Bond Defaults and the Dilemma of the Indenture Trustee
Steven L. Schwarcz
Duke University - School of Law
Duke Law School Class of 2007
August 19, 2010
Alabama Law Review, Vol. 59, No. 4, p. 1037, 2008
Duke Law School Legal Studies Paper No. 159
Long-term debt securities, or bonds, issued to public investors can suffer a collective-action problem. Bondholders cannot act as a cohesive group where individual bondholder investments are relatively small, minimizing economic incentive to take action or cooperate. This is exacerbated by the fact that the identity of bondholders constantly changes, public bonds being actively traded. Although the rise in institutional bondholding - especially the advent of large, activist, hedge- and private-equity funds and the movement of some of these funds into bond investing - has helped to mitigate the collective-action problem, these funds often have conflicts of interest with other bondholders. Furthermore, the recent collapse of several major funds suggests that the collective-action problem could become more significant in future years.
Custom and law have provided a partial solution to the collective-action problem: for each public bond issue, an indenture trustee is appointed to act as a type of agent on behalf of the bondholders collectively. This solution is imperfect, however, because the standard of care for indenture trustees remains somewhat ambiguous, generating cost and inefficiency in the public bond markets.
An inquiry into the standard of care for indenture trustees is now timely, given the number of bond defaults and predictions of an imminent rise in the rate of defaults. Furthermore, public bondholder governance is increasingly recognized as a critical component of the larger realm of corporate governance. In the past, Congress and the legal literature have focused predominantly on the aspects of corporate governance related to equity investors. Given more than eighty percent of capital market financing raised by U.S. corporations now occurs through public bond offerings, greater attention should be devoted to public bondholder governance.
Number of Pages in PDF File: 37Accepted Paper Series
Date posted: December 16, 2007 ; Last revised: August 20, 2010
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