The New Market in Debt Governance

Scholars have traditionally assumed that lenders that protect themselves using credit derivatives like credit default swaps (CDS) have limited interest in debt governance. The rationale behind this proposition seems straight-forward. Lenders that have bought credit protection should have little incentive to invest in monitoring and disciplining a borrower where they know they will be repaid under the CDS. Indeed, scholars argue, lenders that have purchased CDS protection have considerable interest in seeing a borrower fail. When this happens, they can easily and cheaply exit their investment by triggering repayment on the CDS.

This paper, the New Market in Debt Governance, recently made available on SSRN, challenges this consensus and proposes a new theory of governance in the context of credit derivatives trading. While scholars have traditionally focused on lenders that protect themselves using CDS, they overlook the role of financial firms that sell this credit protection and thereby assume economic risk on the underlying borrower. These protection sellers take on the risk of a borrower defaulting, but possess no legal tools with which they can discipline the borrower to stave off default. As a result, unlike ordinary lenders, protection sellers have no direct means to control a borrower’s risk-taking. They possess no legal powers to influence how much leverage a borrower takes on, its use of collateral, cash reserves or its acquisitions and enterprise strategy. Given this precarious position, it follows that protection sellers possess powerful incentives to seek out ways to influence how a borrower company is run to better control how risky it is allowed to become.

Lenders possess an array of powerful legal control levers in their loan contracts with corporate borrowers. Scholars are increasingly recognizing the significance of these modalities of control, reflected in loan covenants, representations as well as through the softer influence that lenders can often exercise on corporate management. These contractual powers are prized by lenders as a means of controlling their risk as well as for profitable gain where they lead to further business opportunities for lenders, or in some cases, lucrative ownership stakes in undervalued distressed businesses. When a lender purchases CDS credit protection, it continues to retain the benefit of these legal rights and influence, but it no longer possesses any credit risk on the underlying borrower. The position of the protection seller is exactly the inverse. It holds the economic risk in debt, but without any of the legal mechanisms that help mitigate this risk to better mediate the flow of credit to the borrower.

This paper makes three key claims. First, the paper shows that lenders and protection sellers have powerful incentives to allow protection sellers a means of exerting influence over how the lender exercises its debt governance powers. Specifically, the paper examines the role of reputational capital as a key driver for co-operation between lenders and protection sellers. Lenders that end up holding loan books that evidence a high degree of non-performance, mismanagement and poor debt governance are likely to face reputational sanction from their peers in the CDS market as well as the inevitable ire of regulators. In such cases, lenders benefit where they can shift the costs of debt governance to a protection seller that is deeply invested in its exercise. More broadly, the paper shows that such negotiation between lenders and protection sellers reduces the participation costs that each side faces in the CDS market. CDS protection sellers benefit because they can better manage their risk; lenders benefit because they can enjoy credit protection provided at lower cost to cover a wider spectrum of credit-quality. This co-operation represents a pareto optimal strategy for CDS traders, enabling them to enter and exit the CDS market at lower cost, while maintaining goodwill and reputational capital among peers.

Secondly, the paper develops this insight to argue that these incentives encourage the creation of an informal market in debt governance. Loan contracts between borrowers and lenders comprise an array of useful tools for risk-management, to include covenants to prevent over-leveraging, restrictions as to how secured assets are used, or waiver requirements before important decisions such as acquisitions or asset sales. Protection sellers can therefore choose to influence specific aspects of debt governance (e.g. a lender’s ability to control a borrower’s leverage) to carefully tailor their intervention. This ability to pick-and-choose their intervention strategies can lead to a more efficient, selective approach towards debt governance that can reduce the negotiation costs between lenders and protection providers.

Finally, in advancing its normative claim, this paper acknowledges that this market comes with benefits as well as costs: benefits arise where the exercise of debt governance rests with those most invested in its use; and costs where the motives of these firms are governed by conflicts and risk-preferences that a borrower may not like or be able to counteract. Critically, where protection sellers are engaged in debt-governance, they can intervene without the debtor coming to know who is pulling the strings and why. In addition, recent reforms under the Dodd-Frank Act to bring transparency to the credit derivatives market are not designed to reveal this impact of CDS trading on corporate governance. The paper concludes by proposing a new conception of the role of disclosure and lender liability regimes to better match the costs and benefits, and the profound impact of credit derivatives trading on debt and corporate governance.

The full paper is available for download here.