Three Faces of Creditor-on-Creditor Aggression.

• Author: Baird, Douglas G.

Creditor-on-creditor aggression has become the central pathology of modern Chapter 11 reorganizations. Distressed debt investors operate under few external constraints and are most unlikely to be either Good Samaritans or Boy Scouts. Instead of confining themselves to vindicating their rights against their debtor, distressed debt investors position themselves to extract hundreds of millions of dollars from their fellow creditors. (1) Beyond the constraints of the loan contract itself, the law does little to prevent these investors from doing this. Once they find a lacuna in the language of the loan documents or the Bankruptcy Code, those bent on capturing value from their fellow creditors can insulate themselves from liability as long as they muster some evidence that they are acting in good faith.

It is possible to confront this problem by imposing more stringent good faith duties on creditors. (2) Creditor advantage-taking, however, manifests itself in modern corporate restructurings in various ways. Different strategic forces are at work, and each presents its own challenges. (3) Moreover, one can contest the amount of legal reform that is necessary. Even though the sums involved are large and the conduct is unsavory, the social costs may be small, and intervention may make things worse. In this paper, I stop short of any general solution and offer instead some landmarks to help navigate legal reform.

Part I of the paper establishes the relevant background. Much of the legal backdrop was put in place by New Deal reforms. These focused on protecting the rights of public bondholders, and as has long been recognized, they provide an awkward starting place. Many of these legal reforms were misguided and addressed an altogether different problem. (4) They focused on the use of divide-and-conquer strategies against diverse creditors who were unable to organize themselves. The inability of creditors to organize themselves is not at the center of the current storm. Indeed, the problem is the opposite. Creditors, far from being unable to organize themselves, form factions, and each faction presses for advantage at the expense of others. The creditors' ability to organize rather than their inability to organize creates the central difficulty.

In Part II, the paper focuses on the aggression that takes place between creditors outside of bankruptcy. It is tempting to think one creditor's appropriation of wealth from another is itself the principal problem. This is a mistake, however. The risk of being subject to such a transfer is one that sophisticated professionals can anticipate and fully price ex ante. The costs of such behavior are to be found elsewhere. Most obviously, the prospect of capturing such large sums itself invites rent-seeking. The risk of others engaging in rent-seeking in turn inspires others to take measures to guard against it. Each hedge fund has an incentive to spend to ensure it comes out ahead or at least does not come out behind.

Reducing such costs is desirable, but doing so may come at a cost. The transactions themselves may value-enhancing as well as value-reducing. To be sure, if the wealth transfer takes place in a transaction in which the debtor is merely playing for time and putting off a day of reckoning, allowing the parties to profit from such transactions encourages social waste. Limiting creditor-on-creditor aggression increases the value of the firm at the same time it eliminates rent-seeking. On the other hand, however, creditor-on-creditor aggression may be associated with transactions that preserve the value of the firm. Activist creditors may capture wealth from passive creditors at the same time they establish new sources of finance that enable the debtor to avoid a costly liquidation.

Academics are poorly positioned to distinguish between transactions that are socially wasteful and those that bring net benefits. By contrast, parties draft their contracts in the shadow of these problems and empirical uncertainties. It is a world in which contracts are dynamically updated as conditions change. Parties can anticipate the battles that take place when the debtor becomes distressed. Moreover, those that lack either the skill or the appetite for such contests can sell their positions to those that do.

Legal interventions are needed most to protect the structural integrity of the contractual mechanisms the parties put in place. Rather than provide creditors with substantive legal protections, the law should ensure that they can enforce their contracts. If, for example, they bargain for the right to vote before any of their rights against the debtor are altered, the law should ensure that every vote is counted and that no one is stuffing the ballot box. (5)

Part III shows that an altogether different problem presents itself in bankruptcy. When a bankruptcy petition is filed, all the rights of creditors are collapsed into a "claim." (6) The specific attributes of the debt under the contract disappear, including rights creditors secure to protect themselves against other creditors. Creditors must rely on the legal protections built into the Bankruptcy Code. These protections consist of straightforward and sensible rules, but clear rules by their nature introduce an opportunity for gamesmanship. This requires an altogether different approach to creditor-on-creditor aggression.

