The continuing difficulties of enforcing credit default swaps have been highlighted recently by the experience of bankrupt Portuguese bank, Banco Espirito Santo ("BES") and its successor "good bank" Novo Banco.

Despite the fact that the 2014 ISDA Credit Derivatives Definitions (the "Definitions") included a new credit event for government bail-ins, the ISDA Determinations Committee (the "DC") decided that a retransfer of bonds from Novo Banco to BES does not amount to a "Governmental Intervention" or other credit event.That decision was confirmed on 15 February 2016 by an external panel of experts. This means that not only will the bonds be worthless, but so will any credit default swaps relating to the bonds because ISDA rules had transferred the swaps to Novo Banco – although the DC still has to consider whether those swaps should now be retransferred to BES.

Background – BES' insolvency and transfer of credit default swaps to Novo Banco

BES filed for insolvency in 2014 and most of its assets were transferred to Novo Banco (the "good bank"), leaving behind most of its liabilities in BES. In August 2014, the DC decided that since more than 75% of BES' debt had transferred to Novo Banco, a Succession Event had taken place under the Definitions. This meant that that all credit default swaps linked to BES were transferred to Novo Banco as the new reference entity. As a consequence, any credit default swaps relating to bonds which remained with BES would be worthless.

Retransfer of bonds to BES

However, in November 2015, the ECB's stress tests decided that there was a €1.4 billion capital shortfall in Novo Banco. In order to raise more capital, and under pressure to make the good bank attractive for an early sale, the Bank of Portugal ("BoP") decided that some bond obligations had to be retransferred to BES. This retransfer occurred on 29 December 2015. The date may have been chosen to avoid the new rules which came into force across the EU on 1 January 2016 under the Banking Recovery and Resolution Directive. Those new rules allow central banks to apply bail-ins across all classes of creditor. It is likely that BoP wanted to rely on powers under Portuguese law in deciding which bonds to transfer rather than being beholden to the new EU regulations.

One of the more controversial aspects of the retransfer is the basis on which the particular bonds were chosen. Only 5 out of 52 BES bonds were selected and it seems that BoP wished to avoid retransferring retail bonds on the basis that upsetting the general public could affect Novo Banco's future retail banking business. It also avoided bonds created offshore, perhaps as a result of the consequences of a decision in December 2014 by BoP. That decision excluded a Goldman Sachs arranged loan to BES from BoP's earlier decision in August 2014 to transfer BES liabilities to Novo Banco. English law governed that loan and Goldman Sachs applied to the English courts for confirmation that the liability for the loan had been transferred to Novo Banco under BoP's August decision. The court ruled that it had jurisdiction under English law to consider the issue and held that, as a matter of English law, the loan had been transferred to Novo Banco(1). Although the English court's decision may effectively be ignored by Portugal, it is understandable if BoP wished to avoid further challenges.

DC decision on "Governmental Intervention"

The holders of the transferred bonds asked the DC to decide whether the retransfer of the bonds amounted to a credit event under the Definitions. In early January 2016, the DC decided by a majority of 11 to 4 that it was not a credit event. It did not fall under the definition of a "Governmental Intervention" (under section 4.8 of the Definitions) which requires either:


a) a reduction in interest or capital,

b) a deferral of a coupon or repayment ... or

c) the subordination of the bonds;

(ii) an expropriation of the bonds;

(iii) a mandatory cancellation, conversion or exchange; or

(iv) any event which has an analogous effect to any of the events in (i) to (iii).

As a result of the decision against a credit event, an external review by an agreed panel of experts had to be held under ISDA rules. The panel has now decided unanimously that the DC's decision was correct. It held that there was no dispute that the retransfer was not an event under (i) or (ii). The only questions were whether (iii) or (iv) applied. Sub-paragraph (iii) did not apply: it was not a cancellation because the bonds continued in existence, nor was it a conversion into some other form of obligation (such as debt into equity), nor was it an exchange because that would require a cancellation of the bonds and their replacement with the issue of new bonds on different terms.

The panel thought that the critical question was whether the catch-all sub-paragraph (iv) was sufficiently broad to include the transfer. It decided to prefer a narrow interpretation to preserve the certainty of section 4.8 as far as possible. In the panel's view, events having an analogous effect should only apply to events which were functionally the same as those in the rest of the section but which for some technical reason fell outside the scope of the defined terms.

A new Succession Event?

A further decision of the DC is now required on the issue of whether the retransfer of the bonds is itself a Succession Event. The question to be answered is whether the retransfer of the bonds means that over 25% of BES' original liabilities are now back with BES. If that is the case, the DC may decide that the credit default swaps should be divided between the two banks. A decision on the issue has now been postponed until the end of April 2016 to allow further information on Banco Novo's asset and liability position to be provided.


The DC has made it clear that for credit default swaps to pay out as a result of a Governmental Intervention credit event, a mere transfer of bonds from one reference entity to another will be insufficient, even if that has the effect of depriving the bonds of their economic value. A Governmental Intervention requires a material change to the terms of the bonds which deprives the bondholders of their full legal rights.

The bondholders' hopes now rest on whether the DC will agree that credit default swaps should also be retransferred to BES along with the bonds.