“It is error only, and not truth, that shrinks from inquiry.”
May 2022


Ought Not and Shall Not

In an important op-ed piece in the New York Times on May 20, David Brooks addresses and analyzes the culture wars going on in the U.S. today. He calls the progressive left wing the “moral freedom” people, while the conservative right is the “you are not your own” faction. One can quickly see how these two groups divide over abortion, but there is much more.

The moral freedom view is about self-realization and individualism. He writes, “The phrase ‘moral freedom’ captures a prominent progressive moral tradition. It recognizes the individual conscience as the ultimate authority and holds that in a diverse society, each person should have the right to lead her own authentic life and make up her own mind about moral matters.” What follows is sweeping freedom to do as one wishes in many areas—sex, gender identification, politics, publishing. One even picks the preferred pronoun by which one would like to be addressed, and uses it in communication.

Conservatives come to the issue of morality and identity quite differently. They see people fitting into a pre-existing moral structure, where the ultimate authority is God or a community with its rules and traditions. Freedom comes from within this community, creating habits that come to be regarded as virtues.

The conservative point of view is regarded by these “moral freedom” adherents as quaint or dangerous and possibly antediluvian. And the left is regarded by “you are not your own” faction as globalist, unpatriotic, sexually deviant baby killers. We see a conservative backlash everywhere around the world—in Brexit, Hungary, France, in Putin’s purported de-Nazification of Ukraine and in Florida.

And so the Civil War is being fought again. Instead of northern abolitionists and manufacturers we have Wall Street. Instead of agrarian slaveowners we have MAGA. The sides are not so very different from their 19th century precursors, and the issues dividing them are no more amenable to negotiation.

These disagreements can be found everywhere you look. In the debate over abortion, but also gun control and COVID policy. Anger, contempt, and knee-jerk opposition have been appropriated by MAGA and AOC politicians alike. And it infects many things.

The credit markets are not immune to these cross currents, and suspicion of financiers is not new. When Hamilton wanted to create faith in the credit of the new United States, in part by closing the discounts in debt that had been issued by the states under the Articles of Confederation, he overcame southern objections to the profits thereby generated for northern speculators by agreeing “in the room where it happened” to relocate the nation’s capital to Virginia.

Since money relates to power, it is no surprise that credit markets are a venue for conflict. And this is where the dichotomy between moral freedom types and conservatives increasingly shows up. Below is a piece we wrote two years ago, “The Ceremony of Innocence Is Lost.” It chronicles the change in focus of debt restructuring from the 45-year-old principles of the Bankruptcy Code to something faster and looser.

The Bankruptcy Code can be understood as a leveling of the playing field between companies, big money guys and little guys—junior creditors, trade creditors, and people like employees with accrued vacation time. The Code also specified how lienholders and litigants against a company would be treated. The Code wants to be universal, comprehensive, and fair in sheltering companies from the clamor of unruly creditors, in pursuit of the rehabilitation of the debtor. And historically its principles have been applied to out-of-court restructurings too.

Thanks in part to the reforms loosely called Dodd-Frank, implemented in response to the sub-prime mortgage debacle, traditional banks are no longer bearing the risk of the loans they make to companies. Instead, leveraged lending has become the province of CLOs, BDCs and other private lenders including hedge funds. With more capital available and many more institutions looking to deploy it, competition among lenders has increased significantly. Over time, this has given borrowers more leverage when negotiating debt documents and, as a result, credit spreads have come down, covenants have been vastly reduced and terms have steadily become more borrower friendly. These loose terms have begotten a new breed of transactions based on a more sequential model whereby the first institutions to access that value can take the lion’s share. In some cases, borrowers are pitting creditors against each other to provide first access to that value to improve the terms of the new financing.

