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E-MailMarcel Kahan is George T. Lowy Professor of Law at NYU Law School and Mitu Gulati is Professor of Law at Duke Law School. This post is based on their recent article, forthcoming in the Capital Markets Law Journal.
On September 19, 2016, the Southern District of New York released its opinion in Wilmington Savings Fund FSB v. Cash America International Inc. At issue was a claim by Wilmington Savings, the trustee on a $300 million bond issued by Cash America some years prior, that Cash America had breached one of its covenants by spinning off a major subsidiary and that this breach had resulting in a covenant default. The court ruled in favor of the investors on the question of the breach. What got the attention of the market observers, however, was not the ruling on the breach but the remedy that the bondholders obtained.
The standard remedy for garden variety covenant violations that result in a default is acceleration—the payment of the obligations at par. But because the covenant breach was voluntary, the court awarded the creditors the amount that Cash America would have owed them had it chosen to redeem the bond early—par plus a sizeable contractually pre-specified “make-whole” premium. The Cash America court, following an earlier Second Circuit opinion, reasoned that the redemption provision set the effective price for a company that choses to violate a covenant and ordered the payment of the redemption price as specific performance of the redemption clause. In a “make-whole” redemption provision, the company has to pay as redemption price the higher of par and the discounted value of the future principal and interest payments.
At first blush, there are reasons to question whether the court’s interpretation reflected the intent of the drafters of the redemption clause. For one, the redemption clause gives the bond issuer an option to redeem the bonds, exercisable at its discretion. The literal provisions neither contain any suggestion that the issuer is ever required to exercise the option nor specify that the function of redemption is to set the price the company is required to pay for a covenant violation.
Second, the remedy afforded by the court is over-compensatory. That is, the payment bondholder would receive after a voluntary covenant breach would exceed the value that the bonds would have had but for the breach. The reason is that the discount rate used to calculate the make-whole payment is very low—lower than the rate at which the market discounts the company future payment obligation.
Third, private placements have long both provided for make-whole redemption and included provisions that explicitly require the company to pay an equivalent make-whole amount upon acceleration (“make-whole acceleration”). By contrast, make-whole provisions, although by now standard (in a sample, 52 of 56 bonds issued between 2007 and 2017 contained them), they are of relatively recent vintage in publicly issued bonds (the first make-whole in our sample was a 1998 issue). But publicly issued bonds provide only for redemptions at a make-whole redemption but, unlike the private placements, do not provide for make-whole acceleration. This partial incorporation of make-whole provisions from private placements to public issues would seem to suggest that the drafters wanted to provide for make-whole redemption but did not mean to require the company to pay a make-whole amount upon acceleration.
This being said, there are reasons to believe that the specific performance remedy fashioned by the courts may be preferable to the par acceleration remedy that bondholders would otherwise have to resort to. For one, while make-whole acceleration is over-compensatory, par acceleration is often under-compensatory. An under-compensatory remedy is particularly problematic with respect to covenant violations that are either opaque–the relevant facts are not known–or disputed–the indenture is not clear as to whether a certain set of facts entails a violation. Opaque and disputed defaults generate frictions in the enforcement process. The indenture trustee, the notional representative of the bondholders, has precious few incentives either to investigate the underlying facts or to engage in a detailed analysis of whether certain facts generate a default. Opaque and disputed defaults require bondholders to take these actions and then persuade either a group holding 25% of the bonds or the indenture trustee to take an enforcement action.
Where the remedy is under-compensatory, these processes are likely never to get started. As a result, companies may engage in opportunistic breaches—actions taken intentionally even though they may violate a covenant in the expectation that bondholders will not bother to detect the violation and pursue a remedy.
To be sure, over-compensatory remedies can also generate problems. In particular, they may induce opportunistic enforcement—enforcement actions taken by activist bondholders, for violations that are minor or based on implausible readings of the indenture, in the hope of getting a windfall. But, at least in the case of voluntary covenant violations, a company can avoid the opportunistic enforcement problem by not undertaking the action that violates the covenant to start with or by seeking an indenture amendment beforehand. For such violations, the problem of opportunistic breach is thus likely to be more severe than the problem of opportunistic enforcement. Moreover, the fact that the standard remedy in private placement is over-compensatory make-whole acceleration shows that an over-compensatory remedy can be the result of bargaining among sophisticated parties.
The aftermath of Cash America is also instructive. The reaction from the elite bar was, for the most part, negative with more than a half a dozen corporate law firms putting out client memos criticizing the ruling (for examples, see here and here). Corporate lawyers started drafting a revised clause to clarify that no make-whole premium is payable upon a default; and, within a few months of the release of the Cash America opinion in September 2016—remarkable speed, given how long it typically takes for standard-form provisions in bonds to get changed—roughly a dozen or so deals got done using the revised language.
But, even more interesting, this move got quashed quickly. By November 2016, articles appeared in Covenant Review (a service for buy-side investors) denouncing the new language as depriving the bondholders of rights they were entitled to and urging investors to organize and resist the inclusion of the new language. By late March 2017, Covenant Review announced triumphantly that all the most recent attempts to introduce the remedial language had been killed (for press accounts, see here and here). Investors apparently didn’t care about what the lawyers thought they had been drafting; they liked the status quo; and the clause was not going to change to benefit bond issuers–at least for the time being (Bloomberg’s Matt Levine has two delightful pieces on this, here and here).
The Cash America case is interesting in and of itself. Our interest in it though is in terms of the questions it opens up.
- First, if the various law firm memos are to be believed, the court’s interpretation of the make-whole provision is inconsistent with what the drafters (the lawyers) intended. Contract law is all about the intent of the drafter. Deviate from, or even muddy in any way, what the sophisticated drafter intended, theory tells us, will result in the redrafting of contracts to clarify what they mean. That this has not happened yet in this highly sophisticated market is puzzling; and begs the question of whether the theory needs modification.
- Second, we describe the remedy provided by the typical make-whole provision as “over-compensatory”. And we do that because the conventional understanding in contract law is that the remedy in cases of contract breach that fully compensates the victim of the breach is expectation damages (that is, the measure that protects what one expected to get) and contract law assumes that, if parties explicitly negotiated for a measure of damages ex ante, that would be it. But maybe the lesson of this case is that investors perceive expectation damages as under-compensatory; as not making them whole in the event of a breach.
- Third, the world of corporate bonds is an international one. Companies are constantly making choices about which market to raise capital from that are a function not only of yields, but also regulations and laws. One would think that the Cash America decision, and the market resistance to redrafting the clause in the US market, would have reverberations in other markets such as the UK, Germany, Japan, Singapore etc. (e.g. should we revise our documents to make it clear that we reject Cash America or should we embrace it?). Figuring out whether that is happening, where and why (or why not), has the potential to yield yet more insight.
- Fourth, redemption provisions in bonds (and the make-whole provision in particular), seem to be suddenly garnering attention in multiple settings in addition to the one we have flagged, such as bankruptcy and the exercise of Special Mandatory Redemption (SMR) rights (see here, here and here—Alexandra Scaggs of the FT Alphaville manages to make SMRs cool). Why the sudden focus on this previously obscure clause?
The complete article is available for download here.
