In 2014, the International Swaps and Derivatives Association, Inc. (“ISDA”), published the 2014 ISDA Credit Derivatives Definitions (the “Definitions”), which updated the 2003 ISDA Credit Derivatives Definitions.[1]

One of the most significant changes in the Definitions was the inclusion of a new credit event for “Governmental Intervention.”[2]  This credit event was intended to address concerns expressed in the market that the credit event for “Restructuring” may not cover certain measures actually taken by governments to support struggling entities, especially banks.  Governmental Intervention[3] is generally defined to include actions or announcements by a “Governmental Authority”[4] that result in, inter alia, the reduction in the rate or amount of interest payable by a reference entity, an expropriation or other event which mandatorily changes the beneficial holder of the relevant obligation, or a mandatory cancellation, conversion or exchange.  This event is similar to Restructuring in certain respects (for example, the reduction in the rate or amount of interest of an obligation may trigger both events).  However, unlike Restructuring, deterioration in creditworthiness is not required to trigger a Governmental Intervention.

It did not take long for this new credit event to be probed and tested by a set of straightforward, but unusual, facts that apparently were not specifically considered by the drafters. In August 2014, Banco de Portugal, the central bank of Portugal, applied resolution measures to Banco Espírito Santo, S.A. (“BES”), a bank organized in Portugal that was experiencing distress.  These measures included a €4.9 billion rescue package for BES, and the transfer of numerous assets, liabilities and deposit-taking operations from BES to a new “good bank,” Novo Banco, S.A. (“Novo Banco”).  However, on December 29, 2015, Banco de Portugal announced the re-transfer of five senior Euro-denominated bonds (having almost €2 billion in principal) from Novo Banco back to BES.[5]  This re-transfer resulted in significant losses to bondholders, up to 90% in secondary market trading.

It was clear that Banco de Portugal constituted a “Governmental Authority” and that it had taken a binding action pursuant to its resolution law. However, irrespective of the undeniable losses suffered by creditors,[6]there was an issue as to whether the re-transfer of the bonds at issue from BES to Novo Banco affected creditors’ rights in one of the ways specified in Section 4.8(a) of the Definitions.

In accordance with the standard practice in the credit default swap (“CDS”) market, purchasers of protection asked the relevant 15-member Determinations Committee (the “Committee”) to determine whether the central bank’s actions amounted to a Governmental Intervention, hence triggering protection payments under CDS contracts.  Under the relevant rules, an 80% supermajority (12 of 15 members) is required for a Committee to decide whether or not a credit event has occurred.[7]   The Committee fell just short of the required percentage, with 11 members voting that there was no Governmental Intervention.  Although the intent, generally, underlying the Governmental Intervention event was to protect investors from governmental actions negatively affecting the value of obligations, the majority of the Committee concluded that the transfer of debt to another institution did not  constitute a “mandatory cancellation, conversion or exchange” and did not have “an analogous effect” to the events specifically enumerated in the definition of Governmental Intervention.

Nevertheless, without the required supermajority, pursuant to the relevant rules governing Committees, the matter was referred for “external review.”[8]  External reviews of Committee decisions are quite rare and entail at least three “experts” nominated by Committee members deciding the issue.  A unanimous decision is needed to override the Committee’s original “No” vote where, as here, over 60% of Committee members voted against the occurrence of a credit event.  On February 15, 2016, the external review panel released a unanimous decision to uphold the negative determination.  In short, the panel decided that the central bank’s transfer did not constitute a mandatory cancellation, conversion or exchange of the obligations, and was not analogous to those types of event.[9]  On the latter point, the panel stated that taking a broader review of the word “analogous” would result in this clause “dominat[ing] the whole of the definition, which is inconsistent with [the] careful and detailed drafting” of the definition.[10]

In addition to seeking a determination that a Governmental Intervention had occurred, protection buyers pursued one more potential avenue for payout under the Definitions: seeking a determination that a “successor” event had occurred with respect to CDS naming Novo Banco as reference entity. A successor event occurs under the Definitions if, generally, more than 25% of the relevant obligations of a reference entity are transferred to another entity and more than 25% of the relevant obligations of the reference entity remain with the reference entity.[11]  The Committee sought additional information from Banco de Portugal and Novo Banco to determine whether this threshold had been exceeded.  After receiving this additional information, the Committee unanimously decided on March 3, 2016 that a successor event did not occur.[12]

Many industry participants believed that the Governmental Intervention was designed to protect against precisely the type of result that precipitated from Banco de Portugal’s actions.  Nevertheless, the Committee concluded, and the external review panel agreed, that the actions of Banco de Portugal did not align with the requirements of the Definitions.  Thus, one lesson from this situation is that Determinations Committees may take a formalistic view of requirements under the Definitions, regardless of the scope of losses incurred by creditors or the spirit or purpose of the language in the Definitions.  CDS purchasers should take note and not overlook the precise words of the Definitions.