Restructuring companies in respect of which there exists a significant credit default swaps (CDS) market adds an additional level of complexity which the debtor and all stakeholders should consider and assess early on in the process, as it could determine the success or failure of a restructuring plan.
Creditors across the capital structure can purchase CDS protection. Where junior creditors with CDS protection also have cross-holdings in the senior debt, these creditors may have sufficient bargaining power to dictate the manner in which a restructuring will proceed. Acting as a group, they may be capable of blocking any proposal that does not also trigger a Credit Event (see below: Credit Events) on the CDS, thus ensuring par recovery on their junior debt even where the restructuring proposal effects a compromise and/or release of that debt.
Settlement of a typical CDS contract referencing a European corporate will be triggered upon the occurrence of one of three events (each a Credit Event): (i) a bankruptcy of the underlying corporate (the Reference Entity), (ii) a failure by the Reference Entity to make a payment on any of its outstanding borrowed money obligations or (iii) a restructuring of any outstanding borrowed money obligations of the Reference Entity.
We examine below some of the complexities that may be faced by debtors and stakeholders where obligations against which CDS has been issued become the subject of a restructuring.
Influence of CDS Holders — Truvo and SEAT
In Truvo, for example, the original consensual restructuring proposal failed to garner sufficient support of noteholders as a large number of noteholders were covered by CDS protection. Not until the company intentionally triggered a Credit Event (in this case a bankruptcy event as a result of Truvo’s Chapter 11 filing), and only after the CDS auction settled, was it able to obtain the required level of support from its creditor constituencies to proceed with the restructuring.
Whether the same will also be true for the Italian directories business, SEAT Pagine Gialle S.p.A (SEAT) remains to be seen. SEAT has been the subject of recent media attention as rumours abound that its over-leveraged balance sheet is ripe for restructuring. There is a significant CDS market on SEAT. There are likely to be cross-holders in SEAT’s subordinated notes (the Lighthouse notes) and SEAT’s senior secured bonds, and undoubtedly some of those cross-holders have purchased CDS protection. In the context of a restructuring, whether fully consensual or otherwise, SEAT’s directors will likely need to consider whether a Credit Event trigger will be a necessary pre-condition to securing the requisite support of its various creditor constituencies.
Which Credit Event?
In the context of a restructuring, holders of CDS are well advised to consider not only whether one or more Credit Events will be triggered by a proposed restructuring, but also the precise type of Credit Event(s) to be triggered, as there are different settlement procedures associated with certain Credit Events which may yield significantly different outcomes for CDS holders.
Unlike the "failure to pay" and "bankruptcy" Credit Events which result in the entire CDS contract being terminated and settled in a single auction, following the occurrence of a "restructuring" Credit Event (see below: Restructuring Credit Event Defined), one of the parties to the CDS has to trigger the settlement process under such CDS to settle in full or only a portion of the notional amount. Any portion of the CDS with respect to which settlement is not triggered following a "restructuring" Credit Event will remain outstanding. Moreover, the auction settlement process following a "restructuring" Credit Event may consist of multiple auctions, each designed to determine the value of the Reference Entity’s deliverable obligations classified by their maturity dates.
Restructuring Credit Event Defined
In order for a Restructuring Credit Event to occur, any of the following events have to take place:
"(i) a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals;
(ii) a reduction in the amount of principal or premium payable at maturity or at scheduled redemption dates;
(iii) a postponement or other deferral of a date or dates for either the payment or accrual of interest or the payment of principal or premium;
(iv) a change in the ranking in priority of payment of any Obligation, causing the Subordination of such Obligation to any other Obligation; or
(v) any change in the currency or composition of any payment of interest or principal to any currency which is not a Permitted Currency",
and such event must (a) bind all holders of the relevant obligation, (b) occur in relation to an obligation with an aggregate amount of at least USD 10,000,000, (c) result directly or indirectly from a deterioration in the creditworthiness or financial condition of the underlying corporate and (d) not have been expressly provided for under the terms of the obligation at the time it was incurred/issued.
An example of how these different settlement rules can impact the price of the pay out under CDS became apparent in case of Thomson SA (now Technicolor). Thomson announced in August 2009 that it entered into a waiver and forbearance agreement with the holders of its senior notes to defer payment of principal, which triggered a "restructuring" Credit Event. Three months later, Thomson requested and obtained the opening of "sauvegarde" proceedings in a French court, which triggered a "Bankruptcy" Credit Event.
CDS holders who settled their CDS contracts on the basis of the auction held following the "restructuring" Credit Event were paid out between 3.75 percent and 36.75 percent (depending on how long-dated was their CDS exposure). Those who waited until the bankruptcy filing and settled pursuant to the second auction ended up getting paid 22.25 percent regardless of whether they held short or long-dated CDS exposure.
Accordingly, CDS holders may have a preference for a specific type of Credit Event trigger depending on their view of the particular situation and may choose to "hold out" for a later "failure to pay" or "bankruptcy" trigger if they consider this will maximise the return on their CDS. The sequence in which multiple Credit Events may occur (whether a "restructuring" trigger happens prior to or after a "failure to pay" or a "bankruptcy" trigger) may then become a key factor in determining the pay out under the CDS contracts.
