How the Automated Restructuring of Tokenized Securities Can Lower the Cost of Capital

In a recent paper, we make the case for a smart contract-based automated restructuring framework that can be used by any firm that issues equity and debt securities in tokenized form. The paper is the basis for an actual smart-contract suite that technically implements the proposal as a template that can be used and built on by any interested firm.

Since it is now possible to administer capital structures on the blockchain, opening them up to smart contract automation has become a reality. The tokenisation of traditional debt and equity securities is an important growth area and promises enhanced liquidity and access to capital for many smaller and medium sized enterprises. To accommodate and facilitate these developments, several jurisdictions have begun to adjust their general private and commercial law frameworks.

Firms in financial distress must frequently rely on the applicable statutory restructuring regimes to put their capital structure on a more sustainable footing. These traditional frameworks seek to mitigate the clash between the demands of ex post and ex ante efficiency: The former requires a quick legal process that can easily overcome minority dissent and holdouts by re-writing investors’ entitlements. The latter necessitates the protection of ex ante agreed property rights to the greatest possible extent. The result is an unhappy compromise that favors the former at the expense of the latter. The inevitable lengthy negotiations and disputes about asset valuation and value attribution are a drain on corporate resources that could otherwise benefit the rescue effort and society overall.

We propose a smart contract design that solves the valuation problem without any prior knowledge of actual asset values and thus without the need for any off-chain data. This solution, in turn, provides a fix for the initiation problem – when to trigger an automated restructuring – by relying on the optimal incentivization of the constituency best placed to make the call. Combining the automated restructuring proposals, developed by Barry Adler and others in the 1990s, with Lucian Bebchuk’s option model, our solution provides token holders with precisely what is due to them under the terms of the issue. Because investors will be much better able to appreciate their treatment in the restructuring context, the cost of capital for firms using our model should be much reduced.

Specifically, capital-structure debt and equity are tokenized and issued through a smart contract (the Capital Structure Smart Contract – CSSC) with an embedded restructuring function. When the restructuring function is called, all equity and junior debt will be cancelled (the respective tokens “burned,” and the token balances set to “zero”). At the same time, New Equity Tokens (NET) will be issued, at an exchange rate of $1 nominal junior debt or$1 par value old equity for $1 par value new equity. The NETs will be credited to a separate smart contract address, the Restructuring Smart Contract (RSC). As a result, the firm immediately emerges with a much-reduced debt load. When called by the CSSC, the RSC will generate a set of new tokenized entitlements and allocate them to the previous holders of equity and junior debt.

These entitlements are rights with embedded options on the newly created equity tokens: Each incumbent equity holder will receive a Shareholder Call Option (SCO) that entitles the holder to purchase his fraction of the New Equity Tokens for a strike price equal to the holder’s pro rata fraction of the total nominal amount of junior debt. The SCO is time-limited and must be exercised, say, two weeks from when the restructuring has been triggered. A shareholder exercises his SCO by sending the respective transaction message and funds (in the form of supported stablecoins) to the RSC. Since it will be on their behalf that management may trigger the restructuring function, shareholders should have time to assess the firm’s prospects and obtain the necessary liquidity in advance.

Each member of the class of junior debt will receive a Junior Creditor Right (JCR). A JCR may be redeemed for the holder’s pro rata fraction of the total amount of junior debt. For any JCR not redeemed, the holder will be entitled to exchange the JCR for her pro rata fraction of NETs. These rights must be exercised, by sending the respective transaction message to the RSC, upon expiration of the SCOs. This time frame should be sufficient for junior creditors to carry out due diligence and obtain the necessary information. Any remaining NETs that have not been claimed either based on SCOs or JCRs will be burned. Redemption of JCRs is managed by the RSC with the funds received following the exercise of any SCOs, which will be used pro rata to redeem JCRs.

Should the firm’s financial condition continue to deteriorate, restructuring may be triggered again, and the process repeated for equity and the next highest debt class (senior debt). Where the tranches of capital structure debt have been exhausted, no further automated restructuring is possible, still leaving the option of a traditional statutory restructuring and an eventual insolvency process.

With our smart contract solution, no class of creditors will ever be worse off following an automated restructuring than what they have bargained for, respecting the principle of absolute priority and preserving ex ante efficiency. The certainty of this (baseline) outcome, in combination with the transparency of treatment, should reduce ex ante financing costs. Equity holders may be worse off in certain circumstances but only if they misjudge the firm’s asset value and fail to fully exercise their SCOs.

Technically, restructuring is triggered simply by sending a transaction message to the CSSC, calling the restructuring function. The firm’s management is best placed to spot the signs of financial distress. In fact, they must stay on top of any warnings if the cash reserves or asset base of the company have been eroded so that the creditors may not get paid when due. Management should trigger restructuring with a view to preventing insolvency as soon as default is on the horizon. This requires a business judgment as to whether the firm can trade out of its difficulties without triggering restructuring or whether an automated restructuring is necessary to save the firm. Our smart contract restructuring solution does not relieve management of having to make that judgment call. It does, however, set incentives to pull the trigger at the right time, reinforced by traditional remedies.

This post comes to us from Michael Schillig, Christoph Kletzer, and Andrei Balcau at King’s College London. It is based on their recent article, “Smart Restructuring Tokens,” available here.

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