As above, while the IMM from step one of the auction was 59, the Auction Final Price from step two of the auction was set 11pts higher at 70. Consequently, CDS positions subject to Auction Settlement would be settled by a final payment from CDS Seller to CDS Buyer of [100-70]% = 30% multiplied by the contracted notional value.
c. Auction Settlement
Matched Buy and Sell requests for physical obligation settlement will be settled at the Auction Final Price. Where the net Open Interest is fully matched, all bids/offers on the side of the net Open Interest will settle at the Auction Final Price against those Limit Order offers/bids that were matched in step two of the auction. Where the net Open Interest is not fully matched, however, all bids/offers on the side of the net Open Interest will settle at 100/0 against all Limit Order offers/bids. The CDS contracts will settle based on the Auction Final Price, with CDS Seller paying CDS Buyer the notional contracted amount multiplied by 100 less the Auction Final Price.
II. Historical Deviations from Cash/Derivative Equivalency
In several historical instances, the potential for a breakdown in equivalency between cash bonds and derivatives has been realized. In particular, in this article, I consider the following transactions: (i) Europcar, (ii) Codere, (iii) Hovnanian, (iv) iHeart, (v) Supervalu (and similar transactions in Neiman Marcus and McClatchy), and (vi) Windstream. While Europcar and Codere were governed by European CDS, the relevant credit events in both cases were either Failure to Pay or Bankruptcy—the two credit events recognized in North American contracts—so they are germane to the analysis.
The breakdown in equivalency can be driven by the manner in which (i) auction settlement is triggered, (ii) the set of debt obligations deliverable at auction is determined, and (iii) the auction clears. Codere, Hovnanian, iHeart, and Windstream implicate (i): the manner in which auction settlement is triggered. In Codere, Hovnanian, and iHeart, the CDS auction was triggered by a deliberate—arguably voluntary—Failure to Pay. In Windstream, the CDS auction was triggered by an involuntary bankruptcy petition against the objections of minority creditors and the debtor. Hovnanian and Supervalu (and similarly, Neiman Marcus and McClatchy) implicate (ii): the set of debt obligations deliverable. Under the alleged facts of Hovnanian, the debtor coupled a deliberate Failure to Pay with the issuance of a low-priced bond that would drive settlement at auction. In Supervalu, an acquired subsidiary of the debtor was made a co-borrower—instead of a guarantor—on the acquisition debt, ensuring that such debt would be deliverable in any auction for CDS referencing the subsidiary. Europcar implicates (iii): the manner in which the auction clears—demonstrating the possibility for an illiquidity-driven squeeze in step two of the auction.
A. Auction Squeeze (Europcar)
In December 2020 the EMEA Determinations Committee determined that a Failure-to-Pay Credit Event had occurred with respect to reference entity Europcar Mobility Group, S.A., due to an October 2020 nonpayment of approximately EUR 9mm in interest on EUR 400mm notional of Senior ’26 notes, uncured beyond the relevant grace period. An auction was held on January 13, 2021.
At auction, the IMM settled at 73, with the lowest bid at 68 and the highest offer at 76.5. The net Open Interest was EUR 43.3mm to buy. Despite EUR 1.1bn in deliverable obligations, only EUR 35.9mm of Limit Order offers were received, at offers ranging from 71 (two points below the IMM) to 87 (fourteen points above it). With unfilled open interest to buy, per the rules of the auction, the Auction Final Price was determined as par, or 100 cents on the dollar. Consequently, the payout for an unhedged CDS buyer was zero. By contrast, Europcar’s final restructuring featured a full equitization of the three deliverable obligations alongside EUR 250mm in bondholder backstopped new-money equity and a backstopped refinancing of a EUR 670mm revolving credit facility.
The result in Europcar demonstrates the risks of entering the CDS auction unhedged—that is, opting for cash settlement without submitting either an initial Physical Settlement Request or Limit Order. While physical settlement ensures receipt of par, cash settlement can lead to volatile and unexpected outcomes. Europcar demonstrates that participants who opt for cash settlement need to still “show up” to the auction.
Consider a CDS buyer opting for physical settlement. CDS Buyer will be looking to sell bonds at auction. If net Open Interest is to buy, CDS Buyer is—axiomatically—guaranteed to sell the bond notional submitted in her initial Physical Settlement Request. If there are insufficient Limit Order offers, the Auction Final Price will settle at par, or 100 cents on the dollar. Consequently, while CDS Buyer will receive 0 cents on the CDS, she will receive 100 cents on the bond sold at par. Similarly, if net Open Interest is to sell and there are insufficient Limit Order bids, CDS Buyer may not be guaranteed to sell her bond, and the Auction Final Price will settle at zero. However, here too, CDS Buyer will receive 100 cents—the settlement value of her CDS position.
The same analysis applies to CDS sellers opting for physical settlement. CDS Seller will be looking to buy bonds at auction. If net Open Interest is to sell, CDS Seller is—axiomatically— guaranteed to buy the bond notional submitted in her initial Physical Settlement Request. If there are insufficient Limit Order bids, the Auction Final Price will settle at 0 cents. Consequently, while CDS Seller will owe 100 cents on the CDS, she will obtain the bonds at 0 cents and receive the ultimate recovery on the bond. Similarly, if net Open Interest is to buy and there are insufficient Limit Order offers, CDS Seller may not be guaranteed to buy her bond, and the Auction Final Price will settle at 100 cents. Here, there is some basis risk, though likely favoring CDS Seller. Seller will owe zero on her CDS position, but she may be unable to purchase bonds and close out a short position. However, this would only disadvantage her to the extent bond prices remain above par subsequent to auction—a technical irregularity unlikely to persist—and she is forced to close out her short position at greater than 100 cents.
