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E-MailYesha Yadav is Professor of Law at Vanderbilt Law School. This post is based on a recent paper by Professor Yadav.
In Debt Buybacks the Myth of Creditor Control, I argue that regulation fails to protect bondholders in the context of a debt buyback—when issuers repurchase outstanding claims with a view to extinguishing these claims from their books. Share buybacks have long constituted rich fodder for researchers, regulators and politicians opining on how these transactions impact investor protection, managerial behavior and national economic growth. By contrast, commentators have paid near negligible attention to debt buybacks despite their ability to radically and rapidly re-shape the bargain between an issuer and entire swath of creditors. A back-of-the-lope calculation suggests that issuers have repurchased around $1.9 trillion worth of debt between 2004-2017. A slew of corporate heavyweights like Kohl’s, Macy’s Verizon, Albertsons and SoftBank have sought to deal with their shaky piles of debt—and the problematic covenants often attaching to them—by looking to buy back billions of dollars in bond and bank claims. Where an issuer can repurchase this debt when it is trading at a discount to par value, the borrower can de-lever while also booking a notional gain on its books. Perhaps most importantly for some firms, debt buybacks—accompanied by solicitations of consent from bondholders—can strip away unwanted creditor control rights, freeing the debtor up to take on more debt, conclude mergers/acquisitions or preemptively escape likely future violations of bond indenture terms and the resulting ire of investors.
The paper makes three arguments. First, bondholders confront pervasive information asymmetries and coordination costs when seeking to get fair value for their claims and the control rights pertaining to them. These transaction costs enable issuers to systematically underpay bondholders for the buyback by an amount approximating these costs, pocketing the difference at investor expense.
To help creditors price complex claims, thick information flows generally accompany extensions of loan and bond debt. In order to determine whether and how fully a debtor will produce the cash flows needed to repay, loan contracts and bond issues are preceded by a thorough airing of the debtor’s affairs and the state of its books. By contrast, no such detailed disclosure attaches to debt buybacks. Where issuers purchase debt on the open market—essentially behaving like any other investor purchasing bonds from another—they are not required to offer any prior indication of their intent to do so (unlike equity buybacks, where prior disclosure of a likely open market buyback is required). For a more formal tender offer, when an issuer proposes to repurchase as much as it can of an entire issue of bonds—only minimal notice is required and far less than what is demanded of issuers doing an equity tender. While the economic rationales driving debt and equity tenders are clearly different, the need for information to calibrate a more exact price for surrendering the claim is not. Owing to this greater opacity, bondholders must pay for their own research and analysis and also coordinate with others to agitate for a better deal. Where these transaction costs are likely to be more than, or approximate, the gains available under an improved offer, investors have little incentive to act. As a result, issuers can strategically underprice a bond tender offer to take advantage of these higher transaction costs that must be internalized by bondholders during a buyback.
Secondly bondholders are ill-equipped to protect themselves against potential coercion by issuers. Conventionally, limited protection for bondholders has been justified on account of their sophistication and the contractual nature of their relationship with issuers. In other words, expert bondholders should be able to rely on their contract with an issuer to acquire information and arrive at a fair bargain. But the effectiveness of contracts, the key source of investor protection, appears overblown in the context of buybacks, failing to tackle the vulnerabilities faced by bondholders. For one, investors lack basic information to determine how best to respond and to more exactly decide on the additional data they might need. They also confront collective action costs to agitate. Indenture trustees—designed to mitigate these costs in public markets—are notoriously apathetic and do not possess the incentives to make a difference. Finally, bond markets lack the usual easy tradability (or liquidity) common to equities, reducing their ability to permit smooth exit and entry, or for bond prices to act as a reliable mechanism to convey information about the worth of securities.
The tender offer and consent solicitation process for debt buybacks is also skewed towards strong-arming bondholder approval and limiting the opportunities for investors to engage in meaningful investigation and deliberation. For all non-payment-related matters, bond terms can be modified if the issuer can get the consent of a majority (sometimes 3/4ths) of bondholders. As such, if over 50% of investors agree to changes, the terms of the bond are altered and holdouts do not receive a tender premium, eventually holding a claim that ends up hollowed out and hard to trade. Bondholders must guess whether or not others will accept. And deadlines to do so are tight—usually 20 business days. Put simply, bondholders face serious pressure to accept the issuer’s terms. Finally, issuers themselves have few incentives or legal imperatives to produce a good deal for bond investors. Bondholders do not benefit from fiduciary protection—unlike shareholders that do. Indeed, it makes a great deal of sense for managers to extract gains from bondholders in order to boost shareholder returns as a matter of legal duty.
Thirdly, the paper posits that debt buybacks open up the possibility of one set of creditors (notably banks) extracting value from bondholders. Banks can gain if issuers repurchase bond claims cheaply. Bank creditors may see a stronger chance of being repaid. They may also enjoy a more influential voice in the boardroom by reducing that of bondholders. Importantly, banks face far fewer collective action costs, enjoy detailed access to a firm’s books and records and may thus be especially persuasive in their abilities to push a coercive buyback.
The under-protection of bondholders in debt buybacks comes with economic and social costs. A common pushback against extending greater regulatory support to bondholders lies in their institutional sophistication. In other words, the paradigmatic picture of the “mom-and-pop” investor is replaced with that of a hedge fund or private equity firm that can confidently protect itself. But a deeper look at the composition of bond markets offers cause for caution. Crucially, bondholders comprise a heterogenous mix of institutional investors. In particular, bonds held by U.S. mutual funds and exchange-traded funds (or ETFs) grew from $1.8 trillion to $4.3 trillion between 2003-2015. Mutual funds, ETFs, state pension funds and insurance companies thus constitute key holders of bonds. Even in the “high-yield” (bonds rated below BBB-) segment of the market, where debt buybacks tend to be particularly popular, specialist mutual funds, insurance companies and pension funds also constitute the largest players. Higher transaction costs for such investors can, therefore, ultimately redound to the detriment of the average saver relying on the predictable and safe returns promised by the bond market.
In concluding, this paper offers ideas for reform. As a first order matter, it suggests pathways for future research and empirical study. Limited attention to debt buybacks has resulted in just a handful of recent research papers and few firm results about the overall impact of debt buybacks for investor protection and capital allocation. From the point of view of policy, I suggest at least equalizing the disclosure regimes governing bond and equity buybacks. More fundamentally, while recognizing the difficulties of imposing a general fiduciary duty, the paper explores the trade-offs of imposing a discrete fiduciary duty to safeguard the interests of bondholders in the specific context of debt buybacks.
The complete paper can be found here.
