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Publicly Offered Debt in the Shadow of Insolvency

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Abstract

Publicly offered debt has widely replaced the commercial bank loan for larger ventures. Adverse effects of this development surface in case of – real or assumed – financial distress. A fragmented, steadily changing (secondary market trading), anonymous and heterogeneous body of creditors confronts all concerned parties with severe economic challenges. Ex ante, the risk of debtor’s misbehaviour will increase if the debtor can hide its action, since information and coordination problems arise because of a cloudy body of creditors. Ex post, dilemma structures, opportunistic behaviour and in particular collective action problems inhibit an economically efficient restructuring. The purpose of this paper is to provide a framework to comparatively analyse solutions to the problems posed by a cloudy body of creditors. The analysis will focus on the UK and explore as to whether the private ordering contractual mechanism can gain the edge over the traditional public ordering procedures in case of publicly offered and traded debt. The framework for comparative analysis of public and private ordering can be applied to analyse the problems of ‘publicly offered debt in the shadow of insolvency’ in other jurisdictions.

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Notes

  1. Bolger (2013) and Stothard (2013).

  2. For relationship lending: Franks and Sussman (2005). For ex post coordination of banks see: Armour and Deakin (2001).

  3. Ehrlich (1936) and Pound (1910). For enforcement variables: Dam 2006), at pp 93–122.

  4. Furubotn and Richter (2005), at p 6 f.

  5. Kirchner and Ehmke (2015).

  6. Buchanan and Tullock (1962), at p 77 f.

  7. A more detailed discussion of what constitutes a win–win situation follows in Sect. 3.1.

  8. Furubotn and Richter (2005), at p 11.

  9. The assumption of self-interested individuals is based on Adam Smith’s pioneering work, in which he showed how self-interested individuals maximise wealth: Smith (2007), esp. at pp 349–350.

  10. The idea of self-interested individuals who choose between alternative market transactions in order to increase their preferences has caused the ‘marginal revolution in economics’: Gossen (1854), Jevons (1871) and Menger (2007).

  11. Coase (1984), North (1990) and Williamson (1985).

  12. Kahneman and Tversky (1979) and Camerer et al. (2004).

  13. The model of ‘bounded rationality’ is attributed to the work of Simon (1957) and Simon (1955).

  14. Banerjee (1992).

  15. Shefrin and Statman (1985).

  16. Arkes and Blumer (1985).

  17. For the impact of incomplete information on capital budgeting: Meyers and Mailuf (1984).

  18. Coase (1937), Picot (1982) and Furubotn and Richter (2005), at p 39 ff.

  19. Williamson (1993).

  20. Kirchner (2015) and Kirman and Teschl (2010).

  21. Arrow (1987).

  22. Kirchner (2015).

  23. Kirchner and Ehmke (2015), section III 2.

  24. Sugden (1989).

  25. However, institutionalised corruption in public administration may be defined as a system of informal rules in which the general rule to bribe is fortified by the, maybe formally even illegal, dismissal of those requests to which no bribes have been attached.

  26. Kirchner and Ehmke (2015), Sections VI and VII.

  27. Sophisticated contract design can overcome this problem (aggregation clause, 5.2.1.2).

  28. Kirchner (2012), at pp 168–171.

  29. Mnookin and Kornhauser (1979).

  30. J Armour (2001) at p 18 f.

  31. Baird and Jackson (1984), Jackson (1982) and Jackson (2001).

  32. For in-depth discussion of the hypothetical bargain: Mokal (2005), at pp 32–91.

  33. Eidenmüller (2005), at p 234 ff.; Suchanek (2007), at pp 18 f. and 153 ff.

  34. Kirchner and Ehmke (2015), Section VI.2.

  35. Rawls (2003), at p 118 ff.

  36. Buchanan and Tullock (1962), at p 77 f.

  37. For Pareto efficiency see Lockwood (2008) and Varian (2010), at pp 15–16. For Kaldor–Hicks efficiency see Hicks (1939) and Kaldor (1939).