CDS participants opting for an outright cash settlement, however, will either receive or pay par less the Auction Final Price. This could be characterized as a defect of the CDS settlement process. Alternatively, it could be characterized as well within the expected set of outcomes. Consider a CDS buyer opting for cash settlement, with no bond holdings. Subsequent to the determination of a Credit Event but prior to the auction, suppose the market for CDS on Company A trades at 40 cents, implying an Auction Final Price of 60 cents. CDS Buyer has the opportunity to settle her position prior to auction but opts instead to wait for the auction. Rationally, Buyer would do so only if she expects the Auction Final Price to settle below 60 cents, thus increasing her recovery.
Suppose further that, after step one of the Auction, CDS Buyer sees there is significant net Open Interest to Buy. Consequently, Buyer is on alert that the Auction Final Price (i) is not capped on the upside and, (ii) if net Open Interest remains unmatched by Limit Orders to sell in step two, could reach par, thus reducing her CDS payout to zero. At this point, it is likely optimal to enter a Limit Order to sell. First, CDS Buyer will benefit from any downward price pressure on the Auction Final Price, and downward price pressure is exerted by offers. Second, CDS Buyer has already expressed a short view on the credit through her CDS position and, moreover, entered the auction expecting the Auction Final Price to settle below 60. This likely implies that Buyer believes the value of the bonds to be significantly less than 60. It follows that—if borrow is available—Buyer would be willing to increase her short position at some price. Perhaps that price is not 60 or 70; it might, however, be 80 or 90. Seen in this light, the result in Europcar might have been prevented by greater vigilance among the outright CDS participants.
However, in a universe with large numbers of participants, one CDS participant cannot unilaterally ensure that the final price in step two hews closely to the IMM in step one. In Europcar, for example, there were EUR 35.9mm of limit order offers in step two of the auction. With net Open Interest to buy of EUR 43.3mm and a concomitant deficiency of only EUR 7.4mm, this might suggest that step two of the auction failed to result in an accurate settlement price. This argument is strengthened by the fact that markets submitted by dealers in step one—to create the IMM—are not mere estimates. Those markets are carried through to step two of the auction and matched against net Open Interest to form irrevocable trades.
As discussed infra, one potential solution to this deviation between IMM in step one and the Auction Final Price in step two would be to make a two-sided—rather than one-sided—cap to the allowed deviation between the IMM and the Auction Final Price.
B. Deliberate Failure to Pay (Codere)
The 2014 ISDA Credit Derivatives Definitions explicitly allow for a Failure-to-Pay Credit Event and subsequent auction to be triggered by a deliberately missed coupon payment negotiated between the Reference Entity and a CDS market participant. Codere provides an example of such a transaction.
In 2013, Blackstone reportedly agreed to roll over existing financing it had extended to Reference Entity Codere, contingent upon Codere’s agreement to deliberately miss a coupon payment. Missing the coupon payment triggered a Failure-to-Pay Credit Event, resulting in an auction that settled at 54.5 and, in turn, a CDS payout of [100–54.5] = 45.5 cents on the dollar.
Negotiation of an Event of Default may appear to violate the spirit of credit derivatives. However, such negotiation appeared to be expressly permitted under the Representations section of the 2014 definitions. Specifically, the definitions provide that CDS participants are permitted to
generally engage in any kind of commercial or investment banking or other business with, the Reference Entity . . . regardless of whether any such action might have an adverse effect on the Reference Entity . . . or the position of the other party to such Credit Derivative Transaction or otherwise (including, without limitation, any action which might constitute or give rise to a Credit Event).
CDS participants are additionally permitted to possess nonpublic information “material in the context of such Credit Derivative Transaction” and are under no obligation to disclose such information to CDS counterparties.
Under the 2019 ISDA amendments, such a deliberately missed payment might not constitute a Failure to Pay, as it could fail to meet the new Credit Deterioration Requirement, which provides that a Failure to Pay has not occurred “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.” However, as discussed infra, the impact of the Credit Deterioration Requirement may be significantly curtailed by the ISDA’s official guidance on its implementation. Specifically, the guidance continues to allow for debtor-creditor negotiations made contingent upon CDS-related transactions, so long as the negotiation is part of a “bona fide” transaction that increases the likelihood of a successful debt restructuring. The Credit Deterioration Requirement has not been tested extensively. Since the July 2019 implementation of the 2019 amendments, there has been only one Failure-to-Pay Credit Event referencing North American CDS: California Resources Corp. In that case, the Americas Determinations Committee found, without providing significant analysis, that the Credit Deterioration Requirement had been met.
C. Deliberate Failure to Pay + Issuance of Cheapest-to-Deliver Deliverable Obligation (Hovnanian)
1. Hovnanian Background
In December 2017, Hovnanian Enterprises announced (i) an exchange offer for existing notes and (ii) new financing transactions with creditor GSO Partners. Under the terms of (i)—the exchange offer—the following would occur:
- Creditors would tender up to $185mm principal of 8% Senior ’19 Notes;
- Creditors would receive a combination of (i) cash; (ii) newly issued 13.5% Senior ’26 Notes; and (iii) newly issued 5% Senior ’40 Notes; and
- Hovnanian would sell $26mm in tendered 8% Senior ’19 Notes to its wholly owned subsidiary, Sunrise Trail.
Notably, the ’40 Senior Notes offered only a 5% coupon, compared with the 13.5% coupon offered on the ’26 Senior Notes. This would, under any reasonable assumption regarding a yield curve, result in a significantly lower cash price for the ’40 note—likely, below 50% of par.
