THE RATIONALE OF CASH AMERICA AND SHARON STEEL

Cash America involved a claim by Wilmington Savings, the indenture trustee for a $300 million bond issue, that Cash America had breached one of the covenants in the bond indenture by spinning off a major subsidiary and that this breach had resulted in an event of default. The court ruled in favor of Wilmington Savings on the question of the breach and resulting default. What got the attention of the elite corporate bar, however, was not the ruling on the breach. Rather, it was the ruling on the remedy. The standard remedy upon an event of default, and the only remedy specifically identified in a standard bond indenture, is acceleration—the right of bondholders to demand the immediate payment of the principal amount of their bonds. But because the covenant breach at bar was deemed “voluntary,” the court awarded the bondholders the amount that Cash America would have had to pay had Cash America exercised its option to redeem the bonds early—the principal amount (“par”) plus a sizeable “make-whole” redemption premium.

Corporate bond indentures often contain optional redemption provisions that give the issuer the right to repay bonds prior to their maturity. In a “make-whole” optional redemption provision, such as the one included in the Cash America bonds, the redemption price is the higher of par and the value of the future principal and interest payments discounted at a contractually specified discount rate. Because the discount rate used in this calculation is typically set well below the issuer’s borrowing costs, a “make-whole” redemption often entails the payment of a substantial premium over par (Arnold et al. Reference Arnold, Amanda, Madison and Mitu2020). In devising its remedy, the Cash America court followed Sharon Steel Corporation v. Chase Manhattan Bank, a canonical Second Circuit opinion from 1982 by Judge Ralph Winter, which awarded bondholders the optional redemption price (par plus a redemption premium) as a “specific performance” remedy for a voluntarily covenant violation.Footnote ³ But there are reasons to doubt that the reasoning of Sharon Steel, which Cash America followed, comports with the provisions of the indenture.

The indentures at issue, as indentures generally do, did not explicitly provide for a right to receive the redemption price as a remedy upon an event of default and nowhere distinguish between voluntary and involuntary covenant violations. Rather, if bondholders choose to terminate the lending relationship and ask for immediate payment in response to an event of default, the acceleration provisions in indentures just provide for the payment of the principal amount (par) without any premium. To be sure, an additional standard indenture provision entitled “Other Remedies” provides that the trustee may “pursue any available remedy by proceeding at law or in equity to collect the payment of principal or of interest … or to enforce the performance of any provision” in the indenture (American Bar Association Ad Hoc Committee 2000, 1137). This broadly worded “Other Remedies” provision includes specific performance as a potential remedy. And as specific performance is an equitable remedy, a court, in the exercise of its equitable powers, could decide to afford this remedy only for a subset of breaches, such as voluntary covenant violations.

But specific performance of what? The provision on “Other Remedies” is limited to the collection of principal and interest, which does not include the payment of any redemption premium, and the enforcement of any provision contained in the indenture. Even setting aside the scope of the “Other Remedies” provision, under general principles of contract law, specific performance is available only to enforce a contractual obligation that already exists, not to fashion a new obligation.Footnote ⁴ Thus, both the “Other Remedies” provision in the indenture and the inherent nature of specific performance require a pre-existing contractual obligation to be enforced but do not permit a court to create a new obligation that is then specifically enforced.

The redemption provisions that were the basis for specific performance in Sharon Steel and in Cash America, however, were standard optional redemption clauses that gave the company, as the bond issuer, an option to redeem the bonds, exercisable at the company’s discretion, and contained no suggestion that the company would ever be required to exercise its option.Footnote ⁵ Under the terms of such standard clauses, therefore, unless and until the company decides to avail itself of the redemption option by giving a redemption notice, bondholders have no right to have their bonds redeemed and, hence, no right that can be specifically enforced (American Bar Association Ad Hoc Committee 2000, 1133).Footnote ⁶

So how did Sharon Steel come up with the specific performance remedy and what did lawyers make of it before Cash America? Since Sharon Steel’s discussion of the remedy spans only two paragraphs, we quote it in full:

This reasoning is problematic. Even if we accept that a “purpose of a redemption premium is to put a price upon the voluntary satisfaction of a debt before the date of maturity,” it does not follow that “it undermines the plain purpose of the redemption provisions to allow a … debtor to avoid their terms simply by failing to take the steps necessary to redeem the debentures, thereby creating a default.”Footnote ⁸ Contrary to the court’s implication, a covenant violation resuting in an event of default does not entitle the company to repay its bonds before maturity; it merely gives bondholders the option to seek acceleration.

