Unconventional CDS Credit Events: Hovnanian Enterprises

Introduction

Over the past few years, a number of issuers in financial distress and their investors have used refinancing and restructuring strategies that capitalize on credit default swap (CDS) contracts written on the issuer, as reference entity, to achieve a better economic outcome. These strategies take various forms but most commonly involve the triggering of the CDS contract via a failure-to-pay credit event. The ensuing monetization of the CDS contracts for the benefit of CDS protection buyers enables them to extend financing to the reference entity on more favorable terms. At the same time, the relatively low failure-to-pay threshold of $1 million in the standard CDS contract enables CDS contracts to be triggered without hitting cross-default thresholds across the reference entity’s capital structure. Failure-to-pay credit events of this type are “unconventional” because they result from voluntary rather than unavoidable payment defaults.

Until recently, the two most prominent examples of these unconventional credit events occurred with respect to Codere SA and iHeart Communications Inc.¹ The CDS market on K. Hovnanian Enterprises Inc. has now taken center stage. On Jan. 29, 2018, Judge Laura Taylor Swain of the U.S. District Court for the Southern District of New York denied a preliminary injunction sought by Solus Alternative Asset Management against Hovnanian and GSO Capital Partners LP to restrain a prospective refinancing transaction involving an unconventional credit event with respect to Hovnanian.²

This article addresses the CDS-related structuring in Hovnanian and the legal issues in the Hovnanian litigation, which is ongoing. In a companion piece, we provide an analysis of the state of the CDS market following these unconventional credit events, the viability of these strategies moving forward and the possible implications for the CDS market with their proliferation.

The Hovnanian Restructuring

The court described Hovnanian as “a large construction firm that ‘designs, constructs and markets, and sells residential properties’ [that] ‘suffered serious financial losses as a result of a recession and collapse of the homebuilding market in the United States’ between 2007 and 2011.” 

On Feb. 1, 2018, Hovnanian closed a series of transactions to restructure and refinance some of its debt maturing 2019 with significant financing provided by GSO. One component of these transactions involved the tender of $170 million of Hovnanian’s 8% senior notes due November 2019 (the 2019 notes) in exchange for $155 million in cash, $90.6 million of new 13.5% unsecured notes due 2026 (the New 2026 notes) and $90.1 million of new 5% unsecured notes due 2040 (the New 2040 notes). In addition, GSO agreed to provide Hovnanian a 5% term loan in the amount of $132.5 million (with an additional $80 million available as a delayed draw) to refinance Hovnanian’s 7% notes due August 2019, and a $125 million revolver available to refinance Hovnanian’s existing $75 million secured term loan and for general corporate purposes.

As part of the exchange offer, Hovnanian’s subsidiary, K. Hovnanian at Sunrise Trail III (Sunrise), agreed to purchase and maintain the outstanding $26 million of the 2019 notes expected to be tendered in the proposed exchange of the 2019 notes for the New 2026 notes and the New 2040 notes. Moreover, the indenture for the New 2026 notes and the New 2040 notes prohibits Hovnanian from making the interest payment due on the 2019 notes held by Sunrise on the next interest payment date in May 2018. A default on the May 2018 interest payment in the amount of $1.04 million may result in a failure-to-pay credit event determination by the ISDA Credit Derivatives Determinations Committee (ISDA DC), although no such determination has yet been made. This, in turn, would entitle CDS protection buyers (including GSO if it maintains the CDS positions it disclosed as part of the litigation) to receive payments on their Hovnanian CDS contracts.

Comparison to Codere and iHeart

The Hovnanian restructuring incorporates elements of both Codere and iHeart. The transaction is analogous to Codere because Hovnanian’s agreement to default under the 2019 notes held by Sunrise is apparently designed, in part, to draw value from the CDS market that will be used, indirectly, to provide value to Hovnanian through favorable financing terms obtained from GSO. As in iHeart, the interest payment that will be missed is on an obligation owed not to street investors, but rather to an affiliate of the reference entity.

Unlike both Codere and, to a certain extent, iHeart, Hovnanian is not a distressed entity, considering the current prices of its publicly traded debt obligations. However, Hovnanian has made it clear that it has a significant and relatively urgent need to refinance its 2019 notes, and due to certain restrictions in its other debt obligations, it cannot fund the refinancing with otherwise available cash. To obtain financing at more favorable rates than would typically be available to it in the market, Hovnanian turned to a more complex refinancing strategy with GSO, central to which is a CDS credit event.

The Hovnanian restructuring also injects a wholly new component with the issuance of the New 2040 notes. These notes provide long-term flexibility to Hovnanian, among other benefits, but with their relatively low 5% rate of interest and extended maturity, they are likely to be the obligation in Hovnanian’s capital structure trading at the lowest level. If so, and to the extent a failure-to-pay credit event is determined to have occurred, we would expect the payments on the CDS contracts to be primarily based on the trading price of that obligation.³  While it is difficult to predict the level at which New 2040 Notes will trade at the time of the credit event, if current trading prices remain somewhat consistent, they would have the effect of increasing the return to CDS protection buyers on their CDS contracts, generating value for GSO through its CDS positions. Some of the value received by GSO then would be passed on to Hovnanian in the form of the favorable financing terms it receives from GSO.

