US companies are facing an escalating threat from activist debt investors, who want to push them into default to make a profit from bearish bets on their bonds.
Credit researchers are warning that an impending court decision in New York could open the floodgates for the tactic, which was used by the credit fund Aurelius Capital Management against the telecoms company Windstream last year.
The corporate defence law firm Wachtell Lipton has labelled the practice “net-short debt activism”. In such cases, a hedge fund buys a meaningful enough position in a company’s bonds to agitate for the company to be declared in default — and an even larger position in a company’s credit default swaps, which pay compensation when that default is confirmed.
“We worry that any judicial imprimatur of Aurelius’ tactics in the Windstream situation could inspire other hedge funds to pair a short via the CDS with a long bond position to force a corporate default that would be destructive both to the company and other long-only 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, a US housebuilder, which agreed to default on some of its bonds in return for new low-cost financing from a hedge fund, Blackstone’s GSO. Blackstone stood to gain from the subsequent CDS payout.
The Windstream situation represents an escalation of the tactic, since Aurelius was offering no benefit to the company.
By the end of 2017, the fund had acquired $300m of Windstream bonds and began a legal case arguing that the Arkansas-based telecoms company had been in technical default for two years — even though existing bondholders had never protested or served a default notice.
Aurelius argued that a complex sale and leaseback deal of Windstream’s fibre optic cable and cell towers in 2015 breached limits on how much debt the company could incur. Windstream countered that the fund was wrong in its interpretation of the bond provisions, and acting opportunistically to trigger profits from its CDS position.
The subsequent legal case was heard earlier this year in New York federal court and a ruling could come as soon as this month. As well as deciding whether Windstream was indeed in default, the judge is also due to rule on the legality of tactics used by Windstream that curbed Aurelius’s voting power.
Lawyers and analysts say that the benign US economy and low corporate default rate means distressed debt funds, which normally invest in troubled companies, are looking at otherwise healthy companies to generate trading opportunities.
“It’s perfectly fair game. This is the kind of thing distress-oriented funds are good at because they know how to read credit documents,” said Bruce Bennett, an attorney at Jones Day. “But their interest in some non-distress situations may reflect a relative scarcity of promising distressed investments.”
There has been a string of such skirmishes. Companies including the retailer Albertson’s and the telecoms group Sprint have been targeted by hedge funds who have tried to hold up merger and acquisition activity, saying the associated financing arrangements violated obscure bond clauses. The hedge funds in those situations demanded payments to withdraw their complaints.
The cat and mouse game between companies and creditors has been ratcheted up by the use of credit default swaps, to the point that the integrity of the CDS market has been called into question. In the midst of the Hovnanian situation, the Commodity Futures Trading Commission put out an unusual public statement condemning “manufactured defaults” and saying that it could investigate them as cases of market manipulation. In the end, Hovnanian and GSO did not follow through on their default plan.
In a widely-circulated memo last month, Wachtell wrote that net short debt activism represented a significant danger to companies. The tactic could be “highly effective” in destabilising a company, “in part because of the asymmetric risk that it presents …The company has the burden of going to court to demonstrate that no default has occurred.”
Until the company prevails in court, other creditors and counterparties may squeeze the company, it wrote.
Aurelius, whose assets under management are around $3bn, has developed a reputation for being unafraid to litigate in disputes over debt documents, as when it targeted the Argentine government over its sovereign debt default.
Mark Brodsky, the fund’s founder and chairman, defended its tactics in the Windstream case, saying companies needed to be held to account.
“There’s nothing new about lenders enforcing bond contracts. What has changed is the aggressiveness with which corporate borrowers have been circumventing or ignoring key financial covenants. Windstream is not unique in this regard, but it is at the extreme end of what I have seen,” Mr Brodsky told the Financial Times.
Windstream declined to comment.