42 Pages Posted: 18 Feb 2008 Last revised: 5 Apr 2009
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.
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
Suggested Citation: 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: https://ssrn.com/abstract=1093387