Moreover, the court’s characterization of the purpose of a redemption provision is inaccurate. The purpose of a redemption provison is to set the effective maximum price a company would have to pay if it wanted to repay its bonds early, whether to avoid a default or for some other reasons. Defaults can have adverse collateral consequences (they can generate cross-defaults, cause reputational harm, and so on), so a company may want to avoid a default even if doing so involves payment above par. But why should that imply that the company is required to pay that price if it violates a covenant—a remedy that easily could have been, but was not, included in the indenture? Even more perversely, the holding of Sharon Steel implies that a company that contracted for a right to optionally redeem its bonds at a premium may have to pay more, upon default, than a company that is not entitled to redeem its bonds.

While we question the doctrinal underpinnings of Sharon Steel, we read Cash America as a straightforward application of Sharon Steel. Having found that Cash America had violated a covenant, that the violation was voluntary, and that it had ripened into an event of default, Judge Furman of the Southern District of New York was obliged to follow the Second Circuit opinion in Sharon Steel as to the available remedies. So why were lawyers so outraged at Cash America, when the real outrage was Sharon Steel? And Sharon Steel is not some obscure case. Other portions of the case, dealing with general principles of indenture interpretation and the successor obligor clause, make it one of the best known bond indenture cases. There are four possibilities.

THE FOLKLORE OF SHARON STEEL

To get a better sense of what accounted for the strong reaction to Cash America, we interviewed forty senior lawyers who work either on the issuer or the underwriter side in bond issuances. To find these senior lawyers, we used the resources of the placement office at one of the institutions at which we teach, where a large fraction of students go into the practice of corporate law. The placement office gave us a list of forty-four lawyers, and we contacted all of them via email. We offered to either meet with them in person at their offices or talk via telephone. Forty of the forty-four responded affirmatively to our request, and all forty opted for the telephone option. Of the forty lawyers, three were women and the rest were men. We did not collect any other demographic information.

Because we wanted to make sure that the lawyers we were speaking to were experienced enough to be familiar with the Cash America litigation, we asked the placement office to list only lawyers that had at least a half dozen years of practice experience in the area of corporate debt. As it turned out, all but one had more than twelve years of experience, and all but one were partners at the firms in question. In three cases, we interviewed two lawyers from the same firm. In all other cases, the lawyers were from different firms. Finally, all the lawyers in our sample were transactional lawyers. We spoke to one litigator with familiarity with the actual Cash America litigation, but that was to obtain background on what happened in the litigation itself.

In every case, we began the discussion by assuring our respondents that nothing they said was for attribution and then set forth several core questions. Then, we allowed our respondents to talk, interjecting follow-up queries when the responses called for them. Each interview lasted between thirty minutes and an hour, with an average time of roughly forty minutes. We are under no illusions that our respondents did not sometimes have their own agendas in talking to us. Our primary goal though was to understand how these lawyers—all of whom were participants in the events we were interested in—articulated the reasons for whether, and why, they regarded the outcome in Cash America as a change in the law and, as we will report later, why the attempt to change the remedies provisions had failed so far.

Our starting point for every interview was: why the outrage over Cash America when it was but an application of Sharon Steel, the controlling precedent in the Second Circuit? We report what we were told in general terms. We are not attempting to report a survey of answers to questions and do not quantify answers to specific questions except in a broad sense. Uniformly, almost no one took the position that Judge Winter’s construction of the remedy in Sharon Steel itself was flawed. Instead, respondents embraced a version of the second explanation put forth above—namely, that Sharon Steel was sui generis. The most common answer we received was that Judge Furman had misunderstood the deeper context of Sharon Steel. Sharon Steel was a case about an issuer that had acted with bad faith vis-à-vis its bondholders. UV Industries had needed to liquidate for tax reasons but was trying to mischaracterize that liquidation as a sale of substantially all of its assets (which would have resulted in the passing of the debt to the buyer of those assets, so long as some procedural requirements were satisfied). Cash America, by contrast, involved an issuer taking a perfectly defensible position regarding an alleged covenant breach.

