Following a period of signiﬁcant debate and anticipation, buyers of credit default swap (CDS) protection on the Portuguese bank Novo Banco S.A. recently learned that their CDS contracts did not protect them against the type of event many expected would have resulted in market-wide protection payments. The transfer by the Bank of Portugal (the Portuguese central bank – a governmental authority) of senior bond obligations of Novo Banco S.A. to its ailing predecessor, Banco Espírito Santo S.A., did not trigger a Governmental Intervention Credit Event (GICE), according to the International Swaps and Derivatives Association (ISDA) credit derivatives determinations committee (DC). Controversial CDS decisions have rarely occurred since ISDA’s DC process was put in place and when they do, the market pays attention. The Novo Banco decision is particularly noteworthy since it represents the ﬁrst application of the GICE provision and will inform future GICE determinations for CDS referencing ﬁnancial entities in an environment where governmental interventions are expected to occur more routinely.
In this memorandum, we examine the GICE provision and the facts giving rise to the Novo Banco controversy. More importantly, we analyze the external review panel’s determination that no GICE occurred, and note the broader implications of the decision for the CDS product in general.
GOVERNMENT INTERVENTION CREDIT EVENT
The 2014 ISDA Credit Derivatives Deﬁnitions (2014 Deﬁnitions) added GICE to CDS contracts referencing ﬁnancial entities in certain regions outside North America. A GICE is an event triggered by a governmental authority under a restructuring and resolution law or regulation that results in binding changes to a reference entity’s debt obligations. This includes:
- any event which would affect creditors’ rights so as to cause (A) a reduction in the rate or amount of interest; (B) a reduction in the amount of principal or premium; (C) a postponement or other deferral for the payment or accrual of interest, or the payment of principal or premium; or (D) subordination of the debt obligation;
- an expropriation, transfer or other event which mandatorily changes the beneficial holder of the debt obligation;
- a mandatory cancellation, conversion, or exchange; or
- any event which has an analogous effect to any of the events specified above.1
A GICE is a new type of credit event added by the 2014 Deﬁnitions in response to the worldwide changes to the recovery and resolution regimes for ﬁnancial institutions after the ﬁnancial crisis in 2008. The European Union Bank Recovery and Resolution Directive (2014/59/EU) (BRRD) provides the resolution authority in the European Union with, among other things, a wide range of recovery and resolution tools to deal with failing ﬁnancial institutions. These include:
- Sale of business – Financial ﬁrms may be sold without shareholder or creditor consent.
- Bridge Institution – A bridge bank may be created to preserve critical banking functions; assets and liabilities may be transferred and re- transferred between the failing bank and the bridge bank.
- Asset separation – Clean and toxic assets may be separated between “good” and “bad” banks; assets and liabilities may be transferred and re-transferred between the “good bank” and the “bad bank.”
- Bail-in – A ﬁnancial ﬁrm’s liabilities may be written down or converted to equity or other debt obligations.
The credit events under CDS contracts prior to the 2014 Deﬁnitions did not provide clear protection for governmental actions taken under recovery and resolution laws.2
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THE NOVO BANCO DECISION
The Novo Banco decision provides rare insight into how a provision under the CDS deﬁnitions will be interpreted by independent legal experts who may not be actively involved in the CDS market. While the decision is not binding precedent for future events, the market, rightly or wrongly, is likely to view the decision as instructive for predicting future interpretations of the 2014 Deﬁnitions.
Lesson One: GICE Does Not Cover All Resolution Tools
One of the primary issues raised in the external review was whether the GICE deﬁnition is broad enough to capture the multitude of ways a resolution authority could implement a recovery or resolution of a failing ﬁnancial institution, including a transfer of assets or liabilities, or whether it is instead limited to the speciﬁc resolution tools enumerated in the deﬁnition, such as expropriation or a “bail-in” in the form of a mandatory cancellation, conversion or exchange.
