Revisiting the Voting Prohibition in Bond Workouts

Abstract

Economic theory suggests that corporate law should enable parties to contract freely in order to promote their best interests, thereby leading to socially optimal arrangements. Nevertheless, the law governing the terms of bonds issued by U.S. corporations contains numerous mandatory rules, including a complete ban on collective action clauses (CACs) that would allow a qualifying majority of bondholders to authorize modifications of the core terms (such as the interest rate, maturity and principal amount) of an entire issue of bonds after their initial sale. The economic impact of this longstanding prohibition, which exacerbates the costs of financial distress by unnecessarily forcing issuers into bankruptcy, has not been thoroughly examined in the legal literature. The limited attention devoted to this subject is puzzling given the critical role played by the corporate bond market in the U.S. economy – on average, corporations issue $250 billion in bonds each year, seven times the amount raised through the issuance of stock.

This Article argues that the ban on CACs in the U.S. bond market is misguided and proposes a rule which affords parties broad latitude in selecting the percentage of bondholders that may authorize changes to the core terms of a bond issue. To support this argument, this Article gathers empirical evidence on parties’ contracting choices from three countries – Chile, Brazil and Germany – that follow alternative approaches to the regulation of CACs and that have recently reformed the laws governing their corporate bond markets. The flexible framework proposed in this Article allows parties to tailor their agreements to their particular needs and provides a more favorable environment for the market-driven evolution of contractual terms. Implementation of the rule proposed in this Article would result in lower interest rates, thereby reducing the cost of capital for issuers and fomenting economic growth. More generally, the findings presented in this Article provide an empirical dimension to the existing theoretical work debating the relative merits of mandatory and default rules and highlights how the dynamic nature of contracting choices drives the innovation and evolution of contractual terms in financial instruments.

Keywords: Collective Action Clauses, Trust Indenture Act, Financial Distress, Debt Restructuring

JEL Classification: K22, G33, G18