There are several flies in this buttermilk. First, nowhere in Sharon Steel is there mention of bad faith or intentional misbehavior on the part of UV Industries. If anything, Judge Winter makes it clear that the provisions at issue in that case did not provide a clear answer and even indicated that a formalist reading would give an answer in favor of UV Industries. He wrote:

Judge Winter proceeds to reject this “literalist approach” not because it lacks a literal basis but, rather, because “a literal reading of the words ‘all or substantially all’ is not helpful apart from reference to the underlying purpose to be served.” Identifying that purpose as “protection for borrowers as well as for lenders”—and rejecting Sharon Steel’s position that the sole purpose of the clause is to permit borrowers to sell assets and liquidate—the court then resolved that “[a]n interpretation which sacrifices a major interest of one of the parties while furthering only a marginal interest of the other should be rejected in favor of an interpretation which sacrifices marginal interests of both parties in order to protect their major concerns.” While the case was maybe not close, the court’s reasoning indicates that UV Industries and Sharon Steel both had a plausible literal basis and an arguable purpose-based basis for their interpretation.

Second, Judge Winter was writing for the Second Circuit on appeal. The trial court, the one that saw the parties and interacted with them, had ruled that UV Industries was only required to pay par, not the redemption premium. In doing so, the trial court found that the voluntariness of the default was irrelevant to the remedy.Footnote ¹⁷ While the Court of Appeals disagreed with this assessment, neither court opinion suggests that UV Industries acted, or was accused of acting, in bad faith. Under these conditions—ones that would have been obvious to Judge Furman—it would probably have been reversible error for Judge Furman to have read Sharon Steel to be about bad faith conduct on the part of the issuer. To be fair to our respondents, there were a couple of bankruptcy court cases in the thirty-five years between Sharon Steel and Cash America that, in dicta, had taken that position. But the authoritative case for Judge Furman was Sharon Steel.

Third, the line between bad intent/bad faith and voluntary breach is a fuzzy one. In both Sharon Steel and Cash America, the respective issuers took positions on the interpretation of a covenant that turned out to be wrong and took voluntary actions based on these positions. The court in Cash America noted that the issuer had been warned that bondholders interpreted the indenture differently—that is, Cash America was on notice that its interpretation was controversial. And, to us, Cash America’s interpretation borders on the frivolous. The covenant at issue in Cash America prohibited certain transfers unless “the aggregate book value of properties disposed of …. does not exceed” 10 percent of the issuer’s “Consolidated Total Assets.”Footnote ¹⁸ Although the indenture clearly referred to the book value of properties, and the benchmark was a percentage of assets, Cash America took the position that “the aggregate book value of properties” referred to the book value of the disposed assets minus the book value of the liabilities disposed with the assets. Under this contorted interpretation, even a transfer of all one’s assets, if accompanied by sufficient liabilities, may not exceed 10 percent of consolidated total assets.

But the clincher in the case was that the assets at issue consisted of stock of a subsidiary. The covenant further provided that “[f]or purposes of determining the book value of property constituting capital stock or similar equity interests of a Subsidiary of the Company disposed of as provided in Section 5.01(2), such book value shall be deemed to be the aggregate book value of all assets of the Subsidiary that shall have issued such capital stock or similar equity interests.”Footnote ¹⁹ Unlike the court in Sharon Steel, Judge Furman did not have to resort to context and purpose or weigh major and marginal interests: he held that the “plain language” of the indenture “compelled” a ruling for the bondholders. If bad faith or bad intent is to be inferred from the weakness of the arguments put forth by the issuer, the bondholders in Cash America win hands down.

