The New Market in Debt Governance

Abstract

Scholars assume that lenders that protect themselves using credit derivatives like credit default swaps (CDS) have limited interest in debt governance. However, 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. This Article 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. For lenders and protection sellers, this bargain reduces participation costs in the CDS market and preserves each side’s reputational capital. The Article argues that these incentives encourage the creation of an informal market in debt governance. Protection sellers can choose to influence specific aspects of debt governance (e.g. a lender’s ability to control a borrower’s leverage) to tailor their intervention in the governance of the borrower. 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. The Article 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.