Under the terms of (ii)—the new financing transactions—GSO Partners would do the following:
- Provide a Senior Unsecured Term Loan facility to refinance Hovnanian’s existing 7% Senior ’19 notes consisting of:
- Initial term loans of $132.5mm, and
- Up to $80mm of delayed draw term loans to redeem or repay notes not participating in the exchange offer;
- Provide $125mm of senior secured first-priority revolving loans to fund the repayment of Hovnanian’s $75mm senior secured term loan facility; and
- Purchase $25mm in 10.5% Senior ’24 Notes.
Additionally, as explicitly stated in the accompanying 1934 Act report, Hovnanian covenanted to “not . . . make any interest payments on the [8% notes purchased by Sunrise Trail] prior to their stated maturity.” Hovnanian noted that such “non-payment of interest . . . may result in the occurrence of a ‘credit event’ under certain credit default swap contracts entered into by third-parties, resulting in significant monetary exposure for those entities that sold such credit default swaps.” GSO Partners was purported to be an entity that would have benefited from such nonpayment, with an estimated $333mm in notional CDS protection.
2. Relevance to CDS Contracts
Relevant to the determination of CDS settlement value, through the aforementioned transactions, Hovnanian agreed to (i) create a Credit Event through nonpayment of interest and (ii) create a deliverable obligation that would likely result in a low Auction Final Price and therefore a high recovery rate on CDS.
In January 2018, a third party, Solus Asset Management, filed a related complaint against GSO and Hovnanian. The complaint asserted claims (i) against Hovnanian and GSO for securities fraud and tortious interference with “prospective economic advantage under its CDS contracts,” (ii) against Hovnanian for material misrepresentation in the tender offer, and (iii) against certain Hovnanian executives for tortious interference and liability as controlling persons. Solus further sought an injunction against actions that would create an intentional default.
In March 2018, the DC issued a statement responding to a General Interest Question submitted by a market participant, which sought interpretation of section 11.1(b)(iii) of the ISDA 2014 Definitions. That portion of the Representations section, discussed supra, appears to explicitly allow for CDS market participants and the Reference Entity to negotiate commercial actions adverse to other CDS counterparties, including “any action which might constitute or give rise to a credit event.” The DC noted that market participants expected Hovnanian to miss an interest payment in May 2018, subsequent to the expiration of a thirty-day grace period on an interest payment due May 1, 2018. However, the DC declined to prospectively interpret section 11.1(b)(iii) in the context of “a live bilateral dispute . . . that may be presented to the DC in a matter of months.”
Ultimately, no such dispute was presented to the DC. On May 30, 2018—before the expiration of the grace period—Solus, GSO, and Hovnanian settled. Under the terms of the settlement, Hovnanian agreed to “pay to Sunrise Trail [its wholly owned subsidiary] all amounts due to it as a result of the missed interest payment on the Sunrise Trail 8.0 percent Notes that was originally due on May 1, 2018.” Hovnanian further noted that terms of the GSO financing transactions remained unchanged.
D. Deliberate Failure-to-Pay Debt Held by Related Entity (iHeart)
In Hovnanian, the Americas Determinations Committee did not reach the question of whether a section 4.5 Failure to Pay had occurred. However, the DC had previously taken a literalist approach to determining whether deliberate nonpayment constituted a section 4.5 Failure to Pay. In December 2016, iHeart Communications arranged for a wholly owned subsidiary to purchase a portion of its debt obligations ahead of maturity. At maturity, iHeart repaid all obligations except those held by the subsidiary “to avoid a springing lien in favor of certain creditors . . . which would have been triggered had all of the 2016 Notes been retired.” Adopting a literalist approach, the DC determined that a Failure to Pay had occurred. At auction, a final price of 35.5 was established—perhaps, in light of the deliberate default, an odd result and a high return on CDS.
E. Orphaned CDS (Supervalu)
If a debt-issuing reference entity were to retire all instruments that could be construed as debt obligations, a CDS on that Reference Entity would become worthless. There would be nothing on which to default and, relatedly, no obligation deliverable in an auction. The Reference Entity would be an “empty box,” leaving the CDS orphaned. For an investor who bought CDS (short credit) prior to the retirement of all debt obligations, this would lock in a loss in value equivalent to premiums paid and remove the possibility of either future mark-to-market gains or receipt of payment upon an Event of Default. Conversely, for a seller of CDS, it would lock in a profit equivalent to the premiums received, removing the possibility of either future mark-to-market losses or payment upon an Event of Default. Consequently, the ability to move debt into and out of the “box” representing a CDS Reference Entity is another tool debtors can use to obtain favorable financing terms.
For example, in October 2018, United Natural Foods (“UNF”) undertook the acquisition of grocery chain Supervalu in a transaction underwritten by Goldman Sachs. Under the terms of the acquisition, UNF would pay approximately $2.9bn for the acquisition, delivering $1.3bn in cash to Supervalu shareholders and the balance of $1.6bn to Supervalu creditors, extinguishing most of Supervalu’s debt. The transaction, as originally contemplated, would be financed largely through a $2.15bn term loan. Supervalu would be a guarantor—but, importantly for standard North American CDS contracts, not a co-borrower—of the term loan. This would have the effect of significantly reducing the value of any CDS contract referencing Supervalu—effectively, “orphaning” the CDS contract by removing all potentially deliverable obligations. At the time of the transaction, there was alleged to exist approximately $470mm in notional value of CDS referencing Supervalu.