  38. Berk and DeMarzo (2014), at pp 85–86. Other risk factors, e.g., currency risk, will not be discussed at this point.

  39. Kirchner (2007), at pp 21–23.

  40. On regulatory capture: Stigler (1971) and Stigler (1972).

  41. Some authors argue in favour of redistribution for reasons different from economic efficiency. See, as a prominent supporter: Warren (1987) and Warren (1993).

  42. Schwartz (1998), at pp 1827–1831, accessed 1 February 2015.

  43. Jackson (1982), at pp 864–865.

  44. Ibid., at pp 866–868.

  45. Rasmussen (1998), at p 1681 f.

  46. Baird and Jackson (1984), at pp 101–104.

  47. For an empirical analysis of indirect insolvency costs: Andrade and Kaplan (1998).

  48. Jensen and Meckling (1976). For principal-agent problems in the relation debtor-creditor: Triantis and Daniels (1995). For reactions to principal-agent problems in the relation shareholder-manager: Kirchner and Ehmke (2013).

  49. Franks and Sussman (2005), at pp 70 f, 91–93.

  50. Manove et al. (2001).

  51. White (2007), at pp 1029–1032.

  52. Roe (1987), at pp 236–239.

  53. For a macroeconomic survey of this hypothesis: La Porta and Lopez-de-Silanes (2001), La Porta et al. (1998); see also Davydenko and Franks (2008).

  54. Schwartz (1997), at pp 134–140.

  55. Berk and DeMarzo (2014), at pp 554–556.

  56. Ibid., at p 553 f.

  57. Bratton (2006), at p 6 f. (cited pages at SSRN).

  58. Ibid., at p 7.

  59. The existence of secured debt if publicly registered sets constraints for capital acquisition.

  60. Bratton (2006), at p 7.

  61. Kirchner and Ehmke (2013), Section 3.1.3.

  62. Baird (1991). Baird points out the important role of managers in the initiation of insolvency procedures.

  63. For a comparative law perspective on how different jurisdictions incentivise managers, see Eidenmüller (2006), at pp 244–254.

  64. Franken (2004).

  65. White (1996).

  66. Povel (1999).

  67. Franks and Sussman (2005).

  68. Armour and Deakin (2001).

  69. A proposal for reforming the London Club in response to the challenges of a cloudy body of creditors: Kirchner and Ehmke (2012).

  70. Dakin et al. (2012), at p 120.

  71. White (2007), at pp 1029–1031.

  72. Fabozzi (2008), at p 332.

  73. Reisel (2014). Reisel’s empirical findings confirm that restrictive covenants have a positive effect on credit cost so that especially debtors with a low credit rating include such terms, while creditors with a good credit rating are rather reluctant to implement tight covenants in order to maintain entrepreneurial flexibility.

  74. Smith and Warner (1979), at pp 131–132.

  75. Bratton (2006), at p 12.

  76. John and Williams (1985).

  77. Chava et al. (2010), at p 1129 (Table 2). Chava et al. use a sample of 4478 bonds from 1064 US issuers in the period 1993–2007 (data from the Fixed Income Securities Database). The result: 6.2 % of investment grade issuers and 44 % of non-investment grade issuers had some sort of payment restriction. Reisel (2014) uses data from the Fixed Income Securities Database: 4267 public bonds, 1302 US issuers, bond offerings between 1989 and 2006. She distinguishes between time frames (1989–1994, 1995–1999, 1999–2006) so that trends can be observed. In her investigation, she finds that a restriction on ‘dividends or other payouts’ could be found in 26.11 % of bonds for the complete time frame, with a clear downward trend (35.81 % for 1989–1994, 14 % for 2000–2006) (at p 254, Table 1).

