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CDS Strikes Again (Aurelius and Windstream)

posted by Stephen Lubben

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.”


Prof. Lubben's conclusions are consistent with what the street expected for this case: the bond indenture says "...no sale and leaseback with the entity..." not "...no sale and lease back with the entity or its affiliates", therefore the sale from the opco and the leaseback to the holdco does not violate the indenture.

But the judge ruled differently so let's take another look at the transaction. WIN opco spun out the assets, and then holdco leased them back. What did holdco do with those assets? Well, they allowed opco to use the assets freely. Hmm, okay, but then how did holdco pay rent? Well, opco pays a dividend to holdco in the exact rent amount and then holdco pays it to the spinoff. I see. So do holdco and opco share the property? No, holdco has no separate address, employees or business, so the property is for the exclusive use of opco. Umm, does this smell funny to anyone else?

In fact, it does! The judge! In his ruling, he cite a body of case law on leases that shows that a person who makes regular fixed payments in exchange for the exclusive use of a space is the holder of a lease, regardless of whether a paper contract exists. Personally, I find this conclusion to be on firmer legal ground than Windstream's version of events, which is essentially that the lease goes to holdco and then disappears inside the company in an opaque cloud of trust.

Of course, the Judge did not rely exclusively on this reasoning for his judgment. He added two further, independent reasons why the opco was party to the lease. The first is that Windstream, as a regulated telecom carrier, required approval from state regulators for the transaction. When regulators expressed concern, WIN formally told them it was a sale-leaseback transaction to reassure them. The judge then estopped WIN from changing its story in court. The second independent reason is that WIN opco signed 120 subleases on the space. You cannot sublease without a lease, therefore opco must have had a lease in order so sign those contracts.

What Prof Lubben has not told you, is that the court's habit of siding with businesses in matters of likely covenant breaches is only about a decade old. Market participants have found it troubling that businesses are given the benefit of the doubt as long as they have some legal explanation, no matter how tenuous. Management has grown increasingly brazen over the last few years, often with the backing of their private equity sponsors. The fact that it has taken an opportunist like Aurelius to right this wrong is proof that there are no heroes here. But maybe one day the legal establishment will wake up and end this plainly predatory behavior.

The narrow (issuer favorable) interpretation of bond indentures is hardly something that just developed in the past decade. E.g., Harris Tr. & Sav. Bank v. E-II Holdings, Inc., 926 F.2d 636 (7th Cir. 1991).

"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'."

I certainly see Professor Lubben's point here, but I would be interested in a more complete explanation of why he's so adamant that this indenture *doesn't* contract for protection against the sale-leaseback transaction that occurred.

The definition of “Sale and Leaseback Transaction” in this indenture is "with respect to any Person, any transaction involving any of the assets or properties of such Person whether now owned or hereafter acquired, whereby such Person sells or otherwise transfers such assets or properties and then or thereafter leases such assets or properties or any part thereof or any other assets or properties which such Person intends to use for substantially the same purpose or purposes as the assets or properties sold or transferred."

"Lease" is not a defined term in the indenture. There's no dispute that the OpCo's sold/transferred assets. There's no dispute that the OpCo's later used those assets in their respective businesses. The question is whether the nature by which the OpCo's did so - directly paying some tenant obligations under a master lease (taxes, maintenance, insurance, capital improvements) and upstreaming money to a newly-created HoldCo that made lease payments - amounted to the OpCo's "leasing" those assets. That could be either directly from the spun-off REIT or indirectly under a lease or sublease from HoldCo.

I will admit there's some ambiguity on that point, but I respectfully differ that "the court readily concedes that the plain language of the indenture does not cover the transaction on its face". Rather, the conclusion - as noted by Sisi Clementine - is that the OpCo's lease these assets as a matter of law.

I confess to having been quite confused by both the opinion (figuring out what the real contract dispute was) and the various reports in the financial press (where the reporters seemed to be even more confused than I was). This blog post is the first piece that clearly illuminates what was going on. And the comments have been extremely helpful too. So, thank you!

Couple of questions:

1. The blog post started out with a mention of the underlying CDS issue. Supposedly, Aurelius bought a bunch of CDS contracts so that it could benefit from its litigation (?). But does anyone know whether this actually is the case? (H Hu has a piece in the FT, but that seems to not have any real data on this matter). And is that a problem?

2. The connection that was drawn to the Aurelius litigation against Puerto Rico was fascinating. Please say more.

3. Finally, I was intrigued by the articulation of New York law. I agree with the observation that NY courts take the position that the best evidence of intent is the contract document. But cases like Sharon Steel do seem to be willing to go to the economic realities of the deal (and isn't that the daddy of all NY indenture interpretation cases?). Of course, here, J. Furman somehow seems to be saying that since he is figuring out whether there is a "lease" and that is not a defined term, he gets to determine it from other evidence (and then it is easy for him).

Clearly, I'm still confused. But this blog post was super helpful. I look forward to reading more.

The comments to this entry are closed.


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