ISDA publishes ‘Small Bang Protocol’ allowing auction settlement following restructuring credit events

On July 14, 2009, the International Swaps and Derivates Association, Inc. (“ISDA”) published the 2009 ISDA Credit Derivatives Determinations Committees, Auction Settlement and Restructuring Supplement (the “July 2009 Supplement”) to the 2003 ISDA Credit Derivatives Definitions (the “2003 Definitions”) and the related 2009 ISDA Credit Derivatives Determinations Committees, Auction Settlement and Restructuring CDS Protocol (the “Small Bang Protocol”) through which parties to a credit default swap (“CDS”) can incorporate the terms of the July 2009 Supplement into their existing contracts. Capitalized terms used but not defined herein have the meaning ascribed thereto in the 2003 Definitions.

The July 2009 Supplement addresses a key issue that prevented CDS contracts that had a Restructuring Credit Event from settling through ISDA’s new auction settlement method, which was implemented in March of this year through the 2009 ISDA Credit Derivatives Determinations Committees and Auction Settlement Supplement (the “March 2009 Supplement”) to the 2003 Definitions and the related 2009 ISDA Credit Derivatives Determinations Committees and Auction Settlement CDS Protocol (the “Big Bang Protocol”). The purpose of the Small Bang Protocol is to implement a standard auction process for most CDS contracts following the occurrence of a Restructuring Credit Event where Modified Restructuring (“Mod R”) or Modified Modified Restructuring (“Mod Mod R”) is applicable.

The July 2009 Supplement provides a process to identify Deliverable Obligations that may be used in an auction while preserving, to the extent possible, the maturity limitation requirements for Deliverable Obligations for Mod R or Mod Mod R. Pursuant to the Small Bang Protocol, following a Restructuring Credit Event that has been triggered by the protection buyer, each CDS contract will be assigned to a “maturity bucket” with a “maturity bucket end date” that is on or immediately following the Scheduled Termination Date of the CDS contract. If the protection seller triggers the CDS contract before the protection buyer, the CDS contract will be assigned to the 30 year maturity bucket regardless of the Scheduled Termination Date of such CDS contract (the 30 year maturity is the maximum maturity of a Deliverable Obligation for a Restructuring Credit Event if Mod R and Mod Mod R do not apply).

The maturity bucket end dates will be each quarterly International Monetary Market roll date (March 20, June 20, Sept. 20 or Dec. 20) occurring on or immediately following the dates that fall 2.5 years, 5 years, 7.5 years, 10 years, 12.5 years, 15 years, 20 years and 30 years after the applicable Restructuring Date. Generally, the Deliverable Obligations for the CDS contracts in each maturity bucket will be only those Deliverable Obligations with final maturity dates of the relevant CDS contract that occur on or prior to the applicable maturity bucket end date. Deliverable Obligations will not be assigned exclusively to one maturity bucket (i.e., a Deliverable Obligation can be used to settle multiple CDS contracts with different maturity bucket end dates). If there are no Deliverable Obligations for a particular maturity bucket, the CDS contract will be re-assigned to the next earliest maturity bucket for which Deliverable Obligations exist.

For each proposed Restructuring Credit Event, the relevant Determinations Committee (the “DC”) will determine whether a Restructuring Credit Event has occurred, and if one has occurred, the DC will publish the Deliverable Obligation(s) for each maturity bucket. Parties to a CDS contract will have five business days after the publication to trigger a Restructuring Credit Event under their CDS contracts, and failure to exercise the CDS contract with respect to such Restructuring Credit Event means that the Restructuring Credit Event may no longer be exercised. With respect to each maturity bucket, the DC will decide whether to hold an auction. For any maturity bucket where 500 or more CDS contracts are triggered and five or more dealers are party to such contracts, an auction will be mandatory; however, the DC may in its discretion hold auctions for other maturity buckets as well.

If the DC declines to hold an auction for any maturity bucket, the affected CDS contract will move (i) into the next earliest maturity bucket for which an auction will be held, at the option of the protection buyer or (ii) into the 30 year maturity bucket, at option of the protection seller, depending upon whether the protection buyer or protection seller acts first in time. If neither party exercises the option to move the affected CDS contract, it will settle using the Fallback Settlement Method (as defined in the March 2009 Supplement) (that is, Physical Settlement, unless Cash Settlement is specified in the CDS contract).

As with the Big Bang Protocol and the March 2009 Supplement, both parties to a particular CDS contract must adhere to the Small Bang Protocol in order to incorporate the terms of the July 2009 Supplement. By adhering to the Small Bang Protocol, a party will be deemed to have adhered to the Big Bang Protocol as well. There is no cost for adhering to the Small Bang Protocol and a party need not be a member of ISDA to do so.

The adherence period for the Small Bang Protocol is scheduled to run through July 24, with the new provisions taking effect on July 27. The materials discussed in this alert are available at ISDA’s website: http://www.isda.org/smallbang/index.html. As with the Big Bang Protocol, ISDA encourages all market participants to adhere to the Small Bang Protocol and expects its terms to become market standard.