Look before you leap
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19 September 2013
2 July 2014
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6 December 2013
6 December 2013
Mr Justice Jacob's recent decision denying the petition for administration against Colt Telecom Group provides keen insights into the rough-and-tumble world of certain hedge fund tactics in distressed economic sectors.
It also highlights the difference between the US statute governing involuntary petitions in the US and the UK Insolvency Act 1986. At the core of a distressed economic sector is the fragility of companies attempting to survive. Experienced persons in distressed economic sectors understand that fragility. Going concerns depend on continuing trade vendor credit, employee loyalty, customer support and sometimes bank support and equity market support.
Once a company is publicly targeted for administration or bankruptcy, the withdrawal of support from one or more of these constituencies can quickly lead to a death-spiral, rendering the company unable to operate outside administration regardless of the merits of the petition for administration.
Because of the potentially disastrous consequences of an involuntary bankruptcy petition, the US statute allows the bankruptcy court to sanction unsuccessful involuntary petitioners with costs and attorneys' fees.
If the court finds the petition was filed in bad faith, the statute further provides for the petitioners to be liable for proximately caused damages and punitive damages. Under some circumstances, the petitioners' attorneys may also be liable.
The spectre of this cornucopian array of punishments makes involuntary bankruptcy petitions extremely precarious undertakings in the US, relatively commensurate with the harm to be expected from imprudent or negligent petitions.
Notably, US courts normally find bad faith when the petitioners know, or should know, their petition will not be sustained, or when they file it for purposes of harassment, unfair competition or other improper motives.
The inherent uncertainty as to what a bankruptcy judge will determine is bad faith, however, is an important factor, prodding US practitioners to be extra cautious.
The 1986 UK Insolvency Act does not expressly provide for sanctions equivalent to those in the US for bad faith petitions, although the general rule in England that costs follow the event means unsuccessful petitioners can expect to suffer a heavy costs burden.
In the world of game theory, this widens the availability of hardball tactics for shrewd investors.
In the Colt situation, all parties and advisers were ultra-sophisticated. There seems little doubt that, when the investor bought Colt's bonds at a discount and shorted Colt's stock, the investor and its advisers had read the 'no-action' clause in the indenture and realised that it might (or maybe realised that it would definitely) preclude successful prosecution of a petition for administration. (Cases cited before Judge Jacob detailed unsuccessful attempts by those backing the investor to defeat no-action clauses in the US in similar circumstances.)
But there is a huge distance between the making of the investment and final judgment, and a plethora of opportunities to profit prior to judgment and then to withdraw the petition.
After all, the investor saw Colt sitting on immense cash reserves and the drill was very likely to simply figure out how to convince Colt to use some of the cash to repurchase the investor's bonds at a profit, or to force the company to agree to a solvent restructuring involving a debt-for-equity swap.
According to Judge Jacob's decision, the investor sent Colt's directors a letter (improperly in his view), not so subtly reminding the company of personal liability under certain circumstances. When that did not convince Colt to part with some of its cash to settle with the investor, the petition for administration followed.
It is highly implausible the investor and its advisers did not understand the petition's obstacles. Aside from the no-action clause in the indenture, Colt's market capitalisation, in excess of £500m, the company's balance sheet net worth of nearly £1bn (after a recent write-down of its assets), its raising of £500m from shareholders a year earlier, its cash reserves of £455m, and its indentures not due for several years, together formed a daunting defence to an insolvency challenge.
Moreover, the investor's advisers were surely in a position to know that its US legal expert on the no-action clause would admit that US courts had interpreted the clause, albeit erroneously in his view, against the interests of the investor.
Likewise, it was positioned to know that its accounting expert would admit that their opinion was not all that reliable.
That the matter proceeded to judgment under these arduous circumstances for the sophisticated investor and its skilled advisers strongly suggests that the investor never believed it would reach judgment, and/or the investor did not believe that there was any significant downside to losing.
That it did not believe it would reach judgment is borne out by the proposed administrator's revelation in the witness box: he thought the chances of an administration order being made were quite low.
If the investor believed there was no significant downside to its position should it lose, then it was clearly wrong (unless it managed to profit from its hedge in some way).
Judge Jacob's decision has placed very considerable hurdles in the way of anyone now seeking to present an involuntary administration petition.
The major credible threat currently available to distressed debt investors negotiating with companies in the UK has been shown to have limits not previously so clearly defined.
Quite possibly, because the market already knew the entire telecoms sector was distressed, Colt was not as adversely affected by the investor's tactics as might have been anticipated.
Colt's courage, its cash reserves and its foresight in having sold bonds with long maturities and no-action clauses paid off.
An interesting inquiry would be what the investor could have done better. Because Colt inserted the no-action clause in its indenture, it is hard to quarrel with the notion that the 'deal' was that Colt would have several years to work on a highly speculative venture without bondholder interference.
If the no-action clause was interpreted differently, petitions for administration could be filed against many start-ups on the day they issue debt just by referring to the risk factors listed in their disclosure materials.
This appears to be a case where in the US the investor would work longer and harder on impressing the directors with their fiduciary duties, while the advisers must be prepared to tell the client what it does not want to hear - namely, that judicial recourse would be wrong. Either that or sell up and choose another victim.
Martin Bienenstock is managing partner of Weil Gotshal & Manges and co-chair of the business finance and restructuring department. Christopher Mallon is head of the business finance and restructuring group at the firm