Decoding Derivatives – Q4 2020

Wrapping the Christmas Risk 

Supply-chain credit risk is a continuous risk vendors and suppliers face, and it is a risk that has some extra venom during the holiday season. With a highly distressed retail sector, suppliers are, as always, seeking to offset their exposure to troubled retailers should the retailers fail before paying for their merchandise. To address this risk, suppliers often enter into vendor puts, offloading the nonpayment risk to a bank or, increasingly, an investment fund. Of course, financial institutions taking this non-payment risk are not drinking the eggnog and gambling on the retailers performing. Instead, investors in vendor puts typically purchase CDS protection referencing the retailer in question – covering against the risk of a retailer default. For the strategy to bear the requisite amount of holiday cheer, though, the mismatch risk between a CDS payout and the recovery on the trade receivable will need to be unwrapped – a task that is not straightforward.

Europcar Disclosures Drive a Credit Event 

As Europcar sought to effectuate its financial restructuring and debt reorganization, certain disclosures made by the company clearly nod to facilitating an orderly settlement of CDS contracts referencing Europcar. On Dec. 7, 2020, the company specifically announced that the Oct. 30 coupon payment it had failed to make as part of its previously announced restructuring was still outstanding after the expiration of the relevant grace period, making it clear a Failure to Pay Credit Event had been triggered. A Failure to Pay Credit Event ensures that CDS contracts are triggered here and now, guaranteeing CDS protection buyers get the benefit of their bargain without having to deal with the relative uncertainty, potential settlement issues and delay that a Restructuring or a Bankruptcy (here a French “sauvegarde”) credit event could entail. Such a smooth outcome for Europcar CDS shows how important reference entity disclosures can be. CDS market participants engaging in restructuring negotiations with a reference entity should keep in mind that negotiating obligations for the reference entity to make certain disclosures can be critical to ensuring the correct outcome for the CDS.

DC Rules Changes

The rules governing actions of the Determinations Committee (DC) were updated on Oct. 2, 2020. The revised rules provide the DC with an express option to deem an auction to take place with a final price of 100 in the event no Deliverable Obligations exist. This mechanism allows the DC to facilitate the close-out of CDS contracts without the need to fall back to a physical settlement method, which would be unnecessarily burdensome operationally since the lack of Deliverable Obligations would inevitably lead to a failed settlement, with the protection seller essentially walking away from the trade.

In addition, the updated rules also amend and streamline the process for market participants to propose Deliverable Obligations prior to an auction. Under the new rules, the DC will publish a preliminary list of Deliverable Obligations no later than 15 business days prior to the CDS auction date. At that time, the DC will solicit the submission of additional obligations from market participants, to be provided within two calendar days. An “initial list” is then published by the DC five business days after the publication of the preliminary list. In terms of challenge, the inclusion (and now) absence of any obligation on the initial list can be challenged by a market participant no later than three calendar days after the publication of the initial list. Also, the DC Rules now allow for market participants to reply to such challenge within the next two calendar days, with the final DC determination to occur no later than two business days prior to the CDS auction. This allows for an orderly challenge process since the previous DC Rules were missing an adequate framework in that respect, forcing market participants to potentially act in a rush to submit any response in time before the next scheduled DC meeting. As under the previous DC Rules, DC determinations in this regard are made by simple majority, other than those relating to a challenge, which require supermajority.  Importantly, the identity of the challenger (or challenge responder) will be published by the DC on its website, a rule that may deter certain market participants from participating in the process (by fear of being associated with aggressive behavior in a market that has attracted its fair share of negative headlines over the years) and the benefits of which are not entirely clear.  The DC Rules also now enable the DC to impose some parameters around the challenge format and submission process on an ad hoc basis. What that will mean in practice remains to be seen, but market participants should expect more control on these issues from the DC going forward.

Subcode: External Review(ed) 

The DC Rules have also been updated to include changes to the external review process – the process used to decide issues on which the DC is unable to reach a supermajority. The changes include establishing minimum standards of expertise for external reviewers, as well as prohibiting individuals recently connected with DC members or the DC secretary from acting as reviewers. In terms of the review process itself, the oral argument/hearing has been made optional. Perhaps most critically, the external review panel may now decide by simple majority (i.e. 2/3 reviewers). This is a significant change as previously, a failure of the reviewers to reach a unanimous decision meant the determination of the DC would stand where the majority achieved at the DC was more than 60%. Now, a simple majority of the external review panel may find in favor of either side of the DC.

Second Circuit Flips on Flip Clauses

Following the Lehman collapse, holders of synthetic collateralized debt obligations (CDOs) sponsored by Lehman and making use of CDS to provide synthetic credit exposure struggled to enforce their contractual rights to be repaid the amount of their investment prior to Lehman getting a bite at the apple to cover the gains made by Lehman on the CDS contracts. The bankruptcy judge first presiding in Lehman (Judge Peck) initially had held that “flip” clauses enabling investors to get repaid first were unenforceable. Noteholders in similar structures had then prevailed in getting the benefit of their contractual bargain in front of the bankruptcy court (then presided over by Judge Chapman), with Lehman then appealing the decision. A little more than 10 years (!) after the initial bankruptcy court decision on this issue, the Second Circuit eventually held that contractually agreed “flip” clauses are fully enforceable as protected under the relatively broad swap safe harbor in Section 560 of the Bankruptcy Code. This represents the right outcome in our view and provides welcome clarity for structured product issuances making use of credit derivatives. For more on this, see our recent Broken Bench Bytes post.

DC Gives SAS CDS Settlement a Little Extra Runway

Following a determination that a Restructuring Credit Event had occurred with respect to Scandinavian Airlines System, the EMEA DC delayed the cut-off date by which a party must trigger the CDS contract to avoid it coinciding with the maturity of certain Deliverable Obligations. Given the limited trading in SAS CDS, the SAS CDS contracts were to settle physically. The delay of the cut-off date by the DC ensured settlement could not be frustrated by obligations maturing between the credit event and a practical settlement date. While not ground-breaking, SAS is yet another example of the DC stepping in to ensure the orderly settlement of the CDS contract in an effort to maintain confidence in the CDS product.