A different version of the foregoing bad faith/bad intent story that we heard from a subset of veteran respondents was that “it was all about Victor Posner” or “Victor Posner’s presence heavily influenced the atmospherics of the case.” Victor Posner was a major figure in the takeover boom of the 1980s and among its most colorful characters. He was the paradigmatic corporate raider of the 1980s, who managed to get into trouble with the tax authorities and the Securities and Exchange Commission. Sharon Steel was his company. Everything we have heard suggests that Judge Winter, a former corporate law professor at Yale, would have been familiar with Victor Posner. Sharon Steel, however, was only the buyer of the assets from UV Industries, and UV Industries was the issuer of the bonds and the entity that breached the covenants in the bond indentures. UV Industries appears to have sold its other assets prior to being in contact with Sharon Steel and Posner. Perhaps Sharon Steel and Posner had suggested that UV Industries take the position that a sale of the remaining assets to Sharon Steel was a sale of “substantially all” assets under the indenture—and perhaps not. In either case, ultimate responsibility would lie with UV Industries.

More to the point, Judge Winter, in his Second Circuit opinion, never mentioned Victor Posner and said nothing suggesting that his actions had affected the holding. Even if Judge Winter was influenced by Victor Posner’s presence, how is a trial court reading this precedent—thirty-plus years after it was decided—supposed to figure this out? To us, there is zero likelihood that Sharon Steel would have been read by a lower court with those atmospherics in mind. Our conjecture is that a folklore had developed around the meaning of Sharon Steel over the thirty-five years since it had been decided. Every transactional lawyer we talked to claimed to have been familiar with the broad contours of what happened in the case. But what he or she had taken from it deviated significantly from what the court had actually done in the case. To transactional lawyers, the notion that a regular voluntary covenant breach would require an issuer to pay a redemption premium would be so far removed from the wording of the indenture that this could not possibly have been the ruling in Sharon Steel. Accordingly, they searched for narrower grounds, like bad faith or unique circumstances involving Victor Posner. Each lawyer’s assessment that Sharon Steel must have involved extreme facts was likely reinforced by the fact that this assessment was widely shared by transactional lawyers, who we suspect talk more often to each other about indentures than they talk to litigators, and that few of these lawyers had recently read Sharon Steel. Boiled down, the primary objection to Cash America seems to have been that Judge Furman should have been, or should have tried to become, aware of this folkloric, shared understanding of the relevant precedent held by transactional lawyers who were experts on bond indentures.

The concept of “interpretive communities” may be thus helpful to explain the assessment of transactional lawyers (Coyle and Weidemaier Reference Coyle and Mark2018, 1709–11). Transactional bond lawyers, who make up one such community, focused on the language of the remedies provisions in the indenture—language that they had drafted and the meaning of which they knew—and accorded a narrow scope to Sharon Steel. Judge Furman, a former assistant US attorney and now a trial court judge, focused on the governing precedent that had interpreted the same provisions that were now in front of him. Judge Furman was thus a member of a different interpretive community—specialists in litigation who, while sophisticated and well versed in commercial disputes, are more attuned to paying attention to precedents and are less familiar with indenture provisions.

The view of a senior litigator we spoke to comports with our assessment. This lawyer noted that his transactional colleagues rarely spoke to him about the risks that many of their standard form clauses posed and remarked: “My transactional colleagues don’t spend any time thinking about how things will play out in litigation. They think that judges will be able to divine what is in their heads.”

Standard Explanations for Contracting Inertia

Transactional lawyers dealing with indentures viewed Cash America as changing the law on bondholder remedies for voluntary covenant violations. Although, in our view, Cash America does not go beyond Sharon Steel, the notion that Sharon Steel afforded bondholders the right to seek specific performance of redemption only in a much narrower set of circumstances—involving bad faith, an intent to induce acceleration, and perhaps unsavory characters—was widely held. In this part of the article, we proceed on the assumption that Cash America, at least as perceived by market participants, indeed created new law. From that perspective, parties entered contracts pre-Cash America that they read to afford bondholders a very narrow (if any) right to specific performance of redemption. Post-Cash America, they found themselves in a situation where the words that they traditionally used had been interpreted to provide bondholders with a much broader right to specific performance.

