The mechanic: a 1/3 holdout in any impaired senior class can block consensual confirmation under most U.S. indentures. If the empty-creditor share of a class exceeds that threshold the firm is functionally forced into Chapter 11 even when every economic creditor would prefer cure. The CDS market does not need to be large in absolute terms to swing a single distressed name — it needs to be large relative to the bond float of that name.
| Creditor type | Net economic exposure | Workout vote |
|---|---|---|
| Unhedged bondholder | +$500M long credit | For — recovery from cure exceeds liquidation |
| Bond + matched CDS (full hedge) | ≈ flat | Indifferent or slight preference for default (CDS basis) |
| Bond + over-hedged CDS | Net short credit | Against — default is the more profitable outcome |
| Naked CDS protection buyer (no bond) | Short credit, no vote | Cannot vote but lobbies and trades against cure narrative |
Worked example — Vanmark Communications faces a covenant breach. Bond float is $2.1B; DTCC weekly net notional CDS outstanding on Vanmark is $1.4B, or 67% of float. Vanmark's restructuring counsel proposes a coupon-deferral and maturity-extension workout. Roughly 32% of the senior class votes against, narrowly clearing the 1/3 blocking threshold under the indenture. Cross-referencing the DTCC participant list against the bondholder register shows that two CDS-net-short funds together hold 28% of the senior class. Vanmark files Chapter 11. CDS contracts settle at the ISDA auction. Empty creditors collect on protection; workout-supporting creditors take a 40% NPV haircut versus what the consensual deal would have delivered.
Three structural mitigants restructuring counsel uses when empty creditors are detected. (1) Pre-package — file a pre-arranged plan with broad lock-up agreements signed before any credit event so individual votes never reach the standard threshold. (2) Exchange offer with consent solicitation — strip restrictive covenants from the existing notes via majority consent so the workout binds even reluctant holders. (3) Voluntary credit event — engineer a narrow-scope event (selective default on a small bond series) that triggers CDS payouts before the broader workout, neutralising the over-hedged holders' incentive to obstruct. Each has trade-offs; none is costless.
Sit with the ideas.
Pelham Holdings is negotiating a coupon-deferral workout with its senior bondholder class. One creditor in the class holds $500M of Pelham senior notes and $700M of single-name CDS protection on Pelham. The proposed workout exchanges the existing notes for new notes plus warrants worth roughly 85 cents on the dollar; under the workout no credit event triggers, so the CDS does not pay. What posture should you expect that creditor to take in the vote?