Ultimately, UNF agreed to add Supervalu as a co-borrower. Subsequent to the transaction, UNF brought a claim for damages against Goldman for (i) two counts of breach of contract, (ii) one count of breach of the implied covenant of good faith and fair dealing, and (iii) one count of fraud. In the complaint, UNF alleged that Goldman repeatedly demanded additional financing concessions, including those implicating CDS. In particular, UNF claimed that Goldman “demanded that UNFI add SUPERVALU as a co-borrower on the Term Loan[,] . . . assuring [UNF] that the change would have a ‘muted impact on UNFI but was meaningful to some select accounts.’” For North American CDS contracts, subsidiary debt guaranteed by the parent is deliverable into parent CDS. However, parent debt guaranteed by the subsidiary is not deliverable into subsidiary CDS. Consequently, adding Supervalu as a co-borrower to the acquisition debt would have the effect of ensuring that deliverable obligations remained at Supervalu, preventing a collapse in the value of Supervalu CDS.
UNF further alleged that these “select accounts” were creditors holding Supervalu CDS, who participated in the term loan as part of a quid pro quo to enhance the value of their CDS. Per the complaint, (i) Goldman received payment in the form of term loan participation and (ii) creditors received the benefit of an increase in the value of Supervalu CDS contracts. In addition to harming Supervalu CDS sellers (credit longs), UNF alleged that retaining Supervalu as co-borrower would leave UNF with “less flexibility in borrowing arrangements for SUPERVALU going forward, in addition to an inability to restructure SUPERVALU’s debt or to sell SUPERVALU outright.”
Stated differently, certain creditors were able to extract value from third-party CDS market participants to both the benefit (vis-à-vis a completed financing transaction) and the detriment (vis-à-vis reduced ability to incur future indebtedness at Supervalu) of the debtor. Similar transactions were purportedly considered with respect to Neiman Marcus (Aurelius Capital Management proposed that Neiman Marcus Group Inc. include language in an exchange offer adding Neiman Marcus Group Ltd. LLC—a separate entity—as co-borrower) and McClatchy (Chatham Asset Management—a McClatchy CDS seller—provided McClatchy with financing on the condition that new financing be incurred at a new entity and the proceeds be used to repurchase certain debt obligations owned by Chatham. However, as McClatchy would provide a guarantee on the new entity financing, the risk of orphaned CDS would be mitigated).
F. Involuntary Bankruptcy Petition (Windstream)
1. Windstream SDNY Lawsuit
In January 2013, Windstream Services, LLC issued $700mm in senior unsecured 6.375% ’23 Notes. Section 4.19 of the Indenture governing the ’23 Notes prohibited Windstream from engaging in a Sale and Leaseback Transaction. Under section 6.01 of the Indenture, a Noteholder holding 25% or more of the ’23 Notes could give written notice of Windstream’s failure to comply with section 4.19; if the failure was not cured within sixty days of notice, an Event of Default would occur. Under section 9.02 of the Indenture, an Event of Default could be waived by a majority of ’23 Note holders.
In April 2015, Windstream finalized a transaction that could be—and ultimately was, by the Southern District of New York—construed as a Sale and Leaseback Transaction. By September 21, 2017, Aurelius Capital held beneficial ownership of more than 25% of the ’23 Notes, satisfying the notice requirement of section 4.19. Moreover, including accrued but unpaid interest, Aurelius held approximately $310.459mm of the notes, which constituted more than half the approximately $585.7mm in ’23 Notes outstanding. This would prevent other creditors from issuing a waiver of the Event of Default under section 9.02 of the Indenture.
On September 21, 2017, Aurelius gave written notice that the 2015 transaction violated section 4.19 of the Indenture. On October 5, 2017, Windstream’s board approved an exchange offer wherein holders of other bond tranches would tender their notes in exchange for new 6.375% ’23 Notes and provide consent to waive the default asserted by Aurelius. The completion of the exchange offer was made contingent upon receipt of the requisite consents. On November 1, 2017, Windstream informed the court that it had received the requisite consents.
Aurelius challenged the validity of the Consent Solicitation and the Exchange Offer. The Southern District of New York ultimately held that (i) the 2015 transaction was a Sale and Leaseback Transaction under the terms of the Indenture, (ii) the new ’23 notes violated the additional–indebtedness restrictions of the Indenture, and therefore (iii) consents related to the exchange offer must be disregarded. Consequently, Windstream failed to obtain the requisite consent to waive the Event of Default. On February 15, 2019, the Southern District of New York held that Aurelius’s Notice of Default “ripened into an Event of Default on December 17, 2017”—after the expiration of the cure period—entitling Aurelius to a money judgment from Windstream in the amount of Notes held plus interest.
2. Windstream Bankruptcy Filing and CDS Auction
The notes had been trading at distressed levels, in the mid 40s to low 50s. Subsequent to the court’s determination, the ’23 Notes traded down further, below 40 cents. Ten days later, on February 25, 2019, Windstream filed for bankruptcy. Post-filing, the notes traded below 20 cents. On February 26, 2019, the Americas Determinations Committee determined that a Bankruptcy Credit Event had occurred and that an auction would be held. It was assumed by some market participants and Windstream itself that Aurelius held a significant notional of CDS protection—possibly exceeding the notional of its cash bond holdings.
On March 11, 2019, the Americas Determinations Committee received a challenge to the initial list of deliverables that challenged the inclusion of (i) the new 6.375% ’23 Notes from the exchange offer and (ii) any of the old 6.375% ’23 Notes specifically held by Aurelius. With regard to (i), the challenge asserted that the new ’23 Notes lacked documentation sufficient to determine the notes’ Outstanding Principal Balance and therefore could not qualify as Deliverable Obligations. With regard to (ii), the challenge asserted that Aurelius’s notes might be subject to equitable subordination by the Bankruptcy Court, resulting in a Prohibited Action that would reduce the Outstanding Principal Balance of those specific notes to zero. This would have the effect of rendering Aurelius’s notes non-Deliverable.
