October 2019 Issue
Over the last few months, borrowers have taken a proactive approach in credit agreements and indentures in an attempt to disenfranchise and otherwise limit the activities of net-short debt activists.
The typical playbook of a net-short debt activist involves the activist investor identifying a default under a borrower’s debt documents, buying into the debt and simultaneously building a larger short position through the use of credit default swaps (CDS). The activist investor then seeks to call the historic default, accelerate the debt and, when the borrower fails to pay, collect under the CDS — generally an amount greater than if the principal amount of the debt owned by the activist had been repaid.
The rise of net-short debt activism can probably be traced back to Cash America, which established that under New York law creditors could be entitled to make-whole redemption premiums upon acceleration of the debt, arguably creating an incentive for CDS-protected creditors to accelerate.
This phenomenon recently culminated in the Windstream case where a bondholder, Aurelius, which was widely reported to be holding a net-short position, asserted a default as a result of a two-year old sale and leaseback transaction in breach of the bond covenants. Windstream attempted to obtain a waiver of the default from its other bondholders through a complex series of exchange offers and consent solicitations. However, following litigation between the parties, the court eventually held that: (i) the sale and leaseback transaction was a breach of the indenture; (ii) the waiver was ineffective; and (iii) Aurelius was entitled to repayment of the principal amount, plus all accrued and unpaid interest. Windstream filed for bankruptcy shortly after.
Windstream highlights the potential concerns for stakeholders facing net-short debt activism. The concerns for a borrower are clear — net-short positions financially incentivise lenders to act in a manner that is adverse to the interests of the borrower. However, other non-net-short lenders would also be concerned, as their interest in the ongoing viability of the borrower and its ability to repay its loan in full is not aligned with the interests of the net-short debt activist who may benefit more from a default and acceleration. In Windstream, it is notable that the non-net-short bondholders were willing to waive the default in question and avoid the bankruptcy that reduced the expected recovery on their bonds. Net-short debt activism also raises concerns for CDS counterparties that may be required to pay out under the CDS upon the default and subsequent acceleration brought about by the net-short debt activist who may have purchased the CDS protection with a net-short play in mind.
Where are we now?
It is not just credit parties that are concerned by the rise of net-short debt activism. The Financial Conduct Authority, the US Commodity Futures Trading Commission (CFTC) and the US Securities and Exchange Commission (SEC) recently issued a joint statement outlining their worry with opportunistic strategies in the credit derivative markets, indicating the possibility of greater scrutiny. Similarly, the International Swaps and Derivatives Association (ISDA) has proposed amendments to its credit derivative definitions that would require a payment failure to result from, or in a deterioration in creditworthiness or financial condition of the borrower in order to trigger a payout under the CDS. While these contractual changes may not restrict net-short debt activism, the proposal shows that ISDA is willing to curb behaviours which, in its view, could negatively impact the CDS market.
Against this background, there have been several known examples of credit agreement provisions aimed at curbing net-short debt activism. Notably, the financing in connection with the buyout of Sirius Computer Solutions in the US loan market and the buyout of Merlin Entertainments in the European market each included anti-net-short lender provisions. There have also been reports on a no-name basis of private loans containing similar provisions.
Analysis of credit agreement provisions
A typical anti-net-short lender provision requires a lender to represent whether they hold a net-short position and, based on that representation, disenfranchise net-short lenders on voting matters, deeming them to have voted in the same proportion as non-net-short lenders. Although it is a simple concept, variations in the provisions raise concerns regarding their effectiveness at restricting net-short debt activism, the weakness of the deemed lender representation and a potential impact on liquidity in secondary markets.
While these anti-net-short lender provisions have worked their way into recent sponsor-backed credit agreements, net-short debt activism may be more of an issue in bond markets where bondholders holding, typically, 25 percent or more of the relevant notes, may instruct the trustee to issue a default notice. Conversely, the loan market usually has a higher threshold for calling a default or accelerating the loans, typically two-thirds in European loans or a simple majority in US loans. As a consequence, net-short debt activists may be put off by the larger long positions that are required for a net-short play in the loan markets.
