The Myth of Creditor Sabotage

Since credit derivatives began to substantially influence financial markets a decade ago, rumors have circulated about so-called “net-short” creditors who seek to damage promising, albeit financially distressed, companies. A recent episode pitting the hedge fund Aurelius against broadband provider Windstream is widely supposed to be a case in point and has at once fueled calls for law reform and yielded an effigy of ostensible Wall Street predation. This Article argues that creditor sabotage is a myth. Net-short strategies work, if at all, by in effect burning money.

When an activist creditor shows its cards, as all activists must eventually do, it also reveals an opportunity for others to profit by thwarting the activist’s plans and saving threatened surplus. We discuss three sources of liquidity that targeted firms could tap to block a saboteur—“net-long” derivatives speculators, the target’s own investors, and bankruptcy. We conclude that it is exceedingly difficult for creditors to make money hobbling debtors and that there is little reason to believe anyone tries. We then examine the Windstream case and find, consistent with our theory, that the strongest reason for thinking Aurelius aimed at sabotage—namely that everyone says so—is weak indeed.

Our analysis suggests that calls for law reform are addressed to a nonexistent or, at worst, self-correcting problem. Precisely for this reason, however, the persistent appeal of the sabotage myth is a lesson in political rhetoric. A story needn’t be true for some to find it useful.