On March 13, 2019, a responsive submission to the DC asserted that removal of the old 6.375% Notes held by Aurelius and new 6.375% ’23 Notes would have the effect of “cutting by more than 56% the unsecured Deliverable Obligations . . . and eliminating altogether the lowest priced Deliverable Obligations (about 30% of the unsecured universe).” To the extent that the universe of Deliverable Obligations is reduced and there are fewer obligations that can be sold into an auction, the likelihood of a squeeze that results in a high Auction Final Price is increased. Consequently, removal of the new and old tranches of ’23 Notes would likely reduce the payout on Windstream CDS contracts. The DC committee ultimately rejected the challenges, and both tranches were deemed deliverable. The auction occurred on April 3, 2019, with an IMM of 26.75 and an Auction Final Price of 29.5.
III. Responses to Historical Deviations from Cash/Derivative Equivalency
A. 2019 ISDA Amendments
1. Summary
In April 2018—after Hovnanian, but before Windstream—the ISDA published a statement addressing engineered defaults. The ISDA noted that to ensure objectivity, predictability, and timeliness in the credit event determination process, the DC was necessarily precluded from subjective assessments or considerations of intent or good faith. However, the ISDA also noted that (i) the occurrence of CDS credit events that did not reflect underlying credit deterioration could negatively impact the overall CDS market and (ii) there was a consequent need to consider amendments to the 2014 definitions.
In July 2019, the ISDA published a list of amendments—the 2019 Narrowly Tailored Credit Event Supplement to the 2014 ISDA Credit Derivatives Definitions—which addressed some of the issues that arose in the transactions just discussed. Specifically, the 2019 Supplement amended the definitions of Outstanding Principal Balance and Failure to Pay while also providing guidance on the interpretation of Failure to Pay.
2. Outstanding Principal Balance
Recall that at auction, price is expressed as a percentage of the Outstanding Principal Balance. While the Outstanding Principal Balance is usually par, that is not necessarily so. The amendments to section 3.8 (“Outstanding Principal Balance”) address the concern that an artificially low Auction Final Price—and consequently high CDS recovery—could be effectuated by delivery of either (i) claims reduced in value by bankruptcy or other applicable law or (ii) original-issue-discount (OID) debt issued at a price significantly below redemption value. This addressed, the concern that Reference-Entity debt issuers could arrange with a creditor for the issuance of below-market-coupon, low-cash-price deliverable obligations, as in Hovnanian.
a. Claims Reduced in Value
The 2019 amendments clarify that the Outstanding Principal Balance will be calculated as if the claim were reduced by applicable bankruptcy or insolvency law, whether or not the Reference Entity is bankrupt. Consequently, if a debt obligation issued at par would be reduced to a claim of 50 cents under applicable law, the Outstanding Principal Balance would represent a 50% reduction of the par redemption value.
Specifically, section 3.8(a)(iii)(B) of the ISDA 2014 Definitions provides that the Outstanding Principal Balance is determined, “in accordance with any applicable laws (insofar as such laws reduce or discount the size of the claim to reflect the original issue price or accrued value of the obligation),” as the “lowest amount of the claim which could be validly asserted . . . if the obligation had become redeemable, been accelerated, terminated, or had otherwise become due and payable.” The 2019 amendments clarify that the “‘applicable laws’ shall include any bankruptcy or insolvency law or other law affecting creditors’ rights to which the relevant obligation is, or may become, subject.”
b. Original Issue Discount Debt
The 2019 amendments also provide that bonds issued at a price less than 95% of the redemption value will have their Outstanding Principal Balance reduced from par, generally pursuant to a straight-line interpolation. Consequently, if a bond were issued at 70 cents, for redemption at par ten years later, the Outstanding Principal Balance five years after issue would be 85 cents.
Specifically, the 2019 amendments provide that if (i) the Outstanding Principal Balance is not reduced pursuant to applicable law under section 3.8(a)(iii)(B), (ii) the issue price was less than 95% of redemption value, and (iii) the obligation does not include contractual provisions specifying the accretive amount that would be due upon an early redemption, then a haircut would be applicable. The applicable haircut would be the lesser of (i) the noncontingent portion of redemption value and (ii) “straight line interpolation between the issue price of the Bond or the amount advanced under the Loan and the principal redemption amount.”
3. Failure to Pay
Most notably in Codere, Hovnanian, and iHeart, the market had observed transactions where a Failure-to-Pay Credit Event was triggered without a corresponding inability of the debtor to pay. The 2019 amendments attempted to address this by adding a Credit Deterioration Requirement to section 4.5 (“Failure to Pay”) of the 2014 definitions. The language is broad: “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 official guidance on interpreting this language is no less broad; it grants significant discretion to the DCs—a marked departure from the intended objectivity and predictability of the credit event determination process referred to in the ISDA’s April 2018 statement. That language in the 2019 guidance follows:
It should be noted that the financial condition of the Reference Entity at the time it fails to pay is not conclusive as to whether or not such non-payment resulted from, or resulted in, a deterioration in the creditworthiness or financial condition of the Reference Entity. Rather, there must be a causal link between the non-payment and the deterioration in the creditworthiness or financial condition of the Reference Entity. While the expectation is that the Credit Deterioration Requirement would generally be met by way of a non-payment resulting from such deterioration, the Credit Deterioration Requirement may also be met by a non-payment that results in such deterioration. This is intended to permit a Failure to Pay to occur where a technical, administrative or operational non-payment occurs that does not itself result from a deterioration in creditworthiness or financial condition, but the consequences of such non-payment result in a deterioration in the creditworthiness or financial condition of the Reference Entity.
