Bloomberg’s multi-talented Matt Levine recently wrote:

One of my favorite recent stories in bond documents is the one about how private equity firms changed a sentence in bond documents, which usually says that companies can’t make restricted payments if “a Default or Event of Default shall have occurred,” to instead say that they can’t make the payments if “an Event of Default shall have occurred.” (here)

As Robert Smith of the Financial Times (quoted in Levine’s piece) explains:

To a layman, [the foregoing likely] sounds the same. But there is an incredibly important distinction.

If you miss an interest payment, it’s a default. But the formal “event of default” doesn’t happen until 30 days later, as the bonds have a grace period.

By deleting the default part, the company could miss an interest payment, and then strip a load of cash out of the business before formally defaulting. That is really bad!

This episode raises all sorts of intriguing questions, such as whether the private equity lawyers were being devious in putting in the change and why the underwriters and their counsel failed to object.  But what interested us the most was the next portion of Levine’s piece:

Bondholders, as it happened, noticed the change and pushed back in a deal last year—but they hadn’t noticed it in several previous deals.

So, as told by Levine, bondholders woke up and noticed the change from “a Default or Event of Default” to “an Event of Default” in the covenant after a few deals with the sneaky language.  Bond investors on the secondary market, in our experience, do not spend a lot of time reading bond contracts. They instead rely on the reputational interests of underwriters and other forces to produce an appropriate standard form and usually only seek to ensure that their bond contracts conform to this standard.  They are, in other words, sleepy as far as policing the language of contract terms.

The question then is:  What makes them notice the kind of tiny change described above, and what happens to future deals when they do?

In our article, “Sleeping Giant Contracts,” we use the events surrounding a November 2016 opinion by the U.S. District Court for the Southern District of New York, Cash America v. Wilmington Savings (here), to explore these questions.

Bond indentures commonly contain what are called “make-whole” provisions that give the issuer of the bonds the option to redeem the bonds, generally at a premium over par. Bond indentures also contain an acceleration clause that gives bondholders the option, upon an Event of Default, to demand immediate payment of the principal amount and receive par. To reiterate, redemption is an option of the issuer while acceleration is an option for bondholders.

In Cash America, the issuer was found to have violated a covenant in the bond indenture, thereby generating an Event of Default.  The court ruled that when the issuer engaged in a “voluntary” covenant breach, holders are entitled to receive as a remedy the amount they would have received upon redemption, that is a premium over the amount receivable under the acceleration clause.  The decision caused much consternation among numerous elite law firms. Transactional lawyers argued that the contract didn’t say anywhere, or even imply, that the bondholders were entitled to such a remedy. (For more detail on the case and the various law firm memos, see here, here, and here). As an aside, although we agree with the transactional lawyers that the Cash America court’s grant of the make-whole remedy to the bondholders was peculiar as a matter of contract interpretation, the court was following Second Circuit precedent.

The level of outrage was such that the elite lawyers were able to overcome the well documented contract stickiness phenomenon (here).  Within a few months (not decades as found in some prior studies), revised language that explicitly negated the Cash America interpretation of the relevant provisions was added to over a dozen newly-issued bonds across the credit spectrum.

But then, in early 2017, driven by the efforts of Covenant Review, a firm that specializes in telling bond investors about the terms of their purchases, everything changed.  Covenant Review raised a hue and cry about how bond investors were getting screwed and events took a U-turn.  Investors organized and quashed the new language that lawyers were trying to insert in the contracts.  As fast as the contract language had gotten unstuck, it got stuck back. By March 2017, attempts to insert the Cash America corrective patch ceased.

This puzzling set of events intrigued us.  After having written a short piece, “Cash America and the Structure of Bondholder Remedies” (here) discussing them, we decided to go deeper and try and figure out what had caused the U-turn. Quantitative data was not going to be enough; we were going to have to talk to the lawyers and investors about why they did what they did.

Drawing on over 40 interviews with lawyers and investors in the high-yield bond world, we find evidence of a phenomenon we call the Sleeping Giant contract effect (here). This is a different dynamic than has previously been identified in the literature as causing contract stickiness, where the causes that have been hypothesized include network externalities, first-mover costs, negative signaling, and endowment effects (here and here).

