It's complicated: lawyers weigh in on debt short sellers

IFR 2304 - 12 Oct 2019 - 18 Oct 2019
4 min read
Christopher Whittall

A growing number of companies are inserting legal fine print into debt documents to ward off would-be short sellers. There's just one problem: it might not work.

Lawyers advising private-equity firms have concocted various provisions in recent months to prevent hedge funds with short positions in a company’s debt from agitating for the firm to default.

That follows the high-profile bankruptcy of Windstream in February after the telecoms provider lost a legal battle with Aurelius Capital Management, which was also allegedly shorting Windstream’s debt.

But legal experts say many of the clauses that have since appeared in debt documents may not be workable in practice and could even deter other lenders from buying the loan.

“So far there have been a range of provisions that may not work very well for either the borrower or the lenders,” said John Williams, a partner at the law firm Milbank LLP.

“It’s extremely difficult to draft an effective provision. There are some versions of this provision that create more damage to the credit ecosystem than others."


The unusual circumstances surrounding Windstream’s bankruptcy earlier this year sparked a flurry of activity among legal advisers to some of the largest buy-out firms.

Aurelius seemed to break new ground in debt investment activism when it built a stake of over 25% in one of Windstream's bonds and subsequently sued the telecoms provider in 2017. The hedge fund argued Windstream had breached debt covenants in 2015 when it spun off a subsidiary, putting the company in technical default.

A US judge ruled in favour of Aurelius in February and said Windstream owed it US$310m in debt repayments, plus interest. Aurelius had also reportedly built a credit-default swap position that would pay out if Windstream defaulted.

The message for borrowers was clear: “net short debt activism” poses a real threat.

A couple of months later, US private-equity firm Clayton Dubilier & Rice inserted language into the US$1bn leveraged loan funding its buyout of data services provider Sirius Computer Solutions that would prohibit investors with net short CDS positions from voting on company matters.

That appeared to be a first for the market and other companies soon followed suit. Lawyers say similar clauses have been discussed on most US leveraged loan deals since and they have also appeared in bond documents. The language has started to crop up in European debt documents too. But the provisions are often overly vague, raising questions as to whether they'll do more harm than good.

“You have to be careful. Being short doesn’t necessarily mean you’re being nefarious," said Todd Koretzky, a partner with the law firm Allen & Overy in New York.

"There’s just a lot of nuance in these terms that could ... have unintended consequences."


One of the thorniest issues centres on how to calculate whether a lender has taken a net short position in a company. An investor may buy CDS protection against a company they’re lending to in order to hedge their exposure. But determining whether that investor has an overall short position is not straightforward.

The Sirius Computers documentation showed one potential pitfall, lawyers said. The way the language was drafted appeared only to take into account whether an investor owned the loan and did not give any credit for owning the company’s bonds or other debt, or holding an equity stake in it.

Whether an investor is determined to have a short position will also depend on when the values of their different positions are calculated: either before or after bankruptcy. That was a potential downfall in the language in the bond from US security company Allied Universal earlier this year, lawyers said.

“It’s just a very technical product. The [language] needs to be very specific," said Williams.

Koretzky said there is now a trend towards fleshing out provisions in an effort to address these issues.

"There’s a reason credit agreements are 200 pages long: people want certainty," he said.

"The devil is in the detail. The details matter."