On Dec. 27, 2016, the ISDA Americas Determinations Committee announced that the election by iHeartCommunications Inc. (iHeartCommunications) not to repay at maturity the principal balance of certain 5.50% senior notes due Dec. 15, 2016, held by one of its subsidiaries constituted a “failure to pay” credit event under ISDA’s 2014 Credit Derivatives Definitions (referred to below as the Definitions) that govern interpretation of credit default swap (CDS) contracts. As a consequence, protection buyers of CDS contracts on the senior unsecured debt of iHeartCommunications with a net notional amount of approximately $432 million were entitled to collect on their contracts.
This article, Part 1 of a two-part series on CDS, discusses the iHeart case. Part 2, also in this issue of Debt Dialogue, examines two other illustrative credit event determinations in the CDS market with relevance to the iHeart determination, and offers suggestions for amendments to CDS contracts that address nonconventional CDS credit events.
iHeartCommunications and its parent, iHeart Media Inc., have for some time been highly leveraged with approximately $20 billion in outstanding debt. The iHeart entities have been, and continue to be, engaged in a variety of activities to restructure their debt.1 Among other things, iHeartCommunications arranged for its wholly owned subsidiary Clear Channel Holdings Inc. (Clear Channel Holdings) to purchase $57.1 million of the 2016 Notes. At the maturity of the 2016 Notes in December 2016, iHeartCommunications repaid all the 2016 Notes except those held by the subsidiary. The purpose of this gambit was to avoid a springing lien in favor of certain creditors over assets of iHeartCommunications, which would have been triggered had all of the 2016 Notes been retired.
S&P indicated that it viewed the non-repayment of the 2016 Notes to the subsidiary as a default, and downgraded iHeartCommunications to “selective default” and the 2016 Notes to a “D” rating. While seemingly a negative, the ratings response bolstered the position of iHeartCommunications that the 2016 Notes held by its subsidiary were indeed outstanding. iHeartCommunications also took affirmative steps to ensure that the 2016 Notes held by its subsidiary would be viewed as outstanding, including seeking a declaratory judgment in the District Court of Bexar County, Texas, to that effect.
Clear Channel Holdings agreed to forbear exercising remedies against iHeartCommunications “at this time,” but reserved the right to claim for the unpaid principal amount of the 2016 Notes in the future. While the failure to repay the 2016 Notes held by Clear Channel Holdings was clearly a payment default, it did not cross-default other debt in the iHeart capital structure because the amount was below the $100 million cross-default threshold found in the other indebtedness.
iHeartCommunications’ objectives with respect to the 2016 Notes — avoiding the springing lien, without suffering cross-defaults — appear to have been totally divorced from the CDS contracts written with reference to its debt. Regardless of its motivations, the actions of iHeart reverberated through the CDS market. Battle lines were drawn on both sides of the question of whether iHeartCommunication’s failure to pay on the 2016 Notes of its subsidiary constituted a failure to pay under the Definitions.
The CDS Settlement Process
Under the standard ISDA terms for cash settled CDS contracts, when a “failure to pay” or other “credit event” (as defined in the Definitions) occurs with respect to the reference entity, a protection seller must pay to its protection buyer an amount equal to the percentage decline in value of the cheapest obligation of the reference entity multiplied by the notional amount specified in the CDS contract. The determination of whether a credit event occurred is made by the Determinations Committee (consisting of buy and sell side members) for the region in which the contracts were written.2 Any market participant may request a determination, but only alleged credit events occurring within the 60 days preceding the request will be taken into account. If the Determinations Committee finds that a credit event has occurred, it will also decide whether to hold an auction to determine market value and the terms under which the auction will be conducted.
In December 2016, the ISDA Americas Determinations Committee, with jurisdiction over the iHeartCommunications CDS, announced that it would consider a request for a credit event determination with respect to iHeartCommunication on account of the 2016 Notes. The Determinations Committee publicized its decision that a failure to pay had indeed occurred and established Feb. 2, 2017, as the auction date. The auction was held, establishing a market price of $35.50. As a result, approximately $154 million changed hands in settlement of the iHeartCommunications CDS contracts.
The iHeart Determination
Arguments for and Against a Failure to Pay
Market participants took opposite positions over whether a failure to pay had occurred by reason of iHeartCommunications non-repayment of the 2016 Notes held by its subsidiary. Proponents of the occurrence of a failure to pay emphasized a literal application of the Definitions. That the 2016 Notes held by the subsidiary were outstanding under the terms of the indenture was not contested.3 The 2016 Notes represented borrowed money and therefore constituted “obligations.” iHeartCommunications’ failure to pay the 2016 Notes was just that, a failure to pay outstanding obligations. The proponents downplayed the agreement of Clear Channel Holdings to forbear from exercising remedies against iHeartCommunications. The indenture had not been amended, they argued, and in the past the Determinations Committee had ignored forbearance agreements in deciding that a failure to pay had occurred.
The opponents of a failure to pay determination stressed the forbearance and maintained that it constituted an amendment in fact of the indenture. The opponents drew an analogy to a prior decision by the Determinations Committee, LaSalle Bank NA (2002), where the Determinations Committee had declined to find a failure to pay following a waiver. That situation was readily distinguishable from iHeartCommunications, however, because Clear Channel Holdings had not waived any rights or remedies against its parent. It had merely agreed to a temporary stay of enforcement while reserving its rights to pursue remedies against iHeartCommunications in the future.
The Decision of the Determinations Committee
The Determinations Committee sided with the proponents of a failure to pay, adopting a literal approach to the Definitions. The Determinations Committee reasoned that:
- Under the terms of the Definitions, a failure to pay occurs three business days after non-repayment, absent any contractually longer grace period. The 2016 Notes indenture provided for no such grace period.
- The 2016 Notes indenture made all interest and principal “due and payable” on the maturity date of the 2016 Notes.
- There was no agreement between the parties modifying or deferring the maturity date.
- The payments owed by iHeartCommunications to Clear Channel Holdings constituted “obligations” for the purposes of the Definitions.
- It therefore followed that a failure to pay occurred on Dec. 20, 2016, the third business day following the maturity date of the 2016 Notes.
From an equitable perspective, and certainly from the perspective of a protection seller, the decision of the Determinations Committee could be disputed. iHeartCommunications had the ability to fully pay the remaining 2016 Notes, but chose not to do so. All notes held by market participants were repaid. The issuer joined with a wholly owned subsidiary to keep a relatively small portion of the 2016 Notes outstanding for purposes that were ancillary to the credit itself. It certainly could be argued that requiring protection sellers in these circumstances to make good on their commitments was a subversion of the spirit of the CDS contracts. The Determinations Committee nonetheless looked only to the literal terms of the contracts, and in its view the plain meaning of those provisions compelled the conclusion that a failure to pay had occurred and the protection sellers were required to perform.
The decision of the Determinations Committee to restrict the interpretation of the Definitions to their literal terms and ignore potentially applicable policy considerations has an understandable rationale. The markets require certainty in the enforcement of CDS contracts, and importing policy consideration into the calculus would necessarily inject a measure of uncertainty and imprecision into their implementation. The iHeartCommunications determination therefore has important implications for the CDS market and other permutations of nonconventional credit events that may arise in the future. Nonetheless, there is a lingering sense that the paradigm may be shifting in the world of CDS, where credit events can be created that are not indicative of the fundamental credit unworthiness of a reference entity.
Part 2 of this series reviews certain other decisions of Determinations Committees of relevance to the iHeartCommunication decision, and suggests a number of possible amendments to standard CDS contracts that may be utilized to prevent atypical credit events.