The Examiners: End the Trust Indenture Act’s Bondholder Voting Ban

How does bondholders’ use of the Trust Indenture Act affect companies’ ability to complete out-of-court restructurings?

Courts are striking down and calling into question an important class of contentious bond restructurings that until now have been viable. The barred restructurings are so-called “exit exchange offers,” in which the debtor company offers new bonds for old bonds. Those exchanging old bonds for new ones must first vote to delete some or all of the bonds’ protections. This structure is controversial—and is now being struck down—because it drops nonparticipating bondholders into a “death trap.” Either the bondholder takes the deal (even if they don’t want to) or suffers as its bonds lose protections and value.

Imagine bonds for which the issuer promised to have at least $100 million in assets. The issuer offers to exchange those bonds for new bonds of an affiliate that will pay back less money. As a condition of the exchange, however, the issuer requires that the exchangers vote to waive that $100 million asset protection. The exchangers don’t care about the lost protection from the issuer, because it’s the affiliate that will owe them money after the protection is gone, so they vote to waive it. But those who do nothing are hurt because after the protection is gone, the debtor could transfer money from itself to, say, its owners, and then drop below $100 million in value. A bondholder might agree to the exchange even if the deal is bad—if it thinks doing nothing would lead to an even worse deal.

In the M&A world, similar coercive transactions were common in the 1980s. Bidders offered to buy a company by paying more to the 51% of the stockholders who sold early than to the 49% who didn’t, because once the bidder controlled the company it could squeeze out the 49% at that lower price. Shareholders rushed to sell for fear of being stuck on the “back-end” of the deal at a lower price.

Such M&A tactics were eventually eliminated in takeovers, yet the bondholder maneuvers persisted—until now. Courts are ruling that the governing law, the Trust Indenture Act of 1939, prohibits exchanges that coerce bondholders into changing the bonds’ core terms—those concerning payment amount, interest rate and maturity date. Recent well-crafted court decisions carefully examined the TIA’s history and concluded that the law was meant to preserve individual bondholder autonomy.

While the courts appropriately applied the statute, the business problem is that ending exit consent coercion often precludes a successful restructuring outside of bankruptcy. That’s because the TIA also bars bondholder votes on core terms, making it impossible to bind holdouts to the deal that the majority want. The holdouts do not drop into the “death trap” but instead walk off with a big chunk of the company’s value. Holdouts can kill many of these deals, as bondholders typically won’t participate if there are many holdouts. Bankruptcy then becomes inevitable.

The problem is the underlying statute, not the court decisions that faithfully apply it. It’s a New Deal law based on the belief that only a judicially supervised bankruptcy can be fair. But today’s marketplace operates by deal making, and institutional bondholders know what they’re doing. The TIA should be updated to the 21st century to allow for uncoerced bondholder votes on core terms. If a fair vote and a recapitalization can keep a company out of bankruptcy, that’s a good result that should not be outlawed.

There is an even better way forward that doesn’t require congressional action. Since 1990, the TIA has allowed the Securities and Exchange Commission to exempt transactions and bonds from the law’s strictures “to the extent that such exemption is necessary or appropriate in the public interest and consistent with the protection of investors.” By using this power wisely, the SEC can greatly improve the restructuring ground rules by exempting bond agreements that allow a binding majority vote while preserving the ban on coercive consent offers. If appellate courts rule that the TIA’s voting prohibition bars exchange offers, there is a way out going forward without an act of Congress. And if the SEC facilitated exchanges of old bonds (with the voting bans) into new bonds (with free and fair voting but barring exit consents), it could facilitate better restructuring ground rules than we now have. The SEC should propound such an exemptive rule.

Mark Roe is a professor at Harvard Law School and wrote The Voting Prohibition in Bond Workouts, published in Yale Law Journal.