Increasingly, one hears creditors and borrowers say of the new rules of the game that permit the screwing of some creditors by others, “if the documents allow it, we’ll do it.” Mostly in out-of-court restructurings where new money is wanted, transactions in which assets are reshuffled away from some for the benefit of a select group of others, or where complex changes are made to allow non-pro rata exchanges, or where large fees are allowed to certain new financiers without notice or competition from others, the ceremony of innocence is indeed lost. Yet at no point, apparently, is the question of “ought”, or morality, introduced. At no point is the Bankruptcy Code, for all its flaws, taken as the community’s codification of what “ought” to be allowed. We may be heading toward the tragedy of the commons.

The economic concept of “the commons” dates to William Forester Lloyd’s lectures and writings in 1833 in which he observed that individual’s actions to increase consumption of a scarce resource differ depending on whether the resource is a shared resource or a private one. His example centers on farmers grazing cows on the English common squares. He observed that when the pasture is private, the farmer will stop growing the herd at a level that balances the benefit of an additional cow with the cost of the depletion of grass. In contrast, on the commons, the cost of the resource is shared among all of the farmers, but the benefit accrues to the individual. This pattern encourages each individual farmer to continue to add cows and ultimately leads to a greater number of cows.

Over 100 years later, ecologist Garett Hardin further explored this concept in his paper entitled “The Tragedy of the Commons.” Hardin observed that the incentive of each individual farmer to add to his herd without bearing the full cost inevitably leads to overgrazing and the destruction of the common good.
“Ruin is the destination toward which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons.”

As first described by Nobel Prize winning economist Elinor Ostrom, one mechanism for minimizing the tragedy of the commons is to control the way the resource is consumed or accessed by the parties and shift from a sequential, first-come first-served model to one that provides uniform access to the resource. A classic example of this shift is in the regulation of ocean fish stocks. Without any limitations on the size of his catch, each fisherman is incentivized to catch as many fish as possible as quickly as possible. This sequential, first-come first-served approach can quickly lead to the collapse of the fish population in any given area. By contrast, if each fisherman is allocated a certain number of fish he can catch over a specified period of time, the fisherman has less incentive to rush to catch all his allotted fish. This model provides uniform access to all fisherman and caps the aggregate number of fish caught over any given period. While enforcement is obviously a challenge, this system has successfully been implemented to prevent the collapse of fish populations.

Common goods are not necessarily limited to the physical world. Consider the enterprise value of a company. While the enterprise value may fluctuate, at any given point in time its value is essentially a limited resource that is shared by a community of stakeholders. This value has historically been allocated to different stakeholders depending on their level of seniority in the capital structure, and holders of any given tranche of capital have historically shared equally in this common resource.

In the context of a distressed company, the common resource of the company’s value has become increasingly scarce, creating conditions that mirror the limited grass available for farmers on the English commons. The relative claims to that resource among different tranches of a capital structure have long been governed by contract and bankruptcy law. But as described above, there have recently been several situations where similarly situated creditors have worked to create an advantage for themselves in order to garner more of this value to the detriment of other holders of the same securities.

And just like in Hardin’s example, what is good for an individual lender is not necessarily good for the community of lenders as a whole. Since this new breed of transactions provides additional capital senior to the existing debt, they often diminish the value of the original debt. And in many cases, these transactions do not fix the capital structure of the borrower; they merely delay the day of reckoning.

As the pendulum swings farther away from the precepts of the Bankruptcy Code, it seems the tragedy of the commons has come to the credit markets. Connecting the dots, “moral freedom” players are gaining over “you are not your own” conservatives. Since businesspeople are more likely to react to incentives than community norms—to shall not rather than ought not – a concern about the market outcomes should lead conservatives to advocate for more regulation. And Democrats should embrace the status quo. Odd, isn’t it?

by David Schulte, Jamie Ellis, Mike Kennedy, Aaron Taylor

The Ceremony of Innocence is Lost

COVID-19’s impact on people, businesses and economies around the world has been so rapid and precipitous that we don’t yet understand the full scope of the damage. One thing we do know even now is that the capital structures of many companies are going to need to be restructured in the not-too-distant future.