From a contractarian perspective, one would expect the parties to change the wording of the indenture to bring it in line with what they originally intended and presumably wanted. Lawyers drafted such a change in wording, and it was initially included in several contracts, but the new wording did not take hold. The aftermath of Cash America was thus characterized by contractual inertia: a failure to change a common term when logic and standard economics would suggest that a change is warranted. Contractual inertia is a familiar phenomenon and has received substantial attention in the literature. In this part, we review the standard explanations for contractual inertia. We argue that Cash America and its aftermath involve specific features that make the standard explanations for contract inertia unsatisfactory. Although we cannot disprove these explanations, they ring hollow. In the following part, we present a different explanation for why the Cash America patch failed to take hold.

Contracts of Inattention

The standard accounts for contract stickiness fail to offer a persuasive explanation for stickiness in our case. We therefore offer a further one. The indenture itself is largely negotiated between the lawyers for the issuer and the lawyers for the underwriter. While the underwriter has reputational interests to assure that the indenture terms conform to a certain standard and needs to ensure that the bonds issued under the indenture can be sold, the underwriter does not have a direct financial interest in the bonds (Kahan Reference Kahan1994). Rather, economically, the real parties in interest are the issuer and the bondholders. Corporate bondholders are typically large, sophisticated financial institutions, such as mutual funds and insurance companies. But bondholders are not represented by their own lawyers in the negotiation or communicate much with the lawyers representing the underwriters, nor do bondholders hire their own lawyers to review the indenture and advise them as to the provisions contained in it. Bond indentures thus fall in a class of contracts that we term contracts of inattention; albeit both sides are sophisticated and have bargaining power, one side is not represented by its own lawyers, lacks full awareness of the fine print contained in these agreements, and, having devoted little attention to fine-print terms, may be eclectic as to their meaning when it enters into the contract. By the same token, the lawyers who draft the contract will tend not to be aware of how bondholders view the contractual provisions.

Other types of contract and contract-like documents that share these hallmark features include charters and bylaws of public companies, certificates of designation governing the rights of holders of preferred stock, contracts governing traded options and credit default swaps, fiscal agency agreements and trust indentures related to sovereign debt, and master trust agreements related to mortgage-backed securities.Footnote ²⁷ Conversely, merger and acquisition contracts, where both sides are represented by counsel who pay attention to terms and communicate with their clients, are not contracts of inattention (Scott, Choi, and Gulati Reference Scott, Choi and Mitu2020).

Contracts of inattention involve a heightened potential for gaps between transactional lawyers’ understanding and investors’ understanding of contractual provisions. Such gaps in understanding are particularly likely to form on terms that are rarely litigated in high-profile cases. High-profile litigation can result in the identification of such gaps and in efforts to close them, as was the case in the aftermath of Cash America.

Transactional lawyers who deal with indentures—whether they represent the issuer or the underwriter—base their understanding on a close reading of the words of the indenture provision and on their general expertise on indentures. The lawyers’ understanding of the remedy section pre-Cash America was that it gave bondholders the right to accelerate at par because that is what the indenture said. Transactional lawyers familiar with Sharon Steel were also vaguely aware that under some circumstances bondholders could obtain the redemption premium, but, as discussed in the third part of this article, they regarded this set of circumstances as narrow because they viewed the express provisions, which provide only for a right to receive par and not for any right to receive a premium, as clear.

But what was the understanding of investors and from where did it derive? Our original plan for this project had been to speak only to the transactional lawyers since they were the ones who draft contracts. But, as we got through our lawyer interviews, we realized that talking to managers at the investment firms who had resisted the corrective patch was also necessary. From our interviews with a dozen investment managers, all of whom were involved in the debate over whether reform was needed after Cash America, we found the following observations. These investors confirmed that they had not focused on the specific wording of the remedy section of indentures and/or consulted with indenture lawyers about what the lawyers thought they had been drafting. In a sense, the investors neither cared nor knew what the lawyers thought they had drafted. Investor understanding, as it was described to us, derived from market practice. Investors’ understanding and lawyers’ understanding existed side by side, with neither side communicating with the other one or specifically aware that the other side’s understanding of available remedies differed from their own.Footnote ²⁸

Since events of default outside of bankruptcy are relatively uncommon and rarely litigated, the most relevant market practice was how much bondholders got paid when an issuer wanted to engage in a transaction that would violate a covenant. And market practice was that such issuers would make a tender offer in which investors were offered a premium above par coupled with a consent solicitation to modify the covenant. To the investors, the Cash America corrective patch looked like an attempt to take away that opportunity to get a premium when the issuer needed to modify a covenant. To quote one investor, “[the Cash America patch] inserts a par call into the bonds.”

To be sure, the fact that issuers generally offer more than par in tender offers does not signify that an issuer, had it instead chosen to violate the covenant and generate an event of default, was contractually required to pay more than par. Events of default and acceleration can have adverse collateral consequences, and a company may well be willing to pay some extra premium in a tender offer to avoid such consequences or optionally redeem the bonds. We thus do not suggest that investors, based on the market practice, believed that they had a legal entitlement to get more than par in general or to get the redemption premium in particular. Rather, most investors had not focused much on their legal entitlement because their main concern was not their abstract legal entitlement but, rather, how much of a premium they got in actual deals.

Put differently, transactional lawyers and investors were members of different interpretive communities. Due to a lack of communication, and due to the fact that the underlying issue had not been salient until Cash America was decided, these communities did not intersect. When Cash America was decided, the reaction of transactional lawyers, whether they worked for issuers or underwriters, was immediate and clear: this is neither what we wrote nor what we meant; let us change the wording to make this clear to future judges. We believe that transactional lawyers representing underwriters shared the negative reaction to Cash America not because underwriters are imperfect agents for investors (which they are) but, rather, because the transactional lawyers working for issuers and underwriters are members of the same interpretive community, and the court’s interpretation actually did not reflect the understanding and intentions of that community.

But investors never really cared what the transactional lawyers who drafted the indenture intended. The lawyers who drafted the indenture were not hired by investors, did not communicate much with investors, and investors had neither reason to find out, nor interest in finding out, what these lawyers thought. Thus, while it was clear to transactional lawyers that Cash America was wrongly decided, investors did not share this assessment because they lacked any clear a priori assessment of their legal entitlements based on the language of the indenture and the intentions of the drafters. On this account, what Cash America did was to focus investors’ attention on their legal entitlements. When confronted with that issue, investors decided that they preferred the Cash America interpretation, not because it correctly interpreted the language of indentures, nor because it correctly applied Sharon Steel—the investors we spoke to had never heard of Sharon Steel—but, rather, because they wanted to retain the threat of being able to get more than par. And once investors decided that this was what they wanted, they prevailed.

The answers we received in our interviews with both lawyers and investors for why the Cash America patch failed to take hold largely support this account. All our respondents, as well as the investors surveyed by the Credit Roundtable in January 2017, pointed to Covenant Review. Covenant Review is a firm that was started by Adam Cohen, a former senior associate at Lathan and Watkins.Footnote ²⁹ Cohen, the story goes, worked on debt covenants while at Latham and had perceived a gap in the market for a service that would examine the covenants in big debt deals and tell investors the basics of what they were receiving. In particular, Covenant Review was to alert investors to any significant deviations from the standard forms that the issuers had put into the deal and that underwriter’s counsel might not have adequately flagged for investors.

In the initial attempts to correct for Cash America, the issuer’s counsel had put in new language to clarify that payment of a redemption premium, as specific performance or otherwise, is not an available remedy. For example, Rackspace did an offering less than a month after the Cash America opinion came out, with the language: “For the avoidance of doubt,Footnote ³⁰ no premium in respect of the notes shall be payable as a result of any default or Event of Default.”Footnote ³¹ We were told that the lawyers doing these deals, on both the underwriter and the issuer side, took the position that they did not need to flag this change since they were just returning to what the contracts meant before Cash America. To quote one of our lawyer respondents, “it was not a material change,” and, hence, it was not noted on the cover page of the sales documents (the prospectuses or offering circulars) as would have been done with something like the addition of new collective action clauses in sovereign bonds in 2003 and 2014.

Covenant Review seized on these deals to alert investors to what it viewed as an assault on their rights. The title of their January 9, 2017 newsletter, was: “The End of Covenants: The ‘No Premium on Default’ Language Is Spreading Like Wildfire—Your Future Covenant Enforcement Is Being Destroyed” (Cohen Reference Cohen2017). Similarly, Adam Cohen, the chief executive officer of Covenant Review, said to Reuters: “In my 20 years as a lawyer in the high-yield bond market, this is the worst potential covenant change I have ever seen” (Caiger-Smith Reference Caiger-Smith2017). The majority of our lawyer respondents, by contrast, stated that no such dramatic change to covenant rights was occurring. They thought that Covenant Review was trying to raise its profile and make a mountain out of a molehill.

