Corporate Distress, Credit Default Swaps, and Defaults: Information and Traditional, Contingent, and Empty Creditors

Henry T. C. Hu is the Allan Shivers Chair in the Law of Banking and Finance at the University of Texas Law School. This post is based on his recent article, forthcoming in Brooklyn Journal of Corporate, Financial & Commercial Law. Related research from the Program on Corporate Governance includes A Capital Market, Corporate Law Approach to Creditor Conduct by Mark J. Roe and Federico Cenzi Venezze (discussed on the Forum here).

Although securities regulators, practitioners, and academics have made vast efforts to ensure a robust informational foundation for investors, informational asymmetries associated with companies in financial distress, but not in bankruptcy, have received little attention. My article, Corporate Distress, Credit Default Swaps, and Defaults: Information and Traditional, Contingent, and Empty Creditors (forthcoming in the Brooklyn Journal of Corporate, Financial & Commercial Law, vol. 13, no. 1, 2018) explores some important asymmetries in this context that are curious in their origin, nature, and impact.

The Article examines two categories of asymmetries. The first relates to information on the company itself. Here, the Article suggests there is fresh evidence for the belief that troubled companies may prove lax in securities law compliance and for the existing “final period” explanation for such laxity. The Article also offers two new explanations: one based on the requirements for class action certification in Rule 10b-5 litigation and the other based on uncertainties as to private enforceability of Regulation S-K “Management’s Discussion and Analysis” (MD&A) disclosure requirements.

Building on the existing Hu-Black analytical framework for “decoupling,” the Article also revisits a less obvious, more complex category of asymmetries: “extra-company” informational asymmetries flowing from the CDS and CDS-driven debt decoupling activities of third parties. The sometimes highly counterintuitive incentives such third parties may have can be determinative of the ultimate change in control: bankruptcy. But reliable public information on the presence, nature, and magnitude of such activities is scant. Even the company itself may have to rely on market rumors.

The combination of such incentives and paucity of information has made “debt governance” perhaps less efficient and definitely more complex. Consider, for instance, what the analytical framework in 2008 called “empty creditors with a negative economic ownership” (and what some practitioners in 2018 began referring to as “net short debt activists”). These creditors (unlike traditional creditors) as well as certain other CDS participants have incentives to cause corporations to go bankrupt even when bankruptcy would make little sense. If a creditor holds $200 million of CDS protection but only holds $100 million in debt, the payoff on the CDS on bankruptcy would exceed the loss on its loan. Such a creditor would have incentives to use its contractual control rights (e.g., covenants in the loan agreement or bond indenture) not to protect the value of their loans but, subject to reputational and legal constraints, to help grease the skids to bankruptcy. In contrast, traditional creditors often work with troubled debtors in manifold ways that would redound to the benefit of both the creditors and their debtors. In addition, this extreme type of empty creditor has incentives to “weaponize” financial covenants, including by seizing on real, but largely technical defaults or even manufacturing “faux” defaults.

This Article provides fresh, granular evidence as to such informational asymmetries and substantive concerns, and additional insights as to possible responses. The Article does so largely through the lens of four recent examples, three of which have not previously been considered in the academic literature.

The first example (Radio Shack—2014-2015) shows the impact of possible CDS sellers being, in effect, contingent creditors of a troubled public company and allegedly taking steps to drive the timing of bankruptcy just beyond the maturity date of their CDS. In Radio Shack’s 2015 bankruptcy proceedings, unsecured creditors alleged that the creditors who had provided financing in late 2014 had “reportedly sold” CDS protection, “betting that the company would not default on its bonds—at least not until December 20, 2014.”

The second example (Norske Skog—2016-2017) illustrates how complex empty creditor incentive patterns can be. In late 2015, the debt of Norske Skog, a Norwegian paper company, reached “unacceptable” levels. Its survival, as least as a temporary matter, was dependent on approval of an exchange offer that was (1) objected to by BlueCrest, an alleged purchaser of CDS protection, and (2) supported by GSO Capital Partners (GSO), an alleged seller of short-term CDS protection and alleged purchaser of longer-term CDS protection. If the CDS holdings were as alleged, GSO would allegedly benefit from the firm not going bankrupt in the short term as well as from the firm going bankrupt in the long term. The true CDS positions and incentives of the key players were disputed in the ensuing litigation. In 2017, Norske Skog filed for bankruptcy.

The third example (Hovnanian—2017-2018) also involved GSO. In July 2017, GSO was likely facing losses on the CDS it held on Hovnanian debt because of Hovnanian’s improving financial position. To avoid losses, GSO wanted to “manufacture” a default that, as a technical matter, would trigger a failure-to-pay credit event payout on the CDS. GSO and Hovnanian struck a deal. GSO would provide below market financing to Hovnanian if Hovnanian would default on an interest payment on debt held by a Hovnanian subsidiary. The default did not result from financial distress but instead from Hovnanian and GSO simply gaming the literal terms of the CDS at the expense of CDS sellers. One CDS seller sued, and concerns arose about the threat such gaming posed to the CDS market. On May 30, 2018, the manufactured default was called off after GSO and Solus settled.

The final example (Windstream Services—2017-2019) stems from the September 2017 decision by Aurelius Capital Master, Ltd., a large holder of notes issued by Windstream Services (Windstream), a telecommunications company, to send a notice of default with respect to a covenant breach that allegedly occurred two years earlier. No one else had complained of this possible issue. And if a court agrees a covenant breach occurred, the decision could trigger cross-defaults on about $5.7 billion in debt, and Windstream may be forced into bankruptcy. Why did Aurelius do so? Aurelius is likely not a traditional creditor. Relying on information from industry sources, Windstream proferred the testimony of a banker that Aurelius would profit “more from its CDS position if [Windstream] defaults than if [Windstream] successfully pays off the bond at maturity, creating an incentive for Aurelius to destroy the value to other noteholders.” If true, this would be an example of the weaponization of a technical default. At time of writing, the litigation on this and related issues was pending.

Informational asymmetries can now materially hinder investor decision-making and market efficiency in the context of troubled companies. The true, faux, and technical defaults arising from third party CDS and debt decoupling activities pose especially complex informational and substantive challenges that must be addressed.

The complete article is available for download here.

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