Availability of Credit Events
Where a restructuring is necessitated by a debtor’s lack of liquidity, a "failure to pay" Credit Event is the most likely Credit Event. However, where there is no immediate liquidity crisis, and a restructuring is pursued for the purpose of right sizing an over-levered balance sheet, there may be no "failure to pay" default Credit Event on the horizon for CDS holders. It may also be difficult for a company’s directors to attempt to bring forward a "failure to pay" without giving rise to potential liability under applicable directors’ duties laws, although there may be formal procedures available under applicable law which could nevertheless trigger a "bankruptcy" and/or "restructuring" Credit Event on the CDS without also causing a formal insolvency of the debtor (something generally best avoided in Europe).
CDS Settlement — Timing and Process
If a CDS holder believes that a Credit Event has occurred, he can request a determination by the relevant credit derivatives determination committee (DC) (see below: Big Bang Protocol). Such determination must be made in a commercially reasonable manner and it is possible for a CDS holder to dispute any such determination. The DC will then also resolve whether to hold an auction for settlement of the CDS and will determine the obligations that may be used to settle the auction (the "deliverable obligations").
Big Bang Protocol
The so called "Big Bang Protocol" adopted by the community of members of the International Swaps and Derivatives Association, In (the ISDA) in early 2009 introduced amendments to the 2003 ISDA Credit Derivatives Definitions (the definitions that govern the transactions entered into in the CDS market) designed to facilitate settlement of existing and future CDS trades and to generally coordinate orderly functioning of the CDS market going forward. It established "Credit Derivatives Determination Committees" or "DCs" – committees consisting of several members of the ISDA, selected primarily on the basis of how large is their overall existing activity in the relevant global or regional CDS market. Among other things, the DCs make determinations as to whether a Credit Event has occurred.
The DC will then select a date for the auction (see below: Auction Settlement). While there is no fixed number of days within which the auction has to take place, in practice the auction is typically held within a month of the DC determining that there has been a Credit Event (this may be later if more time is needed to determine which obligations will constitute "deliverable obligations", in which case, the auction date can be delayed for several months).
Historically, CDS contracts only allowed for physical or cash settlement (bi-lateral settlement between the parties to the CDS). With the growth of the CDS market, it became apparent that multiple parties trying to settle CDS contracts following a Credit Event by delivery of the underlying obligations may lead to significant distortion of the market for the "deliverable obligations". To address this issue, since 2005 the CDS market started adopting ad hoc auctions that were designed to determine the recovery rate under CDS contracts for all transactions referencing the same entity subject to a Credit Event. This mechanism was adopted to apply across the market going forward from 2009.
As was the case in Truvo, a Reference Entity may find it difficult to proceed with its restructuring until after the CDS contracts have been settled and all deliveries are effected, since settlement inevitably leads to changes of ownership of the underlying debt obligations. Where the Reference Entity has not previously bound creditors into a restructuring, it may not be able to identify the requisite holders of its debt whose agreement is needed to complete the restructuring until after the CDS has settled. The debtor and its stakeholders should therefore consider carefully whether and when is the appropriate time to enter into binding agreements or term sheets in relation to the restructuring.
Impact of Intercreditor Releases on Settlement of CDS
Where a restructuring proposal ultimately contemplates the release or equitisation of what would have qualified as "deliverable obligations", CDS holders need to understand whether and how the timing of such release/equitisation impacts on their ability to settle their CDS. The worst possible outcome for a holder of the debt and CDS protection is a situation where the debt that would have qualified as a "deliverable obligation" under the CDS is either released or equitised as part of a restructuring prior to settlement of the CDS and is therefore incapable of being delivered into the CDS auction.
For instance, European LBO restructurings will often involve a pre-packaged share pledge enforcement sale process where the senior creditors will accelerate some or all of their debt (as a pre-requisite to enforcing), which the debtor then fails to pay (triggering a "failure to pay" Credit Event). Immediately following lapse of a short period, the shares will be sold and, potentially, certain out-of-the money obligations may be released by operation of the contractual release provisions embodied in the applicable intercreditor agreement. Critically, if those obligations are the ones that would be used to settle the CDS (i.e., the "deliverable obligations"), then it could become impossible for holders of CDS to deliver them into any CDS settlement process. The critical question then becomes: can the restructuring be implemented so that there is adequate time between the occurrence of a Credit Event and the contractual release of the "deliverable obligations" to allow for settlement of the CDS?
CDS auctions are typically carried out a month (or longer) after a Credit Event is triggered. Where the earliest available Credit Event is the failure to pay accelerated obligations in the context of a pre-packaged share pledge enforcement, there may not be adequate time between the occurrence of the "failure to pay" Credit Event and the contractual release of the deliverable obligations to allow for settlement of the CDS.
Carrying out a restructuring of obligations against which CDS has been issued can be extremely complex. There will likely be critical junctures throughout the process when the debtor and/or its stakeholders are required to make choices that may ultimately have a significant impact on recoveries under the CDS contracts. However, careful pre-planning and communication between a debtor and its stakeholders will go a long way towards avoiding worst case scenarios for the debtor and stakeholder (e.g., the restructuring is delayed or blocked altogether) and holders of CDS (e.g., the "deliverable obligations" are released or equitised prior to settlement of the CDS and therefore incapable of being delivered into the CDS auction).