CLNs are customized credit derivatives in the unregulated over the counter (OTC) market, issued by a bank or financial institution backed special purpose vehicle or trust. They are structured to allow the issuer to transfer a part of the credit risk to investors, who are willing to bear such a risk in return for higher yield. These deals are done outside the country, as OTC derivative contracts have no legal standing in India.This is how a CLN broadly works. A company borrows a certain amount from a bank or makes a convertible offering to that bank. Having loaned the funds, the bank then issues CLNs, which are subscribed to by investors looking for above average returns.
The CLN-issuing bank then invests the proceeds in low-risk-papers, thereby partially mitigating risks. The coupon or rate of return of the CLN is linked to the performance or financial strength of the specified asset or the borrower. But, the investor stands the risk of incurring a loss if either of the bank or the company defaults.
Quoted on the right is the example of Lehman brothers which has taken a substantial stake in the 45 Indian companies.
Lehman Brothers had subscribed to FCCBs of some Indian companies and, at the time of the issuance, issued CLNs to investors including some international banks and overseas arms of Indian banks. When Lehman went bankrupt, investors have been left guessing as to what is in store for their investments through such credit derivatives. These investors were concerned whether they would receive even half of this invested amount. There is uncertainty over how much an investor in a CLN-referenced FCCB can claim after such bankruptcies. Some clarity will emerge after the bankruptcy court reaches upon a decision with this regard.