As you may know, recently Movie Gallery failed to pay a coupon on its second lien term loan, marking the first credit event in the Loan Credit Default Swap market. Movie Gallery subsequently filed for bankruptcy protection on October 16, 2007. Movie Gallery is the subject of single-name Loan CDS trades and is included in the LCDX.NA.8 index. Accordingly, the settlement mechanism of Loan CDS trades will experience its first test. The dealers active in the relevant LCDX index have voted to hold an auction to settle the Loan CDS trades referencing Movie Gallery on October 23, 2007.

The auction mechanism

The auction is a hybrid of cash and physical settlement, similar to auctions for unsecured CDS trades that have evolved over the past few years. It is designed to generate a price which will then be used to cash settle the trades. This process will also enable participating parties to buy or sell the underlying loans at the final price generated by the auction.

Under the auction terms, only eligible dealers may directly participate. However, end-users may submit physical settlement requests up to their net CDS exposure through participating dealers to buy or sell the underlying loans in the auction.

In order to ensure that a transaction is brought within this auction, parties must have delivered a credit event notice and notice of publicly available information (or entered into a settlement agreement deeming these notices to be delivered) effective on or prior to October 22, 2007.

What happens if the auction fails?

If the auction fails to generate a final price, the Loan CDS trades will physically settle using nonnegotiable settlement documents (the physical settlement rider) developed by the Loan Syndications and Trading Association.

Kramer Levin’s derivatives practice group is comprised of members of our corporate, banking, bankruptcy, distressed trading and tax departments and regularly represents investment banks, hedge funds and other financial institutions. Our practice involves the negotiation of ISDA and other derivatives facilities and the structuring and negotiation of customized derivatives transactions.