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"Everybody's Doing It" Legal Theory Does Not Protect English Bank Restructurings

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When people talk about financial innovation one of the main things they mean is legal innovation. CDOs, ETFs, MERS, the poison pill - most of the ways to smooth or roughen the path of investment take the form of jamming entities and contracts together in ways they've never gone together before.

Sort of by definition this innovation gets you ahead of what you know works legally: in the Anglo-American legal system, you mostly know for certain that something works because it already exists and some court or regulatory body has looked at it and found it okay, and for that to happen it has to exist first, before you know it works, all exposed and risky.* (You might ponder in your cold cold heart whether this order of operations helps explain why banking is so scandal-ridden.**) So you go to lawyers and you ask them if it works and they read the tea leaves of statutes and prior court decisions and they say go with it and mostly they're right - because if that wasn't the case you'd get better lawyers - but sometimes they're wrong.

Sometimes you're sort of surprised they're right. Once upon a time a lawyer told a company "here's what you do: you issue rights to all your shareholders, and as soon as a hostile bidder acquires 15% of the company, that bidder's rights will be cancelled and everyone else's will flip into a zillionty billion shares and the hostile bidder will be diluted down to nothing and you'll be like 'haha, now try taking us over.'" This was before my time, but I'm pretty sure that when he said this everyone looked at him funny. And then eventually someone did it, to see what would happen, and the courts looked at it and said "yeah, that sounds good," and now that is a thing (though not as much as it used to be), and that lawyer is pretty rich.

Other times - most times - the lawyers seem right, so you do it, and that becomes self-reinforcing. One company does a novel thing because the lawyers think it's okay, and then another company does that thing, and pretty soon everyone's doing that thing, and every lawyer thinks it's okay because, hey, everyone's doing it, and then when it gets to the courts the lawyers are all "of course this is okay, everyone does it, are you nuts?" Often the courts are persuaded by this, though not always, and again go think about banking scandals where everyone just assumed that what they were doing was okay because everyone else was doing the same thing.

Exit consents have a little of each of those paths. On first principles they are perhaps not as goofy as the poison pill, but they're pretty goofy. Basically exit consents are a device by which bond issuers coerce bondholders into restructuring their bonds. An issuer is expecting to run into trouble paying its bonds. The issuer offers to exchange those bonds for other bonds with a lower principal amount; many bondholders would agree since getting 60 cents worth of new bonds is better than getting 40 cents in default. But! If a lot of bondholders agree then it's a good idea to be a holdout, because if the issuer reduces its debt then it won't default and you'll get 100 cents by holding out. But! If the bondholders could just vote to waive certain rights in the bonds - for example, to allow the new bonds to be senior, or to waive financial covenants - then being a holdout may look less attractive than exchanging for the new bonds. And most bonds by contract allow some supermajority - 2/3, say - of holders to waive a lot of covenants (though, in the U.S., typically not payment terms). And the exit consent allows the issuer to link the vote and the exchange - so you hand your old bonds to the company and arrange by some legal fiction that you vote in favor of waiving the covenants a split second before your old bonds are exchanged for new bonds, which are handed back to you, poof, while the holdouts keep their crappy old bonds that you successfully voted to neuter.

This looks a little counterintuitive, but U.S. courts have allowed it for 25 years, so it's become standard. And like many U.S. financial innovations that have been blessed and become standard here, it's standard worldwide. It's available for sovereign debt restructuring, for instance. And it's widely used for corporate debt restructuring under English law. Until today:

In Assenagon Asset Management S.A. v Irish Bank Resolution Corporation Limited (formerly Anglo Irish Bank), Mr. Justice Briggs in the Chancery Division of the English High Court has ruled that the “exit consent” technique used by Anglo Irish (and a number of other Irish banks) in order to enforce losses on subordinated bondholders is not permitted as a matter of English law, which is the governing law of many of the bonds issued by the banks. Briggs J acknowledged that this was the first time that the legality of “exit consents” had been tested by the English Courts. He considered the US case of Katz v Oak Industries (1986), in which “exit consents” were upheld in Delaware, but expressly chose not to follow that case.

Anna Gelperin at Credit Slips explains why this is a big deal - Spanish bank restructurings! sovereign restructurings! choice of English versus New York law for bond issuance! - and all of these are good points but my favorite is that "The decision shows courts can and do rule on principle, market and policy consequences be darned." The judge is vaguely aware of those consequences - he says:

I was told (although it is impossible for the court to know for sure) that this technique has been put into significant, if not yet widespread, use within the context of bonds structured under English law, in particular in connection with the affairs of banks and other lending institutions requiring to be re-structured as a result of the 2008 credit crunch, so that a decision on this point of principle may be of much wider consequence than merely the amount at issue between the parties to this claim ...

And then goes ahead and decides "screw it, seems unfair, I don't care if it's become market standard and everyone's doing it." Sometimes that happens.

Assénagon Asset Management S.A. v. Irish Bank Resolution Corporation Limited [England and Wales High Court]
Exit Consents Killed in England? [Credit Slips]
Dramatic Development in Eurozone Bank Restructuring [Brown Rudnick]
Bail-ins, an exit consent challenge [FTAV]

* There are important big areas of exception to this, including SEC no-action letters (which, technically, are no guarantee of legality) and the whole thing where you lobby for Congress to explicitly bless something that you don't think is legal under current law before you go and do it.

** Like: Apple innovates by building computers, which for the most part everyone knows are legal. Pharma companies or, like, LightSquared innovate by building things that might be illegal, but they have to get regulator approval before they market them. Banks innovate by pushing legal boundaries, and are mostly tested after the fact. What would that do to your attitude toward law? Discuss. Should there be an FDA for financial innovation?


Rajat Gupta's Lawyers May Try The "Everybody Was Doing It" Defense

There is much to like in this morning's Journal article about the Rajat Gupta insider trading prosecution, including a nice illustration of how the inside information that Gupta allegedly passed to Raj Rajaratnam actually seems to have been out in the market already. But let's start with the transcript of the call between Raj Rajaratnam and his trader Ian Horowitz, which the Journal has redacted not for confidentiality but for saltiness: Just so you can see Raj Rajaratnam saying "fuck" a lot, the full transcript of that call is here. But, anyway, the Journal story: