A Failure to Pay Credit Event allows a CDS buyer to be paid the protection payments when the Reference Entity fails to make a required payment on its debt obligation. Until recently, the credit default swap market embraced the commonsense assumption that any future payment defaults would be solely a product of a Reference Entity’s declining creditworthiness. Based on this assumption, CDS protection sellers provide protection buyers with hedges against this credit risk.

That foundational assumption has been challenged by two well-known examples – Codere S.A. in 2013 and Hovnanian Enterprises Inc. in 2018. Both cases illustrated the ability of a CDS buyer to obtain a windfall under its CDS when it offered valuable consideration to the Reference Entity itself to cause a Failure to Pay Credit Event. The CDS buyer’s scheme succeeded in Codere and nearly did so under Hovnanian (where the ensuing litigation resulted in the abandonment of the scheme).

Market participants are searching for an amendment to the CDS Definitions that will minimize the risk of similar schemes resulting in Failure to Pay Credit Events. This article proposes distinguishing between categories of Failure to Pay Credit Events and applying different rules to the resulting categories. The key distinguishing factor is whether the Reference Entity agrees to withhold payment in connection with, or the non-payment is made a condition to, another transaction. This differentiated treatment for categories of Failure to Pay will serve better to balance the protection provided to CDS buyers uninvolved in the event against the need to deny a windfall to CDS buyers who seek to manufacture a failure to pay.

Today the International Swaps and Derivatives Association circulated proposed amendments to the 2014 ISDA Credit Derivatives Definitions relating to narrowly tailored credit events. This article does not comment on the ISDA proposal, but presents the author’s thinking on the issue to date. Undoubtedly, as market participants make their views known to ISDA, the Definitions will be improved. 

The Importance of Differentiated Treatment 

The goal of any amendment to the Definitions to address manufactured, or a CDS party-instigated, failure to pay should be two-fold: first, to curtail manufactured failure to pay by minimizing the potential of such an event qualifying as a Failure to Pay Credit Event; and second but equally importantly, to avoid creating unwarranted uncertainty with respect to the vast majority of Failure to Pay Credit Events which are not instigated by a CDS party.

In order to achieve the first goal, additional requirements need to be included in the “Failure to Pay” definition to guard against the moral hazard of possible collusion between the Reference Entity and a CDS party who stands to gain from a Credit Event. These requirements should be robust and substantially increase the cost to the Reference Entity associated with its intentional default, address the underlying cause of the default, and make it much more difficult to circumvent the rules. Ideally these requirements would be a deterrent on both a CDS party from soliciting a manufactured default by making it much more difficult to qualify as a Credit Event, and a Reference Entity from acquiescing to the default by fundamentally changing its cost and benefit calculation.

Making a payment default substantially more difficult to qualify as a Failure to Pay Credit Event would be problematic for events that are not instigated by a CDS party. When a Reference Entity, acting on its own, decides to default on its debt payment obligations to a third party holder, that holder suffers a loss and a CDS should be capable of providing a hedge against the credit risk. That was the original intent and use of the CDS product, and continues to be the foundation of the CDS market. CDS should provide that hedge regardless of how many parties may hold the debt obligation, whether the Reference Entity has the ability to pay but chooses not to, or whether the Reference Entity has a reason for the default which is unrelated to the deterioration of its financial conditions. 

Any limitation on the circumstances under which a debt holder may recover its loss from a payment default by virtue of CDS protection will compromise the utility of the CDS product as a hedging tool. Without that clarity, market participants will also be discouraged from using CDS to express a credit view. Thus, in the case of a nonmanufactured Failure to Pay, as long as a debt holder unaffiliated with the Reference Entity would suffer a loss from a payment default that meets the current requirements of the “Failure to Pay” definition, such default should continue to constitute a Failure to Pay Credit Event.

Key Differentiating Factors 

A CDS party who provides any incentive or consideration to a Reference Entity to induce a failure to pay would have included the protection payment under the CDS contracts in analyzing risks and returns. It would therefore ensure that the Reference Entity have an obligation to default on the payment, or such default be a condition to the financing or other inducement it provides to the Reference Entity. The existence of such obligation or condition, therefore, distinguishes a manufactured failure to pay from other, Reference Entity -initiated, failure to pay events. 

Information regarding the Reference Entity’s agreement of or condition to financing transaction is likely disclosed by the Reference Entity, particularly if the Reference Entity is a reporting company in the U.S. Consistent with its disclosure obligations, Hovnanian filed with the U.S. Securities and Exchange Commission the term sheets for the financing transaction, together with a press release which discloses that the terms of the financing transaction included an agreement that Hovnanian would not make any interest payment on the notes purchased by its wholly-owned subsidiary. Similarly Codere, a Spanish company, made the announcement that it had delayed the payment of interest on its senior 

notes by two days beyond the grace period because a payment within the grace period would have caused a mandatory prepayment event under its new senior facility agreement.

In this framework, a failure to pay would be considered “manufactured” if the Reference Entity agrees to withhold the requisite payment in connection with, or the non-payment is a condition to, other transactions between the Reference Entity (or its affiliates) and a third party. A manufactured failure to pay should also exist if the relevant parties make other arrangements that would produce a similar effect.


The “Failure to Pay” definition should be amended to minimize the moral hazard that arises from permitting a CDS buyer to induce the Reference Entity to cause a Failure to Pay Credit Event. Applying stricter rules to this type of failure to pay than those applicable to a Reference Entity-initiated failure to pay would better balance the interests of an innocent CDS buyer to enjoy the benefit of its hedge against those of the CDS market to deny a windfall to a CDS party who instigates the failure to pay. When a Reference Entity agrees to default on the payment obligation in connection with, or such default is made a condition to, a transaction between the Reference Entity and a third party, the stricter “Failure to Pay” rules should apply to substantially increase the cost of the default to the Reference Entity and the likelihood of no Credit Event and no windfall to the CDS buyer.