USA Inc faces growing threat from activist debt investors
US companies face a growing threat from activist debt investors, who want to push them into default to profit from bearish bets on their bonds.
Credit researchers warn that an impending court ruling in New York could open the floodgates to the tactic, which was used by credit fund Aurelius Capital Management against telecommunications company Windstream last year.
Corporate defense law firm Wachtell Lipton called the practice “short net debt activism.” In such cases, a hedge fund buys a large enough position in a company’s bonds to cause the company to go into default – and an even larger position in a company’s credit default swaps, which pay compensation when this default is confirmed.
“We are concerned that any legal imprimatur of Aurelius’ tactics in the Windstream situation could inspire other hedge funds to combine a short position via CDS with a long bond position to force a corporate default that would be destructive to the times for the firm and other hedge fund bondholders,” said Charlotta Chung, senior legal analyst at CreditSights, an independent research firm.
The practice of so-called “manufactured” defaults has sparked controversy, thanks to the case of Hovnanian, an American homebuilder, which agreed to default on some of its bonds in exchange for new low-cost financing from a fund speculative, Blackstone’s GSO. Blackstone stood to gain from the subsequent CDS payment.
The Windstream situation represents an escalation of the tactic, since Aurelius offered no benefit to the company.
By the end of 2017, the fund had acquired $300 million worth of Windstream bonds and launched a lawsuit arguing that the Arkansas-based telecommunications company had been in technical default for two years – even though holders of the bonds existing bonds had never protested or served notice of default.
Aurelius argued that a complex sale and leaseback agreement of Windstream’s fiber optic cable and cell towers in 2015 breached limits on the amount of debt the company could incur. Windstream countered that the fund misinterpreted the bond provisions and acted opportunistically to generate profits from its position in CDS.
The ensuing court case was heard earlier this year in federal court in New York and a decision could be handed down as early as this month. In addition to deciding whether Windstream was indeed at fault, the judge must also rule on the legality of the tactics used by Windstream that limited Aurelius’ voting power.
Lawyers and analysts say the buoyant U.S. economy and low corporate default rate means troubled debt funds, which normally invest in troubled companies, are turning to otherwise healthy companies to generate opportunities commercial.
“It’s a perfectly fair game. This is the kind of stuff distress funds are good at because they know how to read credit documents,” said Jones Day attorney Bruce Bennett. “But their interest in certain non-distressed situations may reflect a relative scarcity of promising distressed investments.”
There have been a series of such skirmishes. Companies such as retailer Albertson’s and telecommunications group Sprint have been targeted by hedge funds that have tried to block merger and acquisition activity, claiming the associated financing deals violated obscure bond covenants. Hedge funds in these situations demanded payments to withdraw their complaints.
The game of cat and mouse between companies and creditors has intensified with the use of credit default swaps, to the point of calling into question the integrity of the CDS market. Amid Hovnan’s situation, the Commodity Futures Trading Commission issued an unusual public statement condemning “fabricated faults” and saying it could review them as cases of market manipulation. In the end, Hovnanian and GSO did not follow their default plan.
In a widely circulated memo last month, Wachtell wrote that net short debt activism posed a significant danger to businesses. The tactic could be “very effective” in destabilizing a company, “in part because of the asymmetric risk it presents… The company has the burden of going to court to show that no fault has occurred “.
Until the company wins its case in court, other creditors and counterparties could squeeze the company, he wrote.
Aurelius, whose assets under management total around $3 billion, has earned a reputation for not being afraid to sue in disputes over debt documents, such as when he targeted the Argentine government for the default of its sovereign debt.
Mark Brodsky, founder and chairman of the fund, defended its tactics in the Windstream case, saying the companies must be held to account.
“There is nothing new about lenders executing bond contracts. What has changed is the aggressiveness with which corporate borrowers have circumvented or ignored key financial covenants. Windstream is not unique in this regard, but it is at the extreme of what I have seen,” Brodsky told the Financial Times.
Windstream declined to comment.