Felix Salmon and I are usually on the same side of the jury box when it comes to the trial of credit default swaps. However, it appears we have reached an impasse concerning creditor control rights in the context of restructurings and bankruptcies. While that sounds like an awfully narrow issue to quibble about, the policy implications of this seemingly obscure issue are far reaching and call into question both the orderly functioning of the debt markets and the soundness of the current bankruptcy regime.
Let's begin by outlining the issue at hand. In my previous article, I wrote:
Suppose that ABC Co. is on the verge of bankruptcy, but wants to avoid bankruptcy by restructuring its debt (renegotiating interest rates, maturity, etc.) with its bondholders. Further, assume that bondholder B has fully hedged his ABC bonds using CDS, or over-hedged to the point where B would profit from ABC's bankruptcy. The problem seems obvious: B either doesn't care if ABC does or actually wants ABC to file for bankruptcy, and so he will do anything he can to stop ABC from restructuring and force ABC into ruin.
In fairness to Felix, here's his added qualification of the issue from his response to my article:
The problem is a bit more subtle than that, and is simply that bondholders who have bought CDS protection have much less incentive to participate in restructuring negotiations.
The key to understanding why we shouldn't expect this change in incentives to lead to any material change in the restructuring process is rooted in the distinction between incentive to act and power to act. Clearly, anyone who expects to profit more from option A than B will choose A given the chance. And so, a bondholder who expects to receive a larger payout from CDS than from a restructuring will choose the CDS payout given the chance. But does that bondholder have any power to bring this result about? As a general matter, probably not.
One Is the Loneliest Number
Restructurings generally take place across the entire capital structure of firm. A firm could have multiple issuances of bonds, loans, and may even have other hybrid debt-equity financing. Each class of creditors has holders with certain control rights. While this complicates the restructuring efforts for the firm, since the firm will have to coordinate with various classes of creditors which may have competing incentives, it also mitigates the influence that any individual creditor/creditor-class can exert on the restructuring process. In addition, it usually means that the firm will require different thresholds of creditor approval from each class. For example, ABC concludes for a given restructuring plan that it needs the approval of 75% of class A holders, 60% of class B holders, etc. The actual threshold will be determined in large part by two main drivers: (i) the agreements that determine the rights of each creditor class (ii) and the number of on-board creditors needed to make the deal economically feasible.
So, even acknowledging the clear incentive on the part of those who stand to gain more from a bankruptcy than a restructuring, their impact on the success of the restructuring will be determined by their ability to affect the firm's ability to achieve the required thresholds. Thus, their impact will be determined by their ownership stake in the debt. And so, in order for Felix's argument to be taken as a serious point of concern, we must posit the existence of a class of hedged creditors who stand to gain more in bankruptcy than restructuring that is so large and well coordinated that it is able to obstruct the restructuring efforts of the firm and those creditors that stand to gain more from restructuring than bankruptcy. While not impossible in a nominal sense, this strikes me as a rather fortuitous state of affairs.
Bankruptcy Is Not A Sure Bet
In analyzing the incentives of the participants, Felix assumes that bankruptcy is certain in the case that a restructuring fails. This is not necessarily the case. He wrote:
I might end up with just 45 cents on the dollar -- $450,000 -- if I agree to the company's [restructuring] plan. If I just let it go bust, on the other hand, I get $600,000 [from CDS]. And so I have an incentive to opt for the more economically-destructive option.
Every filing for involuntary bankruptcy is reviewed by a judge and can be contested by the debtor. And CDS don't payout until judgment is entered against the debtor. That means payout under a CDS as it relates to bankruptcy is an uncertain event. That means that your expected payout should be discounted by the probability that the event will occur. So in the example above, the expected payout should be some fraction of $600,000, which could easily bring it below the $450,000 indifference point. What's worse, that probability might be impossible to calculate for your average bondholder, which holds its bonds passively and is not likely to have access to up to the minute progress reports on the firm's financial condition or the restructuring process.
Review by a judge also means that only meritorious claims for bankruptcy will survive. And so, again, we run into the distinction between the incentive to act and the power to act. That is, whether or not someone would like a firm to go into bankruptcy, its ability to cause that to occur is restricted to only those circumstances where it would have been permissible anyway.
Covenant Thy Lender
In the previous article, I suggested that if companies were truly concerned about their creditors stocking up on CDS and fouling up restructurings, they could require the bondholders to promise to not hedge beyond a certain threshold. Felix responded with the following:
And Charles Davi's idea that companies could somehow constrain their creditors from buying credit protection is even sillier -- and probably illegal. The whole point of issuing bonds is that they're tradable, fungible, and anonymously held. You can't covenant up bondholders in the same way you can with bank lenders.
First, loans are covenant-heavy for the borrower, not the lender. That's why companies like issuing bonds in the capital markets, as opposed to taking on loans. Second, without commenting directly on the legality of the scheme (though I'll note that Felix cites no authority for his claim), it is common place in the MBS market for large, wrapped deals to condition voting rights on bona fide economic exposure. In a wrapped deal, there's an insurer that guarantees payment on the bonds. If the bonds don't pay, the insurer does. In these types of deals, the insurer controls all of the bondholders' voting rights, unless the insurer defaults or goes belly up. So, what bondholders have in these deals are bonds whose voting rights are contingent upon their exposure to risk.
If CDS were truly a problem in the context of restructuring, I would expect companies to issue bonds with voting rights contingent upon maintaining bona fide economic exposure, in a manner analogous to what is done in the MBS market. That said, I wouldn't expect them to be very popular with bondholders.
Note that this voting restriction would not affect tradability or fungibility at all. The bonds would still be identical and therefore completely fungible.
The "Restructuring" Credit Event
Finally, Felix misstates the requirements for recovering under a restructuring. He wrote:
[A]ny restructuring as drastic as the one I described would count as an event of default -- so owners of credit protection would get paid out either way.
That is simply incorrect. First, an "Event of Default" is distinct from a "Credit Event." A Credit Event is caused by the issuer referenced in the CDS. An Event of Default is caused by one of the two parties to the CDS. The former triggers a payout under the CDS. The latter triggers a payout for damages, in essence for breach of contract. For example, if X and Y enter into a CDS naming ABC Co. as the reference entity, any failure by ABC to make a payment on its bonds would be a "Credit Event" and would trigger a payout, let's say from X to Y. Any failure by X or Y to make a payment required under their CDS would be an "Event of Default." The two concepts are completely distinct.
More importantly, Felix misstates the circumstances under which payout occurs. At the outset of a CDS trade, the parties will agree which Credit Events will cause a payout. And indeed, Restructuring is one type of Credit Event. However, only those parties who specifically elect Restructuring as a Credit Event will be entitled to payout upon the occurrence of a restructuring. As such, his analysis of the incentives of participants, which assumes that all trades include Restructuring as a Credit Event, is flawed.
Most importantly, if someone is using CDS to truly hedge against credit risk, they will elect to have Restructuring as a Credit Event. Assuming that this is the case, Felix's entire argument is out the window, since in that case, the hedged creditor is either indifferent towards or, in the case he's over-hedged, has an incentive to see the Restructuring succeed.