The International Swaps and Derivatives Association, Inc. (“ISDA”) published new documentation for credit default swap contracts referencing North American loans (the “Bullet LCDS”) on April 5, 2010. This documentation supersedes the Syndicated Secured Loan Credit Default Swap Standard Terms Supplement published May 22, 2007. (The term “bullet” is part of the name because, as discussed below, one of the key changes is that the contract is no longer subject to acceleration upon repayment of the reference entity’s loans.) The Bullet LCDS documentation, the Bullet Syndicated Secured Loan Credit Default Swap Standard Terms Supplement and the Bullet Markit LCDX Untranched Transactions Standard Terms Supplement will govern North American single-name loan credit default swaps (“LCDS”) and untranched North American loan index credit default swaps (“LCDX”). The Bullet LCDS documentation will not apply to legacy LCDS transactions, unless steps are taken to incorporate these changes into existing trades. Dealers anticipate that the Bullet LCDS documentation will lead to greater liquidity in the LCDS market.
The key features of the Bullet LCDS documentation are as follows:
i. The coupons are standardized (similar to the changes that ISDA implemented to the North American single-name credit default swap market in March of 2009).
ii. The contracts are non-cancellable in the event that the reference obligations are repaid.
iii. A new “Refinancing Event” has been introduced.
iv. There are backstop dates for credit events (similar to the changes that ISDA implemented to the North American single-name credit default swap market in March of 2009).
v. The documentation incorporates the terms of the 2009 ISDA Credit Derivatives Determinations Committees, Auction Settlement and Restructuring Supplement (the “March 2009 Supplement”). As a result, a determinations committee (the “ISDA Determinations Committee”) will determine whether credit events have occurred. In addition, auction settlement is incorporated through the March 2009 Supplement, with certain modifications, including the incorporation of the Bullet LCDS Auction Rules also published on April 5, 2010 (the “Bullet LCDS Auction Rules”).
Bullet LCDS will trade with standard fixed coupons, including 100, 250 and 500 basis points, each with potential upfront payments. In addition, “zero coupon” basis points fixed coupons are available if parties prefer to trade in points upfront with no coupon. To determine the upfront amount of a new Bullet LCDS, there are calculators (Markit Group Limited (“Markit”) provides a free online version) that can convert the traditional spread convention to an upfront price based upon (i) the given fixed coupon (i.e., 100, 250 or 500) and (ii) a recovery rate assumption. As with the North American credit default swap market, the buyer of protection will pay a full first quarterly coupon even if the trade occurred mid-quarter. As a result, the protection seller will reimburse the protection buyer for any pre-trade accrued coupon.
The Bullet LCDS documentation changes the North American single name LCDS market by making trades non-cancellable. Prior to the implementation of the Bullet LCDS documentation, North American transactions were automatically accelerated if the reference entity had no loans outstanding which satisfied the criteria in the LCDS documentation. Under the new Bullet LCDS documentation, a transaction will remain in effect even if there are no reference obligations outstanding. This is a significant change because commercial loans to North American borrowers typically may be prepaid at any time by the borrowers. If such a prepayment occurred under the prior LCDS documentation (and the borrower had no other similar loan outstanding), the trade would terminate and the buyer of credit protection would cease to pay fixed amounts to the protection seller. But under the Bullet LCDS documentation, the protection seller will continue to receive fixed amounts for the original term of the transaction.
Under the 2003 Credit Derivative Definitions (the “2003 Definitions”), if a “Succession Event” occurs, an existing LCDS transaction remains in effect but a new reference entity (or entities) replaces the original reference entity. However, the existing “Succession Event” definition—generally a merger, spin-off, consolidation, amalgamation, transfer of assets or liabilities or similar event—may not apply to certain types of loan refinancings. For example, an entity other than the reference entity might draw down under a new loan facility to repay the existing loan of the reference entity. This scenario would not fit into the traditional definition of “Succession Event” in the 2003 Definitions because it is not clear that the new entity has “assumed” or will become “liable for” the existing obligations since the original loan is extinguished. To address this, the Bullet LCDS introduces the concept of a “Refinancing Event.”
