Decoding Derivatives – Q3 2020

DC Avoids Getting Its Wires Crossed With Wirecard 

Following its application to the Munich District Court to open preliminary insolvency proceedings, Wirecard was alleged to have been subject to a bankruptcy credit event. The Determinations Committee (DC) considered the circumstances and determined that a bankruptcy credit event had in fact occurred, notwithstanding the preliminary nature of the proceedings. In its supporting statement, the DC noted that Wirecard had made a voluntary application for insolvency proceedings under the German Insolvency Code, thus subjecting any disposition of its assets to the consent of a preliminary insolvency administrator. This adds some additional color and jurisdictional coverage to the string of credit events, most recently including Thomas Cook, involving European insolvency or restructuring situations. In the case of Wirecard, the DC noted that its analysis was made more straightforward because the relief was being sought under an insolvency statute, as opposed to a corporate restructuring proceeding.

Untercode: German Schutzschirmverfahren – recently considered in Lufthansa

Schutzschirmverfahren (Protective Shield Proceeding), recently considered by Lufthansa during the pandemic and having become increasingly common in Germany, may well be examined by the DC in the short term to the extent a German reference entity goes that route. The body of cases used in the context of Thomas Cook may well come in handy in forecasting a potential credit event outcome.

Subcode: All Publicity Is Good Publicity for Deliverable Obligations

In determining the list of Deliverable Obligations, the DC noted that it was aware of a revolving credit facility but that it did not have a public copy of the relevant documentation. As such, the revolving credit facility (RCF) was ultimately not included on the final list of deliverable obligations. While the need for publicly available information to support the occurrence of a credit event is widely known, the need for publicly available documentation regarding deliverable obligations or other publicly available information (eligible information) for other events, such as succession events, is often overlooked. Market participants should be reminded that references to obligations in other documentation, such as the RCF in Wirecard or the guarantee in Noble, are insufficient if the terms and documentation of the obligation itself are not publicly available. Banks using credit default swaps (CDS) to hedge their loan originations should consider negotiating a contractual right to publicly disclose the debt documentation upon default by the lender/issuer so as to satisfy this requirement and perfect their hedge.

Chapter 15 Filings Making a ‘Matalan’ Out of a Molehill for CDS Investors

In substantially similar circumstances to those in Thomas Cook, the DC was asked to consider whether a Chapter 15 filing by Matalan to recognize a scheme of arrangement being implemented in the U.K. amounted to a bankruptcy credit event. The result in Matalan, a bankruptcy credit event, was the exact opposite to the outcome in Thomas Cook. The reason for the diverging views of the DC was that in Matalan, critically, the Chapter 15 filing seeking to recognize a “foreign main proceeding” did not ask the court to waive the automatic stay requirement typically imposed in connection with the recognition of foreign main proceedings. Taken together, Matalan and Thomas Cook shed light on the highly technical nature of certain definitions and the precision required by CDS market participants to navigate those issues and accurately predict an outcome. In Thomas Cook, we argued in a DC determination request that a scheme of arrangement recognized under Chapter 15 and implementing a Chapter 11-like debt reorganization should trigger a bankruptcy credit event regardless of the application of an automatic stay. In Matalan, the DC continues to be reluctant to follow that approach. But one may then wonder what is the benefit of waiting until a scheme of arrangement has potentially wiped out the debt (e.g., via a debt for equity exchange), making it impossible to settle CDS contracts and thereby providing a windfall to protection sellers.

“Waive” Goodbye to Deemed Auctions … Maybe

HEMA BondCo I B.V., the financing arm of Dutch retailer HEMA, recently agreed to terms with its noteholders to restructure certain senior secured notes. In negotiating the restructuring, HEMA entered into a lockup agreement with more than 85% of its senior noteholders under which the noteholders agreed to waive a July 15 coupon payment to ease liquidity. Following the expiration of the 30-day grace period for the coupon payment, a CDS market participant alleged that, notwithstanding the lockup agreement, a failure-to-pay credit event had occurred as a result of the missed coupon payment. The DC agreed. The swift finding of a failure-to-pay credit event before the restructuring, along with the move by the DC to expedite the timetable for finalizing the list of deliverable obligations so as to anticipate the date of the CDS auction, provided the conditions for an orderly trigger and settlement of the CDS contracts (the CDS auction was held a mere 12 business days following the credit event determination). In the worst potential scenario, waiting for the restructuring to trigger the CDS could have resulted in a deemed auction with a DC-determined Final Price of 100% with no settlement payment, as in a few recent cases such as Intelsat and TopGun Realisations. The DC’s approach here would also be welcome news for market participants buying CDS expiring on the Sept. 21 roll date, ensuring a payout when the restructuring looked to possibly be extending beyond the roll date.

