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Colin Rice, partner and head of the Asian derivatives & structured products team at Norton Rose Fulbright, discusses International Swaps and Derivatives Association’s (ISDA’s) recently published 2019 Narrowly Tailored Credit Event Supplement to the 2014 ISDA Credit Derivatives Definitions.
On 15 July 2019 ISDA published the 2019 NTCE Supplement to the 2014 ISDA Credit Derivatives Definitions (2014 Definitions) following consultation with market participants to address issues with narrowly tailored credit events (NTCE Supplement). The NTCE Supplement is intended to be applied by market participants to new credit default swap (CDS) contracts and also incorporated into existing CDS contracts by adherence by market participants to the ISDA 2019 NTCE Protocol published on 27 August 2019.
Concerns have been raised by market participants, the ISDA board of directors and the Commodity Futures Trading Commission in relation to narrowly tailored credit events, being certain arrangements with corporations that appeared to involve intentional or ‘manufactured’ failure to pay credit events leading to settlement of CDS contracts but with minimal impact on the corporation (Narrowly Tailored Credit Events). The 2019 NTCE Supplement is intended to restore confidence in the efficiency, reliability and fairness of the CDS market.
The 2019 NTCE Supplement also seeks to address market concerns in relation to potential distortions to the value of physical settlement created by obligations issued at a discount being used for physical settlement.
The nature of Narrowly Tailored Credit Events means that it is not possible to devise an exhaustive definition that would capture all such arrangements so the NTCE Supplement instead focuses on the common feature that distinguishes Narrowly Tailored Credit Events from normal payment defaults which is that they do not result from, or in, the deterioration in creditworthiness or financial condition of the reference entity.
The NTCE Supplement amends the ‘Failure to Pay’ credit event to add a requirement that the relevant non-payment must directly or indirectly either result from, or result in, a deterioration in the creditworthiness or financial condition of the reference entity (Credit Deterioration Requirement). Parties must specify that the Credit Deterioration Requirement is applicable in the relevant confirmation.
In addition, and unusually, the NTCE Supplement incorporates a new guidance note as Exhibit F to the 2014 Definitions which is intended to assist in the determination of whether the Credit Deterioration Requirement is satisfied in relation to a non-payment such that it will constitute a ‘Failure to Pay’ credit event. The guidance note assumes that the credit derivatives determinations committee will be responsible for making the determination of whether a ‘Failure to Pay’ credit event has occurred but its principles are intended to apply equally if the question is referred to an external review panel by the determinations committee or if the question is being determined on a bilateral basis.
The guidance note sets out:
that there must be a causal link between the non-payment and the deterioration in the creditworthiness or financial condition of the Reference Entity—the failure to pay need not only be the result of such deterioration. A failure to pay which is caused by a technical, administrative or operational issue which subsequently causes a deterioration in the creditworthiness or financial condition of a Reference Entity would therefore still constitute a ‘Failure to Pay’ credit event
a non-exhaustive list of factors which may indicate that the Credit Deterioration Requirement has not been satisfied, being where the relevant non-payment:
arose from an arrangement or understanding between the reference entity and one or more entities with the essential purpose of the arrangement or understanding is to create a benefit under a CDS transaction to a buyer or seller of credit protection by virtue of the triggering of a credit event due to such non-payment
arose from an arrangement or understanding described in sub-paragraph (i) above, and as part of such arrangement or understanding, the reference entity agrees to issue or incur either (A) a new debt obligation which would likely be the cheapest-to-deliver deliverable obligation in any CDS auction following such ‘Failure to Pay’ credit event; or (B) a material amount of additional debt obligations that would constitute deliverable obligations in any such CDS auction
did not result in the reference entity’s other debt obligations being accelerated or becoming capable of being accelerated
did not have a technical, administrative or operational cause and the reference entity had access to sufficient liquidity to pay its debts as they fell due
was promptly cured following the expiry of the relevant grace period, or
related only to debt obligations which were unlikely to be accelerated or subject to enforcement action
a non-exhaustive list of factors which may indicate that the Credit Deterioration Requirement has been satisfied, being:
the reference entity previously appointed professional financial advisers that specialise in restructuring and/or insolvency situations
the relevant non-payment occurred pursuant to a creditor process which was overseen or approved by a court or independent insolvency official
