Empty creditor syndrome and vivisepulture: preventing credit-default-swap holders from pushing companies into premature graves by refusing to negotiate restructurings.

INTRODUCTION

Our financial industry faced nearly unparalleled distress in 2008. (1) Numerous banking and insurance institutions whose names were synonymous with the triumph of American capitalism--e.g., Lehman Brothers (2) and AIG (3)--either filed for bankruptcy or were bailed out by the federal government to prevent their failure. Meanwhile, competitors bought out other stalwarts facing potential bankruptcies. (4)

In 2012, the distress has not entirely subsided, and the financial industry continues to recover. (5) More troubling, however, is the effect the financial industry's collapse has had on the broader economy. (6) Between January 2008 and February 2010, the United States lost 8.8 million jobs. (7) Simultaneously, the unemployment rate ballooned from roughly five percent to nearly ten percent. (8) Unsurprisingly, business bankruptcies increased throughout the country over a similar time frame. (9)

Many pundits have argued that a "housing bubble" caused this collapse. (10) Academic research offers the same conclusion but with additional insight into why and how the decline of property values could lead to catastrophic results for the broader economy. (11) One of the more nuanced observations points to the role of complex financial instruments in exacerbating the economic decline. (12) This observation led government officials to enact regulations that could prevent this economic chaos from reoccurring. (13) The result was the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"). (14) Dodd-Frank's drafters focused, in part, on the regulation of sophisticated financial instruments because of their direct relationship to the turmoil. (15) One such financial instrument was the credit default swap. (16)

A credit default swap is a contract under which the seller agrees to pay the purchaser if a negative event befalls a debt instrument; in return, the purchaser agrees to pay the seller a percentage of the payout either up front or over time. (17) Credit default swaps played an integral role in the system-wide collapse of the financial markets, (18) as they tied the fate of large amounts of capital to shaky debt instruments and intertwined the risks of massive financial institutions. (19)

Although Dodd-Frank's regulation of credit default swaps may succeed in stemming some of the systemic risk that these derivative financial instruments create, the statute does not prevent credit-default-swap holders from forcing companies into bankruptcies that otherwise would not occur. Specifically, under current law, parties who invest in a company's debt and who have also purchased a credit default swap on that investment have incentive to resist that company's attempts to restructure its debt in order to avoid bankruptcy, even when a restructuring would be beneficial to other creditors and the economy at large. In an effort to rectify this inefficient outcome, this Comment proposes a rule that Congress should adopt to improve the efficacy of its credit-default-swap regulation.

First, this Comment outlines the basics of the credit default swap, discusses the relationship between the credit-default-swap market and the financial crisis of 2008, and describes the way Dodd-Frank addresses the systemic problems that credit default swaps cause. Next, it explains that Congress's pre- and post-Dodd-Frank regulation of credit default swaps has already led to bankruptcies that otherwise would not have occurred and will continue to do so. Finally, it proposes a rule that solves this problem: Congress should allow the seller of a credit default swap to refuse to make a payout to a purchaser that does not negotiate a restructuring with the debt issuer underlying the swap.

1. CREDIT DEFAULT SWAPS: THE BASICS

   1. What Is a Credit Default Swap?

      Conceived in the aftermath of Drexel Burnham Lambert's (20) creation of collateralized debt obligations (21) in the late 1980s, (22) a credit default swap is a "promise[ ] to make a specified payment in the event a particular debt instrument experiences an event of default, such as a payment default or if the issuer files for bankruptcy protection." (23) In other words, credit default swaps are "derivative instruments that seek to mitigate the risk of failure of a security through purchase of insurance against the occurrence of such event." (24) For example, suppose Sara purchases Company X's bonds but is worried that X may be unable to repay her according to the terms of her investment. She could turn to a third party who, for a price, will guarantee her a return by agreeing to pay her if X fails to do so. (25) The contract between Sara and the third party is a credit default swap.

