Walling Out Those Movie-Fan Freeloaders

Since bankruptcy is not available for sovereign nations, exit consents have become a critical means by which sovereigns can restructure. That fact is behind much of the keen attention now directed at Assenagon Asset Management S.A. v. Irish Bank Resolution Corp.

In certain circumstances, a bond issuer must persuade all the holders to accept an exchange of bonds for replacements with less onerous terms. Exit consent is a strategy for doing this by inviting holders to make the exchange, with the proviso that they must commit to vote on a resolution that will cripple the hold-outs in some respect. The crippling resolution won’t actually change the payment terms on the held out bonds, but it can often change other terms that significantly devalue the instrument in other ways.

As The Hon. Mr. Justice Briggs put it in his decision in Assenagon, July 27, 2012, “[A] holder who fails to offer his bonds for exchange and either votes against the resolution or abstains takes the risk, if the resolution is passed, that his bonds will be … devalued by the resolution or, as in this case, destroyed by being redeemed for a nominal consideration.”

The Death of Drive-Ins
In a well-known American precedent, Katz v. Oak Industries various covenants and significant legal protections were to be removed from the older bonds by the resolution, punishing the non-exchanging hold-outs.

This is a way of addressing one of the classic quandaries of collective action in the absence of a central authority: the free-rider problem, or positive externalities.

Here’s a textbook analogy. An entrepreneur creates a drive-in movie theatre, because it is cheaper just to put up a screen than to build a whole building. At first things work fine but over time cinephiles discover that they don’t have to drive into the entrepreneur’s lot and pay him in order to watch the movie: they can enjoy the same movie for free by parking on the opposite side of the street. The entrepreneur either internalizes the benefit (puts up walls) or he goes out of business.

In the case of a distressed sovereign, the benefit, the desired movie-viewing experience, is the continued solvency and security of the sovereign itself. Many bondholders will be willing to accept a haircut on their bonds in order to ward off a default. But they will worry about the holdouts – those who’ll try to get the same benefit although parked across the street. So the “exit consent” strategy puts up walls.

Now comes a decision, Assenagon, which threatens some variants of that strategy, at least where English law applies. As Briggs noted, exit consents similar to the one that he invalidated have survived scrutiny in the U.S., notably in Katz, the 1986 Delaware decision described above. He said that the parties challenging the bond involved in Katz focused in their arguments upon the relationship between the issuers and the bondholders, and the contractual obligation of good faith in that relationship. The Chancery Court found no violation of that obligation.

The Best Interests of a Class as a Whole

But, Briggs continued, his focus under English law must be somewhat different: it is upon the relationship between the majority and the minority bondholders. Majority bondholders , when they act in such a way to bind the whole class of bondholders, (in this case, holders of 10 year bonds issue in 2007) must act in good faith in the best interests of that class as a whole.

It is fitting that this decision comes just four days after a 2d circuit court of appeals argument in New York about Argentina’s efforts to do what the Anglo-Irish Bank was trying to do here: restructure debt in a way that will have definite losers, but that will (it is hoped) restore the defaulting party to the good graces of world credit markets.

In the case of the bonds of the Anglo-Irish Bank, there is no real distinction between commercial bonds and sovereign bonds. On January 21, 2009, the government of the Republic of Ireland nationalized the bank. Its condition continued to deteriorate after nationalization. In May, Ireland infused €4 billion into the bank by purchasing new common stock, a measure approved by the EC a month later.

The condition of the bank still worsened, so the government had to make new infusions of capital three times in 2010: in March, May, and August. After the last of those, it initiated this effort at restructuring, in order in the words of the Minister of Finance to “address the issue of burden-sharing by subordinated bondholders.” In 2011, the issuing bank would be merged with another failed bank and renamed the Irish Bank Resolution Corporation, which is its name as a litigant in this action.

It is reasonable to expect there will be appeals from this decision. Indeed, Anna Gelpern, of American University’s Washington College of Law, calls that a certainty (in her recent contribution to the estimable blog Credit Slips). After all, if there is one dependable fact about this second decade of the 21st century, it is that banks and sovereigns will continue to search for flexibility, for some way to reconcile their desire to retain access to the credit markets with their periodic inability to pay their old debts. That reconciliation requires some finagling, or the creation of some walls around their movie screen.