Dark Knights: The Rise in Firm Intervention by Credit Default Swap Investors

Abstract

There have been several cases in recent years where credit default swap (CDS) buyers and sellers intervene in the restructuring of a distressed firm. We show theoretically that this can increase firm value. Intervention by CDS buyers solves the commitment problem between equity and debt holders but increases the probability of inefficient liquidation. Intervention by CDS sellers reduces the issue of excessive liquidation while keeping the benefits of CDS buyer intervention. Having both types of intervention decouples the commitment problem from the liquidation problem. Under certain assumptions, the so-called empty creditor problem can be solved, and firm value reaches first best. This paper was accepted by Lukas Schmid, finance. Supplemental Material: The internet appendix is available at https://doi.org/10.1287/mnsc.2023.4717 .