Effectiveness. One of the key issues for the effectiveness of disenfranchisement provisions is whether they can, or should, take into account the short positions of a lender’s affiliates. A provision that only restricts the lender of record from voting while holding a net-short position would do little to address concerns of misaligned interests if another entity in the same group holding a net-short position is not also taken into account. However, lenders would likely reject as unduly onerous any provision that requires them to monitor the short positions of their affiliates. Recent iterations extend these provisions to affiliates of lenders, other than regulated banks, and, in respect of those affiliates that are independently managed and separated by an ethical wall, are subject to a reasonable inquiry obligation only. Similar to developments restricting transfers to affiliates of competitors, the loan market may coalesce around language that extends the anti-net-short debt provisions to affiliates of lenders that are commonly managed. Nonetheless, a determined net-short debt activist would be able to structure around these provisions.
There are also practical concerns surrounding how these provisions calculate and define ‘net-short’ positions. For example, calculations based on the face value of debt, which the lender may have acquired below par, and the notional amount of CDS could be ‘net-neutral’ or ‘net-long’ for the purposes of such provisions, but provide the same incentives as a net-short position. Additionally, the current iterations of anti-net-short lender provisions do not address how lenders may be net-short in other ways, such as being long on debt but short on equity, or otherwise be incentivised to accelerate the debt as a result of Cash America.
Deemed lender representation. The deemed lender representation is typically made as of the date of determining whether the requisite votes have been obtained, rather than an ongoing representation. The representation would be most relevant in the context of a contested lender vote where a misrepresentation may be used by the borrower to claim that the relevant lender thresholds were or were not obtained. Outside of those circumstances, if a lender were to misrepresent its net-short position, a borrower will likely have the usual remedies for breach of contract, although it is unclear what losses would arise.
Provisions that provide for net-short lenders to lose their information rights would require more frequent net-short representations. Arguably, a borrower would be able to show a greater loss if a lender accessed information it was not entitled to following a net-short misrepresentation.
Liquidity. The majority of reported anti-net-short lender provisions do not prohibit holding a short position. Rather, they only prevent the lender from voting while holding that short position. It is doubtful whether such disenfranchisement provisions would materially impact liquidity in the secondary loan markets, especially because non-net-short lenders also have an interest in curbing this activity and net-short debt activists are likely to be only a small part of the market.
More aggressive iterations of anti-net-short lender provisions, however, classify net-short lenders as disqualified lenders. Consequently, transfers to net-short lenders are prohibited and the borrower is entitled to prepay and cancel, or require the transfer of, existing net-short lenders’ loans and commitments at the lower of par or the amount paid to acquire such interest. From a lender’s perspective, such provisions excessively restrict legitimate hedging strategies even when the lender is not seeking to vote with its net-short position.
Overall, the impact on liquidity may be more acute in the bond market than the loan market that has accepted certain restrictions on transferability. Although this area is a continuing battleground between lenders and borrowers, the more aggressive iterations discussed above likely go a step too far, even for the loan market, and may materially impact liquidity.
Other developments arising out of net-short debt activism
The rise of net-short debt activism and the Windstream case have inspired other developments in credit agreement documentation, including: (i) contractually shortened limitation periods on claiming past defaults, running from the date of the transaction giving rise to the default was publicly disclosed or notified to the lenders; (ii) express provisions enabling judicial extension of cure periods for defaults subject to litigation; and (iii) higher acceleration voting thresholds. These provisions may be more useful to borrowers because their effectiveness is more certain than the disenfranchisement provisions discussed above and, as they apply outside of net-short situations, such provisions also benefit borrowers more widely. However, for the same reason, it remains to be seen whether it will become common for non-net-short lenders to accept general limitations on their enforcement rights from borrowers attempting to curb net-short debt activism.
Mark Darley is a partner and Zoe Cooper Sutton is an associate at Skadden, Arps, Slate, Meagher & Flom (UK) LLP. Mr Darley can be contacted on +44 (0)20 7519 7160 or by email: firstname.lastname@example.org. Ms Cooper-Sutton can be contacted on +44 (0)20 7519 7265 or by email: email@example.com.
© Financier Worldwide
Mark Darley and Zoe Cooper Sutton
Skadden, Arps, Slate, Meagher & Flom (UK) LLP