  78. Smith and Warner (1979), at pp 125–126.

  79. Bratton (2006), at p 14.

  80. Chava et al. (2010), at p 1129 (Table 2), find ‘direct investment restrictions’ in 0.04 % of investment grade bonds and in 2.4 % of non-investment grade bonds. Reisel (2014) identifies ‘restrictions on risky investments’ in 4.41 %, with a downward trend (8.08 % for 1989–1994, 1.29 % for 2000–2006) (at p 254, Table 2).

  81. Bratton (2006), at p 10; Lloyd (1991), at p 341.

  82. Bratton (2006), at p 10.

  83. Hartley and Weaver (2010), at pp 219–220.

  84. Hornuf et al. (2015) work with a sample of 1165 investment grade bonds issued by 356 primarily European industrial firms with a value of at least 100 EUR or GBP. The result: a negative pledge clause can be found in 91 % of European bonds, 71 % of US bonds and 72 % of UK bonds. A debt covenant can be found in 6 % of European bonds, 11 % of US bonds and 18 % of UK bonds (at p 23, Table 2). However, the sample for US issuers (55) may be too small for an accurate picture. Reisel (2014) identifies the negative pledge clause in 82.75 % of bond issuances, with a clear upward trend, making the clause an almost standard feature (75.88 % for 1989–1994, 97.41 % for 2000–2006) and a debt clause in 24.56 %, with a steady trend in the converse direction (33.43 % for 1989–1994, 14.00 % for 2000–2006) (at p 254, Table 2).

  85. Chava et al. (2010), at p 1129 (Table 2). Reisel (2014): 59.43 % with an upward trend (51.75 % for 1989–1994, 68.71 % for 2000–2006) (at p 254, Table 2).

  86. Hornuf et al. (2015), at p 22 (Table 2). Reisel (2014) finds that a sale-of-asset covenant is a common feature in the US (90.32 % for the whole period of the study, 86.09 for 1989–1994, 96.71 for 2000–2006) (at p 254, Table 2), which does not necessary conflict with Hornuf et al.’s findings. Reisel’s definition of an sale-of-asset covenant is quite open, i.e., includes any requirement for asset sales, e.g., that assets are sold at a ‘fair market value’, i.e., not at an undervalue.

  87. Bratton (2006), at p 13.

  88. Asquith and Wizman (1990) and Bratton (2006), at pp 15–18.

  89. Bratton (2006), at p 13.

  90. Chava et al. (2010), at p 1129 (Table 2) find a ‘merger covenant’ in 92.1 % of their sample, with no significant differences between investment and non-investment grade bonds. Reisel (2014) identifies a merger covenant in 90.39 % of bond issuances, with an upward trend (85.91 % for 1989–1994, 96.82 % for 2000–2006) (at p 254, Table 2). The findings of Hornuf et al. (2015) seem to contradict the previous findings, although the pairing of the merger covenant with other covenants into one feature and the small sample of especially US bonds raise doubt about the representative status of Hornuf et al.’s empirical results.

  91. Chava et al. (2010), at p 1129 (Table 2), find a ‘change-in-control poison put’ (see Sect. 5.1.4) in 74.2 % of investment grade bond documentations but in only 24.4 % of investment grade bond documentations.

  92. Bratton (2006), at pp 15–18, and Hornuf et al. (2015), at pp 15–19.

  93. Hart and Moore (1999).

  94. Norley and Sprayregen (2002) and Tricot (2010), at p 194 ff.

  95. Rawlings (2007), at pp 46–50.

  96. This is a problem which can be especially observed in credit rating practice, White (2010), at pp 214–216, 220 f.

  97. Norley and Sprayregen (2002) and Rawlings (2007), at p 49.

  98. Rawlings (2007), at pp 50–55.

  99. Norley and Sprayregen (2002).

  100. Brown et al. (1993).

  101. See Sects. 2.2.1 and 6. For the advantages of a private ordering majority amendment clause in contrast to the public ordering equivalent provision.

