On 6 March 2019 the International Swaps and Derivatives Association (ISDA) published proposed amendments(1) to the 2014 ISDA Credit Derivatives Definitions(2) relating to so-called 'narrowly tailored credit events' (NTCEs). ISDA describes an NTCE as an arrangement with a corporation which causes a credit event that results in settlement of credit default swap (CDS) contracts, while having minimal impact on the corporation. However, its proposed amendments relate only to 'failure to pay' credit events. The amendments would – if adopted and when applicable to relevant credit derivatives transactions – require a subjective determination that a failure to pay credit event resulted from or resulted in a deterioration in the creditworthiness or financial condition of the reference entity. This requirement would mark a significant departure from current practice. If adopted, it is expected that market participants will use the amended definition for new CDS contracts and that, in due course, a market protocol will provide market participants the opportunity to apply the amended definition to existing credit derivative transactions.
The proposal comes in the wake of concerns raised by market participants over certain failure to pay credit events, or claimed failure to pay credit events, that have occurred in recent years. In particular, the 2017 agreement by Hovnanian Enterprises to default on an interest payment to an affiliate in order to obtain favourable refinancing terms from GSO Partners received significant attention. Under CDS contracts with Solus Alternative Asset Management LP, GSO would be paid out on Hovnanian's default if such default was considered a failure to pay credit event. Solus sought an injunction to block the arrangement, which was denied, and followed with an action accusing Hovnanian and GSO of market manipulation under Section 10(b) of the Securities Exchange Act 1934 and Rule 10b-5 thereunder.(3) The matter was ultimately settled in a manner that allowed Hovnanian to make the interest payment on which it defaulted prior to the expiration of the grace period, such that a failure to pay credit event would not be triggered in the CDS contracts.(4)
Prior to the settlement, both the Commodity Futures Trading Commission (CFTC) and the ISDA board of directors released statements that generally criticised arrangements that appear to involve intentional or manufactured credit events.(5) The CFTC stated that these may constitute market manipulation and could damage the integrity of CDS markets. The ISDA board of directors stated that it intended to consider amendments to the ISDA Credit Derivatives Definitions to address such situations.
The ISDA working group expressed concern that NTCEs can create incentives for a corporation and protection buyers under a CDS contract referencing that corporation to "engineer" a payment default inconsistent with the "normal incentives of borrowers and lenders". ISDA, as well as other market participants, has noted that it is difficult to devise a definition of 'NTCE' that is comprehensive, objective and not subject to the risk of gaming or abuse. However, the proposal takes the position that a distinguishing feature of an NTCE is that it is not the result of, and will not result in, a deterioration in creditworthiness or financial condition of the reference entity.
To address the concerns described above, the working group is proposing to amend the definition of 'failure to pay' to include a requirement (which can be applied by protocol adherence and so will be stated in the trade confirmation) that the failure to pay resulted from, or results in, a deterioration in the creditworthiness or financial condition of the reference entity.
Specifically, the definition of 'failure to pay' in Section 4.5 of the 2014 Credit Derivatives Definitions would be amended as follows:
Section 4.5. Failure to Pay. 'Failure to Pay' means, after the expiration of any applicable Grace Period (after the satisfaction of any conditions precedent to the commencement of such Grace Period), the failure by the Reference Entity to make, when and where due, any payments in an aggregate amount of not less than the Payment Requirement under one or more Obligations, in accordance with the terms of such Obligations at the time of such failure. If 'Credit Deterioration Requirement' is specified as applicable in the related Confirmation, then, notwithstanding the foregoing, it shall not constitute a Failure to Pay 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. (Emphasis added.)
ISDA has also prepared proposed guidance on the interpretation of the credit deterioration requirement. The guidance assumes that the relevant credit derivatives determinations committee (DC) or external review panel would make the determination of whether an event constitutes a failure to pay; however, the principles are intended to apply even if the interpretation is made on a bilateral basis.
