Narrowly Tailored Credit Events: Proposed Changes to the Credit Derivatives Definitions and Preliminary Takeaways

Overview

Narrowly tailored credit events have emerged as one of the most controversial opportunistic CDS strategies in recent years, as we have been reporting in prior publications. In the cases of Codere, iHeart and Hovnanian, voluntary payment failures were criticized as artificial defaults not reflecting the “spirit” of the Credit Derivatives Definitions (the Definitions). In addition, the case of Hovnanian also resulted in a widely publicized market manipulation claim and criticism from regulators. 

Following the highly-publicized Hovnanian litigation and subsequent interest in the CDS market from regulators, the ISDA Credit Derivatives Steering Committee (Steering Committee) has proposed a change to the CDS contract intended to prevent artificial defaults (i.e., defaults that do not necessarily reflect a genuine inability of a Reference Entity to make a payment) from triggering the CDS contracts (the Proposal).

This alert describes the proposed change and provides some preliminary takeaways.

Proposed Change

The Proposal is relatively mild in scope, in light of the wide array of potential issues and modifications considered by the Steering Committee over the past several months. The Proposal works what is essentially a subtle change to the definition of the Failure to Pay Credit Event, by adding a requirement that the relevant payment failure result from or in a deterioration in creditworthiness or financial condition of the Reference Entity. Specifically, the definition of Failure to Pay would provide that:

“It shall not constitute a Failure to Pay if such failure does not directly or indirectly either result from, or result in, a deterioration in the creditworthiness or financial condition of the Reference Entity.” 

The Proposal recognizes that this approach introduces an element of subjectivity, which in turn may create some level of uncertainty in the determinations process. It may be difficult to say with complete assurance that a payment default did, or did not, result from or in the deterioration in creditworthiness or financial condition of the Reference Entity. This uncertainty is in fact desired by the Steering Committee, since it was felt (and the interpretive guidance explains) that uncertainty over whether an arrangement will lead to a credit event for CDS contracts would reduce the incentive to create a narrowly tailored payment default.

In an effort to provide some clarity on how the new criterion should be applied, the proposed change comes with interpretive guidance setting forth the purpose of the credit deterioration requirement and a nonexhaustive list of factors that should be taken into account in making a determination. These factors are intended to be binding not only on the Credit Derivatives Determinations Committee (the DC) when considering Failure to Pay credit event requests, but also on market participants in purely bilateral matters.

Also, importantly, the Proposal would establish a presumption that the credit deterioration requirement is satisfied unless “Eligible Information” sufficient to overcome that presumption is available. 

Interpretive Guidance

The interpretive guidance requires a causal link between the credit deterioration and the potential Failure to Pay. This causal link may exist where the Failure to Pay results directly or indirectly from a credit deterioration, or where such credit deterioration results directly or indirectly from such Failure to Pay.

To aid with this determination, the interpretive guidance sets out certain factors the DC should take into account when considering a narrowly tailored Failure to Pay. These factors are only indicators of whether a deterioration in creditworthiness is implicated (or not), and are not intended to be exhaustive or conclusive.

Factors suggesting that the credit deterioration requirement has not been met include:

• The payment failure arises directly from an arrangement with a third party with a principal intention of creating a benefit for CDS contracts. The interpretive guidance notes that this factor may not be probative where the issuer may be seeking to break basis trades, as discussed below.
• The Reference Entity’s agreeing to issue or incur a new debt obligation which is likely to be the “cheapest-to-deliver” Deliverable Obligation, or a material amount of additional debt obligations that would constitute Deliverable Obligations in an Auction.
• The nonpayment not resulting in the Reference Entity’s other debt obligations generally being accelerated or becoming capable of being accelerated.
• The Reference Entity having access to sufficient liquidity to meet its debt obligations as they were scheduled to come due, and the absence of Eligible Information that such nonpayment had a technical, administrative or operational cause.
• The nonpayment is deemed promptly cured following the expiry of the relevant grace period, including a grace period deemed to apply under the Definitions.
• The nonpayment relating only to debt obligations held by affiliates or other persons not likely to accelerate or take enforcement action. (This factor is also qualified by a sympathetic inclination towards breaking basis trades.)

