Inadequate credit administration

The existence of credit protection may provide an incentive for protection purchasers
to administer the underlying borrower relationship improperly. For example, consider
technical covenant violations in a loan agreement a bank may ordinarily waive. A
bank with credit protection may be tempted to enforce the covenants and declare a
default so that the timing of the default occurs during the period covered by the
credit protection. It is unclear whether the protection seller has a cause of action
against such a bank by charging that it acted improperly to benefit from the credit
derivative.
Another potential problem could involve the definition of a default event, which
typically includes a credit restructuring. A creditor that has purchased protection on
an exposure can simply restructure the terms of a transaction, and through its
actions alone, declare a credit event. Most contracts require a restructuring to involve
a material adverse change for the holder of the debt, but the legal definition of a
material adverse change is subject to judgment and interpretation. All participants
in credit derivative transactions need to understand clearly the operative definition
of restructuring.
In practice, credit derivative transactions currently involve reference obligors with
large amounts of debt outstanding, in which numerous banks participate as creditors.
As a result, any one creditor’s ability to take an action that could provide it
with a benefit because of credit derivative protection is limited, because other
participant creditors would have to affirm the actions. As the market expands,
however, and a greater number of transactions with a single lender occur, these
issues will assume increasing importance. Protection sellers may consider demanding
voting rights in such cases.