In an attempt to narrow the language, the 2019 amendments provide a non-exhaustive list of Eligible Information that may indicate the Credit Deterioration Requirement is not met. The list includes transactions where
- nonpayment arises from an arrangement between Reference Entity and a third party “where an essential purpose of the arrangement . . . . is to create a benefit under a Credit Derivative Transaction”;
- as part of an arrangement, the Reference Entity either (i) issues a bond likely to be cheapest to deliver in the auction or (ii) issues a material amount of additional deliverable obligations;
- The nonpayment did not result in the acceleration of other debts;
- The Reference Entity had sufficient liquidity to pay;
- The nonpayment was cured promptly after the grace period expired; and
- The nonpayment was only on debt held by affiliates or others unlikely to accelerate.
The 2019 amendments similarly provide a non-exhaustive list of Eligible Information that may indicate the Credit Deterioration Requirement is met. The list includes transactions where
- the Reference Entity previously announced financial distress or intent to restructure;
- the Reference Entity hired professional advisers;
- the nonpayment occurred as part of a judicial proceeding;
- the nonpayment was on debt held by multiple parties;
- the nonpayment occurred due to an inability to refinance;
- the nonpayment occurred on a day clearly scheduled well in advance; and
- other debt obligations are accelerated, the Reference Entity fails to pay other debt obligations, and/or the Reference Entity files for bankruptcy.
Ostensibly, these factors—though subjective—might have prevented triggering of a Failure to Pay in, Codere, Hovnanian, or iHeart. However, two caveats provided in the interpretive guidance suggest otherwise. Specifically, the guidance suggests that where (i) a deliberate nonpayment is the result of arm’s-length negotiation between the debtor and a significant portion of its creditors by value and (ii) transaction participants could articulate some bona fide reason for the transaction, the deliberate nonpayment will be deemed to result from a deterioration in creditworthiness. Specifically, the guidance notes that
[i]f a Reference Entity enters into a forbearance, standstill or other similar arrangement with its creditors for bona fide commercial reasons related to a deterioration in its creditworthiness or financial condition, this would rarely result in a determination that the relevant non-payment . . . did not . . . result from a deterioration in the creditworthiness or financial condition.
More directly, the guidance states that where the engineered default is part of a bona fide transaction that increases the likelihood of a successful restructuring, a section 4.5 Failure to Pay will be triggered:
[W]ithin the context of a bona fide debt restructuring, if the Reference Entity enters into an arrangement or understanding with such creditors that includes a failure to make a payment with the purpose of causing settlement of such Credit Derivative Transactions so as to increase the likelihood of success of such bona fide restructuring, and in circumstances where without such restructuring the Reference Entity would be likely to enter into bankruptcy or similar proceedings, such arrangement or understanding should generally be considered to have the essential purpose of facilitating such restructuring rather than creating a benefit under a Credit Derivative Transaction as described in paragraph 1.10(a) [Eligible Information indicating that Credit Deterioration Requirement is not satisfied].
Consequently, in two of the pre-2019 Amendments transactions—Codere and Hovnanian—a Failure to Pay might still be triggered under the new definitions. Conversely, in iHeart, where the Failure to Pay was for the Corporate’s benefit—to avoid a springing lien—outside the context of a restructuring, it likely would not be triggered under the 2019 Amendments.
B. Private Disclosure Requirements (Windstream Provisions)
In the wake of Windstream, some debtors have inserted “anti-net short” or “Windstream” provisions in their credit agreements. In short, these provisions aim to limit a lender’s ability to vote if their net economic position in the debtor’s obligations is “short”—that is, where it benefits from a deterioration in creditworthiness. For example, in May 2019, Sirius Computer Solutions included the following language in a credit agreement:
[A]ny Lender (other than (x) any Lender that is a Regulated Bank and (y) any Revolving Lender as of the Closing Date) that, as a result of its interest in any total return swap, total rate of return swap, credit default swap or other derivative contract (other than any [such swap] entered into pursuant to bona fide market making activities), has a net short position with respect to the Loans and/or Commitments shall have no right to vote any of its [loans] and shall be deemed to have voted its interest as a Lender without discretion in the same proportion as the allocation of voting with respect to such matter by Lenders who are not [net-short lenders].
As other commentators have noted, these provisions seem to address a limited landscape of CDS-related issues. The provisions might prevent a creditor from holding CDS protection in excess of its bond notional where that bond notional is sufficient to vote in a manner likely to trigger an Event of Default (e.g., by constituting sufficient notional to issue a notice of default and/or to vote against a waiver of default). However, such provisions would not prevent a creditor from the same use of its bondholder rights if the CDS position were equivalent, nearly equivalent, or merely sizeable in relation to its bond position.
For example, a distressed credit investor willing to sit on her long cash bond investment might nonetheless be incentivized to push the debtor into bankruptcy to realize an immediate cash profit on her CDS position. A basis trader—trading on the divergence in CDS spread and cash bond credit spread—would retain voting rights despite trading activity that may be indifferent to or even incentivized to effectuate a default, depending on her view of likely auction dynamics. A bondholder might be of the view that there is a significant excess of CDS buyers in relation to CDS sellers, that consequently there would be significant net Open Interest to sell bonds at auction, and that a lack of buyers would drive the Auction Final Price lower, and the CDS recovery higher, than reflected in the ultimate recovery on cash bonds.
None of these transactions would be precluded by an anti-net-short provision similar to the Sirius provision above. However, as discussed infra, such activity might implicate good-faith requirements under section 1112 (filing) and section 1126 (voting) of the Bankruptcy Code, as well as the section 364 (financing) requirement for notice and hearing. This implication of the Bankruptcy Code’s requirements militates in favor of broader disclosure requirements.
C. Regulatory Disclosure Requirements Outside Bankruptcy
For CDS and other security-based swaps, there is no current equivalent to the Rule 13d‑3 disclosure requirements for equity holdings. Comparable disclosure requirements may be forthcoming, however, in a finalized version of the SEC’s recently proposed Rule 10B‑1 swap regulations.