Factors suggesting that the credit deterioration requirement has been met include:

• The Reference Entity’s being in financial distress and/or sought to restructure its debt obligations (including seeking arms-length forbearance agreements from creditors) prior to the nonpayment occurring.
• Appointment of restructuring and/or insolvency advisors.
• The nonpayment occurring pursuant to the terms of a creditor process that is overseen by or approved by a court or independent insolvency official.
• The nonpayment occurring because the Reference Entity was not able to refinance (including as a result of general market conditions or external factors) in order to meet its debt obligations when due.
• The payment date on which the nonpayment occurred was a scheduled payment date under the terms of the debt obligation at the time such debt obligation was originally incurred; or, if such payment date was amended, it was amended well before the date such nonpayment occurred.
• Any additional impact resulting from the payment failure such as (i) other debt obligations of the Reference Entity generally being accelerated or capable of acceleration; (ii) the Reference Entity’s failure to make payments in respect of its other debt obligations and/or (iii) a bankruptcy of the Reference Entity.

The interpretive guidance does not directly address how the proposed credit deterioration requirement comports with the somewhat similar requirement applicable to Restructuring Credit Events. It remains to be seen whether the DC will look at credit rating declines and public filings indicating financial difficulty as creating a sufficient link between a payment failure and the creditworthiness of a Reference Entity. The wording of the Proposal indicates that the tests are different in scope and application and that those factors alone are not conclusive.

In this respect, the Proposal leaves open a variety of questions — for example, whether an engineered payment failure at a distressed (or even, simply, stressed) Reference Entity represents a bona fide Failure to Pay, albeit perhaps timed to optimize a restructuring package, or, alternatively, an artificial default that should be disregarded for the purposes of CDS. Questions like these may be an unavoidable consequence of the uncertainty desired by the Steering Committee. 

Forbearance Agreements

As noted above, the interpretive guidance mentions forbearance agreements as positive indicators that the credit deterioration requirement has been met. However, the interpretive guidance only favorably views forbearance agreements “entered into for bona fide commercial reasons.” These are presumed by the Proposal to be those entered into with a majority of the external creditors by volume, on an arm’s-length basis, and memorialized in a formal agreement. 

The interpretive guidance may underappreciate, however, the circumstances in which a forbearance agreement may arise. In particular, depending on how strictly the arm’s-length requirement will be applied, certain legitimate forbearance agreements may not qualify. Requiring participation of a majority of creditors by volume may also prove problematic. Where a Reference Entity has multiple obligations, it would be entirely possible that a forbearance arrangement would only be necessary in respect of certain of those obligations, which may happen to be closely held. These and other indicative criteria suggested under the Proposal would seem to inject a fair amount of uncertainty into the DC’s determinations and will add pressure on the DC to use its discretion wisely.

Eligible Information

It remains to be seen what the DC will consider sufficient information to overcome the presumption that the Credit Deterioration Requirement has been satisfied. The interpretative guidance provides that statements made by the Reference Entity will be taken into account, although they will not be determinative. This will likely promote public relations activism by market participants to achieve the outcome they desire. They might, for instance, seek to advance their positions via media outlets, as has been observed in recent cases, or take a more direct route by influencing or controlling the Reference Entity’s own disclosures. Public disclosure requirements in the jurisdiction of the Reference Entity might also be manipulated to influence the decision of the DC.^[1] A carefully crafted disclosure by a Reference Entity supporting a Failure to Pay determination in accordance with the relevant factors may be difficult to overcome, unless there is a clear indication of collusion between the Reference Entity and one or more market participants. In any event, the DC will have to consider potentially divergent pieces of information, which will likely complicate its task and extend the time it will take the DC to make a determination.