But while this interpretation makes sense from the perspective of transactional lawyers who believed that the Cash America patch was innocuous relative to pre-Cash America law, it does not fully address the issues. The issues are not just why Covenant Review rang the alarm bells but also why, having been alerted by Covenant Review, so many institutional investors took the position that they would not buy bonds if they contained the Cash America patch.Footnote ³² This inquiry brings us back to what the clients of Covenant Review thought about their legal remedies before Covenant Review informed them about the patch. One possibility is that they agreed with the lawyers that we interviewed that Cash America went significantly beyond Sharon Steel but nevertheless opportunistically resisted the inclusion of the patch to preserve their newly bestowed contractual rights. We cannot disprove this possibility. But, in our view, if investors had agreed that the Cash America patch just reverted remedies to the pre-Cash America status quo, it is unlikely that they would have put up such a fight.

Another possibility is that investors had always understood Sharon Steel to afford broader rights to obtain specific performance of the redemption premium and saw Cash America as confirming these long-standing rights. While this would explain the resistance to the patch, the notion that investors got Sharon Steel right while transactional lawyers got it wrong flies in the face of the fact that investors have much less legal sophistication and knowledge than transactional lawyers. And if investors were so sophisticated and knowledgeable about Sharon Steel, why were so many of them apparently unaware of the existence of the Cash America patch until they were alerted by Covenant Review?Footnote ³³ We therefore also regard this possibility as implausible.

The most plausible account is that investors were eclectic about their legal entitlements pre-Cash America. They started dealing with the matter only once they were confronted with the patch and Covenant Review’s call for resistance. It was at that point that investors, for the first time, had to make a conscious decision as to the legal remedies that they wanted the indenture to provide. And it was only at that point that they demanded a legal entitlement to receive a redemption premium upon a voluntary default.Footnote ³⁴ In other words, Covenant Review was able to succeed because of a pre-existing disconnect between lawyers’ and investors’ understanding of the remedy provisions in the indenture. Transactional lawyers looked to the wording of the indentures for their understanding and tried to reverse court decisions that they viewed as inconsistent with the wording. Investors looked at past market practice, decided that they were satisfied with it, and insisted that the practice should not be undermined. Whether Covenant Review itself—which, unlike its clients, presumably had a good sense of the legally availably default remedies prior to Cash America—had a different understanding of the remedy provisions than the transactional lawyers we interviewed (perhaps because the lawyers at Covenant Review had read Sharon Steel more carefully) or whether, as several respondents suggested, it was trying to raise its profile is not relevant from this perspective.

When we inquired why issuers quickly dropped the patch once it encountered resistance, our respondents gave two reasons. First, the event being contemplated—a voluntary default on some covenant while fully solvent—was extremely rare. What was of paramount importance, our respondents agreed, was that the deal get done. To quote one respondent, “[n]o one wants delays because the lawyers want to add in some obscure legalese for an event that won’t ever occur.” So far, so good. But the second explanation that we received from a handful of respondents holds more interest: they asserted that it was unlikely that future courts would make the same errors in terms of understanding Sharon Steel and how to determine contract damages that Cash America had.Footnote ³⁵ To us, these responses are remindful of the earlier discussion of what transactional lawyers made of Sharon Steel and illustrate the persistence of folklore.

Rather than rereading Sharon Steel and accepting the notion that a district court judge, as a member of a different interpretive community, would take the case for what it says and not for what transactional lawyers thought it must have meant, transactional lawyers maintained their view of Sharon Steel and engaged in wishful thinking that Cash America—the most important decision applying Sharon Steel—would not be followed. This idea, to us, carries the seeds for the emergence of a new folklore that posits that it is widely accepted that Cash America was wrongly decided and that the case therefore does not need to be taken seriously—a folklore that shares the feature that it confuses the view of transactional lawyers (who may indeed believe that Cash America was wrongly decided) with the way another court would read Cash America (as a well-reasoned decision applying binding Circuit Court precedent).