      To purchase a credit default swap, the buyer makes "a single upfront payment, or possibly a series of payments, in exchange for the counterparty's obligation to make ... [a] payment that is contingent upon the occurrence of any one of a specified set of possible credit events." (26) In this way, the instruments are similar to insurance systems we have in society. (27) Consider Ben's purchase of car insurance against the possibility of damage or theft. Ben pays the insurance company a monthly payment, and the insurance company assumes the risk of catastrophic damage to the car by promising to pay Ben if such a catastrophic event occurs. When the buyer of a credit default swap also owns the investment on which the instrument is based, the swap operates as insurance.

      Not all credit default swaps, however, serve the traditional insurance function. (28) Instead, investors who do not own a debt instrument (29)--e.g., bonds, or notes--but believe that the institution issuing the debt will face some type of crisis in the future buy credit default swaps from third parties for "protection" against that crisis. (30) Imagine Tim taking out "insurance" on Ben's car--without having any ownership stake in the vehicle because he believes someone will soon steal it. (31) Effectively, investors pay third parties monthly premiums or up-front payments with the hope that a credit event befalls the debt instrument, leaving the investor with a large payout from his credit default swap. When investors use swaps in this manner, it is easy to view them as speculators (32) or gamblers. (33)

   2. The Benefits of Credit Default Swaps

      From a macroeconomic viewpoint, the credit-default-swap market provides two main benefits to the broader economy. First, credit default swaps allow investors and creditors to hedge against risk by permitting them to "offset[] their exposure to the risk of loss that is inherent in lending arrangements such as credit facilities or the acquisition of debt securities." (34) More specifically:

      Credit default swaps separate the risk of loss that a creditor faces upon entering into a debt investment and redistributes the risk among the creditor and its credit default swap counterparties. As a result of the redistribution, risk is not concentrated in the same manner that risk is concentrated between a single borrower and a single lender engaged in a traditional credit arrangement. (35) In addition to benefiting investors and creditors, this risk-shifting helps the broader financial market because, "[i]f derivative contracts allow an agent such as a producer to hedge the risk of cash market price fluctuations[,] this may reduce the risk premium that the produce[r] will apply in making investment decisions." (36) Such a reduction decreases producers' cost of production and, therefore, may lead to lower prices for consumers. (37)

      Second, the credit-default-swap market assists the broader economy by acting as a pricing mechanism "by giving an incentive to agents to become better forecasters of market conditions in the future." (38) The market helps "allocat[e] resources to the most valuable uses" (39) because, "if in the future there will be an increase in demand that will lead to a price increase, then [market participants] who buy derivatives contracts ... will bid up their prices in anticipation of that demand increase." (40) Thus, producers of financial instruments are better able to understand what to produce, for whom, and at what price. (41)

   3. The Role of Credit Default Swaps in the Great Recession

      Although credit default swaps may appear to be a rather harmless way for investors to make money, one of the United States' most famous investors, Warren Buffet, once described them as "financial weapons of mass destruction." (42) At the heart of this ominous description is Buffet's understanding that credit default swaps produce systemic risk. (43) That systemic risk becomes apparent when one understands that numerous investors can purchase credit default swaps on the same type of investment or even the same investment itself. (44) For instance, consider the following hypothetical.

      First, imagine that Investor L, who owns Company X's bonds, purchases a credit default swap from Insurance Firm Z to hedge against the risk that X will fail to make payment on those bonds. Under this deal, Z agrees to pay L $1,000,000 if X fails to meet its obligations so long as L makes monthly payments to Z of $1,000. Second, Insurance Firm Z, confident that X will not fail to make payments, strikes the same deal with Investors M and N. Third, Investor L, noticing that other investors believe that X may go bankrupt, originates her own credit default swap with a $1,000,000 payout if X fails and sells it to Mutual Fund A. In return, A promises to pay L $2,000 per month. Not to be outsmarted, Investors M and N also originate and sell credit default swaps to Mutual Funds B and C, respectively, for $2,000 per month. (45)

      At this point, Mutual Funds A, B, and C hold credit default swaps protecting against X's bankruptcy that they purchased from Investors L, M, and N. L, M, and N also hold credit default swaps protecting against X's bankruptcy that they purchased from Insurance Firm Z. L, M, and N think that they have made...