The Volokh Conspiracy - What New Bond Covenants Would You Demand

as protection against political risk following the government's pressures on senior and secured creditors of Chrysler?

In my development finance work in the developing world, I have undertaken a lot of negotiations with businesses (mostly media companies) in places ranging from South Africa to Guatemala to Serbia looking to borrow money. The nonprofit private equity fund I work with has standard loan documents, of course, and over the years has looked to tailor them to fit risky investment in these environments with less than perfect adherence to the rule of (contract) law.

As I watch the Detroit restructurings unfold, particularly the strong-arming of senior and secured creditors, I wonder what new covenants creditors might want to put into new bond issuances by US businesses that might eventually become entangled with government. I've been reflecting on this looking back over the standard documents that I have used over the past twenty years. Interestingly, the contract forms I've used do not have very many special political risk terms.

Why not? Because the general assumption is that no political risk covenant can really protect you in a place where contracts are not enforced — political risk of that kind involves yanking the floor out from under the investor altogether. If a contract term that provides for secured creditor status will not be enforced, why think that a covenant requiring repayment in case of political risk such as expropriation will be enforced either? The nature of political risk is that it is a risk running to the very rules of the game.

Of course that is not completely true. There are political risks and there are political risks, if you are investing in the developing world or, alas, today the United States. The United States seems, in these contract matters, not to resemble the rule of law in Angola, sure — but it is distinctly starting to resemble, ever so little-bit-by-little-bit, the rule of law in China. There is a certain amount of neutral contract enforcement, but also a hefty amount of political thumb on the scale, and many uncertainties attached — and without getting hysterical about it, the American trend line is going that direction. It might be most useful to look at Western contracts with Chinese companies to get good ideas on "mixed" cases of this 'sort-of-rule-of-law, sort-of-not', because that seems to be the drift of Obama administration industrial policy.

So here's my question. What covenants would you put into a new bond issuance by an American company — say a non-Detroit car manufacturer — or an insurance company or a health care provide? Some company in which you thought the chances of US government behavior of the kind on display in Chrysler were not negligible or hypothetical over the next decade. Assume you are looking for senior creditor status; not so worried about special issues of secured versus senior status - focus on political risks common to all senior creditors in this new (third) world.

Plenty of commentators have said that creditors will, over time, demand higher interest rates to compensate them for higher risk from political re-ordering of creditor priority. True. Less discussed (as far as I know but I welcome links to good discussions) is that creditors and borrowers will presumably also look to reduce that interest rate hike by trying to reduce the uncertainties of political risk, through bond covenants that would allocate the risks today of future political contingencies. If you can't trust the rule of contract law at all, then those efforts are for naught. But if what happens if you think you can't trust creditor priority in bankruptcy — but other kinds of contract terms might be enforced? Should you negotiate for those covenants, or is this like being a little bit pregnant?

Here's an example. Something I have sometimes negotiated into developing world debt covenants is a political risk form of a poison put. It is merely a standard poison put, used to address changes of corporate control, adapted to political risk. Nothing special. It simply says that if certain political contingencies occur, such as a government (or union) move to take direct or indirect control of the borrower-corporation, the creditor bondholders can at their option put the bonds back to the corporation and require full repayment of principal, and whatever is negotiated for interest and penalties. It is a response to this particular political risk, not of full-blown rule of law breakdown — but instead of what might be under local law a legal move by the government. It allocates the risk and presumably gives the borrower-corporation some incentive not to seek government involvement.

I haven't inserted it often, and have never even thought about trying to enforce it (Montenegro or Macedonia? Zimbabwe? Indonesia?). Is this kind of political risk poison put worth using in future American corporate bonds? Or is it 'a little bit pregnant' and no matter what you wrote in the poison put, it would be subject to the same political re-writing? After all, though I haven't looked, isn't it likely that Detroit's existing bonds have change of control provisions anyway? Leaving aside its practical effect (or not), what about the effect on the interest rate? Would this be likely to reduce the uncertainties and so reduce the interest rate for risk? Or is it a mostly futile exercise?

Finally, let me ask if there are any other covenants you would think to negotiate into future bond issuances to protect against political risks. (And I have to say, the idea that I would ever be publicly airing such a question about leading US corporations and the bond market, looking to my experiences in the developing world for counsel and advice is, well, shocking.)

(Update: A couple of the comments make the very fair point that the assumption of the post is that the government intervention makes the bondholders worse off. The commenters are correct - that is the post's assumption, and it might well be contested. For purposes of this post, however, let me make that assumption, because what I propose to get at is whether there is a reason to seek covenants in cases where the bonholders will indeed be made worse off and, assuming such covenants could be drafted and enforced, what they might be. I grant that I am assuming that the current Detroit interventions make bondholders worse off than otherwise.)