Implications

The presence of gaps between lawyers’ and investors’ understanding in contracts of inattention raises the question about how courts should interpret contracts when the understanding of a provision held by the lawyers who drafted it differs from the understanding of investors who only focus on the provision when a dispute arises. Currently, most courts treat contracts of inattention like other contracts among sophisticated parties—what the drafter intended is what the parties must have desired. But, as the aftermath of the Cash America case shows, the lawyers for the underwriters are too far removed from bond investors to assume that the drafters intentions reflects the parties’ objectives.

In the final analysis, it may be that we decide that the traditional mode of contract interpretation is still appropriate. In particular when the terms of a contract are clear, there are strong reasons for courts not to rewrite the contract. However, when a term is ambiguous, or when custom and usage is relevant to interpret a term, there is no inherent reason why the term should be given the meaning intended by the transactional lawyers who drafted it or, for that matter, that courts should resort principally to the usage by transactional lawyers to interpret the term. Rather, in contracts of inattention, the subjective intent of transactional lawyers who draft a provision should not be relevant at all since the lawyers who drafted the term neither represent or communicate with the investors, and while the general understanding of a provision among the transactional lawyer community may be relevant, so is the understanding, or lack thereof, by the bondholder community.

A recent case involving a redemption provision in bonds issued by Chesapeake Corporation exemplifies the different approach courts should take to contracts of inattention. Chesapeake’s bonds were subject to redemption provisions that permitted it to call its bonds at par prior to March 15, 2013 and at a make-whole premium thereafter. A dispute arose over whether, under the particular wording of the redemption provisions in the bond indenture, Chesapeake just needed to give a notice of the redemption prior to March 15 or whether it also had to pay for the bonds by March 15.Footnote ³⁶ Chesapeake introduced evidence that the lawyers who wrote the provisions meant to permit Chesapeake to redeem the bonds at par as long as it gave notice by March 15. The District Court rejected this evidence as inadmissible under the parol evidence rule, finding that the indenture unambiguously provided that giving notice by March 15 was sufficient. On appeal, a majority of the panel on the Second Circuit also rejected the evidence of the lawyers’ intent, this time reasoning that the indenture unambiguously provided that payment by March 15 was required.Footnote ³⁷ The most interesting opinion for our purposes, however, was a dissent by Judge Katherine Polk Failla. Finding the clause to be ambiguous, Judge Failla nevertheless argued that the intent of the lawyers should not be considered in interpreting it. Rather, Judge Failla opined, the court should have examined how the bonds were marketed by Chesapeake’s officials to investors.

While Chesapeake addresses the subjective intent of specific lawyers, we believe that the logic of Judge Failla applies equally to the general understanding of terms by transactional lawyers. To be sure, transactional lawyers’ general understanding of a term does not share the feature of the subjective intent highlighted by Judge Failla—namely, that investors would have no way of knowing what the lawyers thought. But it would still be wrong to presume that investors ought to be aware of the general understanding of a term by transactional lawyers and to deem them bound by it. Thus, in Chesapeake, the relevant inquiries would be not only how the term “redeem” is used in the fine print of the indenture—an inquiry undertaken by the majority Second Circuit opinion—or how it is used in indentures generally but also whether bond investors understand the term “redeem,” whether in an indenture, prospectus, or marketing materials, to refer to the notice date or the payment date of a redemption.

Again, the nature of contracts of inattention—that they are written and negotiated by lawyers but that these lawyers neither represent nor communicate with the ultimate purchasers—is important to this conclusion. In agreements negotiated by sophisticated parties that are both represented by their own team of lawyers—say, in merger agreements—we believe that, if both sets of transactional lawyers have a specific subjective intent or if transactional lawyers generally have a clear understanding of what a provisions means, the lawyers’ intent and understanding should generally control. In this context, lawyers act as agents for their clients. They have the ability and the incentives to discuss the terms of the contract and their clients’ interests with their clients. It is therefore justified to impute their intentions and understandings to their clients. In contracts of inattention, where investors are left to their own devices, the lawyers’ understanding should carry less weight.