We’ve already seen a large increase in the number of businesses seeking bankruptcy protection: 94 large companies with a total of $132 billion of funded debt have filed for Chapter 11 this year alone. Compared to the same period last year, the number of large Chapter 11 filings has increased 68% and the cumulative funded debt of those companies has more than doubled. We expect this trend to continue until the virus is contained.

The U.S. Bankruptcy Code has guided debtors and creditors in navigating economic challenges and precipitous downturns for decades, including during and after the post-9/11 recession in the early 2000s and the Great Recession of a decade ago. But the bankruptcy environment has evolved significantly since 2009, and the scope of changes for debtors and creditors is hard to overstate.

Following the recession of 2009, Congress and regulators attempted to protect the public and the financial system by restricting traditional banks’ ability to provide leveraged loans. Like water running downhill, however, capital has found its way to leveraged borrowers through the proliferation of other intermediaries: collateralized loan obligations funds (CLOs), business development companies (BDCs), and direct lenders.

Since 2009, loans held by CLOs have doubled to more than $600 billion, representing half of the $1.2 trillion leveraged loan market. Assets under management for BDCs—which typically lend to middle-market companies—quadrupled during the same time period, and direct lending platforms have become increasingly prevalent with assets under management now topping $250 billion.

These lenders, like the traditional banks that came before them, typically employ leverage to enhance returns. They are also subject to some structural limitations that decrease their flexibility when it comes to restructuring troubled companies. CLOs, for example, have certain self-imposed restrictions: while they may be able to accept equity in exchange for debt in a deleveraging transaction, they are often ill-equipped to participate in a new money investment.

The reshuffling of players in the speculative-grade debt market has coincided with a sustained period of historically low-interest rates. This macro environment has not offered sufficient yield to fund the needs and desires of the real parties in interest—pension funds, insurance companies, and the investing public—forcing investors to accept greater levels of risk for a given amount of return.

The combination of investors’ thirst for yield and alternative credit providers’ ability to offer it (albeit not without risk) has led to an oversupply of capital for leveraged lending. As funds compete with one another to deploy that capital, negotiating leverage has shifted toward borrowers. New issue lenders have lost their ability to dictate terms in credit documents, and historical protections afforded to senior lenders have been whittled away. First came the removal of financial covenants. Between 2015 and 2018, the share of “covenant-lite” loans in the leveraged loan market increased from 64% to 79%. With covenants largely removed, borrowers began pushing for increased flexibility on other terms, including the ability to issue new debt, move assets, and pay dividends.

The confluence of these changes in the credit markets has created an entirely new rulebook for working out troubled companies—one that does not necessarily preserve the spirit and principles set forth in the Bankruptcy Code. The Code dictates few outcomes and mainly establishes ground rules. Its approach is to require negotiation among parties, and it has its very own judiciary to interpret and enforce it. But the Code has held three things dear:

  1. The primary goal of rehabilitating the debtor
  2. The requirement that similarly situated creditors should be treated similarly
  3. The requirement that liens on collateral security be respected

The first question a leveraged company facing major trouble must answer is where to turn for the cash it needs to operate. The most obvious answer has always been, and is still, its existing constituencies, whether equity or debt holders. These are investors who have already signed on to the company and its future.

When loans were held by individual banks or small groups of banks, the company had few options but to accept the terms and restrictions placed on any new capital. In the current environment, distressed borrowers are finding that they can take advantage of their credit documents and competition among creditors to strike deals that are favorable to the company and certain commanding stakeholders.

Three novel transaction structures have emerged so far:

  1. The transfer of collateral away from secured lenders
  2. The use of non-pro-rata exchange provisions to restructure the entire priority scheme within a credit
  3. Exploitative financings

There has been significant coverage of the collateral transfer tactic since the 2016 J.Crew transaction that transferred $250 million of intellectual property to unrestricted subsidiaries. Taking advantage of borrower-friendly terms in its credit agreement, J.Crew was able to transfer intellectual property outside the reach of its lenders, and was free to borrow against those assets to address unsecured debt maturities.

