Traditionally, senior lenders have wielded all the control in bankruptcy and out-of-court restructurings. They usually hold liens on all or substantially all the debtor’s assets and enjoy payment priority over virtually all other claimants. Meanwhile, modern debt instruments often contain covenants that give lenders control over the debtor’s business and financial decisions.

But in recent years, large corporate debtors such as J.Crew and Serta Simmons have aligned with certain of their senior lenders to pursue highly aggressive bankruptcy and out-of-court private loan restructurings. These transactions, which I called in a previous article “hostile restructurings,” are distinguishable from normal debt restructurings by their use of aggressive tactics to overcome not only the traditional minority-lender holdout problem, but also the collective bargaining power of an entire syndicated lender group.

The lenders that participate in hostile restructurings receive economic benefits in the form of new credit enhancements and investment opportunities, while nonparticipating lenders lose payment priority and lien rights. Most important, the lender group, as a whole, receives less than it would have received had it engaged in restructuring negotiations as a unified group. In this way, the debtor drives a wedge between its senior lenders, effectively dividing and conquering them.

In a recent article, I consider whether and to what extent alliance politics – rather than sound financial and economic decisions – may be driving restructuring outcomes, introducing new risks and inefficiencies in the financial markets. Specifically, I consult a rich body of literature – spanning political science, economics, business management, law, and psychology – on wedge strategies and divide-and-conquer tactics and use these insights to describe and analyze techniques by debtors and their stakeholders to prevent, break up, and weaken coalitions of senior lenders to achieve hostile restructurings.

I find that these tactics exacerbate the coordination problems already faced by senior lenders. In the modern commercial lending market, coordination among senior lenders is highly regulated via private ordering. They may be co-lenders under a syndicated loan, or their separate loans may be coordinated by intercreditor agreements. To help facilitate out-of-court restructurings, many commercial loan facilities are subject to collective action clauses that prevent lenders from “defecting” by unilaterally exercising remedies at the expense of both the debtor and the other lenders in the syndicate. Instead, these clauses require collective action for the enforcement of remedies. Then, to facilitate efficient restructurings, commercial loan agreements typically allow for amendments or modifications with less-than-unanimous (usually majority or supermajority) consent. These provisions are designed to prevent opportunistic holdups by lenders holding relatively small amounts of debt.

Wedge strategies and divide-and-conquer tactics succeed because they introduce new opportunities for lender defection from the syndicate, essentially recasting the nature of the coordination game played by senior lenders and driving up strategic uncertainty. Defection might involve taking independent actions that achieve mutual agreement with the debtor at the expense of the other lenders. For instance, defection does not necessarily involve rushing to the courthouse to exercise unilateral state law remedies; indeed, lenders that are part of a syndicate are normally prevented from taking such steps anyway. Rather, defection might involve negotiating a side deal with the debtor to restructure in a way that offers generous concessions to the debtor while providing a handsome payout to the defecting lenders and shutting out the other lenders entirely. In essence, these transactions succeed because they reintroduce a defection option, causing lenders to value mutual agreement with the debtor over continued coordination with the lender group.

By design, these transactions increase uncertainty and siphon value away from senior creditors to other preferred stakeholders. They also allow debtors to effectuate economically irrational restructurings by overpowering senior lender groups that would have collectively (and rightfully) pushed a company to liquidate. This is because wedge strategies and divide-and-conquer tactics shift lender attention away from the threshold question of economic efficiency, causing them to focus inward on their own economic interests relative to their peer lenders. And, by participating in the hostile restructuring, the defecting lender obtains a more secure position in the firm’s capital structure, shoring up its own liquidation preference in a future bankruptcy. This makes defection attractive, whether or not the firm is worth more as a going concern. With the exception of truly dire situations where the firm is deteriorating in value and has little to no meaningful future revenue, defecting lenders have no real incentive to focus on the threshold question of whether the firm is worth restructuring. In essence, the modern lender defection strategy is a liquidation strategy cloaked in the guise of restructuring.

In some cases, these dynamics allow the debtor to effectuate an otherwise economically rational restructuring that opportunistically redistributes value away from the senior lender group to other stakeholders. But in other cases, they allow the debtor to effectuate an altogether irrational restructuring by overpowering a lender group that would have collectively (and rightfully) pushed the company to liquidate. This can happen because lender defection to shore up the defecting lender’s own liquidation preference becomes even more attractive as the debtor’s financial condition deteriorates. In other words, hostile restructurings may be most likely to occur when the debtor is severely distressed and there is relatively little hope of a meaningful turnaround.

This flies in the face of classic economic justifications for business reorganization. And, to the extent the financial markets rely on senior lenders to play an important monitoring and signaling role for the benefit of other investors, these developments are even more troubling. For all these reasons, debtor wedge strategies and divide-and-conquer tactics on balance probably cause a loss of economic value for companies and the capital markets.

The article focuses specifically on wedge strategies and divide-and-conquer tactics. But the field of corporate restructuring would benefit from a broader theory of alliance politics. Such a theory would consider how coalitions form within and among organizational parties to large and complex commercial restructurings, as well as on the steps taken by other parties to achieve unitary actor status and counterbalance other, more powerful actors who derive their power from their legal and contractual rights to control the firm or from their senior contractual rights and property interests in the firm. It would also examine features of the capital markets that may be setting the stage for challenging alliance politics.

Future research should also consider the role of other legal mechanisms, market standards, and customary practices in helping to bolster lender coordination. For instance, analyses should focus on the strength and durability of inter-lender relationships, as well as the role of the administrative agent and other representatives who help coordinate groups of lenders. These investigations are important because there may be opportunities to enhance lender unity by strengthening group coordination and leadership. Research should also consider whether and to what extent the size and composition of lender syndicates impacts unity.

This post comes to us from Diane Lourdes Dick, the Charles E. Floete Distinguished Professor of Law at the University of Iowa College of Law. It is based on her recent article, “Alliance Politics in Corporate Debt Restructurings,” available here.