Under the Bullet LCDS documentation, a Refinancing Event is one of the following:
i. Redemption/Repayment Through New Loans or Bonds. A refinancing where all or any portion of the relevant obligations (i.e., the obligations of the reference entity that satisfied the “syndicated secured characteristic” prior to the refinancing event) have been redeemed, repaid or otherwise discharged in full by the proceeds of the drawdown of loans or issuance of bonds for at least one of which the reference entity is not an obligor.
ii. Asset Acquisition. A refinancing where all or any portion of the relevant obligations have been redeemed, repaid or otherwise discharged in full and all or any portion of the assets securing the relevant obligations have been acquired (directly or indirectly) by the proceeds of the drawdown of loan(s) or issuance of bond(s) for at least one of which the reference entity is not an obligor.
iii. Repayment or Discharge of Relevant Obligations. A refinancing where all or any portion of the relevant obligations have been redeemed, repaid or otherwise discharged in full and all or any portion of the relevant assets cease to secure all or any portion of the relevant obligations and instead secure one or more loan(s) or bond(s) for at least one of which the reference entity is not an obligor.
iv. Amendment of Documentation or Corporate Restructuring. A refinancing where, in connection with (a) an amendment, restatement or other modification to the credit agreement or related documentation relating to all or any portion of the relevant obligations (including, without limitation, the termination of a guarantee obligation) or (b) a corporate recapitalization or restructuring event, the reference entity ceases to be an obligor for all or a portion of the relevant obligations, and an entity or entities other than the reference entity remain or become obligor(s) under loan(s) constituting all or any portion of the relevant obligations.
v. Other. A refinancing where any other event occurs that has an effect substantially similar to any of the above including, without limitation, a redemption, repayment or discharge in full of all, or any portion of, the relevant obligations with a dividend financed by the proceeds of the drawdown of loan(s) or issuance of bond(s) for at least one of which the reference entity is not an obligor.
This change should benefit credit protection buyers because, if a Refinancing Event occurs and as a result no reference obligations of the reference entity are outstanding, a new reference entity (or entities) will be substituted. Instead of the buyer continuing to pay for credit protection on a reference entity which has no loans outstanding, the buyer will have credit protection on the new reference entity.
Categorizing Event as Succession or Refinancing
The Bullet LCDS documentation provides that a law firm (a “Designated Law Firm”)—rather than the ISDA Determinations Committee—will determine whether a Succession Event and Refinancing Event has occurred and, if necessary, identify any successors. If, at the time of the relevant Succession Event or Refinancing Event, a reference entity is included in the bullet LCDS database (the “Bullet LCDS Database”)—which initially will be the Markit RED LCDSTM database—the Designated Law Firm will make such determinations. The Designated Law Firm is appointed by the administrator of the Bullet LCDS Database.
If the reference entity is not included in the Bullet LCDS Database at the time of the relevant Succession Event or Refinancing Event, the ISDA Determinations Committee may elect to determine whether a Succession Event or Refinancing Event has occurred. If the ISDA Determinations Committee does not make such election, the calculation agent in the Bullet LCDS contract will be responsible for determining whether a Succession Event or Refinancing Event has occurred.
Under the terms of the Bullet LCDS documentation, a credit event must be recognized within 60 days of its alleged occurrence and the Succession Event or Refinancing Event must be recognized within 90 days of its alleged occurrence. This is similar to the changes that ISDA implemented to the single-name credit default swap market in March of 2009.
Determination of Credit Events, Deliverable Obligations and Auction Settlement Terms
The Bullet LCDS documentation incorporates the terms of the March 2009 Supplement. As a result, the ISDA Determinations Committee’s decision as to whether or not a credit event has occurred is binding for all relevant Bullet LCDS transactions. In addition, the Bullet LCDS documentation provides for the auction settlement method set forth in the March 2009 Supplement, with modifications made in the Bullet LCDS Auction Rules. One of the key modifications to auction settlement with respect to the Bullet LCDS documentation is that an auction may be canceled by a subsequent determination by a majority of the participating dealers prior to the auction final price determination date. If no auction is held or the auction fails or is abandoned, physical settlement will apply to LCDS transactions under the most recently-published form of LSTA Physical Settlement Rider.
LCDS and CLOs
Early in the development of the CLO market, synthetic CLO structures became a common form of balance sheet CLO. With the advent of the single-name LCDS market, LCDS began to be included in full capital structure CLOs and “hybrid” CLOs. However, the global financial crisis caused declines in volumes of both CLOs and LCDS. If the changes to the LCDS documentation described above are successful in creating liquidity in this product, LCDS will be an attractive product in which CLOs can invest. Since a CLO typically is a credit protection seller, a non-cancellable LCDS should provide greater certainty regarding the duration of the CLO’s investment.