March 13, 2019 - The Windstream bankruptcy has focused much attention (including ours) on “bankruptcy hardball” and “manufactured defaults”. Last Wednesday, the LSTA hosted a webinar on those issues and how they could impact the loan market. Coincidentally, the same day, ISDA published a consultation paper proposing amendments to their Definitions that would limit the impact of “narrowly tailored credit events,” which currently trigger CDS contracts while minimizing the actual financial impact on the company. Why do we care? While the loan-only CDS is relatively modest, many of our members invest up and down the capital structure and rely on the CDS market to hedge their positions (or express short positions and the proliferation of unconventional uses of CDS could have a deleterious impact on that product. Following is a dive into what gave rise to the consultation, what it recommends, what it might accomplish, and what happens next.
For the past few years, a number of stressed or distressed companies have engaged in opportunistic credit default strategies. In these situations, companies “manufacture” payment defaults on relatively small amounts of debt sufficient to trigger “payment defaults” under CDS but not large enough to trigger cross default provisions on their other debt. These schemes, such as in iHeart Media, Codere, and most recently, Hovnanian, have in common that they do not result from, or in the deterioration in creditworthiness of, the reference company. For example, in the context of a broad refinancing of its debt, GSO provided Hovnanian with advantageous financing terms in return for which Hovnanian agreed to default on an interest payment on a small amount of its bonds held by its own subsidiary. This would not only have triggered a failure to pay credit event and entitle CDS protection buyers, including GSO, to receive payments on its Hovnanian CDS contracts but would have also established below-market securities that could have been deliverable under the CDS contract as “cheapest to deliver” thereby boosting the value of the CDS contract (which is generally measured by the insured value minus the cheapest to deliver security). For reasons beyond the scope of this article, including litigation and regulatory intervention, the scheme was ultimately abandoned.
In April 2018, ISDA’s board issued a statement suggesting that narrowly tailored defaults could negatively impact the efficiency, reliability and fairness of the overall CDS market and the proposed amendments reflect that view. Their recently proposed amendments address this challenge by adding to the definition of “Failure to Pay” a “Credit Deterioration Requirement” that negates the failure to pay default if such failure “does not directly or indirectly result from, or result in, a deterioration in the creditworthiness or financial condition” of the company. The consultation follows with four pages of Interpretive Guidance that lays out the intention behind the amendment, explains the assessment of the credit deterioration requirement and distinguishes forbearance, standstill and other bona fide arrangements that would rarely result in a determination that a non-payment event did not result from credit deterioration. As always, much is left to the discretion of ISDA’s “Determination Committees” that are charged with deciding whether a Credit Event has occurred.
While many market participants support ISDA’s view, not everyone agrees that manufactured defaults are wrong or would damage the CDS market. Matt Levine, in a recent Bloomberg Opinion piece, noted that while they appear to be manipulative, manufactured defaults do help the company get financing. “It is a way for real companies to get financing at the expense of CDS sellers, to whom the company owes nothing.” Similarly, during the Hovnanian litigation, Kramer Levin observed that the “CDS market shows few signs of disruption on account of engineered credit events involving financially distressed” companies. But, perhaps most importantly, the CFTC is not happy with this trend and that view is likely to carry the day.
Comments are due by March 27th and the LSTA will be closely following this consultation.