June 1, 2021 - by Elliot Ganz. What is going on with loan market norms? A provocative article by Duke Law professor Elisabeth de Fontenay puts this question front and center. The events triggering de Fontenay’s article are the fallout from the huge mistaken payment made by Citibank in the Revlon loan and the collateral stripping and subordination transaction that preceded it. But she notes the broader widening gap in leveraged finance between the wishes and expectations of market participants and the outcomes they achieve under common law or through ever more heavily negotiated contracts. While the aggressive tactics used in several recent restructurings of distressed loans have been the topic of much conversation (and the LSTA itself has written about Serta and other liability management transactions and hosted a series of webinars discussing these strategies), Professor de Fontenay identifies the complex underlying causes including the eclipse of common law and the inability to construct a “complete” contract. And while there are some provocative ideas to address the challenge, there are no easy solutions.
The eclipse of common law? Loan agreements are overwhelmingly governed by New York law, primarily because New York law has traditionally been viewed as superior in substance to, and more predictable than, other jurisdictions. Professor de Fontenay questions whether these explanations remain true considering several recent decisions. In the Citibank/Revlon decision, for example, the court allowed lenders to retain the mistaken payment by relying on “(arguably) anachronous sources of authority” (based on circumstances that existed 30 years ago) and by failing to consider market expectations as to the correct outcome or undertake a thorough policy analysis. To be clear, the judge, in de Fontenay’s assessment, did exactly what judges typically do when interpreting the common law, i.e., apply relevant precedents and avoid making policy. The problem is that neither the decision maker (a generalist judge), the substance of the law, nor the methodology for reaching a decision (appealing to case-law precedent rather than market expectations) “seems well-suited to resolving today’s disputes over complex financing transactions among the most sophisticated parties.” Professor de Fontenay wonders whether parties to future financing transactions might be better served avoiding application of judge-made law to the maximum extent possible, either by (i) relying on alternative dispute resolution options (such as arbitration before a panel of experts) or (ii) highly negotiated contracts that contemplate in advance all contingencies.
The myth of the complete contract. De Fontenay notes that sophisticated parties have been relying on increasingly lengthy and complex contracts over the past few decades, seeking to avoid judicial intervention beyond simply reading and enforcing them precisely as written. The problem, she notes, is that contracts can never actually be complete: “There are always future states of the world that cannot be predicted, outcomes that cannot be provided for by contract even when predicted, linguistic ambiguities, and myriad other contracting frictions that render the complete contract a myth.” Ironically, attempts to write complete contacts often backfire; the complexity and length of the contracts can lead to unexpected interpretations, allowing parties to engage in “contractual arbitrage”. The lengthy and complex Revlon agreement, for example, did not prevent the company from stripping collateral and subordinating lenders in a manner they did not intend. The large number of recent contractual disputes involving distressed companies leads inexorably to the conclusion that not only have more detailed contracts not prevented opportunistic behavior, but they have also created new opportunities for such behavior.
What does this portend for the future of the market? De Fontenay first identifies two additional factors complicating the debt markets: (i) the decline in norms and relationships among market participants and their lawyers, and (ii) the decline in contractual protections for lenders resulting from the sustained demand for high-yielding loans. Suppose a judge is faced with a distressed borrower’s aggressive attempt to enforce a contract provision in a way that might not have been contemplated., Should the judge (i) reject such an attempt as impermissibly opportunistic because no contract can anticipate every contingency, or (ii) conclude, instead, that the lenders should have anticipated it and simply chose not to due to competitive market conditions? De Fontenay notes that while litigants generally do not desire robust judicial intervention in disputes among sophisticated parties, they will never succeed in writing contracts that insulate them from all risks. Thus, she concludes, we are left with the current paradox in the distressed debt world: Loan documents keep getting longer, yet opportunistic behavior by borrowers, agents and lenders is more prevalent than ever, and unexpected outcomes have become the new normal.
Can anything be done? This seemingly implacable problem may require “out-of-the-box” thinking. While not fully developing these concepts in her article, Professor de Fontenay identifies two possible solutions: (i) Replacing New York law with Delaware law to govern loan agreements and (ii) adopting alternative resolution solutions, such as arbitration, rather than relying on courts. De Fontenay argues in a footnote that in contrast to New York commercial law, Delaware corporate law “is thriving and widely respected by market participants, despite depending heavily on common law (or “judge-made” law)”. She cites two main factors. First, because Delaware judges are typically experienced practitioners and the court’s jurisdiction is limited to disputes among sophisticated parties, the judges have expertise in the subject matter and familiarity with market participants’ competing concerns, and second, the Delaware legislature constantly updates the corporate statute in response to suggestions from market participants and recent case law, such that Delaware’s judge-made law and statutory law “are in a continuous conversation with the market and with each other”. The reasons why arbitration might be attractive are similar. Arbitration panels typically consist of experienced market experts who understand the context of contractual disputes as well as the market’s expectations. The value of norms. The solutions cited above are clearly aspirational. Ideally, a return to norms would serve the market best. The loan market has been well served by long-standing norms of good faith and fair dealing, allowing it to grow into an efficient and vital source of capital for US companies. Such principles are fundamental to the LSTA’s mission: to promote a fair, orderly, efficient, and growing corporate loan market while advancing and balancing the interests of all market participants. Adherence to norms is important for the long-term health of any fair and free market, but they are ultimately contingent upon all market participants abiding by them.