Subcode: Unpacking the Asset Package Delivery Component

The DC also took the highly unusual step of establishing some form of asset package delivery optionality via the auction terms to enable the settlement of the CDS contracts even in a situation where deliverable obligations would be converted into some other assets prior to the settlement of the trades formed in the auction. This provides a road map for protection buyers also invested in the bonds/loans of a reference entity relative to relying on a failure to pay when structuring a debt reorganization so they get the benefit of their bargain with respect to their CDS contracts. Could this be market manipulation? Probably not. In instances where that is not feasible (e.g., there is no upcoming coupon payment date), this begs the question as to when the product will allow for an asset package delivery where a restructuring wipes out all deliverable obligations of a reference entity, an issue that is unfortunately not new in European credits. 

California Resources Test Drives NTCE Updates 

In connection with its failure to pay interest on certain loans, California Resources Corp. entered into a forbearance agreement with its creditors. The forbearance agreement delayed creditors’ right to enforce remedies by two weeks. Given the cooperation between the reference entity and its creditors, before concluding that a failure-to-pay credit event had occurred for the purposes of the California Resources Corp. CDS, the DC considered whether the credit deterioration requirement imposed under the newly adopted, narrowly tailored credit event supplement had been met. While the DC did not publicly specify precisely which factors it considered in making its determination, it ultimately determined that the forbearance agreement was an arm’s-length transaction and bona fide. Despite there not being any suggestion of nefarious conduct surrounding the forbearance agreement, this was still the first opportunity the DC had to consider the new NTCE supplement. The DC has since made similarly straightforward determinations in HEMA and PizzaExpress. It is also reassuring that, even when considering the new provisions, the DC has been able to make its determinations in short order — maintaining its penchant for swift determinations where the facts are sufficiently clear.

(N)OID – Chesapeake Exchange Results in No Reduction for CDS Auction 

Alongside the introduction of the credit deterioration requirement, the NTCE protocol also updated the definition of “Outstanding Principal Balance,” an oft-overlooked amendment. The updated definition effectively seeks to clarify that, even where a bankruptcy credit event has not occurred (e.g., in a failure-to-pay scenario), bankruptcy rules relating to the principal balance of an obligation such as original issuance discount (OID) can still be taken into account to reduce the outstanding principal amount of an obligation. In another first, the DC, in Chesapeake Energy, considered whether an exchange offer of senior notes for second lien notes should attract OID. At issue was the exchange offer whereby existing debt was exchanged for the new second lien notes, resulting in bondholders taking a 30%-40% reduction in the principal amount of their notes in exchange for higher interest. The DC, predictably, determined that the outstanding principal balance of the second lien notes was par and that no reduction or discount would apply.

ESG Promotes Sustainability, Just Not for CDS

With the booming interest in ESG investments, IHS Markit and MSCI reportedly received a substantial interest in an index CDS product linked to ESG reference entities. However, despite the notable headwinds in ESG generally, the index has thus far failed to get off the ground, with no significant trading reported. Does this mean the CDS product is not a desirable hedge for ESG investments? Not quite. The issue with index CDS is that the basket of reference entities must behave in a manner representative of the risk it is designed to hedge. The issue with ESG investing, at least at present, is the market has yet to establish a true market standard, thus creating significant differences between reference entities. There also continues to be a fair amount of deviation in what investors consider to be ESG, making the creation of a basket of reference entities to satisfy investors as a whole an impossible task. With all this variation, it is likely we will see investors looking to create their own single-name CDS baskets for the foreseeable future.

In case you missed it …

Credit Events Go Up and Recoveries Go Down: CDS Investors Are Along for the Ride 

As we noted in our Q2 2020 issue, CDS final prices have been at near-historic lows in 2020 — significantly below the average and the assumed recovery modeled by IHS Markit and Bloomberg for the purposes of CDS indices and quoted spreads. These low final prices can lead to significant losses for CDS protection sellers anticipating near-model recoveries, sellers of index CDS protection, and investors in structured credit deals taking significant exposure to risky tranches. As the year advances, final prices continue to be low, with California Resources (1.125), Wirecard (11), Chesapeake Energy (3.5), Noble (1.0) and Matalan (36.5) all representing low recoveries on the underlying credit.