We Mean What We Don't Say: The Archer Daniels Midland Case, Reputation, and the Curiosity of Refunding Clauses

Abstract

The Archer Daniels Midland litigation and its aftermath highlighted the oddity of the continued use of the refunding clause in bond covenants, despite its legal ineffectiveness. This Note suggests three reasons for why the refunding clause might have retained value despite judicial curtailment of its legal reach: investor ignorance of the legal details of bond indentures, discounted but residual legal value, and extra-judicial reputation-based enforcement. The reputation-based hypothesis construes the refunding clause as a division of benefits between issuers and investors, where issuers retain the right to call -bonds for "legitimate" business purposes, but investors are promised all gains from market interest rate movements. In this view, the refunding clause is an implicit pledge by issuers not to appropriate bondholders' market gains. As this line is too fine for courts to police, the understood pact is enforced via investor retaliation against future bond issues and other reputation effects. Initial empirical observations yield mixed results: There is support for the preconditions of the reputation-based hypothesis as to investors, but observations of bond issuances are less supportive, suggesting that the use of the refunding clause, while still done by some companies, decreased sharply following the Archer Daniels Midland decision. These observations also suggest, however, that many other factors were at work and that this drop in use might be the result of changes aside from the clause's legal value.