The Solus Action

As with any bilateral market, for all the economic benefit this transaction presents for Hovnanian and, presumably, GSO, there is a converse loss for CDS protection sellers. One CDS protection seller, Solus Alternate Asset Management LP, filed a complaint against both GSO and Hovnanian in New York federal district court. The Solus complaint alleged Solus will suffer monetary losses if the ISDA DC determines that a failure-to-pay credit event occurs following the planned May 2018 interest payment default. But Solus also suggests that the transaction could result in irreparable harm to the CDS market generally.

In the first instance, Solus sought an injunction to block the exchange offer for the 2019 Notes. The court denied Solus’ request, citing the availability to Solus of monetary damages and the ability of ISDA to craft solutions addressing problems in the CDS market generally.⁴ With the denial of the requested injunction, the Solus action will transition to a traditional litigation process of responsive pleadings, motion practice, discovery and possibly a full trial.

The complaint, on which Solus must now proceed on the merits, alleges a number of causes of action against GSO and Hovnanian. 

• Market Manipulation

Solus accuses Hovnanian and GSO of violating Section 10(b) of the Securities Exchange Act of 1934 and related Rule 10b-5 by manipulating both the price of CDS contracts and the price of Hovnanian’s outstanding bonds. In this regard, a single-name CDS is a security for purposes of anti-fraud rules of the federal securities laws.

To establish market manipulation, Solus will have to prove that GSO and Hovnanian engaged in a fraudulent or deceptive course of conduct. A classic claim of market manipulation typically rests on the creation of a perception of market activity where none exists, or of pricing generated artificially by deceptive practices rather than free market forces. Solus will likely be battling uphill in this respect. The terms of the restructuring have been disclosed, and their effects on the pricing for Hovnanian debt and CDS contracts that reference the Hovnanian debt are the predicable outcome of the known features of those instruments. 

• Disclosure Claims

The Solus complaint makes a further allegation under Section 10(b) and Rule 10b-5 that Hovnanian failed to properly disclose the benefits of the transaction to GSO. As with its market manipulation claim, Solus will be encountering a relatively high bar. Even if Hovnanian has not expressly articulated the CDS drivers for the transaction, the market has clearly understood them.  With no harm and no undisclosed facts (as opposed to perceived motivations), it is difficult to see where Solus goes with this claim, other than perhaps to obtain some additional disclosures from the issuer.

• Tortious Interference

Finally, Solus falls back on a claim of tortious interference by Hovnanian and GSO with Solus’ CDS contracts or (under Solus’ amended complaint) its business relationships. Tortious interference has historically proven to be a difficult claim on which to succeed, as pursuing one’s own economic interest is not tortious, notwithstanding that there may be an adverse consequential impact on contractual or business relationships of a third party. Particularly here, where the CDS contracts will pay off only if the ISDA-DC determines that a credit event has occurred in accordance with the terms of the contracts, it would seem difficult to establish that the defendants have engaged in tortious conduct.  

Conclusion

Hovnanian, together with GSO, has taken a strategy pioneered in Codere and iHeart and further refined it to extract value from CDS protection sellers in order to facilitate a comprehensive refinancing. An adverse ruling in the Solus case on the merits could put the brakes on this strategy, but Solus would seem to have a difficult road ahead to prevail in the case. At this stage, if the court’s ruling on the request for injunctive relief is any indication, it is a fair bet that the court will not choose to wade into an area of private contract in which the expertise resides with the ISDA and the ISDA DC, which have tools at their disposal to correct perceived inequities and inefficiencies.  

In the companion article, we explore various policy and market considerations regarding unconventional credit events following the renewed focus on these tactics in the Hovnanian case. ISDA will likely need to address these considerations if it is determined to implement marketwide changes to constrain financial restructuring strategies predicated on the engineering of a failure-to-pay credit event.

¹  For a discussion of the unconventional credit events with respect to those reference entities, together with an analysis of the resulting strategic implications, see article here.

² Solus Alternative Asset Management LP v. GSO Capital Partners L.P., No. 18 CV 232-LTS-BCM (SDNY Jan. 29, 2018).  Kramer Levin is not involved in the Hovnanian litigation, but the authors’ article iHeart and Other Unconventional CDS Credit Events was cited by the court in its decision.

³ The New 2040 notes are trading at 32.276 as of March 26, 2018. Another Hovnanian obligation (the 2% notes due 2021) is trading around 82.082  as of March 26, 2018. All other debt is trading near par as of March 26, 2018.                           

⁴ See the authors’ article suggesting a number of changes to the standard ISDA CDS contracts that might be adopted to address perceived challenges to the CDS market from unconventional credit events.