A memorandum prepared by law firm Wachtell Lipton looks at what it calls the “rise of the net short debt activist.” Wachtell Lipton earned its wings on Wall Street as a defender of established managements when those managements find themselves facing activism or takeover. Indeed, one of the founding partners, Martin Lipton, invented the “poison pill” as a mechanism for frustrating takeovers.
The authors of the debt-activist memo, Joshua A. Feltman et al., begin with the observation that the market for corporate debt/bonds would not seem a likely source of “activism.” The holders of debt do not have votes in the election of a board, for example, or on major transactions. The typical purchaser of a bond is determinedly passive.
The New Activists
But a new sort of debt investor has appeared on the scene quite recently, the memo says, and this new activism defies the old mold. The activists in question buy long corporate debt in order to assert defaults and in this way to profit on a short position (such as a credit default swap) that enables the activist to collect on a default.
The investor must have a position on the long side in order to assert the default, and of course given the strategy at work the investor will have a smaller long position than the short.
If it takes a large enough long position it can serve a formal default notice. As the memo observes this usually involves 25% of a bond tranche. But that is not necessary for working this strategy. Even a public letter asserting a covenant violation can increase the value of the short position on the one hand and worsen the target company’s position in the credit markets on the other.
Such activism creates an asymmetric risk for the targeted company.
Feltman et al., invoke the Windstream case as a paradigm of this strategy. A hedge fund run by Mark Brodsky, Aurelius Capital, sent a notice letter to Windstream Services in September 2017 asserting that Windstream, a telecom company, had defaulted in certain senior unsecured notes, 6.37% senior notes due 2023, by virtue of violations of the 2013 indenture. Specifically, Aurelius alleged that the spin-off of a REIT in April 2015 had constituted a sale and leaseback transaction and that such transactions were prohibited under section 4.19 of the indenture.
If this notice was in fact a written notice of default (a characterization that Windstream would dispute) then it would have triggered a 60-day grace period, at the end of which holders could declare the principal amount of all outstanding 6.375% notes to be immediately due and payable.
Such notices can trigger epic and complicated litigation. In the Windstream case, the issuing company filed suit against US Bank NA, the Indenture Trustee, in Delaware Chancery Court seeking a declaration that it had not violated any provisions of the 2013 Indenture. In October 2017, that Trustee filed suit in federal district court in Manhattan seeking a declaration that defaults had occurred.
While contesting the claim that it was in default, Windstream has also worked to cure the alleged default, with a series of debt exchanges and consent solicitations. Both the litigation and the efforts to cure are expensive, and they exemplify, as the Wachtell memo says, the risks that activists of this sort can pose.
Wachtell recommends that its clients take the lesson to heart, for example by avoiding covenants that lend themselves to technical breaches that would in turn give ammunition to such an activist.
A Final Thought
In a more recent follow-up memo, Wachtell has added the term “default archeology” to the corporate lawyers’ lexicon. It says that “because debt documents almost never include an express time bar for defaults, the acquiescence of debt holders to a corporate transaction when it actually occurs … does not necessarily prevent a default activist from asserting defaults based on the same transaction years later.”