The following comes to us from Yesha Yadav, Assistant Professor of Law at Vanderbilt Law School:

Scholars have long lamented that the growth of modern finance has given way to a decline in corporate governance. According to current theory, the expansive use of credit derivatives has made these lenders uninterested, even reckless, when it comes to exercising creditor discipline.  Credit derivatives, such as credit default swaps (CDS), allow lenders to trade away the credit risk of the loans they extend. Without economic skin-in-the-game, lenders are left with little motivation to invest in ensuring that debtors remain creditworthy.  Indeed, their interests may be entirely the opposite: to push debtors towards liquidation in order to quickly and cheaply exit their investment by triggering repayment on the CDS.

My recent article, Commoditizing Creditor Control, argues that, far from dooming governance to failure, credit derivatives can prove to be a positive force in corporate governance. In its analysis, it highlights the role of credit protection sellers (i.e., firms that offer to protect lenders against default and thereby assume risk on the underlying loan). Although these actors assume economic risk, they have no real means to discipline a borrower and to control their exposure. The article explores the dynamic between lenders and credit protection sellers to suggest that both sides have incentives to bargain in the interest of better creditor discipline. As a mechanism to harness these cooperative incentives, the article proposes the creation of a market in creditor control. This market would allow lenders and protection sellers to trade in the control rights in underlying debt and, in so doing, to better ensure that these rights come to be used by those most invested and interested in their exercise.

This market offers a fix to an otherwise difficult and costly problem in corporate governance: the misalignment seen in modern markets between those who hold economic risk in debt and those best incentivized to control it.

The full article, which will appear in the Vanderbilt Law Review in April 2014, is available here.