the relevant non-payment occurred related to debt obligations which were held by a number of parties
the relevant non-payment occurred as a result of the reference entity being unable to refinance its debt obligations
the relevant non-payment occurred on a scheduled payment date under the terms of the debt obligation at the time it was originally incurred or if such payment date was amended, it was amended well before the date such non-payment occurred, or
regarding whether the non-payment directly or indirectly resulted in a deterioration in the creditworthiness or financial condition of the Reference Entity, any of the following occurs:
the reference entity to fail to pay its other debt obligations, and/or
a ‘Bankruptcy’ credit event occurs in respect of the reference entity
guidance in the context of forbearance, standstill and other arrangements by a reference entity with its creditors and indicative factors as to whether such arrangements would be considered to have been for bona fide commercial reasons, including the facilitating of a debt restructuring, or for the essential purpose of creating a benefit under CDS contracts
The ‘Original Principal Balance’ of an obligation under the 2014 Definitions determines the principal amount of that obligation that must be delivered to physically settle a CDS contract, including the physically-settled contracts entered into pursuant to a CDS auction. Part of the definition of the ‘Original Principal Balance’ provides for the ‘Original Principal Balance’ of an obligation to be determined as the quantum that could be claimed in relation to that obligation in accordance with applicable laws that reduce or discount the size of the claim to reflect the original issue price or accrued value of the obligation. Where bonds are issued at a substantial discount to their principal amount, but applicable laws would not reduce the size of the claim, that bond could be delivered for its full principal amount for CDS purposes. In an effort to address market concerns in relation to distortions created by obligations issued at a discount, ISDA has amended the definition of ‘Outstanding Principal Balance’ so that the quantum of the claim shall be determined in accordance with any applicable laws, which will now include any bankruptcy or insolvency law to which the relevant obligation is, or may become, subject. This amendment gives the determinations committee additional discretion to discount obligations pre-bankruptcy on the basis that the applicable bankruptcy or insolvency laws would discount the relevant obligation post-bankruptcy, which should give the determinations committee further leeway to prevent such distortions in the market.
An additional option to elect for ‘Fallback Discounting’ to apply has also been incorporated which sets out a methodology for determining the Original Principal Balance of an obligation issued at a discount in circumstances where applicable laws do not have the effect of reducing the claim from the principal amount of such obligation.
The market has welcomed ISDA taking steps to address the two contentious issues dealt with in the NTCE Supplement, but it remains to be seen what proportion of the market adheres to the ISDA 2019 NTCE Protocol.
In relation to Narrowly Tailored Credit Events:
the broad drafting of the Credit Deterioration Requirement such that non-payment can ‘indirectly… result … from… a deterioration in the creditworthiness or financial condition of the reference entity’ could mean that even where there is a manufactured arrangement between a reference entity and its lender to default on its debt obligations, if such arrangement occurs against a backdrop of financial distress the non-payment could be said to be the indirect result of a deterioration in the creditworthiness or financial condition of the reference entity and so still potentially satisfy the Credit Deterioration Requirement—we will have to wait and see how the determinations committee deals with this if the point is raised
in the absence of a public statement by a reference entity there may be a paucity of information relating to the cause of a payment default, meaning the determinations committee may struggle to assess the situation in detail and make an objective determination on the basis of publicly available information, and
finally, some market participants have highlighted that Narrowly Tailored Credit Events relate solely to manufactured payment defaults. Other manufactured arrangements are outside of the scope of the NTCE Supplement including ‘manufactured non-defaults’ where steps are taken to prevent a reference entity from defaulting on its debt to avoid triggering CDS contracts or the deliberate ‘orphaning’ of CDS by restructuring the debt which is subject to the CDS contract, both of which have the potential to undermine confidence in the CDS market further
In relation to the amendment to the ‘Original Principal Balance’ definition and discounted obligations, there is a concern that the determinations committee may be required to consider bankruptcy or insolvency law issues in respect of original issue discounted obligations in circumstances which have not yet been tested in the courts.
Interviewed by Emma Millington.
The views expressed by our Legal Analysis interviewee are not necessarily those of the proprietor.
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