Contracts, such as high-yield bonds, involve, on one side, sophisticated actors who are nevertheless not represented by their own lawyers. These are the big investors such as insurance companies, pension funds, mutual funds, and so on. Although these investors look carefully at the pricing terms, they generally do not read, or spend resources on hiring their own lawyers to read, their bond contracts which can easily run to 100 or so pages. As to non-pricing terms, these investors are mostly interested in whether the terms in their deals broadly conform to the standard “market” forms.  In effect, then, as far as the fine print in their contracts, investors are asleep. This was probably how the first dozen or so deals with the Cash America corrective patch got through.  Since the lawyers for both the issuers and the investment bankers were in agreement that the Cash America decision had misinterpreted the redemption provisions, they saw themselves as just correcting the contracts to put them back at the status quo – and hence saw no need to alert investors to a change in the contract language.

The fly in the buttermilk for the transactional lawyers who made the change, based on how they understood the language they had drafted, was that the investors who buy these bonds disagreed.  Investors, to the extent that they had any clear-cut expectations at all, based them not on the legal language, but on their experience with companies seeking to engage in transactions that would violate a covenant.  Such companies made a tender offer for their bonds at a premium, paid a consent fee to change the covenant, or redeemed their bonds at a premium.  What these companies did not do was violate the covenant and then say to bondholders: Make my day and accelerate to get par.  As investors saw it, the transactional lawyers for the issuers and investment bankers were putting these premia at risk by adding in their Cash America corrective language. They did not like this.  So much so that they decided that they were not going to buy bonds that used this language. And that was it.

What happened was unusual.  Investors are usually content with the standard package of contract terms and do not pay attention to the legalese.  But Covenant Review, by crying fire, woke the investor Sleeping Giant. Once awoken, the giant decided that what the fancy transactional lawyers were doing was not acceptable.

One characteristic of Sleeping Giant contracts is the gap in contractual understanding between the lawyers who drafted the contract language and investors. This gap is the key to the U-turn in the aftermath to Cash America.  Although, in our view, the lawyers were correct in their assessment that the contract language they drafted was not intended by the drafters to give bondholders the right to obtain the redemption premium upon a default, the court’s interpretation came closer to what investors thought the bond indenture should provide.

The core of our inquiry ends there. We were interested in unpacking the causal dynamics of the U-turn that occurred after the Cash America case.  It is, however, worth thinking about the broader implications of the Sleeping Giant phenomenon.

In particular, there are implications for the effect and function of courts’ interpretations of contract terms in Sleeping Giant contracts. For one, courts engaged in interpreting the meaning of ambiguous contract language in Sleeping Giant contracts should not look at what the lawyers who did the drafting say they were thinking.  In contracts where both parties are represented by lawyers, and these lawyers can inform their clients about their understanding of the contractual terms, it may be appropriate to impute the understanding and intent of the lawyers to their clients.  But bond investors in Sleeping Giant contracts lack the benefit of such legal representation and advice and should not be bound by the intent of lawyers that neither represent them nor communicate with them.

Second, a court ruling interpreting Sleeping Giant contracts may have the effect of focusing attention on what the contract should provide.  Under the standard paradigm, parties’ intentions precede, and are independent of, a court’s interpretation of a contract; if the court’s interpretation of certain language does not reflect these intentions, the parties will change the language accordingly.  In Sleeping Giant contracts, by contrast, it may be that parties’ intentions are not fully formed, and it is a court’s interpretation that induces parties to reflect upon how they want the contract to address a certain issue – in other words, a court’s interpretation may precede and affect parties’ intentions.

More broadly, Sleeping Giant contracts constitute a third contractual paradigm that lies between the classical paradigm – contracts between two parties that both understand and consent to the terms of their contracts – and contracts of adhesion, contracts where one side lacks the ability to modify and often fails to read the contract.  As in contracts of adhesion, bond investors often fail to read the bond contracts and only have a general sense of its provisions; but unlike in contracts of adhesion, bond investors have the ability to induce changes in these contractual provisions.

Sleeping Giant legends can be found around the world – including in Northern Ontario (here), Alabama (here), and Hawaii (here). Mitu’s childhood favorite is from India; the rakshasa Kumbhakarna, from the Mahabharat (here).

This post comes to us from professors Marcel Kahan at NYU School of Law and G. Mitu Gulati at Duke University School of Law. It is based on their recent article, “Sleeping Giant Contracts,” available here.