Thu 03/07/2019 11:36 AM
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Relevant Document:
Proposed Amendments

On Wednesday, an International Swaps and Derivatives Association, or ISDA, working group comprising members of ISDA’s Credit Steering Committee and additional ISDA members “active in the CDS market” posted proposed amendments to the 2014 ISDA Credit Derivatives Definitions intended to “address issues relating to narrowly tailored credit events,” or NTCEs (emphasis added). In April 2018, ISDA published a statement from its board of directors “noting concerns with the impact of [NTCEs] on the efficiency, reliability and fairness of the overall CDS market.”

According to the document, NTCEs are “arrangements with corporations that cause a credit event leading to settlement of CDS contracts while minimizing the impact on the corporation.” The release adds that while the working group has not yet completed its work, the proposed amendments “represent some of the most important aspects of the proposed changes agreed by the working group to date.”

NTCEs and their effect on the CDS market and its participants have been a topic du jour considering recent CDS-triggering transactions. In February, Reorg hosted a panel - an audio recording of which can be found here - discussing, among other things, the regulatory landscape for the CDS market.

The working group proposes the following two amendments (discussed further below):
 
  • An amendment to the failure to pay definition to “add a requirement that the relevant payment failure result from or in a deterioration of creditworthiness or financial condition of the Reference Entity” (emphasis added).
     
  • A clarification that the “applicable law” used in determining the “Quantum of the Claim” with respect to the “Outstanding Principal Balance” includes any bankruptcy or insolvency law that would apply to a reference entity.

According to the ISDA release, feedback on the proposed amendments is due March 27 by email to isdalegal@isda.org with the subject line, “NTCE Proposal Feedback.”

Background

The working group explains that if a payment default “is arranged in such a way that it will have no or minimal impact on a borrower or its general creditors in the cash market, but is a Credit Event for CDS contracts referencing the borrower as Reference Entity, it can create an incentive for the Reference Entity and CDS contract holders to engineer a payment default that does not reflect the normal incentives of borrowers and lenders.” That “divergence” could reduce the efficiency of CDS as a barometer of credit risk, according to the working group.

Further, the working group adds that while it “is not possible” to exhaustively define narrowly tailored payment defaults, a common distinguishing feature of NTCEs is “that they do not result from or in the deterioration in creditworthiness or financial condition of the Reference Entity.” Accordingly, the cause of a payment default “is not directly observable and must be inferred from the information available,” which introduces subjectivity in determining whether a credit event occurred and “in turn may create some level of uncertainty as to whether such payment default resulted from or in the deterioration in creditworthiness or financial condition of the Reference Entity.” The working group says that it is “desirable that a regular payment default, including one that occurs in the context of a standstill agreement, should continue clearly to qualify as a Failure to Pay Credit Event for CDS contracts” (emphasis added).

Proposed Amendment to Failure to Pay Definition

The working group proposes that the definition of “Failure to Pay Credit Event” be amended to “add a requirement that the relevant payment failure result from or in a deterioration in creditworthiness or financial condition of the Reference Entity,” with such requirement applying to corporate and financial reference entities but not sovereign reference entities. A guidance memorandum would be published to provide additional clarity, according to the working group. The memo would set out the purpose of the requirement and a nonexhaustive list of factors to be taken into account in making a determination under the new failure to pay determination test.

According to the proposal, changes would be made to existing transactions by an ISDA protocol, and for the changes to be effective, participants would need to adhere to the protocol.

Annex 1 of the document includes the proposed amendment and the text of the guidance memo. The amendment and guidance memo introduce a “Credit Deterioration Requirement” for all corporate and financial transaction types into the “Failure to Pay” determination, with the proposed revised section 4.5 of the 2014 ISDA Credit Derivatives Definitions to now include the underlined text:
 
“‘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.

Guidance on the interpretation of ‘Failure to Pay’ is set forth in Exhibit F.’”

The guidance memo provides several guidelines with respect to the assessment of the “Credit Deterioration Requirement.” According to the memo, “[T]he financial condition of the Reference Entity at the time it fails to pay is not conclusive as to whether or not such non-payment resulted from, or resulted in, a deterioration in the creditworthiness or financial condition of the Reference Entity,” but rather, “there must be a causal link between the non-payment and the deterioration in the creditworthiness or financial condition of the Reference Entity.” The memo adds that while “the expectation is that the Credit Deterioration Requirement would generally be met by way of a non-payment resulting from such deterioration, the Credit Deterioration Requirement may also be met by a non-payment that results in such deterioration.”

The guidance notes that the Determinations Committee “will have regard to the broader context in which the non-payment occurred” and that the factors are not exhaustive and no single factor is conclusive.

Under the proposed amendments, eligible information that would be indicative of the Credit Deterioration Requirement not being satisfied includes:
 
  • “[T]he non-payment arises directly from an arrangement or understanding (whether or not evidenced in writing) between the Reference Entity and one or more entities where an essential purpose of the arrangement or understanding is to create a benefit under a Credit Derivative Transaction referencing such Reference Entity to either a buyer or seller in such capacity by virtue of triggering a Credit Event due to such non-payment.
     
