Part 1 of this series described the recent decision of the ISDA Americas Determinations Committee to declare that a “failure to pay” had occurred with respect to iHeartCommunications Inc., notwithstanding that the only non-payment had been to a wholly owned subsidiary. The non-payment was orchestrated to avoid a springing lien that would have been triggered had all the notes of a particular issue of iHeartCommunications debt been paid in full. It did not reflect on the creditworthiness of iHeartCommunications.

Here, two other credit event determinations of relevance to the iHeartCommunications decision are discussed. They too are instances of a nonconventional “credit event” (as defined in the 2014 Credit Derivatives Definitions, referred to below as the Definitions) that could be viewed as subverting the spirit of the protections for which CDS contracts were designed. The article concludes with some suggested amendments to the standard CDS contracts that may be considered to address nonconventional credit events of this sort.

Other Determinations on Unconventional Credit Events

Codere — a Precursor to iHeart

Codere SA operates betting parlors and race tracks in eight countries in Europe and Latin America. In 2013, it was attempting to restructure about 1 billion euros of debt after posting losses over a number of consecutive quarters. GSO Capital Partners LP, a subsidiary of Blackstone Group LP, offered to lend money to Codere, reportedly conditioned on Codere’s not making an interest payment in respect of other indebtedness until after the applicable grace period. The condition resulted in a failure to pay credit event in respect to CDS protection that GSO had purchased. The ISDA Americas Determinations Committee made a failure to pay determination; as a result GSO reportedly received a $15.6 million payment in settlement of the CDS contract that it had purchased. This, of course, enhanced the returns on the loan that it made to Codere.

The triggering of the CDS credit event in Codere was facilitated by the disparity between the threshold for a failure to pay under the CDS contract — usually $1 million — and the size of a non-payment needed to trigger cross-defaults under the other Codere debt. The same was true in the iHeartCommunications situation; but in the case of Codere, this divergence was even greater since the failure to pay was limited to a single interest payment. Thus, the collaborating parties could take advantage of the CDS market without bringing down the capital structure of the reference entity as a whole. In Codere, the engineering of a failure to pay credit event enabled capital to be drawn from the CDS market and injected as liquid cash into Codere, ultimately preventing the immediate potential insolvency. This engineered failure to pay ultimately reflected the status of the distressed credit (and therefore maintained CDS market certainty) while also providing Codere with a vital lifeline.

iHeartCommunications could be seen as a natural progression of the technique pioneered in Codere. Whereas Codere involved cooperation between a reference entity and an unaffiliated lender, iHeartCommunications created a credit event — albeit for a wholly separate purpose — between itself and a wholly owned subsidiary, without the collaboration of any other market participant. The next evolutionary phase could well be a situation in which an issuer or borrower attempts to obtain leverage over its bondholders or lenders by threatening to take unilateral action that could trigger a credit event. This could, of course, occur with the wider financial health of the company in mind (as in Codere) or could simply be used as a means to pressure certain bondholders or lenders into concessions.

MBIA — an Unsuccessful Takeoff on iHeart

iHeartCommunications and Codere were situations in which credit events were created despite the ability of a reference entity to pay the debt that triggered the event. But the new world of nonconventional CDS credit events may also encourage market participants who would profit from a credit event to aggressively advocate for one even where its existence is doubtful at best.

MBIA Insurance Corporation, a monoline insurer and a wholly owned subsidiary of MBIA Inc., was obligated under insurance policies wrapping so-called Zohar II notes issued by affiliates of Patriarch Partners LLC that came due in January 2017. In December 2016 and January 2017, MBIA Corporation engaged in certain transactions to facilitate satisfaction of its payment obligations under the Zohar insurance policies. With the proceeds of a financing[1] and the acquisition of certain of the Zohar II notes as consideration for the sale of a subsidiary, MBIA Corporation was able to pay in full the amounts owed to third-party noteholders of the wrapped Zohar notes at maturity. The various transactions were fully disclosed in Forms 8-K filed by MBIA Inc.

Notwithstanding the full disclosure, and the absence of any evidence for a failure to pay, unknown market participants alleged the occurrence of a credit event at MBIA Corporation and requested a determination of the ISDA Americas Determinations Committee. The request posited that the Zohar notes acquired by MBIA Corporation should be presumed to remain outstanding and unpaid, absent proof that the insurer had fulfilled its obligation under the wrap and repaid those notes. Clearly, the persons submitting the request were seeking to leverage the decision of the Determinations Committee in iHeartCommunications.