  102. Kirchner and Ehmke (2012), Section 3.8.3 (2).

  103. Haldane et al. (2004).

  104. For sovereign debtors: Eichgreen and Mody (2004).

  105. Ehmke (2015). Corporate debt restructuring: UK, US, and Germany. INSOL 2014 Conference Proceedings Booklet (forthcoming); Kirchner and Ehmke (2012), Section 3.8, Norley and Sprayregen (2002) and Roe (1987). Majority amendment clauses for payment terms are a common feature in bond terms under English law. They are, in stark contrast, prohibited under US law, Sec 316(b) Trust Indenture Act 1939, 15 US Code § 77 ppp.

  106. Roe (1987), at pp 246–250.

  107. For a comparative-analysis see Drake (2014).

  108. Assénagon Asset Management SA v. Irish Bank Resolution Cooperation Limited [2012] EWHC 2090 (Ch), Briggs LJ.

  109. For implied terms supplied by the court itself see Liverpool City Council v. Irwin [1977] AC 239.

  110. Re Hawk Insurance Co Ltd [2001] 2 BCLC 480 (Chadwick LJ).

  111. Pre-restructuring: value of the firm: 1; equity value held by X, i.e., 0.5 + debt value held by X, i.e., 0.375 = 0.875; debt value held by other parties = 0.125.

    Post-restructuring: value of the firm: 1, no debt; i.e., equity value held by X = 1, i.e., X gains 0.125.

  112. Kirchner and Ehmke (2012), Section 3.7.7.

  113. Azevedo & Anor v. Imcopa Importacao, Exportacao E Industria De Oleos Ltd & Ors [2013] EWCA Civ 364, [2014] 3 WLR 1124. Dan Awrey (typescript) makes a valid point when he criticises the ‘consent payment’ as coercive in context of a dispersed body of creditors. In a game theory model, Awrey shows that a consent payment can make the approval of the debtor’s restructuring offer (even though the offer may be strategically low) the dominant strategy for individual bondholders who can neither block the restructuring offer on their own, nor know how the other bondholders will vote.

  114. Kirchner and Ehmke (2012), Sections 3.7.4, 3.8.3 (3); Norley and Sprayregen (2002) and Rawlings (2007), at pp 46–54.

  115. Buchheit (1993).

  116. Rawlings (2007), at pp 46–54, and Weidemaier and Gulati (2013), at pp 65–70.

  117. Rawlings (2007), at pp 49–50.

  118. Concord Trust v. Law Debenture Trust Corp Plc [2005] 1 W.L.R. 1591 (HL).

  119. For a summary and analysis of Concord Trust v. Law Debenture Trust Corp Plc (ibid.), see Rawlings (2007), at pp 58–62, 64–66.

  120. Elektrim SA v. Vivendi Holdings1 Corp [2008] EWCA Civ 1178.

  121. Re Colt Telecom Group plc [2002] EWHC 2815.

  122. Sakoui (2009) and William (2007).

  123. The CVA moratorium is not applicable to larger firms, which we can assume in case of publicly offered debt; Insolvency Act 1986 1A, Insolvency Act 1986 Schedule A1, Companies Act 2006s 382(3).

  124. This statement is only true for bonds issued by corporate debtors subject to a public ordering insolvency regime. The widely discussed case of sovereign debtors is entirely different. A sovereign debtor, although legally obliged to serve its debt obligations (US Sovereign Immunity Act 1976, UK State Immunity Act 1978), often opportunistically hides behind its national borders and escapes enforcement. It is accordingly easier for a sovereign debtor to ‘force’ its creditors into a private ordering agreement. See Ehmke (2015).

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Authors and Affiliations

  1. Faculty of Law, Humboldt University of Berlin, Berlin, Germany

    David Christoph Ehmke (MSc (Oxford)

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  1. David Christoph Ehmke
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Correspondence to David Christoph Ehmke.

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The author is in particular grateful to Kristin van Zwieten and to an anonymous referee for valuable and helpful comments.

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Ehmke, D.C. Publicly Offered Debt in the Shadow of Insolvency. Eur Bus Org Law Rev 16, 63–96 (2015). https://doi.org/10.1007/s40804-015-0007-x

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