(Further update — a couple of other quick thoughts. Thanks for these interesting comments. On the question of a party getting third party insurance, eg through a swap or other derivative, it might solve that party's problem, but ultimately, overall, new political risk (using my assumptions above) have been introduced into the system as a whole and risk shifting among parties doesn't make that go away (although it might allocate the risks more efficiently to some extent but, to be honest these days, let's not 'bet' on it (a joke sufficiently obscure but funny to qualify for XKCD status??)).

With reference to the question of what's the problem with government intervention if it makes the company stronger - the question is not whether it makes the company stronger, but the next question of whether it makes the bondholders stronger. It's a little like the classic question of what does 'return' mean in the triad of risk, return, and control: there might indeed be a return to the enterprise, but unfortunately you don't share in it. Here, the restructuring (on my assumptions, granted) might leave the company better off, but does so in a way to leave the UAW better off and the bondholders worse off.

With respect to the suggestion that the bondholders might simply insert covenants allowing the bondholders to bail for any reason any time they like ... it's possible that raising the possibility of political risk that a rational bondholder might want to protect against, if possible, is like simply allowing the bondholder the option bail on whatever grounds it likes. I suppose. But that does not seem like the best way to understand the problem. There seems to be a political risk problem that didn't seem to be there before. Asking whether there are specific ways in which that can be addressed in advance - if it can - is not asking to have a free-exit card. Poison puts have existed for decades with specific rights, but also negotiated limits, attached.

Finally - because I have to go to the gym this summer and improve my chances of living through middle age - I want to raise a question about how best to analyze the point in the comments that the only real protection is to charge a higher interest rate. Why? Because if you can't trust enforcement in the future, you should instead collect up front. Of course, carried to its logical extreme, you would protect against everything by lending the money now and collecting a nanosecond later. The comment was not proposing that, but it was proposing collecting higher interest payments in order to have more money upfront to compensate for future risks. How should we analyze that from a financial instruments perspective? Form of an option, I suppose, in which the other party - the government, say - has the option to alter the payback terms in various ways, and so is the holder, while the lender is the writer who is collecting a premium in the form, not precisely of interest payments as such, but rather the excess interest payment over what would have been charged absent the option held by the government. I suppose that is how you would price the additional interest stream, but I am ready to be corrected. Okay off to the gym - an option, I guess, running in favor of God? Or the other way around?)