In December 2021, the SEC proposed two rules—9j‑1 and 10B‑1—intended, in part, to address engineered CDS transactions through (i) application of anti-manipulation prohibitions (9j‑1) and (ii) heightened disclosure requirements (10B‑1). Proposed Rule 9j‑1 would apply the general anti-manipulation prohibitions of Exchange Act section 10(b) to CDS. Proposed Rule 10B‑1 would require public reporting—comparable to Rule 13d‑3 requirements—of net CDS/debt positions exceeding $150mm notional and gross CDS/debt positions exceeding $300mm. On June 7, 2023, the SEC adopted a finalized version of Rule 9j‑1. As of June 7, 2023, the SEC had yet to adopt a finalized version of Rule 10B‑1.
1. Finalized Rule 9j‑1
Finalized Rule 9j‑1 would apply the general anti-manipulation prohibitions of section 10(b) of the Exchange Act to security-based swaps, which includes single-name corporate CDS. The rule is intended, in part, to address engineered CDS transactions. Specifically, Rule 9j‑1(a)(6) is intended to “prohibit manipulation and attempted manipulation of the price or valuation of any security-based swap, in connection with effecting or attempting to effect a transaction in, or purchasing or selling, or inducing or attempting to induce the purchase or sale of, any security-based swap.” The SEC declined to adopt any bright-line, concrete triggers for Rule 9j‑1(a)(6) applicability, adopting instead a fact-specific inquiry that the SEC asserts is supported by an existing body of anti-manipulation case law. Consequently, the extent to which Rule 9j‑1(a)(6) would have implicated historical examples of cash-derivative deviation is unclear.
Militating toward broad application of Rule 9j‑1 to manufactured credit events, the SEC notes that actions prohibited under Rule 9j‑1(a)(6) “may include, for example, orphaning a CDS, avoiding termination of a CDS for a period of time, or causing the termination of a CDS,” as well as “artificially influenc[ing] the composition of the deliverable obligations in a CDS auction.” Respectively, such fact patterns might implicate transactions similar to Supervalu, Codere, iHeart and Windstream, and Hovnanian.
Militating toward narrow application of Rule 9j‑1, the SEC appears to provide a carve-out for transactions coupled with a legitimate financing need. The SEC notes that
reference entities often rely on financing and other forms of relief to avoid defaulting on their debt . . . [and] final rule [9j‑1] is not intended to discourage lenders and prospective lenders from discussing or providing such financing or relief, even when those persons also hold CDS positions. Rather, the Commission is adopting Rule 9j‑1(a)(6) to account for actions taken outside the ordinary course of a typical lender-borrower relationship (or a prospective lender-borrower relationship).
By extension, one reading of the rule is that so long as there is some articulable, non-CDS-related justification for a transaction, the prohibitions of Rule 9j‑1(a)(6) would not apply. Consequently, Rule 9j‑1 might not reach transactions with fact patterns comparable to those discussed, where CDS participants could have argued legitimate needs for (i) financing (as in Codere, Hovnanian, and Supervalu), (ii) avoidance of a detrimental security assignment (as in iHeart), or (iii) the protections of bankruptcy (as in Windstream). Absent a body of case law specific to engineered CDS transactions, the effective reach of Rule 9j‑1 to CDS will remain unclear.
2. Proposed Rule 10B‑1
a. 10B‑1 Requirements and Applicability
Pursuant to Regulation SBSR—effective as of February 14, 2022—certain CDS transactional data are already subject to public dissemination, on a basis confidential as to market participant and aggregate position. Publicly disseminated data under SBSR includes underlying debt obligation, effective date and termination dates, coupon payments, time of transaction, price, and notional. However, publicly disseminated data excludes the identity of counterparties and aggregate market positions. Rule 10B‑1 purports to change this by providing a public reporting mechanism for CDS and other security-based swaps.
Under Proposed Rule 10B‑1, the SEC would rely on authority pursuant to the 2010 Dodd-Frank Act to require security-based swap reporting that is comparable in form—but distinct in applicability—from Rule 13d‑3 requirements applicable to equity securities. While Dodd-Frank section 766(e) purports to grant the SEC authority to broaden 13d‑3 Beneficial Ownership to encompass security-based swaps, the SEC appears to have relied instead on Dodd-Frank section 763(h) to implement Rule 10B‑1. Section 763(h) broadly authorizes the SEC to require market participants to “report such information as the Commission may prescribe regarding any position . . . in any security-based swap.”
Relevant to CDS, Proposed Rule 10B‑1 would require reporting of any net-long CDS (short credit), short-CDS (long-credit) position with a notional exceeding $150mm, or any gross position exceeding $300mm notional. The net amount would be calculated by netting positions in the underlying debt obligation against the CDS position, while the gross amount would aggregate both positions. Qualifying positions would be reported under a proposed Schedule 10B form and made publicly available. The SEC notes as a benefit of public reporting that,
in the case of manufactured or other opportunistic strategies in the CDS market, . . . market participants and regulators [are provided] with advance notice that a person (or a group of persons) is building up a large CDS position which could create an incentive to vote against their interests as a debt holder, possibly with an intent to harm the company, even if such conduct is not inherently fraudulent.
