In the standard model of capital markets contracting, issuers select non-price terms a la carte, optimizing future flexibility in light of the price they imagine investors will charge for it. A recent development in restructuring practice—invention of the so-called non-pro rata uptier exchange—offers a rare opportunity to assess the model’s explanatory power with respect to terms that are economically meaningful in expectation but only contingently applicable.
In an uptier, the borrower and a bare majority of its lenders agree to subordinate ostensibly pari passu debt, transferring wealth from minority lenders to the majority and especially to the borrower’s equity investors. Not all loans are susceptible to an uptier, however. After Summer 2020, when three uptiers were executed in short order, newly originated loans became likely to include a provision blocking the transaction. The mechanism that caused contracts to change is, however, unclear.
To assess the notion that price discipline induced the contractual change, we study the returns to loans outstanding in Summer 2020 around events that disclosed the uptier’s legality and commercial practicability. If investors price the relevant terms, then yields on susceptible and immune loans ought to have diverged. In a sample of all publicly available loans, however, we find only weak evidence of a relationship between susceptibility and abnormal returns.
Several possibilities could explain our results. The most likely, including mere insufficiency of statistical power, cast doubt on the notion that borrowers could observe the price of uptier flexibility—or, by extension, that they can observe the prices of similarly important contractual provisions—in a manner that would allow them to calibrate terms optimally. Instead, our results support a model of financial contracting in which “talk” sourced from non-price mediating institutions such as lawyers and trade associations play an important role in term selection.