Lee C. Buchheit and G. Mitu Gulati1
Multicreditor debt instruments such as bonds and syndicated bank loans are uncommon legal arrangements. In most contracts, the parties know each other's identity beforehand, and they make a conscious decision to enter into a legal relationship. In a multicreditor debt instrument, the borrower's identity is of course known by each investor, but what the investors do not know - what they often never know - is the identity of each other. Bond investors are like the patrons in a theatre audience: each one has decided to see a particular play on a particular night, but none has any idea who he or she will be seeing it with. If you wish to carry the analogy further, the tradable nature of bonds means that fellow patrons are constantly leaving and entering the theatre throughout the performance.
Now this promiscuous grouping of investors in a bond issue is not troubling as long as you believe that the only important relationship here is that between the debtor and each separate investor. Look at a bond issue close enough, this theory contends, and you will see that it breaks down atomically into hundreds or thousands of bilateral contracts between the bond issuer and each investor; the appearance of an investor group or syndicate is just that, an appearance, with few practical or legal implications. This view assumes, of course, that all bondholders are the passive recipients of payments from the issuer and that the behaviour of any one bond-holder is a matter of indifference to the other bondholders.
And so it may be, but only until things go wrong. It is when the bond issuer runs into financial difficulties that the actions of any one bondholder can dramatically affect the interests of all the other lenders. For example, if each holder has the unfettered discretion to accelerate its bonds following an event of default, to commence a lawsuit and attach the borrower's assets, to force a foreclosure on collateral or to push the borrower into bankruptcy, the other bondholders may then find that their own options in dealing with the situation are dangerously curtailed. Non-litigious bond-holders, however large their majority, are thus at the mercy of their most ruthless colleagues. Visible financial strains on the bond issuer will thus