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Yadav on Dodgy Debt Buybacks

posted by Mitu Gulati

I’ve long been fascinated by debt buybacks by issuers, in large part because they seemed to occupy a loophole in the securities disclosure laws.  A company could do a buyback of bonds and, because bondholders are not owed fiduciary duties by the company, there was no requirement for disclosure. That means that the company, to the extent it was in possession of secret information (the discovery of a gold mine, for example), could screw over the bondholders by buying back their securities before the news got out and the price went up.  Of course, the gold mine situation doesn’t occur all that often. But in the area that I do most of my research in, sovereign bonds, there are often large asymmetries of information between issuers and creditors. And yet, one rarely sees large scale buybacks of debt. (for the classic piece on sovereign buybacks, by Bulow and Rogoff, see here).

For years though, I’ve thought that this topic was of interest to no more than the three or four people in the legal academy who found bonds interesting (Marcel Kahan, Bill Bratton and a couple of others).  But just a few days ago I came across a wonderful new article by Yesha Yadav on precisely this topic. The draft article, “Debt Buybacks and the Myth of Creditor Power” is available here.  Yesha argues that the dramatic increase in corporate debt buybacks in recent years (apparently in the trillions of dollars) should be concerning not just because of the aforementioned disclosure loophole, but because these buybacks undermine corporate governance (when they are done in order to strip covenants) and allow shady behavior by banks seeking to increase the value of their loans at the expense of bondholders.

The story Yesha tells is more than plausible and she gives lots of vivid examples that support her arguments.  Since my particular interest is in flaws in the bond contract drafting process, the questions that her article raised for me have to do with why private contracting has not fixed the problem she identifies.  After all, the parties involved in these deals are super rich and sophisticated (with the fanciest of Wall Street law firms at their beck and call).

More specifically, the bond contracts that I’m most familiar with – sovereign ones -- often contain two sets of provisions that should play a role here.  These are repurchase restrictions and redemption provisions (Issuer Calls). I’ll take them in turn.

Repurchase restrictions seem particularly relevant.  In most sovereign bond contracts, these provisions allow the issuer wide discretion to do buybacks.  But there are some cases where this discretion is constrained, in that the issuer may not be allowed to do a buyback when it is in default (there is a history of some sneaky sovereign buybacks having been done in the past,– such as Peru in 1995 and Ecuador in 2009; on the latter, see here and here). So, one might ask: If creditors are worried about issuers doing these repurchases without disclosing the fact that they recently found a gold mine, can’t they contractually require this disclosure?  In fact, if they wanted, they could ask for fiduciary duties to apply in such a context.  The fact that they do not probably means one of two things: Either creditors are not willing to pay for these rights (in which case, we probably should not change the regulatory structure to force those rights on them) or there is some dysfunction in the contract bargaining process.

And then there are the redemption provisions.  Yesha’s article talks about how many of the problematic debt buybacks are done via tender offers.  My anecdotal impression is that the prices offered in these tender offers, particularly when they are motivated by a desire to eliminate onerous covenants that might block something like a profitable merger, tend to be just a small amount below the Issuer Call price (after all, the Issuer can force creditors to sell at the Issuer Call or “make-whole” price – and anything below that has to be done with creditor consent).  And these Issuer Call prices, at least in the high-yield bond world, tend to be supra compensatory for much of the lives of the bonds (for discussions, see here and here).  I should caveat here though that my impressions about what prices are paid in tender offers are drawn from a small set of interviews with lawyers and investors in the high-yield world that I did for a couple of articles on “make-whole” provisions, and not on quantitative data on the actual prices being offered. So, I might be totally off base.

Yesha’s article is a delight to read, even if you are not obsessed with the puzzle of the debt buyback loophole as I have been for years. (So also is her recent piece on the dysfunctional regulatory structure in the US Treasury market (here), but I’ll discuss that on another occasion).  The abstract of the buyback piece reads as follows:

This Article argues that regulation fails to protect bondholders in the context of a debt buyback – when an issuer repurchases its debt with a view to extinguishing the claim. Scholars have developed an expansive body of research examining share buybacks and debated their significance for policy and economic welfare. Little attention, however, has focused on debt buybacks despite their ability to rewrite bargains and strip away creditor control rights in the process. Between 2004-2017, approximately $1.9 trillion worth of corporate debt was subject to a buyback, highlighting the importance of this technique for redefining issuer- bondholder relations and corporate capital structure.

To show how regulation systematically under-protects creditors, this Article makes three points. First bondholders confront information asymmetries that enable issuers to buy back creditor claims cheaply. While disclosure accompanies the extension of debt, buybacks are much less revelatory, with regulation imposing negligible requirements on issuers to provide information. Lacking fiduciary protection, creditors also become vulnerable to being short-changed by issuers in the interests of securing gains for shareholders and managers. Second, buybacks diminish the power of creditor control rights, recently enjoying prominence owing to the emergence of bondholder activists. Alongside limited disclosure, bondholders confront coordination challenges and tight deadlines within which to evaluate a buyback. This difficulty gives issuers scope to underprice creditor controls. Bondholders will not agitate where the gains will be less than the cost of information gathering, coordination, valuation and action. By strategically underpricing a buyback by an amount approximating these transaction costs, an issuer can pocket the difference between the price paid for the claim and that which should have been paid to bondholders in recognition of their bargain. Third, debt buybacks open up the possibility of one set of creditors (notably, banks) extracting value from bondholders. By pushing a borrower to buy back bond claims cheaply, banks (usually with greater individual exposure through their loans) can increase their chances of being repaid. They can also acquire a more powerful voice for themselves in the borrower’s internal governance by muting that of bondholder activists. In concluding, this Article offers proposals to bolster bondholder protection, advocating for greater disclosure and a discrete fiduciary duty to be imposed on managers in the context of debt buybacks. These steps help to more fully realize the goals of investor welfare and reduce the cost of capital in securities markets.

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