It says much about the times that collective action clauses in debt securities are a hot enough topic to make the mainstream news. Although such clauses are widely incorporated in the terms and conditions of debt securities, and have long been a contentious subject in the fixed income sphere, it is comparatively rare for them to result in reported litigation. The recent Chancery Division decision in Assénagon Asset Management SA v Irish Bank Resolution Corporation Limited (Formerly Anglo Irish Bank Corporation Limited)(1) sets out some limits on the permissible use of collective action clauses and the related concept of the exit consent procedure.
Collective action clauses embody the principle of bondholder democracy. In essence, they establish a procedure whereby a majority or qualified majority of a given class of bondholders can vote to permit the amendment of the terms of the bond held by that class as a whole and, in doing so, to bind the minority to the same changes in contractual terms in relation to the issuer (which must also assent to the changes).
Although democracy is a fine concept, the context is important. Collective action clauses may be capable of wider theoretical application, but the explicit purpose for which they were devised is to facilitate an orderly process of restructuring of the issuer's debts if the issuer is forced to default on its obligations. Restructuring necessarily means imposing some form of 'haircut' on the bondholders - making them less than whole on their original investment. All bondholders are likely to find this an unwelcome prospect, but their attitudes to the issuer's proposals may vary widely, from resigned acceptance to implacable opposition. Some may have come in late, with the specific intention of seeking to benefit from holding out against the restructuring proposals and thereby obtaining an outcome that is better than market expectations (and hence better than their entry price).
Collective action clauses provide the issuer with a means of seeking to impose the prospect of negative outcomes for those bondholders that would otherwise be minded to hold out by refusing to accept the restructuring terms being offered by the issuer. This is usually effected by combining the use of the collective action clause with an exit consent procedure. In a restructuring, the issuer is typically offering to exchange an old (ie, existing) bond for one or more less valuable new bonds. An exit consent procedure makes it a condition of participating in this exchange that the bondholder give a binding pledge to vote in favour of amending the terms of the old bond (under its collective action clauses) before those bonds are exchanged for the new bonds. The purpose is to ensure that unfavourable amendments will be made to the old bond by the exiting bondholders, to the prejudice of those that refuse to participate in the exchange and therefore remain as holders of the old bond. In this way, the exit consent procedure incentivises bondholders to participate in the restructuring, as long as it is clear that a sufficient super-majority will accept the terms of the exchange. These techniques can play a valuable role in encouraging realistic and pragmatic attitudes towards necessary restructurings.
The question remains: how far can this punishment of hold-outs go? This, essentially, is the question that the judge in Assénagon had to determine. It is a controversy that has existed for as long as collective action clauses and exit consent procedures themselves. However, in Assénagon the facts were relatively extreme.
The case concerned the restructuring of the debt of the collapsed Anglo-Irish Bank (AIB). Over the course of AIB's slow demise, Assénagon - a fund manager - had acquired a €17 million nominal holding of subordinated AIB bonds at an average price of just over 40%. In Autumn 2010 AIB sought to restructure its subordinated debt. It offered to exchange every €1 of the series of bonds which Assénagon had purchased for €0.20 of new senior bonds (which reflected the current market price of the old bonds). The kicker for potential hold-outs was that the bondholders that accepted the offer had to agree to amend the old bonds under their collective action clause provisions by inserting into them a call option whereby AIB would have the right to redeem every nominal €1,000 of the old bonds for just €0.001 cents.
This was a fearsome threat. Unsurprisingly, it secured AIB acceptance in respect of 92.3% of the total new bond issue by November 19 2010, the closing deadline that it had set for acceptance of the exchange offer. Each bondholder acceptance was conditional on AIB securing the requisite super-majority - which it did comprehensively. AIB duly accepted the conditional offers on November 22 2010. Assénagon was in the minority which had not accepted the exchange offer. On November 23 2010 a bondholder meeting was held in which the terms of the old bonds were amended to include the call option. On the following day the exchange of bonds for the participating bondholders settled. On November 30 2010 AIB exercised the call options on the remaining 7.7% of old bonds, and in doing so redeemed Assénagon's €17 million nominal holding for just €170.
Assénagon sought to quash the resolution by which the exiting bondholders had amended the terms of the old bond to include the call option on three grounds:
- The ultra vires argument - the collective action clauses did not confer power on the majority bondholders to authorise an expropriation of principal;
- The disenfranchisment argument - the exiting bondholder's bonds were beneficially owned (or their voting rights were controlled) by AIB at the time of the bondholder meeting which voted to amend the terms of the old bond to include the call option and, as such, the holders of those bonds were not permitted to vote under provisions of the collective action clauses; and
- The abuse of power argument - the particular use of the collective action clauses was an unlawful abuse of power by the majority on the minority.
Ultra vires argument
Assénagon argued that the bondholder resolution (to amend to include the call option) was, in form, a conferral of a power of expropriation on AIB, which fell outside the parameters of the amendments which the bondholder majority was permitted to make under the collective action clause. The judge clearly felt considerable sympathy for this and regarded the call option as a de facto expropriation. However, albeit with clear reluctance, he found that the terms of the relevant instrument (ie, the trust deed) expressly contemplated the prospect that the collective action clause could be used to effect a cancellation of principal. Accordingly, he found against the claimant on this ground.
