The Myth of Creditor Sabotage

Vince Buccola is an assistant professor at the Wharton School at the University of Pennsylvania; Jameson Mah is an Investment Analyst at Cyrus Capital Partners; and Tai Yi Zhang is an economics undergraduate student at the Wharton School at the University of Pennsylvania. This post is based on their recent article forthcoming in the University of Chicago Law Review.

Net-short creditor activism isn’t real. The fact that people talk as though it were real is, however, deeply interesting as a matter of economic sociology. So we claim in our new article, The Myth of Creditor Sabotage.

Readers of this blog are likely familiar at least in outline with the Windstream case. In 2017, Aurelius acquired a majority position in some of Windstream’s notes. Aurelius used the customary authority of a majority holder to assert that a spin-off transaction Windstream had closed some two years earlier was in fact an incurable breach of its sale-leaseback covenant. The matter went to trial, Aurelius prevailed, and Windstream filed for bankruptcy relief. That much is fact. But it is a theory of Aurelius’s motivation rather than the bare facts that has intrigued market participants as well as scholars. According to a widely rehearsed story (for example, here, here, and here), Aurelius did not believe its lawsuit would maximize the value of its notes. On the contrary, it believed (and hoped) the lawsuit would reduce the notes’ value. Having established a short position in CDS bigger in magnitude than its long position in Windstream’s notes, Aurelius had, the story goes, found a way to profit from value destruction.

The story illustrates a dynamic that scholars of corporate finance have worried about since credit derivatives became widespread in the 2000s. An activist investor could at once assemble a position in a company’s debt and a (larger) short position on the same. The activist could then use the governance levers associated with its investment to reduce value and provoke a default. The concern is a decade old, but Windstream, the proof of concept, has catalyzed anxiety, leading to experiments in debt-contract voting provisions and calls for more legal change to root out the bad conduct.

We say, though, that the story doesn’t add up. The nub of our skepticism lies in the incentives and capacities of investors other than the net-short activist to foil the activist’s plans. The objective of all net-short activism is to reduce a targeted company’s value. There is a variety of tactics for doing so, but all turn on creating a liquidity crisis for the target. The nature of net-short activism thus implies as a matter of mathematical identity that others can make money preventing or curing the liquidity crisis. Our article discusses in detail some of the ways they can do so.

If we are right, then it is a puzzle why a sophisticated investor would think it could succeed. A net-short activist bets not just on debt prices falling, as all short interests do. It bets rather on its own ability to cause the prices to fall. But in placing such a bet, the activist must know it is daring rival investors to profit by punishing it. The whole approach seems misguided.

Which brings us to Windstream. We identify a number of ways the company’s management and others could have been expected to thwart net-short sabotage. So why did Aurelius think it could prevail? We don’t believe it did and don’t believe it tried. The publicly available facts are consistent with Aurelius instead seeking to impose what we call a “breach tax” (sometimes pejoratively described as creditor greenmail). This is a low-risk strategy with high risk-adjusted returns, and we argue it would have looked more promising than sabotage in the summer of 2017.

We can’t say what Aurelius did with respect to Windstream, because we have no access to its books and records. But nor do other commentators who have opined on the story. To us, then, one of the most intriguing features net-short activism is its rhetorical appeal. We suggest that the appeal lies in a kind of mythological function—that net-short sabotage has, in particular, the cautionary form of a good urban legend.

The complete article is available for download here.

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