The finalized version of Rule 10B‑1 remains to be seen, and it may be subject to challenge. I have argued elsewhere that, in its current form, Rule 10B‑1 exceeds the mandate of Dodd-Frank. As explained in Part III.C.2.b (“10B‑1 Enforceability”), the public disclosure of individual position data likely violates the confidentiality mandate of Dodd-Frank section 763(i), and the potential inapplicability of 10B‑1 to offshore transactions may frustrate the proposed rule’s purpose.
b. 10B‑1 Enforceability
The Dodd-Frank authority to mandate public reporting of aggregate, confidential swap data appears uncontroversial. The Dodd-Frank Act was passed to reduce systemic, market-wide risk posed by undisclosed securities leverage, and public disclosure of aggregate, confidential transactional data does not exceed that scope of authority. However, while Proposed Rule 10B‑1 meets many systemic risk-reduction goals, portions of the rule exceed the scope of and/or fall short of the mandate of Dodd-Frank.
First, Rule 10B‑1 calls for the public dissemination of participant identity, which may exceed the scope of Dodd-Frank section 763(h) and contradict the confidentiality mandate of section 763(i). Section 763(h) authorizes the SEC to require swap participants to “report such information as the Commission may prescribe.” Similarly, section 763(i) authorizes the SEC to “make security-based swap transaction and pricing data available to the public in such form and at such times as the Commission determines appropriate to enhance price discovery.” However, section 763(i) also circumscribes the authority to identify individual participants, requiring that any disclosure requirement be “in a manner that does not disclose the business transactions and market positions of any person” and does “not identify the participants.” The legislative history similarly supports a bifurcation of (i) public disclosure of aggregate transaction data and (ii) confidential regulatory disclosure of individual transaction data.
Second, the exemption from public dissemination of certain offshore transactions may prevent full public disclosure of the systemic risk at which Dodd-Frank was aimed. By the SEC’s own admission, offshore exemption might encourage jurisdictional arbitrage and investor re-domiciliation. Third, Rule 10B‑1 does not require reporting entities to disclose the purpose of their transaction and requires only a “brief description” of related third-party arrangements. Limited substantive disclosure may conflict with the SEC’s stated goal of providing market transparency.
D. Regulatory Disclosure Requirements Inside Bankruptcy
1. Disclosure Generally: 11 U.S.C. § 501; Rule 3001; Rule 2019; 11 U.S.C. § 1102
Inside the bankruptcy process, position disclosure requirements are limited. Disclosure consists primarily of (i) 11 U.S.C. § 501 (“Filing of proofs of claims or interests”), (ii) Rule 3001 (“Proof of claim”), (iii) Rule 2019 (ad hoc committee disclosure requirements), and (iv) 11 U.S.C. § 1102 (applicable to official committee information disclosure requirements).
11 U.S.C. § 501 provides that “[a] creditor . . . may file a proof of claim.” Rule 3001 does not require that a proof of claim include information related to holdings of CDS or other security-based swaps. Rule 2019 provides disclosure requirements for unofficial, ad hoc creditor committees. Rule 2019(c) provides that each member of such committees must disclose “the nature and amount of each disclosable economic interest held in relation to the debtor” as of the dates on which (i) the committee was formed and (ii) a “verified statement” disclosing the committee’s existence to the court is made. “Disclosable economic interest” is defined as “any claim, interest, pledge, lien, option, participation, derivative instrument, or any other right or derivative right granting the holder an economic interest that is affected by the value, acquisition, or disposition of a claim or interest.” The comments to Rule 2019 provide that “disclosable economic interest” is sufficiently broad to cover any economic interest that could affect the legal and strategic positions a stakeholder takes in a chapter 9 or chapter 11 case” and “includes, among other types of holdings, short positions, credit default swaps, and total return swaps.”
2. Inadequacy of Rule 2019
a. Timing Mismatch: CDS Settlement Precedes Rule 2019 Verified Statement Filing
There are three important ways in which Rule 2019 may not capture relevant interests. First, Rule 2019 requires only disclosure of “disclosable economic interest” held (i) “as of the date . . . the group or committee was formed” and (ii) “as of the date of the statement” filed with the bankruptcy court. Consequently, if the CDS auction settlement date precedes the creation of an ad hoc committee, there would be no CDS position to disclose in a Rule 2019 Verified Statement. Thus, the disclosure timeframe of Rule 2019 may capture ISDA standard CDS where the auction is triggered by a Bankruptcy Credit Event. However, Rule 2019 would likely not capture ISDA standard CDS where the auction is triggered by a Failure-to-Pay Credit Event.
To see this, consider the case of California Resources Corporation. On June 11, 2020, the DC determined that a Failure-to-Pay Event had occurred with respect to California Resources Corporation. The CDS auction took place on July 7, 2020. One week later, on July 15, 2020, the debtor filed for Chapter 11 in the Bankruptcy Court for the Southern District of Texas. The Verified Statement(s) Pursuant to Bankruptcy Procedure 2019 for the Ad Hoc Term Lender Group and Ad Hoc Crossover Group were not filed until July 17 and July 27, respectively. Exhibit A to the former lists Disclosable Economic Interest “accurate as of close of business July 16, 2020.” Exhibit A to the latter lists Disclosable Economic Interest “accurate as of July 21, 2020.” In neither case were interests held as of July 7, 2020 (the date of the CDS auction) or July 10, 2020 (the date of settlement) disclosed. Consequently, had any of the Ad Hoc members held CDS positions referencing the underlying claims, those positions would not have appeared on the Rule 2019 Verified Statement. The CDS would have ceased to exist by the July 10, 2020, settlement date, and there would have been nothing to disclose on July 16 or 21.
Subsequent to the 2011 amendments to Rule 2019, the Americas DC has confirmed the occurrence of five Failure-to-Pay Credit Events, four of which resulted in an auction. In all four, the earliest Rule 2019 Verified Statement was filed after the auction’s settlement date. Consequently, committee members’ CDS positions—if any—would not have appeared on those Rule 2019 filings. The table below demonstrates the timing mismatches:
