Over the past few years, a number of issuers in financial distress and their investors have used refinancing and restructuring strategies that capitalize on credit default swap (CDS) contracts written on the issuer, as reference entity, to achieve a better economic outcome. These strategies take various forms but most commonly involve the triggering of the CDS contract via a failure-to-pay credit event. The ensuing monetization of the CDS contracts for the benefit of CDS protection buyers enables them to extend financing to the reference entity on more favorable terms. At the same time, the relatively low failure-to-pay threshold of $1 million in the standard CDS contract enables CDS contracts to be triggered without hitting cross-default thresholds across the reference entity’s capital structure. Failure-to-pay credit events of this type are “unconventional” because they result from voluntary rather than unavoidable payment defaults.
Until recently, the two most prominent examples of these unconventional credit events occurred with respect to Codere SA and iHeart Communications Inc.1 The CDS market on K. Hovnanian Enterprises Inc. has now taken center stage. On Jan. 29, 2018, Judge Laura Taylor Swain of the U.S. District Court for the Southern District of New York denied a preliminary injunction sought by Solus Alternative Asset Management against Hovnanian and GSO Capital Partners LP to restrain a prospective refinancing transaction involving an unconventional credit event with respect to Hovnanian.2
This article addresses the CDS-related structuring in Hovnanian and the legal issues in the Hovnanian litigation, which is ongoing. In a companion piece, we provide an analysis of the state of the CDS market following these unconventional credit events, the viability of these strategies moving forward and the possible implications for the CDS market with their proliferation.
The Hovnanian Restructuring
The court described Hovnanian as “a large construction firm that ‘designs, constructs and markets, and sells residential properties’ [that] ‘suffered serious financial losses as a result of a recession and collapse of the homebuilding market in the United States’ between 2007 and 2011.”
On Feb. 1, 2018, Hovnanian closed a series of transactions to restructure and refinance some of its debt maturing 2019 with significant financing provided by GSO. One component of these transactions involved the tender of $170 million of Hovnanian’s 8% senior notes due November 2019 (the 2019 notes) in exchange for $155 million in cash, $90.6 million of new 13.5% unsecured notes due 2026 (the New 2026 notes) and $90.1 million of new 5% unsecured notes due 2040 (the New 2040 notes). In addition, GSO agreed to provide Hovnanian a 5% term loan in the amount of $132.5 million (with an additional $80 million available as a delayed draw) to refinance Hovnanian’s 7% notes due August 2019, and a $125 million revolver available to refinance Hovnanian’s existing $75 million secured term loan and for general corporate purposes.
As part of the exchange offer, Hovnanian’s subsidiary, K. Hovnanian at Sunrise Trail III (Sunrise), agreed to purchase and maintain the outstanding $26 million of the 2019 notes expected to be tendered in the proposed exchange of the 2019 notes for the New 2026 notes and the New 2040 notes. Moreover, the indenture for the New 2026 notes and the New 2040 notes prohibits Hovnanian from making the interest payment due on the 2019 notes held by Sunrise on the next interest payment date in May 2018. A default on the May 2018 interest payment in the amount of $1.04 million may result in a failure-to-pay credit event determination by the ISDA Credit Derivatives Determinations Committee (ISDA DC), although no such determination has yet been made. This, in turn, would entitle CDS protection buyers (including GSO if it maintains the CDS positions it disclosed as part of the litigation) to receive payments on their Hovnanian CDS contracts.
Comparison to Codere and iHeart
The Hovnanian restructuring incorporates elements of both Codere and iHeart. The transaction is analogous to Codere because Hovnanian’s agreement to default under the 2019 notes held by Sunrise is apparently designed, in part, to draw value from the CDS market that will be used, indirectly, to provide value to Hovnanian through favorable financing terms obtained from GSO. As in iHeart, the interest payment that will be missed is on an obligation owed not to street investors, but rather to an affiliate of the reference entity.
Unlike both Codere and, to a certain extent, iHeart, Hovnanian is not a distressed entity, considering the current prices of its publicly traded debt obligations. However, Hovnanian has made it clear that it has a significant and relatively urgent need to refinance its 2019 notes, and due to certain restrictions in its other debt obligations, it cannot fund the refinancing with otherwise available cash. To obtain financing at more favorable rates than would typically be available to it in the market, Hovnanian turned to a more complex refinancing strategy with GSO, central to which is a CDS credit event.
The Hovnanian restructuring also injects a wholly new component with the issuance of the New 2040 notes. These notes provide long-term flexibility to Hovnanian, among other benefits, but with their relatively low 5% rate of interest and extended maturity, they are likely to be the obligation in Hovnanian’s capital structure trading at the lowest level. If so, and to the extent a failure-to-pay credit event is determined to have occurred, we would expect the payments on the CDS contracts to be primarily based on the trading price of that obligation.3 While it is difficult to predict the level at which New 204 Notes will trade at the time of the credit event, if current trading prices remain somewhat consistent, they would have the effect of increasing the return to CDS protection buyers on their CDS contracts, generating value for GSO through its CDS positions. Some of the value received by GSO then would be passed on to Hovnanian in the form of the favorable financing terms it receives from GSO.
The Solus Action
As with any bilateral market, for all the economic benefit this transaction presents for Hovnanian and, presumably, GSO, there is a converse loss for CDS protection sellers. One CDS protection seller, Solus Alternate Asset Management LP, filed a complaint against both GSO and Hovnanian in New York federal district court. The Solus complaint alleged Solus will suffer monetary losses if the ISDA DC determines that a failure-to-pay credit event occurs following the planned May 2018 interest payment default. But Solus also suggests that the transaction could result in irreparable harm to the CDS market generally.
In the first instance, Solus sought an injunction to block the exchange offer for the 2019 Notes. The court denied Solus’ request, citing the availability to Solus of monetary damages and the ability of ISDA to craft solutions addressing problems in the CDS market generally.4 With the denial of the requested injunction, the Solus action will transition to a traditional litigation process of responsive pleadings, motion practice, discovery and possibly a full trial.
The complaint, on which Solus must now proceed on the merits, alleges a number of causes of action against GSO and Hovnanian.
- Market Manipulation
Solus accuses Hovnanian and GSO of violating Section 10(b) of the Securities Exchange Act of 1934 and related Rule 10b-5 by manipulating both the price of CDS contracts and the price of Hovnanian’s outstanding bonds. In this regard, a single-name CDS is a security for purposes of anti-fraud rules of the federal securities laws.
To establish market manipulation, Solus will have to prove that GSO and Hovnanian engaged in a fraudulent or deceptive course of conduct. A classic claim of market manipulation typically rests on the creation of a perception of market activity where none exists, or of pricing generated artificially by deceptive practices rather than free market forces. Solus will likely be battling uphill in this respect. The terms of the restructuring have been disclosed, and their effects on the pricing for Hovnanian debt and CDS contracts that reference the Hovnanian debt are the predicable outcome of the known features of those instruments.
- Disclosure Claims
The Solus complaint makes a further allegation under Section 10(b) and Rule 10b-5 that Hovnanian failed to properly disclose the benefits of the transaction to GSO. As with its market manipulation claim, Solus will be encountering a relatively high bar. Even if Hovnanian has not expressly articulated the CDS drivers for the transaction, the market has clearly understood them. With no harm and no undisclosed facts (as opposed to perceived motivations), it is difficult to see where Solus goes with this claim, other than perhaps to obtain some additional disclosures from the issuer.
- Tortious Interference
Finally, Solus falls back on a claim of tortious interference by Hovnanian and GSO with Solus’ CDS contracts or (under Solus’ amended complaint) its business relationships. Tortious interference has historically proven to be a difficult claim on which to succeed, as pursuing one’s own economic interest is not tortious, notwithstanding that there may be an adverse consequential impact on contractual or business relationships of a third party. Particularly here, where the CDS contracts will pay off only if the ISDA-DC determines that a credit event has occurred in accordance with the terms of the contracts, it would seem difficult to establish that the defendants have engaged in tortious conduct.
