A pair of recent commentaries on high-profile battles between management and large financial creditors reveals two things: Such battles might be heating up, and opinions continue to differ sharply on what judges should do about this.
On a popular insolvency blog, corporate finance expert and Seton Hall law professor Stephen Lubben critiques a recent decision from the Southern District of New York reigning in an aggressive interpretation of an indenture covenant. The case involved the telecom conglomerate Windstream and the indenture governing some senior unsecured notes. To preserve access to value available to unsecured creditors in the event of any post-default collection efforts, the noteholders extracted a covenant that certain Windstream entities would not alienate any of their assets via sale-and-leaseback. Windstream management and its clever legal advisors devised an end-run around this covenant. They had not promised not to create any new entities within the corporate family, to transfer assets to those new entities, and to allow those new entities to enter into sale-and-leaseback arrangements with those transferred assets (with lease payments to be covered by the original Windstream entities, of course).
While the language of the covenant clearly did not prohibit this precise action, to a major hedge-fund noteholder, this sounded like the kind of sophistry offered by a clever child when caught with his hand in the cookie jar. Crucially, this investor is (in)famous for funding scorched-earth litigation, so the threat of wasted litigation expense on a risky legal challenge was not the deterrent in this case that it often would be. Surprisingly to many, especially Professor Lubben, the court sided with the noteholders, finding that the overly clever Windstream construction of the negative covenant could not reason away a breach of the indenture “as a matter of practical reality” by the “true” parties to the sale-and-leaseback deal, the original Windstream companies. Lubben echoes a longstanding academic critique of judges who rewrite the plain but insufficient language of financial contracts to track the “economic realities” of the case. Were not the major hedge-fund investor and its co-noteholders sufficiently sophisticated to negotiate proper covenant protection if they wanted it? Why grant such entities drafting hindsight that they “were not savvy enough to negotiate in the first place,” Lubben wonders? Lubben’s reaction is a common one among members of the corporate finance academy who emphasise a recurring jurisprudential theme, ‘If you want protection, you’d better contract for it’.
Taking an opposing stance on this issue are prolific UC Hastings law professor Jared Ellias and co-author Robert Stark, a Brown Rudnick partner. In their recent working paper, Ellias and Stark decry a “paradigm shift” in corporate management’s mistreatment of mid-level creditors that they call “control opportunism”. Lamenting the Delaware courts’ recent abrogation of actionable fiduciary duties to creditors, they highlight several horror stories that depict what they view as a sudden rise in brazen manipulation of the soft spots in corporate law and the bankruptcy and restructuring process: A $1.5 billion fraudulent transfer by PetSmart management away from creditors and to shareholders and a recently formed subsidiary; Forest Oil’s technically strained evasion of a change-in-control covenant to subordinate bondholders to $1.65 billion of legacy Sabine Oil & Gas Company secured debt; Cumulus Media’s transformation of a revolving line of credit into a senior secured term loan, subordinating existing unsecured term lenders to $305 million of prohibited, secured, high-interest new debt, now held by previously out-of-the-money bondholders.
Ellias and Stark express their disagreement with the welcome-to-the-jungle sentiment of academics like Professor Lubben. Even powerful institutional creditors, they argue, are not in fact situated to protect themselves adequately with negotiated contractual terms. No one can possibly foresee every clever manipulation of language and evasive maneuver by corporate counsel that might support the type of control opportunism witnessed increasingly today. Some degree of judicial intervention remains necessary, they argue, to smooth the rough patches. And not the type of management- and reorganization-biased judicial intervention so often observed in the US, Ellias and Stark hasten to add. They cite a Southern District of New York bankruptcy judge’s comment that the court’s “highest responsibility is to ensure that our patient [the debtor-company] doesn’t die on the operating table”.
Management manipulation of this very restructuring-friendly philosophy is part of the problem, the authors argue, as illustrated by a series of further case studies Ellias and Stark acknowledge the longstanding academic dispute about whether and to what extent judges should liberally construe covenant language to ensure fairness, or leave creditors to rely on contractual protections “strictly construed”. But their assertion that this is a new era of brazen corporate manipulation brought to mind a not-so-new case featured in a prominent Business Associations law school casebook. In the mid-1990s, Kaiser Aluminum needed to recapitalise to avoid bankruptcy but did not want to dilute the control rights of its primary shareholder. It thus proposed to split all of its existing shares into two new classes of high-vote and low-vote shares, issuing more only of the latter to raise new funds. Existing convertible debt holders seized on an obvious typographical error in the certificate, which seemed to entitle them to receive pre-conversion ‘common stock’ after any conversion of those securities into new classes of ‘common stock’. Ironically, Kaiser’s recapitalisation effort was defeated by a literal capitalisation error, as the Delaware courts accepted the sophistic arguments of the debt holders that the conversion could not take place without respecting their literal entitlement to ‘common stock’. This “hopelessly ambiguous contract” was construed against the drafter, which the court found to be Kaiser. Control opportunism is a weapon not only of management, but also of creditors. Perhaps there is an important role to play for more court intervention, but Kaiser demonstrates that such intervention has to be informed by reason and justice, not partisan doctrinal slogan.