The Empty Creditor Hypothesis
ISDA Research Notes, November 2009
16 Pages Posted: 27 May 2010
Date Written: November 3, 2009
Abstract
The empty creditor hypothesis suggests that bondholders and other creditors can use credit derivatives and other financial contracts to unbundle exposure to default from non-economic rights such as voting under debt agreements and in bankruptcy. According to the hypothesis, hedged creditors have weaker incentives to cooperate with distressed corporations to avoid bankruptcy and might even build up a “negative economic interest” under which failure is the preferred outcome. In addition, the hypothesis suggests that, once a firm enters bankruptcy, hedged creditors will be indifferent to the value of the firm. This paper argues that there is little if any evidence to back up the assertions of the empty creditor hypothesis. Further, given the cost of hedging distressed credits, the incentive effects of hedging are unlikely to lead systematically to behavior that would distort credit markets. Finally, because credit derivative settlement procedures essentially decouple compensation from ultimate recovery, they should in most cases have no effect on creditor behavior in bankruptcy proceedings.
Keywords: empty creditors, credit derivatives, credit default swaps, bankruptcy, derivatives
JEL Classification: G29, G33
Suggested Citation: Suggested Citation
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