CDS Strikes Again (Aurelius and Windstream)

02/24/19

Long ago I warned that the growth the of the CDS (credit default swap) market represented a threat to traditional understandings of how workouts and restructurings are supposed to happen. The recent Windstream decision from the SDNY shows that these basic issues are still around, notwithstanding an intervening financial crisis and resulting regulatory reform.

Windstream is a corporate group in the telecommunications sector. In 2013 it issued some senior unsecured notes due in 2023. Under the indenture for those notes, specific legal entities in the Windstream group agreed not to engage in any sale-leaseback transactions, presumably to maintain legal title to the groups’ assets available for the noteholders to collect against.

But the indenture did not prohibit the creation of new affiliated entities, nor did it bind such new entities to the prohibition on sale-leasebacks. Windstream did exactly that – popping up a new holding company to enter into the lease, and dropping down a new REIT subsidiary to be the owner of the leased assets. A clear end-run around the probable “intent” of the parties (whatever that means in the context of a bond indenture), but not against the express terms of the indenture, which legions of New York Court of Appeals decisions suggest is the only place to look for intent when reading an indenture.

Nonetheless, Aurelius Capital Master, Ltd., a fund managed by Aurelius Capital Management, LP and its affiliates, instructed the indenture trustee to bring suit against Windstream for breaching the terms of the indenture. As the holder of more than 25% of the notes, the Aurelius fund was entitled to give the trustee such instructions.

As many Slips readers will already appreciate, Aurelius is well-known in the restructuring community for its fondness for a robust sort of litigation. To put it mildly. And it is alleged that Aurelius has fully hedged its Windstream position with CDS, meaning that it can afford to be quite aggressive, because damage to Windstream will actually increase the value of the CDS position.

I’ll try to condense this as much as possible, but readers can see that we are headed into one of my longest posts in a while …

Seeking to the head Aurelius off at the pass, Windstream launched an exchange offer, attempting to swap any of its outstanding debt for the senior unsecured notes. The new holders of the senior unsecured notes would agree to waive any default associated with the sale-leaseback transaction. Because this was an “entry consent,” in place of the more typical exit consent, the mechanics were a bit awkward. In short, the new noteholders could not consent before they were actually noteholders, but Windstream did not want to go ahead with the swap if there were not going to be enough consents.

The senior unsecured notes indenture also contained typical debt covenants, and the exchange transaction increased Windstream’s total outstanding debt by about $40 million.

The district court found that the sale-leaseback transaction breached the indenture. Despite the lease being signed by the new holding company as “tenant,” the subsidiaries who had previously owned those assets continued to use those assets. As a result, the court found that the subsidiaries were the “true” parties to the lease:

as a matter of practical reality, the Transferor Subsidiaries have exclusive control over the Transferred Assets during the term of the Master Lease. Indeed, since the asset transfer, the Transferor Subsidiaries are the only entities within the Windstream family that use and occupy the property.

The lease allowed the new holding company to let the subsidiaries use the leased property, but the court felt that the subsidiaries exercised too much control over the property to be anything but the "real" parties to the lease.

The court also felt that the subsidiaries were effectively paying the rent on the lease, because the subsidiaries were making dividend payments to the holding company to enable it to make the lease payments to the new REIT subsidiary. Note that the Puerto Rico Oversight Board, assuming it is still around to do so (Aurelius again, more on that to come), can now cite this opinion to support its argument that the Building Authority's debt is really Puerto Rico’s own debt.

The court also decided that Windstream was estopped in this case, because it had told state regulators that the old subsidiaries were going to lease back the property in question. The court decided that the old subsidiaries’

use and enjoyment of the Transferred Assets walks like a lease and talks like a lease. That is because it is a lease. And, regardless, [Windstream] cannot be heard to argue otherwise in these proceedings because it previously took a contrary position in the legal proceedings before state regulators and that position was adopted by the regulators. Accordingly, the Court holds that the 2015 Transaction constitutes a Sale and Leaseback Transaction within the meaning of the Indenture. It follows that, unless excused or cured by the [exchange offer], the 2015 Transaction constitutes a breach … of the Indenture.

The court then proceeded to find that the exchange offer violated the debt level covenants in the indenture, and that at least one of the exchanges was not properly done to effectuate the needed waiver.

How Aurelius has any standing to argue about the last point – it was not part of that exchange offer – is left unsaid in the opinion. If those bondholders are happy to have waived, have they not consented to the waiver as it actually happened, notwithstanding the inconsistent documents?

But let’s talk about the main holding – that the sale-leaseback violated the terms of the indenture. The court readily concedes that the plain language of the indenture does not cover the transaction on its face. Rather the court repeatedly argues that the “economic realities” of the transaction bring it within the terms of the indenture.

In essence, the court has granted Aurelius covenant protection that it (and its predecessors) were not savvy enough to negotiate in the first place. That’s the kind of interpretive stretch that law professors expect to see with sympathetic plaintiffs – the classic “widowers and orphans.” But Aurelius?

As the author of a law school corporate finance text, I’ve read my share of these sorts of opinions. I often tell my students that the one constant theme running through the bulk of corporate finance jurisprudence is that “if you want protection, you’d better contract for it.”

The Windstream opinion represents a clear departure from that trend. Instead, the theme seems to be, “I know what you really meant.”

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