CDS Market Integrity After Hovnanian
Hovnanian is another step in the evolution of CDS contracts from a pure hedging or bespoke investment product to an opportunistic, stand-alone investment strategy. Historically, CDS tied into restructuring conversations as an inhibiting factor to debtholders negotiating on equal footing. In that context, the CDS market can provide an economic incentive for CDS protection buyers holding obligations of the reference entity to negotiate in a refinancing (e.g., by breaking basis trades). In the newer model of CDS as an opportunistic investment, the CDS market is being used affirmatively as a source of capital for participating debtholders to supplement a refinancing package and thereby allow for more favorable terms to the issuer.
This new restructuring technique, of course, rests on the backs of the CDS protections sellers, and Solus, as a protection seller, was unwilling to play along. Solus in effect argued that the proliferation of engineered failure-to-pay credit events risks damaging the CDS market to the point of collapse. In support of this thesis, Solus’ expert witness opined that CDS contracts become impossible to price where credit events can be engineered, CDS contracts would cease to serve their beneficial risk-spreading function and that consequently, liquidity in the CDS market would dissipate. Solus further argued that ISDA, whose rules and procedures govern the CDS market, was incapable of protecting the markets against the adverse consequences of engineered credit events. The court, at least on a preliminary injunction motion, declined to enter this thicket.
Analyzing the Solus Argument: Pricing and Liquidity
GSO’s expert argued against the Solus position. Engineered defaults, he observed, have been around for some time now — at least since the Codere episode in 2013 — and they have not as yet, and likely will not, threaten the viability of the CDS market. The reason is that the market is capable of embedding additional premium into pricing to reflect the risk of engineered, opportunistic credit events. Moreover, the enhanced risk/reward opportunities have attracted new participants that, to the contrary, have increased market depth.
Pricing of a CDS contract reflects (i) the probability that a failure-to-pay will occur with respect to the reference entity, and (ii) the likely value of the CDS contract in the event a failure-to-pay does occur. The probability of default must now factor in the possibility that a reference entity will pursue a strategy involving an engineered default. Numerous factors enter into this assessment — cross-default thresholds, acceleration terms, other provisions of the underlying debt, the financial condition of the reference entity and its short- and long-term capital requirements, among others. According to the GSO buy-side position, there appears no reason why the prospects for an engineered credit event cannot be modeled and priced. In addition, the highly specific fact pattern required to make a particular reference entity an attractive candidate for such strategies limits the universe and can generally be identified through publicly available information.
As discussed in the companion article, Hovnanian introduced a new feature into the pricing calculus that was absent in prior engineered credit events. Not only did Hovnanian commit to a failure-to-pay, it also agreed to issue a debt instrument that may trade below the market price for the issuer’s existing debt obligations, and if so would therefore be the cheapest to deliver upon the occurrence of a credit event. It would be this instrument that would primarily impact the payout under the CDS contracts on which Hovnanian was the reference issuer, at levels that would likely be higher than they would be in the absence of this new obligation.
The risk to a CDS protection seller that a reference issuer might issue additional, lower-priced obligations during the term of its CDS contract is not new. It is a risk that has been baked into the pricing for CDS contracts from the start (even though the impact on pricing was likely based on anticipated market terms that could be achieved by an issuer and potential lenders negotiating on an arm's-length basis). The risk is also not wholly unquantifiable, even with the advent of obligations specifically engineered to be the cheapest to deliver upon the occurrence of a credit event. To be viable, these engineered strategies require the auction at which the payout on the CDS contracts is established to land in a particular, and therefore somewhat predictable, range. So, the argument goes, CDS protection sellers should be able to assess the risk of the Hovnanian strategy on a particular name and price accordingly. As mentioned above, in many cases the availability of these strategies to a particular reference entity can be identified through diligence and, therefore, these risks can be assessed with some degree of accuracy.
