CDS may undermine debt governance -law professor

By Jane Baird

VIENNA, April 18 (Reuters) - The explosive growth of derivatives has made it possible that holders of credit default swaps (CDS) could sabotage the interests of a company and its other debtholders, a U.S. professor told a conference this week.

"Empty creditors could undermine debt governance," Professor Henry T.C. Hu, professor of law in banking and finance at the University of Texas, told the annual meeting of the International Swaps and Derivatives Association (ISDA).

For example, a hedge fund or other investor could hold $200 million of a company's bonds but could also have bought protection against default in the CDS market for $500 million worth of the company's debt.

In that case, the investor stands to profit more from its swap position than it would lose from its bonds and may act to help push the company to fail, such as by opposing an out-of-court restructuring.

The issue is taking on greater significance as analysts and debt investors expect the rate of global bankruptcies to increase later in 2008 and 2009 from what have been historically low levels.

By debt governance, Hu refers to the creditor's control rights in credit agreements and under bankruptcy law.

"Both loan contracts and the (U.S.) Bankruptcy Code are premised on the assumption that creditors ... have an economic interest in the company's success and will behave accordingly," Hu and Professor Bernard Black wrote in a law review paper in January.

"Large-scale, hidden debt decoupling weakens our ability to rely on these assumptions."