Notably, the credit derivatives DC may consider eligible information available to it at the time of its determination and is not obliged to conduct further investigation. The DC may presume that the credit deterioration requirement is met in the absence of eligible information to the contrary. The guidance notes that there must be a causal link between non-payment and creditworthiness deterioration such that either:
- the creditworthiness deterioration causes the non-payment; or
- the non-payment causes the creditworthiness deterioration.
Information that would tend to indicate that the credit deterioration requirement has not been met includes, but is not limited to:
- non-payment that results from an arrangement with the reference entity whereby the essential purpose is to benefit under a credit derivatives transaction through triggering a credit event through such non-payment;
- non-payment that did not accelerate the reference entity's other debt obligations or cause them to become capable of being accelerated;
- the reference entity having access to sufficient liquidity to pay its debts and no eligible information suggested non-payment had a technical, administrative or operational cause;
- non-payment that is promptly cured following the relevant grace period; or
- non-payment that relates only to debt unlikely to be accelerated or subject to enforcement.
The guidance also listed the following information that would tend to indicate that the credit deterioration requirement has been satisfied if:
- the reference entity announces that it is in financial distress or eligible information indicates that the reference entity was in financial distress or considering restructuring its debts;
- non-payment is due to a creditor process overseen by a court or independent insolvency official;
- non-payment relates to debt obligations held by numerous parties;
- non-payment results from the reference entity being unable to refinance;
- non-payment occurs on a payment date scheduled under the terms of the debt obligation at the time it was incurred or, if amended, was scheduled well before the non-payment date;
- other reference entity debt obligations are accelerated or becoming capable of acceleration; or
- the reference entity fails to pay other debt obligations or is subject to a bankruptcy event.
The guidance further states that if a reference entity enters into a forbearance, standstill or other similar arrangement with its creditors for bona fide commercial purposes due to a deterioration in creditworthiness or financial condition, this would likely satisfy the credit determination requirement. Also, if a reference entity enters into an arrangement or understanding with creditors – which have hedged their exposure to the reference entity through credit derivatives that includes a failure to pay, with the purpose of causing settlement of such derivatives so as to increase the likelihood of a successful bona fide restructuring – this would generally be considered to have the essential purpose of facilitating restructuring rather than creating a benefit under the credit derivative transaction.
The proposal also makes an unrelated additional amendment to the description of the calculation of 'outstanding principal balance' such that the applicable laws to be considered in determining the quantum of the claim component of such balance must include any bankruptcy or insolvency law affecting creditors' rights to which the relevant obligation is, or may become, subject.
ISDA has sought comments from market participants on the amendment. ISDA has also stated that it is discussing the proposal with relevant regulators, which may have views on the amendment in light of the concerns previously raised by the CFTC and others concerning intentional or manufactured credit events.
If ISDA and market participants determine to move forward with the amendment, it is expected that it would be incorporated into new standard CDS transactions (through an amendment to the CDS physical settlement matrix) and existing transactions (through an ISDA protocol to which market participants could adhere).
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Endnotes
(1) See ISDA, "Proposed Amendments to the 2014 ISDA Credit Derivatives Definitions Relating to Narrowly Tailored Credit Events" (6 March 2019).
(2) See ISDA, "2014 ISDA Credit Derivatives Definitions" (30 June 2014).
(3) Solus Alternative Asset Management LP v GSO Capital Partners LP 18-CV-00232-LTS-BCM, Docket 69 (29 January 2018).
(4) See Andrew Scurria, "Blackstone Stands Down on Hovnanian Swaps Wager", The Wall Street Journal (30 May 2018).
(5) See ISDA, "ISDA Board Statement on Narrowly Tailored Credit Events" (11 April 2018); and CFTC, "Statement on Manufactured Credit Events by CFTC Divisions of Clearing and Risk, Market Oversight, and Swap Dealer and Intermediary Oversight" (24 April 2018).