But bankruptcy and nonbankruptcy worlds cannot be neatly separated from one another. In the run-up to bankruptcy, creditors and the debtor are well advised to meet and anticipate the direction the reorganization is likely to take. Free-fall bankruptcies, bankruptcies that arise unexpectedly and for which no one has done advance planning, usually end badly. But when major players plan together before the Chapter 11 begins, they can reshape the bankruptcy process in a way that circumvents the bankruptcy rules that protect nonparticipating creditors. Those left out of the winning coalition awake in bankruptcy to find their contractual rights are gone and the protections of the Bankruptcy Code defused. The greatest challenge that creditor-on-creditor aggression presents lives in this netherworld.

1. COERCIVE EXCHANGE OFFERS AND STRATEGIC BEHAVIOR

   Firms that encounter hard times often cannot keep their promises. In the simplest case, a debtor is unable to make an interest payment. More often, debtors break some other promise first. Debtors operate under many covenants, and even mild headwinds can leave them in breach of one or more of them. Modern loan agreements are long and complicated. They can run dozens of pages, and each contains many promises. When even just one is broken, the creditor can declare a default and demand immediate payment in full. The creditor uses such a breach to renegotiate its deal. The debtor is excused from keeping the promise and in return the creditor acquires better terms or additional control over the direction of the business or both.

   Debt, however, can be dispersed. (7) Bonds are publicly traded, and private loans are syndicated. One-on-one negotiations are sometimes not possible. The simplest alternative to relying on negotiations in the face of changed circumstances is the exchange offer. The debtor retains financial consultants and investment bankers. These professionals survey the landscape, persuade the debtor to alter its course, and recommend a new debt structure that leaves everyone better off. Creditors are then asked to trade their existing bonds for new ones. The new bonds have different covenants. These give the debtor breathing room. The debtor is better managed and has a simpler capital structure that is more consistent with the condition in which it finds itself. Each of the new bonds is worth more, as each individual creditor enjoys a stream of payments and a set of promises that takes account of the realities the debtor faces. It is in the individual interest of each creditor to accept the new bond.

   Such restructurings have been around for a long time. The entirely voluntary restructuring of the Atchison, Topeka, and Santa Fe Railway in 1890 is a good example. (8) The old managers of the railway had expanded too much, and the expansion had led a chaotic structure of many different types of bonds secured by discrete assets held in multiple subsidiaries. The railway's earnings could not both pay the bonds and keep the railroad running on a sound basis. The investment bankers brought about a management change and persuaded the diverse bondholders to exchange forty-two different bonds for two bonds backed by all the assets of the railroad. (9) This more sensible capital structure reduced the railroad's debt burden and at the same time promised each bondholder better security and more predictable cashflows over the long term. (10)

   When a debtor is sufficiently distressed, however, the investment bankers often cannot put together a package attractive enough to induce each individual investor to part with its bond. There is the familiar collective action problem. Each creditor makes the group as a whole better off when it waives its rights, but each creditor bears the entire cost of making such a waiver. The creditors as a group might benefit if all agreed to the new structure, but it does not make sense for any individual creditor to give up its rights.

   A hypothetical captures the dynamics. Firm is run by managers who are honest agents. They hold no ownership stake. They aspire to maximize the value of the business. (11) If the debtor remains on its current course, the firm will be worth $120 or $40 with equal probability in a year's time. There are a hundred equityholders, each of whom holds one share of stock. A group of one hundred dispersed creditors is owed $1 each. The loan is due in five-years' time. No interest payments are due before then, and the loan is not in default.

   With debts of $100 and assets with an expected value of only $80, the debtor is...