Hedge Funds Do Tech Takedown in Bond Market

There is a fascinating story up on Bloomberg about how various large hedge funds are exploiting the current option back-dating scandal in a new and unsettling way. Here is how it works:

  • A public company announces it is under investigation for option back-dating.
  • Rather than certify incorrect financial statements and violate Sarbanes-Oxley, the company says it may have to delay routine financial filings until the investigation is resolved.
  • Hedge funds take a big position in the company’s bonds, and announce that because of non-filing the company is in violation of bond covenants.
  • The company technically must repay debt at 100 cents on the dollar, often on debt that is trading at 90 cents on the dollar or lower.

Creative, is it not? Absolutely, and profitable too, with the bonds often rising in anticipation of these antics. Sometimes companies are also paying special fees to appease bondholders too, on the order of 10 to 500 additional basis points.

This is a classic example of unanticipated consequences of new regulation. No-one, I’m sure, anticipated that SarbOx would force someone into technical default on debt over an option back-dating investigation, but here it is happening — and here are hedge funds reaping returns as a result.

Yes, bondholders are doing what is their right, but “companies are getting screwed for technicalities”, as one fund manager told Bloomberg. This is, fundamentally, a punishment disproportionate to the alleged crime, sort of like sending someone to jail for jaywalking. It is also, however, an interesting example of how creative hedge funds can be at engineering returns from unusual places.


  1. Now won’t the companies turn around and sue their banks for not advising them of the risks of these convenants?
    In the grand scheme, this is probably nothing compared to the economic cost of the productivity stifling nature of Sarbox every day of the year.

  2. Yes, for sure this pales against the cost of SarbOx overall. But this is material stuff, with something like $36-billion in bonds at stake, in the limit.
    Either way, I’d expect covenant language to begin changing in a hurry. The interesting question is how you will separate technical and non-meaningful default from real and meaningful default. Go too far in the direction of protection against bond bandits and you disadvantage bondholders unduly in favor of corporates.

  3. Brent Buckner says:

    Hmmm. On first blush, it doesn’t appear to me to be outrageous (although perhaps suboptimal and not representing smooth functioning of capital markets).
    Bond-holders, who don’t get to vote, get to demand payment of the bonds if a company is so dysfunctional that it cannot file routine financial statements in a timely fashion.
    The underlying cause: Sarb-Ox required signatories do not have sufficient confidence that the company has not authorized option activity that resulted in material mis-statements. Doesn’t strike me as jay-walking.

  4. I agree with Brent. Not optimal, but certainly not outragous. The company apparently screwed up and the market’s punishing it.

  5. If a compnay can’t file statments on time and the mgmt won’t sign as per SarbOx regs, and the covenants allow for early forced redemption, I don’t know why anyone would expect Hedge Funds or other holders to play the Red Cross and not demand early repayment.
    Get your stuff together, file on time, don’t BACKDATE OPTIONS and this won’t happen to you. Sounds like an afterschool special [Jenny Eat Something!] doesn’t it?

  6. This is fabulous…the market, through the hedge funds, penalizing managements for self-enrichment.
    Another proof of the self-regulating function of markets…

  7. Linda Bolton says:

    It’s not that the hedge funds have it wrong – nor that SOX has it wrong. It’s the target company itself – playing fast and loose with their ethical decisions – looking over the shoulders to see if anyone was watching. Well there’s an army of stakeholders watching.
    That’s the heart of the issue. That’s why my company is developing a Leadership Ethics workshop for CEO’s and Board Members.
    Set the right tone at the top – set expectations -and reinforce until – no one’s even thinking about it. There’s still a lot of money to be made.
    Linda Bolton
    Bolton Associates,Inc.