Shareholder Opportunism in a World of Risky Debt

Abstract:     
Modern finance is increasingly dominated by derivatives and similar contracts that create “contingent” debt, which becomes payable only upon the occurrence of an uncertain future event. This Article identifies a pervasive opportunism hazard presented by contingent debt that lawmakers and scholars have overlooked. If a firm’s contingent debt is especially likely to be triggered when the firm is insolvent, the contingent debt contract enriches the firm’s shareholders at the expense of its creditors. Firms therefore have incentive to engage in correlation-seeking—that is, to sell contingent claims against the firm that correlate, or through asset purchases can be made to correlate, with the firm’s insolvency risk. Correlation-seeking is especially pernicious because, unlike other forms of shareholder opportunism, it reduces risk borne by shareholders even while increasing shareholder returns. Correlation-seeking produces social costs including overinvestment, higher borrowing costs, financial distress and potential systemic risk. Such costs are illustrated by the collapse of AIG, which occurred because the company bought up assets that were likely to lose value just as deep liability on its derivative contracts was triggered. Yet current and proposed legal rules for derivatives and other contingent debt contracts ignore matters of correlation, leaving room for another AIG in the future.

Keywords: derivatives, credit default swap, correlation, bankruptcy, guaranty, fraudulent conveyance

JEL Classifications: K22, G13, G20

Accepted Paper Series