On March 6, 2019, the International Swaps and Derivatives Association, the main trade group for credit default swaps (“CDS”), proposed amendments to the rules governing the standard-form contracts on which CDS are written. The proposed amendments are aimed at addressing “issues relating to narrowly tailored credit events,” also known as manufactured defaults. See Proposed Amendments to the 2014 ISDA Credit Derivatives Definitions Relating to Narrowly Tailored Credit Events (hereinafter, “Proposed Amendments”) para. (a)(1) (Mar. 6, 2019), https://www.isda.org/2019/03/06/proposed-amendments-to-the-2014-isda-credit-derivatives-definitions-relating-to-narrowly-tailored-credit-events. These amendments may be a step forward, but they fall short of addressing certain strategies already known to the market, including a strategy used by CDS sellers to avoid credit events (and thus avoid paying out on CDS)—referred to here as a “manufactured non-default.”
A brief framework of CDS is helpful to understand the import—and limitations—of these proposed amendments. A CDS can roughly be compared to insurance on an investment. As a very simple example, consider an investor that invests in debt issued by ACME corporation. If ACME corporation does well, it will pay off its debt in full and on time. But if ACME corporation does poorly, it may miss payments, causing the investor to suffer losses. A CDS contract lets the investor hedge its investment in ACME corporation. In a typical CDS contract, the investor—a CDS buyer—agrees to make periodic payments to a CDS seller for a specific period of time—similar to an insurance premium. If, during that time, ACME corporation defaults, the CDS seller pays the investor a lump sum equal to the credit loss on the loan determined by an ISDA auction, thereby allowing the investor to mitigate the losses he would otherwise have suffered. Though this example helps to conceptualize how CDS typically work, CDS buyers do not actually have to own debt issued by ACME corporation to purchase CDS. Thus, CDS contracts can be viewed as a “bet” on the company: CDS sellers—who are long on the company—bet that the company will remain healthy and pay off its debts in full and on time. CDS buyers—who are short on the company—bet that the company will suffer losses and default on its debt.
CDS market participants have devised several creative—and controversial—strategies in an attempt to ensure that their bets will pay off, including so-called “manufactured defaults.” In a manufactured default, an otherwise healthy company agrees to default on a portion of its debts in exchange for something of value from the CDS market participants. One of the most famous manufactured defaults was engineered in 2013 by the Blackstone Group, LP and involved Spanish gaming company Codere SA. More recently, Quinn Emanuel successfully represented an investor to prevent Blackstone from engineering a similar manufactured default on CDS referencing debt issued by homebuilder Hovnanian.
In the Codere-Hovnanian-type of manufactured default, a CDS buyer offers the company an incentive—like below-market financing—to default on a portion of its outstanding debt. The default is a technical one. In Codere, the company defaulted simply by making an interest payment two days late. In Hovnanian, the company missed a payment on debt held by an affiliate, which, because of its relationship to the debtor, would not take any actions adverse to the company for missing the payment. Nevertheless, these technical defaults require CDS sellers to pay the CDS buyers the amounts due under the CDS contract. But the result perverts market expectations: a company otherwise able to pay its debts defaults. The CDS seller must pay under the CDS contract, even though the seller correctly evaluated the company’s ability to pay. The CDS buyer, who incorrectly assessed the company as a default risk, receives payment as if its assessment were correct.
In Hovnanian, Quinn Emanuel brought claims for violations of Sections 10(b), 14(e), and 20(a) of the Securities Exchange Act asserting a cross-market manipulation theory. After significant market attention, the CDS buyers and the Company agreed to a settlement.
ISDA’s proposed amendments come on the heels of the Hovnanian case. These proposed amendments would change the definition of “failure to pay” set forth in the 2014 ISDA Credit Derivatives Definitions to add a “credit deterioration requirement.” If the credit deterioration requirement is included in the CDS contract, a failure to pay would not trigger payment under the CDS contract “if such failure does not directly or indirectly either result from, or result in, a deterioration in the creditworthiness or financial condition of the Reference Entity.” Proposed Amendments, Annex 1, para. 1.2. Together with the proposed amendments, ISDA published a memo to provide interpretive guidance describing whether this requirement has been met in a given situation by setting out a “non-exhaustive list” of considerations, many of which reflect the experience of the Codere-Hovnanian manufactured default. Proposed Amendments, para. (b)(2); id., Annex 1, para. 2.10(a)-(f).
The proposed amendment to the definition of “failure to pay,” however, fails to address manufactured non-defaults, which have recently created their own controversy. Manufactured non-defaults involve strategies by CDS sellers to avoid paying out on CDS contracts by taking steps to ensure that a company does not default even when the company would otherwise be unable to pay its debts as they come due. The RadioShack CDS are a prime example. With RadioShack, CDS sellers had received significant payments from CDS buyers on CDS that expired December 20, 2014. To ensure that RadioShack did not default before that date, the CDS sellers agreed to a “rescue package” that would keep RadioShack afloat temporarily. As a result, the CDS sellers kept the payments made by CDS buyers even though RadioShack probably would have otherwise defaulted before December 20. CDS buyers asked ISDA to declare a credit event anyway, but ISDA declined to do so.
Another manufactured non-default strategy used by CDS sellers is known as CDS “orphaning,” attempted recently for CDS referencing newspaper publisher McClatchy Co. At a point when McClatchy was clearly headed toward default, it agreed with a CDS seller to refinance its debt using a wholly owned subsidiary to take out new loans that were used to pay the parent company’s debts. As a result, McClatchy’s debts were paid in full, thereby ensuring the CDS seller would not have to pay out under the CDS contracts. The fact that the subsidiary might default on its debt was irrelevant because the CDS contracts did not protect against the subsidiary’s default. Thus, the CDS seller was paid by CDS buyers to protect against an essentially default-proof investment.
The proposed amendments fail to account for these CDS seller strategies because they rely on the occurrence of a “failure to pay.” Admittedly, addressing manufactured non-defaults through an amendment is more difficult because, in a manufactured non-default, a credit event never occurs and CDS payments are never triggered. One way to address manufactured non-defaults may be to make a “restructuring” credit event—which occurs when there is a reduction in, or change in the composition of, principal or interest payments, a postponement in these payments, or a change in the priority of payments—a standard credit event in North American CDS contracts, just as it is in European CDS contracts. But there are reasons why restructuring typically is not a credit event in North American CDS contracts—including the complexity in determining when a restructuring is a credit event and its lack of a counterpart in CDS index trades—and these reasons may outweigh the benefits, suggesting that other solutions should be favored. ISDA opened the proposed amendments to a comment period through April 10, 2019. On May 24, 2019, ISDA published a second proposed amendment aimed at clarifying the definition of Original Principal Balance, with a comment period open through June 17, 2019. This additional proposed amendment does not address manufactured non-defaults. ISDA has not yet published additional responses. As ISDA responds to comments it receives on the proposed amendments, it will be interesting to see if ISDA chooses to broaden the amendments to address other strategies like manufactured non-defaults or if ISDA leaves manufactured non-defaults and other strategies to be addressed at a later date.