GSO’s expert witness also attacked the specter conjured up by Solus of a frozen CDS market if engineered credit events were left unchecked. The expert observed that CDS have evolved over the years from a pure hedging/default protection tool to an opportunity-seeking investment strategy. The influx of return-seeking market participants has deepened the CDS market and enhanced its liquidity. Multiplying the input variables for CDSs contracts and increasing the uncertainty of outcome should enhance the attractiveness of the market to return-seeking investors.
The market reaction, more precisely the absence thereof, to the Codere and iHeart cases appears to support this thesis. The CDS market (at least right now) has been undeterred by the engineered credit events showcased in those two widely analyzed situations. Hovnanian similarly appears to have had minimal impact on the market, although its failure-to-pay will not occur until May 2018 and the analysis may change closer to that time as the market prices in losses.
No Calls for Change, Yet
The Solus “cries of wolf” are undermined by yet another indicator of market viability. Despite the proliferation of engineered strategies, both implemented and contemplated, there has been no groundswell of calls on ISDA to modify the form CDS contract to eliminate perceived abuse. While it is clear that groups of market participants are discussing changes to the CDS contract, it is not clear that there is a critical mass on the horizon sufficient to drive ISDA to make such changes.
One reason for the CDS markets to date having taken engineered credit events in stride is quantity. While there have been a few well-publicized engineered credit events, and others have been proposed, the actual number of cases has been relatively small and the universe of possible cases appears limited also.
Another reason for silence in the broader market may be that all instances of engineered credit events thus far have involved financially distressed, albeit performing, entities. Codere was trading at distressed levels, and, in the absence of the engineered failure-to-pay credit event, the company would likely have experienced near-term defaults. iHeart was, and remains, highly leveraged, and its active pursuit of a restructuring, now in a bankruptcy context, indicates that its capital structure is unsustainable in the short-to-medium term. Similarly, Hovnanian is under financial pressure and at risk of a default absent a refinancing. The common thread in each of these situations is a credit event, albeit an unconventional one, driven by the ill health of the reference entity.
It remains to be seen how far these strategies may be pushed. At the current time, the market appears willing to live with, and price in, the possibility of unconventional credit events for entities in financial difficulty, even where the debt markets have yet to fully reflect the difficulty. However, the possibility exists that CDS protection buyers may seek to replicate their strategy with financially sound companies. That being said, the likelihood that a financially sound company would entertain such a strategy appears fairly low given that it would presumably have access to a number of much less complex financing alternatives not involving the relative uncertainty and risks implicated by unconventional credit events. Moreover, identifying/creating an obligation trading at a sufficient discount to par to make the unconventional credit event strategy economically viable is more difficult at a financially sound reference entity, particularly given the maximum maturity limitations in the Credit Derivatives Definitions.
If the strategy is adopted by an entity not in need of a financial restructuring, this may put sufficient pressure on ISDA and the community of protection sellers generally for them to draw a line in the sand. Monetizing CDS in support of a restructuring may bend the rules of the CDS model, but at least it remains in the realm of financial reorganization. Monetization of a CDS contract through the legerdemain of an engineered credit event without a capital structure under stress would cut CDS loose from their original moorings entirely. If such credit events were attempted, it is anyone’s guess how the market would react, but a backlash could well reach Hovnanian-type deals as well.
The Hovnanian litigation is ongoing, and surprises may yet be in store there for unconventional failure-to-pay credit events in the CDS space. An adverse ruling in the Solus case on the merits could put the brakes on this strategy, but Solus would seem to have a difficult road ahead to prevail in the case. Also, notwithstanding the Solus arguments in that case, the CDS market currently seems to show few signs of disruption on account of engineered credit events involving financially distressed reference entities. That could change, however, if events of this nature were to proliferate to a level that threatens the ability of protection sellers to achieve risk-commensurate pricing. The extension of engineered credit events to financially sound reference entities, if this were to happen, would undoubtedly apply greater pressure on the CDS market. In these as yet uncharted waters, ISDA may be forced into modifications of the form CDS contract to assure the continuing viability of the CDS market. However, at least for now, engineered credit events are simply part of the market and, in the right circumstances, are an innovative new source of refinancing capital.