In contrast to the situation at iHeartCommunications, however, the Zohar notes were not held at a subsidiary of MBIA Corporation but rather transferred to MBIA Corporation itself. Offset arrangements were also agreed upon between MBIA Corporation and the trustee for the Zohar notes, and were appropriately documented, making it clear that all payment obligations on the Zohar notes had been discharged in full. The Determinations Committee had no difficulty finding that a credit event had not occurred. The case nonetheless illustrates the velocity of new concepts in the CDS market, particularly with respect to nonconventional situations. It may also serve as an object lesson for issuers engaged in debt repurchases seeking to avoid the inconvenience and distractions of dealing with an alleged credit event, to properly document and publicize retirement of the acquired debt.

Possible Contractual Amendments

Based on the precedent of iHeart, Codere and MBIA, it may be worthwhile to consider modifying the terms governing standard CDS contracts to limit the ability of reference entities and market participants to engineer credit events not reflective of issuer creditworthiness.

On the one hand, it is common for protection buyers to acquire CDS contracts without any exposure to the underlying reference obligations, and indeed the notional amount of CDS contracts often exceeds by orders of magnitude the principal amounts of the corresponding debt obligations. Viewed from this latter perspective, a CDS contract is just another implement in the toolkit of financial risk and reward, and judgments should not be made about the use of CDS contracts in unconventional ways.

On the other hand, modern-ay CDS contracts have their roots in hedges against defaults under borrowed money that still create corresponding market expectations. If so-called credit event engineering becomes widespread, protection sellers could be deterred from writing contracts, adversely affecting the orderly functioning of the CDS markets.

Suggested Amendments

On the theory that engineered credit events do frustrate market expectations and therefore should be constrained, the following amendments to the standard terms of ISDA-regulated CDS contracts may be considered: 

·         Express exclusion of debt owned by affiliates from the definition of “obligations” taken into account for the purposes of credit events, something that is already done for purposes of “succession event” determinations.

·         An increase in the threshold amount, the nonpayment of which gives rise to a credit event. The threshold could be fixed at a percentage of outstanding indebtedness held by nonaffiliates of the reference entity, but should be lower than the lowest cross-default trigger in other indebtedness of the reference entity, to preserve the relevance of a failure to pay (otherwise the failure to pay would likely trigger an acceleration of all the Reference Entity’s debt, which would likely trigger a Bankruptcy credit event).

·         Inclusion of a term requiring the failure to pay to impact a defined number of holders, similar to the agreement of multiple holders required for a “restructuring credit event.” This could be coupled with a requirement that the impacted holders must hold a certain amount or percentage of the outstanding debt, perhaps varying based on the total amount of outstanding debt at the reference entity.

·         Removal of a failure to pay as a credit event in certain markets and/or regions, perhaps coupled with the introduction of a voluntary restructuring as a credit event to mitigate the impact of the removal. However, abandoning failure to pay as a credit event will have negative implications for debtholders using CDS to hedge a particular debt obligation as the CDS contract would no longer be tailored to the risk they are exposed to by holding the debt. This may also have negative capital implications for banks using CDS to mitigate risks on their books.

The efficacy of each of these modifications, individually or in combination, in deterring an “engineered” credit event would depend on the circumstances of the reference entity and the amount and dispersion of the debt of the reference entity.

Effecting the Amendments

Amendments to CDS contracts could be effected via a protocol to which CDS market participants would adhere. The amendments, however, would likely affect the value of outstanding CDS trades. It is unlikely, therefore, that market participants who are net buyers of CDS protection would be willing to adhere to the amendments without being compensated for the reduction in value of their contracts.

Another approach would be to create an additional type of CDS contract that would trade with the amended terms. Such an approach might be better received by market participants, but it would have the consequence of splitting the market by certain names into two buckets, trading at different prices. This would be an undesirable outcome for a CDS market that has become thinner over the years and is in no need of fragmentation.

Concluding Observations

Nonconventional credit events in the CDS markets may be here to stay, unless constrained by contractual changes in the market. Whether such constraints are desirable may be a matter of perspective, but there are no doubt some market participants who believe that certain credit events witnessed of late are inconsistent with market expectations and could be harmful to the orderly functioning of the CDS markets. How to implement corrective changes is likely to be a challenge, however, both because a one-size-fits-all approach may not work and because the structure of the CDS market creates resistance to change.