	[Kenneth Anderson, June 2, 2009 at 11:05am] Trackbacks What New Bond Covenants Would You Demand as protection against political risk following the government's pressures on senior and secured creditors of Chrysler? In my development finance work in the developing world, I have undertaken a lot of negotiations with businesses (mostly media companies) in places ranging from South Africa to Guatemala to Serbia looking to borrow money. The nonprofit private equity fund I work with has standard loan documents, of course, and over the years has looked to tailor them to fit risky investment in these environments with less than perfect adherence to the rule of (contract) law. As I watch the Detroit restructurings unfold, particularly the strong-arming of senior and secured creditors, I wonder what new covenants creditors might want to put into new bond issuances by US businesses that might eventually become entangled with government. I've been reflecting on this looking back over the standard documents that I have used over the past twenty years. Interestingly, the contract forms I've used do not have very many special political risk terms. Why not? Because the general assumption is that no political risk covenant can really protect you in a place where contracts are not enforced — political risk of that kind involves yanking the floor out from under the investor altogether. If a contract term that provides for secured creditor status will not be enforced, why think that a covenant requiring repayment in case of political risk such as expropriation will be enforced either? The nature of political risk is that it is a risk running to the very rules of the game. Of course that is not completely true. There are political risks and there are political risks, if you are investing in the developing world or, alas, today the United States. The United States seems, in these contract matters, not to resemble the rule of law in Angola, sure — but it is distinctly starting to resemble, ever so little-bit-by-little-bit, the rule of law in China. There is a certain amount of neutral contract enforcement, but also a hefty amount of political thumb on the scale, and many uncertainties attached — and without getting hysterical about it, the American trend line is going that direction. It might be most useful to look at Western contracts with Chinese companies to get good ideas on "mixed" cases of this 'sort-of-rule-of-law, sort-of-not', because that seems to be the drift of Obama administration industrial policy. So here's my question. What covenants would you put into a new bond issuance by an American company — say a non-Detroit car manufacturer — or an insurance company or a health care provide? Some company in which you thought the chances of US government behavior of the kind on display in Chrysler were not negligible or hypothetical over the next decade. Assume you are looking for senior creditor status; not so worried about special issues of secured versus senior status - focus on political risks common to all senior creditors in this new (third) world. Plenty of commentators have said that creditors will, over time, demand higher interest rates to compensate them for higher risk from political re-ordering of creditor priority. True. Less discussed (as far as I know but I welcome links to good discussions) is that creditors and borrowers will presumably also look to reduce that interest rate hike by trying to reduce the uncertainties of political risk, through bond covenants that would allocate the risks today of future political contingencies. If you can't trust the rule of contract law at all, then those efforts are for naught. But if what happens if you think you can't trust creditor priority in bankruptcy — but other kinds of contract terms might be enforced? Should you negotiate for those covenants, or is this like being a little bit pregnant? Here's an example. Something I have sometimes negotiated into developing world debt covenants is a political risk form of a poison put. It is merely a standard poison put, used to address changes of corporate control, adapted to political risk. Nothing special. It simply says that if certain political contingencies occur, such as a government (or union) move to take direct or indirect control of the borrower-corporation, the creditor bondholders can at their option put the bonds back to the corporation and require full repayment of principal, and whatever is negotiated for interest and penalties. It is a response to this particular political risk, not of full-blown rule of law breakdown — but instead of what might be under local law a legal move by the government. It allocates the risk and presumably gives the borrower-corporation some incentive not to seek government involvement. I haven't inserted it often, and have never even thought about trying to enforce it (Montenegro or Macedonia? Zimbabwe? Indonesia?). Is this kind of political risk poison put worth using in future American corporate bonds? Or is it 'a little bit pregnant' and no matter what you wrote in the poison put, it would be subject to the same political re-writing? After all, though I haven't looked, isn't it likely that Detroit's existing bonds have change of control provisions anyway? Leaving aside its practical effect (or not), what about the effect on the interest rate? Would this be likely to reduce the uncertainties and so reduce the interest rate for risk? Or is it a mostly futile exercise? Finally, let me ask if there are any other covenants you would think to negotiate into future bond issuances to protect against political risks. (And I have to say, the idea that I would ever be publicly airing such a question about leading US corporations and the bond market, looking to my experiences in the developing world for counsel and advice is, well, shocking.) (Update: A couple of the comments make the very fair point that the assumption of the post is that the government intervention makes the bondholders worse off. The commenters are correct - that is the post's assumption, and it might well be contested. For purposes of this post, however, let me make that assumption, because what I propose to get at is whether there is a reason to seek covenants in cases where the bonholders will indeed be made worse off and, assuming such covenants could be drafted and enforced, what they might be. I grant that I am assuming that the current Detroit interventions make bondholders worse off than otherwise.) (Further update — a couple of other quick thoughts. Thanks for these interesting comments. On the question of a party getting third party insurance, eg through a swap or other derivative, it might solve that party's problem, but ultimately, overall, new political risk (using my assumptions above) have been introduced into the system as a whole and risk shifting among parties doesn't make that go away (although it might allocate the risks more efficiently to some extent but, to be honest these days, let's not 'bet' on it (a joke sufficiently obscure but funny to qualify for XKCD status??)). With reference to the question of what's the problem with government intervention if it makes the company stronger - the question is not whether it makes the company stronger, but the next question of whether it makes the bondholders stronger. It's a little like the classic question of what does 'return' mean in the triad of risk, return, and control: there might indeed be a return to the enterprise, but unfortunately you don't share in it. Here, the restructuring (on my assumptions, granted) might leave the company better off, but does so in a way to leave the UAW better off and the bondholders worse off. With respect to the suggestion that the bondholders might simply insert covenants allowing the bondholders to bail for any reason any time they like ... it's possible that raising the possibility of political risk that a rational bondholder might want to protect against, if possible, is like simply allowing the bondholder the option bail on whatever grounds it likes. I suppose. But that does not seem like the best way to understand the problem. There seems to be a political risk problem that didn't seem to be there before. Asking whether there are specific ways in which that can be addressed in advance - if it can - is not asking to have a free-exit card. Poison puts have existed for decades with specific rights, but also negotiated limits, attached. Finally - because I have to go to the gym this summer and improve my chances of living through middle age - I want to raise a question about how best to analyze the point in the comments that the only real protection is to charge a higher interest rate. Why? Because if you can't trust enforcement in the future, you should instead collect up front. Of course, carried to its logical extreme, you would protect against everything by lending the money now and collecting a nanosecond later. The comment was not proposing that, but it was proposing collecting higher interest payments in order to have more money upfront to compensate for future risks. How should we analyze that from a financial instruments perspective? Form of an option, I suppose, in which the other party - the government, say - has the option to alter the payback terms in various ways, and so is the holder, while the lender is the writer who is collecting a premium in the form, not precisely of interest payments as such, but rather the excess interest payment over what would have been charged absent the option held by the government. I suppose that is how you would price the additional interest stream, but I am ready to be corrected. Okay off to the gym - an option, I guess, running in favor of God? Or the other way around?)