The second notable transaction structure is the non-pro-rata exchange, which was executed in 2017 by certain creditors of denim brand NYDJ. This group acquired just over 50% of the company’s first lien term loan and engineered a transaction in which it amended the credit agreement to permit an exchange that effectively subordinated the term loan lenders not in the group. This was a controversial amendment, and would not have been conceivable were it not for borrower-friendly terms in the original credit agreement. The minority lenders litigated, and the case was ultimately settled. The end result, however, was that a group of lenders was subordinated to the majority holders of the exact same debt instrument. Like the assetstripping J.Crew transaction, the NYDJ non-pro-rata exchange highlighted how borrowerfriendly credit documents can expose creditors to risks that were once unimaginable.

Both of these tactics were in play in the contentious Serta Simmons transaction earlier this year. The borrower negotiated with competing groups holding the same debt instruments—one of which was pursuing a collateral transfer transaction and the other a non-pro-rata exchange—to raise $200 million of new debt capital and eliminate a significant portion of its existing debt.

While the non-pro-rata exchange transaction that was ultimately executed was beneficial for the equity sponsor—enabling it to continue its turnaround effort of a highly leveraged business without needing to put up additional capital itself—the creditors who did not participate in it were effectively subordinated to the group that did. Without the contractual loopholes in the credit agreement, the likely outcome would have been a more universal negotiation over ownership of the restructured entity and a broader opportunity to invest in it.

Even in court-supervised Chapter 11 cases, sharp-elbowed creditors have devised a way to extract value from their similarly situated brethren. Sponsoring creditors structure Chapter 11 plans to provide pro-rata treatment among creditors, but take advantage of one big opening— dilution from a new capital financing. Sometimes new investment is needed by a company, but opportunistic creditors have seized upon that need to fashion a way to exploit the others.

The terms of the financing have come to be complex, hard to untangle and layered with other terms to create economic advantage for the sponsoring creditors. Under the guise of promoting a quick and efficient process, there is rarely a market test, and in some cases participation is only open to the sponsoring creditors. This practice has largely been allowed on the theory that any favorable economics are attributable to the new money as opposed to recovery on the old. Even when participation in a new money investment is opened up to a larger group, creditors that are ill-equipped to invest new capital can see their recovery dwindle to nothing if the new money financing terms include provisions—such as make-whole premiums and warrants—that swallow the lion’s share of the value of the reorganized entity.

The subscription rights offering is one form of financing for distressed borrowers, and—done fairly—it is a useful tool. Pricing fresh capital for a troubled company is notoriously difficult, and a rights offering can solve that dilemma by giving creditors the opportunity—but not the obligation—to invest new money. But the potential for exploitative pricing has made it possible for rights offerings to deliver unfairness as well. If “rights” in a rights offering relate more to the Rights of Man than to Might Makes Right, the tool is sensible, valuable, and fair. All that’s needed is for subscription rights to be transferable, so unable or impecunious holders have something to sell, and for fees and benefits of backstop financiers to be reasonable.

To be sure, the Code allows for less than full agreement among creditors, and applying pressure to minority creditors is as old as the Code itself. Tight timelines, financing hurdles, death-traps and cram downs of junior interests are all traditional tools, but in today’s environment those tools are being pushed to the extreme.

How has this changed the traditional key tenets of the Bankruptcy Code? Similarly positioned creditors are no longer always being treated equally. Those creditors able to cut a deal with the borrower generally get the benefit of an improved position, while non-participating creditors are disadvantaged. The supply of credit has allowed borrowers to pursue out-of-court restructurings that are not governed by the Code, often impairing the strength of lenders’ liens. Different tactics but similar outcomes can occur in a bankruptcy. When a new money financing is sponsored by a dominating creditor, those who cannot or do not wish to participate in it can be crushed.

These are tough times to be a creditor of a distressed company. In the words of Paul Newman, “if you’re playing a poker game and you look around the table and can’t tell who the sucker is, it’s you.”