Assénagon's second ground rested on a standard provision in the collective action clause which excluded from voting rights any bonds that were held by or beneficially for the issuer, AIB. As the participating bondholders had all made conditional offers to exchange their old bonds to AIB, the conditions of those offers had been met, and the offers had then been accepted by AIB, the argument was that all of the participating 92.3% of bonds were excluded from the class of voting rights because they were being beneficially held for AIB by the time of the bondholder meeting.
AIB's responses to this argument were varied. The response which the judge took most seriously was an argument that the time at which the beneficial interest in the bonds in question was to be judged (for the purpose of determining whether they were excluded from the voting class) was the time at which the bondholder decided whether to make the conditional offer to accept the exchange offer - and thus before the contract to exchange bonds with AIB was formed and before AIB could have had any beneficial interest in the old bonds. The judge found that it would be impractical to expect the bondholder meeting to be conducted with reference to such a test of entitlement, which would require an enquiry as to the position of each bondholder at the time that it reached its decision. Accordingly, he found that this could not have been the contractual intention, which must have been that the entitlement to vote be determined at the time of the meeting at which the votes were to be cast.
AIB also argued that the beneficial ownership of the participating 92.3% of bonds had not passed to it at the time of the bondholder meeting, as that was held the day before the settlement date and the contracts were not capable of specific enforcement. The judge accepted that securities market contracts are ordinarily incapable of specific enforcement because the liquidity in those markets means that replacement securities can be readily obtained, such that damages are an adequate remedy. However, in this case the judge found that AIB was seeking to retire the whole issue of bonds. Accordingly, he found that damages would not have been an adequate remedy for AIB if the participating bondholders had failed to settle in the exchange, and so the contracts were capable of specific enforcement. This meant that AIB held the beneficial interest in the 92.3% of bonds submitted in the exchange offer, and so all of those bonds were disqualified from voting under the collective action clause procedure. As such, the resolution to amend the old bonds to include the call option was declared invalid.
Abuse of power
Although it was not strictly necessary to do so in light of his finding on the second issue, the judge went on to consider Assénagon's third limb of attack. One key principle - which was common ground between the parties - was that, as Viscount Haldane put it in the Privy Council case of British America Nickel Corporation Ltd v MJ O'Brien Ltd:(2)
"There is, however, a restriction on such [similar] powers, when conferred on a majority of a special class in order to enable that majority to bind a minority. They must be exercised subject to a general principle, which is applicable to all authorities conferred on majorities of classes enabling them to bind minorities; namely, that the power given must be exercised for the purpose of benefiting the class as a whole, and not merely individual members only."
Assénagon argued that the imposition of the call option did not meet this test of benefiting the class of bondholders as a whole, and that it was instead simply an unfair oppression of the interests of the minority bondholders by the majority.
AIB's position was that the exchange offer and the proposed exit consent procedure had to be considered as a whole – at the point at which it was presented to the bondholders as a class, it was open for acceptance by all. The inducement inherent in the call option was made clear and public. In that regard, AIB relied on various case law and persuasive materials which suggested, in the words of the judge, that:
"where the alleged abuse of a power to bind a minority lies in the offer of an inducement to support the scheme (usually to some rather than all of the class) then the objection will usually fail if the inducement is properly disclosed to all members of the class."
The judge agreed with this proposition to an extent. However, he found that the transparency of the inducement could not override the requirement that the majority exercise the power in the interests of the class as a whole. He concluded that the question which he had to determine was "whether it can be lawful for the majority to lend its aid to the coercion of a minority by voting for a resolution which expropriates the minority's rights under their bonds for a nominal consideration".
As to which, the judge concluded:
"the correct answer to it is in the negative… The exit consent is, quite simply, a coercive threat which the issuer invites the majority to levy against the minority, nothing more or less. Its only function is the intimidation of a potential minority, based upon the fear of any individual member of the class that, by rejecting the exchange and voting against the resolution, he (or it) will be left out in the cold…
Putting it as succinctly as I can, oppression of a minority is of the essence of exit consents of this kind, and it is precisely that at which the principles restraining the abusive exercise of powers to bind minorities are aimed."
Although potentially subject to appeal, this judgment sets down some clear limits to the use of collective action clauses and the exit consent procedure. These should not be overstated. Both the judge and Assénagon's counsel accepted that an exit consent procedure which resulted in the minority being given the same treatment as the majority would be a very different case. For instance, if the collective action clauses and exit consent procedure had been used merely to amend the terms of the old bond to match the new bonds, the outcome would almost certainly have been different. It was in the differential treatment of the minority - and especially in the de facto expropriation from the minority bondholders - that AIB, acting through the majority bondholders, had overreached itself.
The case would also have been very different if there had been an opportunity for the minority bondholders to enter into the exchange offer after it had become clear that a sufficient majority of the bondholders had accepted the exchange to mean that the old bonds would be transformed into worthless assets. As it was, there was no such opportunity for the minority bondholders to avail themselves of that equal treatment.
The judgment leaves ample room for issuers to construct exit consent procedures which give meaningful inducements to facilitate the orderly restructuring of debt obligations, while setting some welcome and obvious barriers to help protect against such egregious abuse of those procedures.
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