The external review panel reasoned that the requirements of GICE were tightly drawn, and therefore should be interpreted narrowly. In particular, the panel relied on the fact that the word “transfer” is used in other parts of the 2014 Deﬁnitions, including in sub- paragraph (ii) of the GICE deﬁnition to refer to transfers that result in a change of beneﬁcial ownership of the debt obligations, and the word is not otherwise used in the GICE deﬁnition. The panel found that the GICE deﬁnition was drafted during a time when a version of the BRRD was available for market participants to review, and reasoned that because the drafters were aware of the resolution tools involving “transfers” of debt obligations between “good banks” and “bad banks,” the drafters had intended to exclude a transfer from a good bank to a bad bank from GICE by omitting any reference to such transfers.
The panel followed this reasoning further by adopting a formalistic reading of the words “cancellation, conversion or exchange” in the GICE deﬁnition. To the panel, these words had to mean something different than “transfer” even if a transfer caused an impairment of creditors’ rights similar to a cancellation, conversion or exchange.
More importantly, the panel read sub-paragraph (iv) of the GICE deﬁnition (“any event which has an analogous effect” as one of the above enumerated events) to cover only those other events that are the “functional equivalent” as the enumerated ones, and relegated the powerful potential of the word “analogous” to “a relatively small and potentially unknowable species of events.” This limited and conﬁned reading of “analogous” is likely the most signiﬁcant aspect of the panel’s decision. As a result, CDS protection buyers may consider the fact that future governmental interventions must fall squarely within one of the speciﬁcally (and narrowly) enumerated GICE structures to trigger protection payment. The panel’s decision decreases the value of including GICE in a CDS contract, and the market will need to quantify the potential gaps in coverage for recovery and resolution measures.
Lesson Two: Impairment of Creditors’ Rights Is Not Required
The external review panel concluded that an impairment of creditors’ rights by virtue of governmental action does not necessarily result in a GICE. In addition, the panel pondered whether, due to the “prevailing mood of Section 4.8,” the words “conversion” and “exchange” in sub-paragraph (iii) ought to be understood as requiring impairment of the creditors’ rights. The panel concluded that it was dangerous to imply such language and introduce an uncertain test.
This clariﬁcation is helpful in ascertaining the parameters of the GICE deﬁnition, although it also reinforces the principle of “form over substance” for purposes of the CDS contract interpretation. GICE determinations depend on the form and structure of the governmental action and not the economic result, even if the action unequivocally impairs creditors’ rights.
Lesson Three: The Relationship between GICE and Successor Provisions Remains Unresolved
The CDS successor provisions govern events where debt obligations of the CDS reference entity are assumed by or transferred to another entity, and require an assessment of the percentage of the affected debt obligations. If a sufﬁcient percentage of the relevant debt obligations have been transferred to or assumed by a new obligor, then the CDS contract is modiﬁed to reference such new obligor.
It is therefore possible that an event which constitutes a succession could also result in a credit event such as a GICE. The CDS deﬁnitions do not specify which provision should take precedence in the event that both can be viewed as having occurred.
The external review panel declined to address this issue, partly because it is moot as the panel has decided that a GICE did not occur, and partly because the question of whether a succession occurred as a result of the re- transfer is also pending at the DC. Thus the market is left, for now, without any resolution to this potential conﬂict.
The Novo Banco decision is the ﬁrst application of the new GICE provision. The CDS market will need to digest the results of the decision and consider a number of questions it raises. How will the deﬁnition of GICE be construed in the future in light of the various types of resolution tools at the disposal of the resolution authorities in Europe? Was the narrow reading adopted by the external review panel intended by the drafters? Is this reading too limited as compared to market expectations and, if so, will the deﬁnitions need to be revised or clariﬁed? The Novo Banco example may cause CDS market participants to reconsider the value and scope of the inclusion of GICE in their CDS contracts. It is also a reminder that the provisions of the CDS deﬁnitions will be carefully analyzed both textually and contextually – for what they say and for what they don’t say.