Holdout Panic

Abstract

Corporate creditors, perhaps like Americans generally, like to think of themselves as rugged individuals, while at the same time they work within a communal system. The fundamental tension is clearest at the point of default: Too much individuality, and a small minority of creditors can block a useful deal that would get the debtor-firm back on track. But too much collective process, and the majority can bulldoze the minority, forcing them to take outsized losses when the majority cuts a side deal with the firm and its managers.

The restructuring system – comprised of chapter 11 of the Bankruptcy Code, parts of the securities laws, and related contractual and equitable principles – exists to mediate this tension. Thus, Bankruptcy Code section 1123(a)(4) provides that “a plan shall… provide the same treatment for each claim or interest of a particular class.” Nevertheless, modern restructuring practice is in the grip of an unbridled fear of holdouts, and this fear has opened the door to a tyranny of the majority.

The essential balance of the system is at risk, and we are close to a world where the majority always wins. Modern chapter 11 cases routinely involve plans in which certain bondholders (those who sign the restructuring support agreement) get a better recovery than those who do not. The Trust Indenture Act’s section 316(b), designed to protect minority bondholders from abuse by both the debtor and their fellow bondholders, has been read so narrowly as to almost never apply. And in at least three recent cases, a subgroup of bank lenders has voted to give themselves “super priority” status over their fellow lenders in the same loan agreement, yet thus far none of these “uptier” transactions has been stopped by a court.

I argue that it is the unbridled fear of holdouts which has opened the door to greater and greater “flex” in the restructuring system, and thus ability for abuse of a majority position. That is, in an incremental way, each obnoxious, over-litigious holdout has helped to create the weakened reorganization system that makes it increasingly difficult to stop a deal with majority support.

Ironically, in many cases the judicial response to holdouts may actually further encourage such holdouts. For example, by reading section 1123(a)(4) narrowly, courts have encouraged the creation of blocking positions in chapter 11 cases, which can then extract special treatment in exchange for not “holding out.”

Deals with majority support are not inherently bad, but when the majority knows that its deal will surely be approved, it opens the door to reorganizations that are largely about moving value from those who are outside the deal.

Keywords: Chapter 11, RSA, uptier, exchange offer, cramdown