Abstract

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Hedge Fund Activism in the Enforcement of Bondholder Rights


Marcel Kahan


New York University School of Law; European Corporate Governance Institute

Edward B. Rock


University of Pennsylvania Law School


Northwestern University Law Review, Vol. 103, p. 281, 2009
U of Penn, Inst for Law & Econ Research Paper No. 08-02
ECGI - Law Working Paper No. 100/2008
NYU Law and Economics Research Paper No. 08-09

Abstract:     
Activist hedge funds have transformed how bondholders respond to violations of their contractual rights. Insurance companies and mutual funds, the traditional investors in bonds, often slept on their rights and turned active only little and late. Hedge funds, by contrast, seek out opportunities for activism in order to make profits. In the wake of their activism, hedge funds have not only benefitted themselves, but their fellow bondholders as well.

Alas, the remedy scheme for violations of bondholders rights - in particular, the centrality of the acceleration remedy - introduces its own set of imperfections. When treasury interest rates have increased or the stock price of a company that has issued convertible bonds has declined, acceleration generates a windfall: bondholders receive compensation in excess of the harm associated with the violation. In these cases, activists will spend excessive resources in detecting and pursuing potential claims and companies have excessive incentives to stave off potential violations. When treasury rates have declined, the tables are turned, and bondholder rights are underenforced.

Whether this selective enforcement has generated aggregate benefits for bondholders and companies in the short term is unclear. Over the long term, however, the market will adjust to hedge fund activism by changing other terms in corporate bond indentures. In particular, we suggest that the contractual remedy scheme be revised by giving companies an expanded defeasance option and offering bondholders a make-whole premium upon acceleration, which would reduce, respectively, the incentives for overenforcement and underenforcement.

Number of Pages in PDF File: 42

Keywords: Banking and Finance, Contracts, Corporations, Economics, Law and Economics, Hedge funds, bondholders, contractual rights, acceleration remedy, defeasance option, make-whole premium

JEL Classification: G21, G32, K12, K22

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Date posted: February 18, 2008 ; Last revised: April 5, 2009

Suggested Citation

Kahan, Marcel and Rock, Edward B., Hedge Fund Activism in the Enforcement of Bondholder Rights. Northwestern University Law Review, Vol. 103, p. 281, 2009; U of Penn, Inst for Law & Econ Research Paper No. 08-02; ECGI - Law Working Paper No. 100/2008; NYU Law and Economics Research Paper No. 08-09. Available at SSRN: http://ssrn.com/abstract=1093387

Contact Information

Marcel Kahan (Contact Author)
New York University School of Law ( email )
40 Washington Square South
New York, NY 10012-1099
United States
212-998-6268 (Phone)
212-995-4341 (Fax)
European Corporate Governance Institute ( email )
c/o ECARES ULB CP 114
B-1050 Brussels
Belgium
Edward B. Rock
University of Pennsylvania Law School ( email )
3501 Sansom Street
Philadelphia, PA 19104
United States
215-898-8631 (Phone)
215-573-2025 (Fax)
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