Breaking Basis Trades

In the context of a debt restructuring, a company may have to engage with bondholders who are flat or who short the company on a net basis as a result of their CDS positions. These basis traders often have different priorities than the net long bondholder/lender group. It is not uncommon for restructuring negotiations to make little progress until such time as the CDS contract is triggered and settled. Thereafter, the remaining bondholders should be incentivized to participate in an out-of-court restructuring. Recognizing that one approach to dealing with basis traders is for the Reference Entity to simply default on its payment obligations, the guidance provides that organized payment failures designed to break the basis trades and facilitate a restructuring should not disqualify a Failure to Pay Credit Event.

Implementation and Consultation

As with other changes to ISDA contracts, the proposed changes would be effected via a protocol. ISDA would also publish a new version of the physical settlement matrix, which would incorporate the proposed changes into all CDS contracts referencing the amended matrix.

ISDA is soliciting feedback on the Proposal from market participants. The consultation period is open, and any feedback must be submitted to ISDA by Wednesday, March 27, 2019.

Main (Preliminary) Takeaways

• Narrowly tailored credit events have been one of the most controversial issues facing the credit derivatives market in recent history. The Steering Committee has evidently taken the view that unhindered proliferation of engineered defaults is not beneficial for the CDS marketplace. That said, the Proposal injects subjectivity into the DC’s determinations process and thereby would create a fair amount of uncertainty for market participants.
  
  
• It is unclear how much weight the DC will give to critical market indicators such as credit ratings and public recognition of financial difficulty. For example, a similar credit deterioration test in the Restructuring Credit Event definition was tested at External Review in the Cemex case. The External Review Panel in that case viewed public statements by the Reference Entity and ongoing credit rating downgrades as confirmation that a credit deterioration had occurred. However, the Steering Committee’s apparent discomfort with the Codere and iHeart events, and the wording of the Proposal, would suggest that the DC may afford less weight to these indicators in the context of a Failure to Pay.
  
  
• Using its discretion under the Proposal, the DC may question, and perhaps decline to make, a credit event finding regarding certain voluntary but less offensive engineered defaults, such as defaults designed for breaking basis trades. Indeed, breaking basis trades appears to have been one of the intended consequences of the Failure to Pay in Codere and iHeart, which have become poster children for CDS reform. How Codere would be decided under the Proposal is uncertain. Reference Entities and market participants in these circumstances may therefore be motivated to inject tendentious information into the market to influence determinations of the DC.  While the DC strives to source quality information to support its determinations, there have been instances where such tendentious information has formed a significant portion, if not all, of the publicly available information with respect to a credit event.
  
  
• Consideration of breaking basis trades raises another issue. It is likely that many of the determinations the DC will be asked to make under the Proposal will involve some interplay between bond/loan and CDS positions. Distinguishing between breaking a basis trade vs. enabling certain market participants to inappropriately profit from artificial defaults may prove difficult. There is frequently a substantial number of basis package holders involved in a credit, such that the DC will be under pressure to make a determination that reflects reasonable market expectations. If it fails to do so, the DC would risk undermining the utility of the CDS product for the bondholder constituency holding the bonds on basis.
  
  
• We would also expect the proposed change to engender heightened participant activism in the CDS market. In relatively complex credit events over the past two years, market participants have increasingly been submitting (or attempting to submit) information to the DC. The information submitted has included not only debt documentation and press articles, but also extensive analysis of the Definitions and contractual terms at issue. Going forward, such advocacy may be expected to focus on the new interpretive guidance, which may serve as a framework for future analytical submissions to the DC.
  
  
• Finally, the appetite of market participants for the Proposal remains to be seen. Market participants may disfavor the additional discretion and subjectivity injected into the DC determinations process because of the added uncertainty that this entails. On the one hand, uncertainty may have the effect of deterring aggressive market participants from promoting narrowly tailored credit events. On the other hand, more traditional market participants may favor clear-cut rules, and for them the marginal benefit of preventing episodic engineered credit events may be outweighed by the disruptive consequence of a vague rule set. What is certain is that the Steering Committee will need to garner widespread support for the Proposal, from all corners of the market, if it hopes to drive adherence to the proposed change. Whether this is achievable remains to be seen.

 ^[1] This may be of particular significance in non-U.S. markets, where the public disclosure requirements do not necessarily require a Reference Entity to publicly disclose information relating to these restructuring strategies.