The Drama Over the Windstream Case: Boiled Down

05/18/20

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Perhaps the most discussed and hotly debated corporate finance/contracts case of the last year was Windsteam LLC v. Aurelius (SDNY 2019) (for Stephen's wonderful post on this, see here).  A couple of days ago, Elisabeth de Fontenay put up her article "Windstream and Contract Opportunism" on ssrn (here) that is one of first deep dives into the implications of what happened in the case.

The story of the case is fascinating for those of us who study contract arbitrage because it involves sneaky contract opportunism on both sides of the transaction.  Cribbing from Elisabeth's superb narrative, the saga starts when the company in question, Windstream, does a sale-leaseback transaction in violation of its bond covenants (it claims it is not actually violating the covenant because it did the transaction through a subsidiary blah blah -- but as the judge points out, its attempt to elevate form over substance falls flat).  As it turns out though, none of the bondholders seem to have either noticed or cared about the violation at the time it happened. The violation only bubbles to the surface when Aurelius, a notorious hedge fund, shows up two years later up and demands that the trustee declare a default. At this point, I'd have expected that Windstream would have paid Aurelius some kind of greenmail to get them to disappear.  But for some reason that doesn't happen.  Instead, if memory serves, Windstream officials and Aurelius get into a nasty battle of words in the press.

At this point, Windstream tries to retroactively cure its covenant violation by getting the non-Aurelius creditors to say that they were okay with the transaction and do not want to call the company to the carpet. In theory this should have been doable via exit consents and other familiar corporate moves.  But, in a comedy of errors, Windstream manages to screw up the retroactive cure (and the judge wasn't willing to elevate substance over form on this side of the equation).  End result: Windstream loses and goes into bankruptcy.  That is, everyone loses, including the bondholders because the the value of the bonds goes into the toilet.

 

So, at first cut, it looks like both sides, Windstream and Aurelius, lost as a result of their contract shenanigans and their failure to cut a deal. However, the rumor is that Aurelius actually made a bundle here because it had purchased a bunch of CDS contracts betting that Windstream would tank.  As an aside, no one seems to actually know whether Aurelius lost big or won big. But almost everyone who tells the story does so under the assumption that Aurelius won big. I'd love to know the details, but Judge Furman didn't push Aurelius on this -- and probably wouldn't have gotten a straight answer (Justice Alito actually tried to get Aurelius to fess up to what their strategy was in a recent case involving Puerto Rico that also looked -- on its face -- to be a lose-lose situation for all the parties involved (here), but didn't succeed).  

The interesting questions of course have to do with the big picture implications.  A number of the folks who have written about this case use it as an illustration of what is often referred to as the "empty voting" problem. (e.g., here)  Elisabeth does talk about this in her article, but she sees a bigger and potentially more interesting problem.

That is the problem of judges taking a highly unrealistic view of how even the most sophisticated parties write contracts.  Judges in these sophisticated corp fin cases, according to Elisabeth, view parties as being able to write complete contracts. That is, contracts that anticipate every contingency ahead of time.  But that view, even for the most sophisticated parties, is utterly unrealistic.  The product of this unrealistic view, Elisabeth explains, is the contracting parties keep trying to write more and more complete contracts (that is, anticipating more contingencies) and the contracts grow longer and more complex.  End result is that the contracts end up being rife with even more ambiguities and confusions than they were in the first place. And that is a recipe for opportunism. Absent strong norms against opportunism, we end up with cases like Windstream.  (For a fuller treatment of this dynamic, see Elisabeth's recent article in the Wisconsin Law Review, "Complete Contracts in Finance", also posted a couple of days ago, here).

So, what should be done?

There are a couple of possible solutions. Neither one is particularly satisfactory.

First, the parties could try to fix the Windstream problem contractually by requiring disclosure of CDS holdings or putting a time bar on how long investors can wait before they assert covenant violations.  I suspect that this is probably what is being attempted.  But it plays right into the problem Elisabeth identifies.  Even more gibberish gets added to the contract. 

Second, judges could try to police opportunism more aggressively, using more robust good faith duties and implied inter creditor duties blah blah.  But I think that Elisabeth would say that that is inadequate.  The big problem is that the incentive system that judges are creating, with their unrealistic mode of viewing corporate contracts, impacts the production of contracts in a fashion that incentivizes opportunism by players like Aurelius.  In a world with shorter and tighter contracts -- such as in Germany of maybe even England -- maybe we'd see fewer of these problems?  (Although those settings might also have stronger norms against opportunistic behavior).

I agree with Elisabeth on her diagnosis of the problem. I wonder though whether judges can be persuaded to change their behavior in these corporate contracting cases.  The law, as it exists, already allows judges enough room to police opportunism. And, as Elisabeth points out in her Wisconsin article, they have shown themselves to be able and willing to do that in a number of other areas of contract law. So, maybe it is just a matter of educating judges about the reality of these corporate contracts (that they suck).  I'm skeptical though that judges will change their behavior if they gain a better understanding of the impossibility of drafting complete corporate bond indentures.  I suspect that the reason they rule the way they do in these cases is that they find them difficult to understand -- who wants to read a hundred page corporate bond indenture -- and don't want to spend the kind of intellectual resources that would be required to understand what shenanigans are going on. (One of the ironies here is that Judge Furman seems to have actually put in the effort to try to figure out what was going on; and he still managed to accrue an enormous amount of criticism).  Bottom line: This is a fascinating case and Elisabeth has written a very fun and interesting pair of articles.

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