A company requires capital to function and achieve its vision. The necessary capital is obtained
through equity infusion or loans. When a company borrows, the lender faces a risk of nonrepayment. To mitigate this risk, lenders can utilize credit default swaps. A CDS can be
compared to an insurance policy taken out by lenders in the event of borrower default,
protecting them from loss. In a CDS, the lender pays a certain amount of periodic premiums to
a CDS protection seller. In cases of default, as per the contract agreement, the protection seller
pays the lender the principal amount, as well as the accrued interest. In this way, the lender
shifts the risk to a third party. In India, CDS was made legally available by the Reserve Bank
of India in 2011 through the issuance of 'master directions'.
To ensure the stability of the financial system, the RBI provides strict guidelines on who can
provide protection in a CDS contract, and also regulates who is eligible based on their risktaking capacity. RBI divides the market into two categories: Market makers and non-retail
users, and only they are allowed to sell CDS protection. While this helps mitigate risk and
stabilise the banking sector, it creates a major paradox within the legal framework of
Insolvency. The Insolvency and Bankruptcy Code, 2016, revolves around the idea that the
Committee of Creditors has an interest in maximizing value and reviving the company. It is
assumed that the financial creditor has 'Skin in the game' and therefore would use its
commercial wisdom and voting rights for the resolution of the insolvent company.
Unfortunately, in a scenario where a CDS protects the financial creditor, they're most likely to
push towards liquidation or a failure to revive the company, as they'd benefit from a full payout
from a CDS rather than a haircut. Here, the lender retains the voting right, as they have the
evidence of the loan given to the debtor, but at the same time faces no economic risk; this
creates an "empty creditor." An empty creditor is a financial creditor who holds the steering
wheel of the company's future, but would likely crash the car, as they have a 100% payout
waiting for them.
In India, the Commercial wisdom of the Committee of creditors is given legal status by the
courts; the hidden motives of an empty creditor could lead to sub-optimal results. There are
only two outcomes to the corporate insolvency resolution process: A successful Resolution or
liquidation. Liquidation can be considered as the death of the company, and a financial creditor
with CDS benefits from it; hence, they will use their voting rights in the CoC to either ambush
the resolution plan or push for direct liquidation. To avoid the insolvency process, companies
often attempt an "out of court settlement" as it is cheaper and faster; however, CDS contracts
usually have specific triggers that do not include a simple out-of-courtsettlement. The contracts
might state that a payout is only possible if there is a formal filing of insolvency at the National
Company Law Tribunal. Financial creditors, who usually allow a specific time period for their
debtors to repay the loan, will no longer do so to ensure that they can file for insolvency with
the NCLT. CDS creates a perverse incentive where a creditor benefits more from the borrower's
failure.
CDS is a powerful tool to strengthen the Indian bond market, as it enables banks and other
financial creditors to mitigate risk. The current challenge is to avoid a lack of transparency and
protect the integrity of the committee of creditors from hidden hedging. Under the IBC 2016
framework, the interim resolution professional or resolution professional verifies the claims
given by the creditors based on the debt owed by the corporate debtor. However, there is no
mandatory provision for creditors to disclose whether the debt has been hedged or not through
a CDS. When a creditor votes against a viable resolution plan, it creates a vulnerability in the
CoC, leaving the other stakeholders in the dark. To preserve the spirit of the true intentions of
the IBC, the regulatory boards must address the issue of empty creditors. The regulatory board,
such as the Insolvency and Bankruptcy Board of India, should mandate that all members of the
CoC must disclose whether they have hedged any of their funds via CDS or any other similar
method. In cases where the financial creditor is fully protected through such hedges, the legal
framework must provide a provision that reduces the voting rights of such a creditor, as their
interests do not align with those of the IBC, since they are no longer interested in the
maximization of the company's value. As India's credit markets mature, the legal framework
should require the Committee of Creditors to prioritize the long-term viability of enterprises
when exercising its "commercial wisdom," rather than short-term financial gains.