptcy law, regimes designed to bring unruly investors together to settle matters by majority vote. In contrast, the law actually stands in the way of majoritarian decisionmaking with bond workouts. The primary governing law is the Trust Indenture Act of 1939 (TIA), a hoary New Deal securities law that mandates terms in the contracts governing publicly issued bonds. (1) Section 316(b) of the TIA prohibits majority-vote amendments of the payment terms of bonds, foreclosing workout by direct contractual amendment. (2)

But the TIA leaves open a second route to restructuring--the exchange offer, in which the debtor offers to exchange new, scaled-down bonds for the original bonds. (3) Exchange offers are intrinsically susceptible to disruption by holdout bondholders and coercive tactics by issuers. Few of the process protections accorded by corporate and securities law to stockholders receiving tender and exchange offers apply to bond exchanges. (4) There is no judicial oversight of the restructuring process, as would be the case in bankruptcy. Nor does contract law provide in the way of protection against distorted bargaining in a financial context like this one.

The TIA itself bears much of the responsibility for the empty doctrinal toolbox. The TIA was a New Deal reaction to the excesses of a Depression-era out-of-court restructuring market in which insider equity holders and their favored creditors siphoned value away from bondholders. (5) The statute's drafters wanted restructurings to proceed in bankruptcy under judicial and administrative oversight so as to prevent process abuses. (6) They largely succeeded. The TIA's very success in shifting restructuring practice into bankruptcy resulted in the atrophy of the federal equity doctrine that policed earlier restructurings. (7)

In recent years, however, the picture has changed quietly but markedly. Workouts have started to work. A substantial portion--around one-fifth of restructuring activity--has shifted from bankruptcy court to out-of-court workouts effected through exchange offers made only to large institutional investors. (8) The shift resulted from a temporary external shock--the brief disappearance in 2008-2009 of debtor-in-possession financing for bankrupt companies. (9) But the altered pattern persists.

Coercive tactics figure more prominently than ever in the new workouts. Ugly facts and court challenges result. Thus confronted, but possessing no obvious doctrinal tool, courts in the Southern District of New York--the near exclusive forum for bond litigation--responded by adopting a new reading of TIA section 316(b) that would give courts broad power to police workouts. (10) The Second Circuit Court of Appeals subsequently reversed the leading Southern District case, likely returning the law of bond workouts to its earlier posture. (11) Even so, the episode was the biggest jolt to the normally staid world of bond contracting since the leveraged takeovers and buyouts of the 1980s. While we are sympathetic to the policing impulse behind the broad reading of section 316(b), we think the broad reading went much too far. In a context where fact-sensitive policing is needed, the broad reading imposed bright-line mandates that overrode terms in bond contracts and threatened to choke off the new workouts altogether.

This Article exploits the bond market's reaction to these decisions to reassess a longstanding debate in corporate finance regarding the desirability of TIA section 316(b). Section 316(b) has attracted intense criticism in the past, with calls for its amendment or repeal because of its untoward effects on the workout process and tendency to push restructuring into costly bankruptcy. (12) Section 316(b) also has been staunchly defended on the ground that mom-and-pop bondholders need protection from strong-arm tactics. (13)

We draw on a pair of original, hand-collected data sets to show that many of the empirical assumptions made in the debate over section 316(b) no longer hold true. First, we show that workouts are more tractable than thought heretofore. But for the recent judicial intervention in the Southern District, the markets have learned to live with section 316(b), denuding the case for repeal of any urgency. (14) Workouts generally succeed, so there is no serious transaction cost problem stemming from the TIA; when a company goes straight into bankruptcy, there tend to be independent motivations. (15) Second, we show that workout by majority amendment will not systematically disadvantage bondholders. Indeed, the recent turn to secured creditor control of bankruptcy proceedings makes workouts all the more attractive to unsecured bondholders. Third, we show that bond workouts are more coercive than previously thought in some respects, but also less coercive in others.

Based on this empirical background we cautiously argue for the repeal of section 316(b). (16) Section 316(b) no longer does much work, even as it prevents bondholders and bond issuers from realizing their preferences regarding modes of restructuring and voting rules. We do not know what contracting equilibrium would obtain in the wake of repeal, but think that the matter is best left to the market. It follows that repeal should be complete and prospective. We recognize, however, that markets are imperfect and that a free-contracting regime may result in abuses. Accordingly, we argue that a repeal of section 316(b) should be accompanied by the resuscitation of a long forgotten, but still valid, equity doctrine of intercreditor good faith duties, which presents a more fact-sensitive and targeted tool for policing overreaching in bond workouts than the Southern District's broad reading of section 316(b). (17)

This Article makes several contributions to the scholarly literature on corporate restructuring. First, the Article is the only comprehensive treatment of bond workouts. Section 316(b) is a central topic in the law of corporate finance, yet there has been no thorough inquiry into the practice pattern. We go beyond anecdotal evidence to develop a working empirical picture while simultaneously explaining the development of the applicable law against the background of a theoretical discussion of group decisionmaking by investors.

Second, the Article shows that there has been a marked change in the world of debt restructuring, and that a cognizable part of restructuring activity has moved outside of bankruptcy. We explain why the shift is occurring, looking to securities law compliance practice and incentive realignment in the wake of secured creditor control of Chapter 11 proceedings. We draw on an original data set to provide a first glimpse of the new workouts. The descriptive data show that contemporary workouts are flexibly structured and tend to succeed where those attempted before 2008 tended to fail. Specifically, we show that the holdout problem assumed by the previous literature has diminished in salience and that the position of small bondholders, to the extent they still exist, also looks different because they are simply ignored in contemporary exchange offers, which are made only to large institutional investors.

Our third contribution to the literature stems from a second original data set that collects the process terms of contracts governing bonds issued under the Rule 144A exemption and thus not subject to the TIA. The data offer a glimpse at the preferences of bond issuers and...