  • An arrangement or understanding within the scope of sub-paragraph ... above is entered into and, as part of such arrangement or understanding, the Reference Entity agrees to issue or incur either: (i) a new debt obligation which is likely to be the cheapest-to-deliver Deliverable Obligation in any Auction resulting from the Credit Event triggered by such non-payment (i.e. the new debt obligation would trade at a lower value compared to the other debt obligations that could be delivered into the relevant Auction); or (ii) a material amount of additional debt obligations that would constitute Deliverable Obligations in such an Auction.
     
  • The non-payment did not result in the Reference Entity’s other debt obligations generally being accelerated or becoming capable of being accelerated.
     
  • The Reference Entity had access to sufficient liquidity to meet its debt obligations as they were scheduled to fall due and there is no Eligible Information that such nonpayment had a technical, administrative or operational cause.
     
  • The non-payment was promptly cured following the expiry of the relevant grace period, including a Grace Period deemed under the Definitions.
     
  • [T]he non-payment related only to debt obligations held by affiliates or other persons not likely to accelerate or take enforcement action.”

Eligible information that under the proposed amendments would be indicative of the Credit Deterioration Requirement being satisfied includes:
 
  • “The Reference Entity previously announced that it was in financial distress and/or seeking to restructure its debt obligations prior to the non-payment occurring, or other Eligible Information indicates that this is the case (such as the entry into the sort of forbearance, standstill or other similar arrangement with creditors ...).
     
  • The Reference Entity previously appointed professional financial advisors that specialize in restructuring and/or insolvency situations.
     
  • The non-payment occurs pursuant to the terms of a creditor process that is overseen by or approved by a court or independent insolvency official.
     
  • The non-payment related to debt obligations that were, at the time of the non-payment, held by a number of parties.
     
  • The non-payment occurred because the Reference Entity was not able to refinance (including as a result of general market conditions or external factors) in order to meet its debt obligations when due.
     
  • The payment date on which the non-payment occurred was a scheduled payment date under the terms of the debt obligation at the time such debt obligation was originally incurred; or if such payment date was amended, it was amended well before the date such non-payment occurred.
     
  • Regarding whether the non-payment directly or indirectly resulted in a deterioration in the creditworthiness or financial condition of the Reference Entity, following or as a result of the non-payment, any of the following occurs: (i) other debt obligations of the Reference Entity are generally accelerated or capable of acceleration; (ii) the Reference Entity fails to pay in respect of its other debt obligations; and/or (iii) a Bankruptcy occurs in respect of the Reference Entity.”

The guidance adds: “If a Reference Entity enters into a forbearance, standstill or other similar arrangement with its creditors for bona fide commercial reasons related to a deterioration in its creditworthiness or financial condition, this would rarely result in a determination that the relevant non-payment by the Reference Entity did not directly or indirectly result from a deterioration in the creditworthiness or financial condition of the Reference Entity” (emphasis added). According to the memo, information that may indicate that a forbearance, standstill or other similar arrangement was not entered into for bona fide commercial reasons related to the credit deterioration of a reference entity include: “(i) a Reference Entity has entered into such arrangement with its creditors other than on arm’s length terms, (ii) no written and binding agreement setting out the terms of such arrangement exists and/or (iii) such arrangement is not entered into between the Reference Entity and a significant portion of its creditors by value.”

The memo includes additional guidance with respect to the indicator providing that the Credit Deterioration Requirement may not be satisfied if an “essential purpose” of an arrangement is to create a benefit under a credit derivative transaction as follows:
 
“Creditors who have hedged their exposure to a Reference Entity using Credit Derivative Transactions may be likely to reject any restructuring of the Reference Entity’s debt obligations if the terms of such restructuring would impair the value of such Credit Derivatives Transactions. Accordingly, within the context of a bona fide debt restructuring, if the Reference Entity enters into an arrangement or understanding with such creditors that includes a failure to make a payment with the purpose of causing settlement of such Credit Derivative Transactions so as to increase the likelihood of success of such bona fide restructuring, and in circumstances where without such restructuring the Reference Entity would be likely to enter into bankruptcy or similar proceedings, such arrangement or understanding should generally be considered to have the essential purpose of facilitating such restructuring rather than creating a benefit under a Credit Derivative Transaction.”

Proposed Clarification to Outstanding Principal Definition

The working group also proposes clarifying the definition of “Outstanding Principal Balance,” which is determined by using the “Quantum of the Claim” under applicable law. The proposed clarification would add that determination in accordance with applicable law includes any bankruptcy or insolvency law that would apply to a reference entity if it were to enter bankruptcy or insolvency proceedings. According to the working group, this “would clarify that such rules will be relevant to determine the Quantum of the Claim where the Reference Entity is not currently in a bankruptcy or insolvency proceeding.”

According to the proposal, the clarification would be added to existing transactions by an ISDA protocol. Market participants “would need to adhere to the Protocol” in order for the clarification to be added.

Annex 2 of the document includes the proposed amendment, which uses the following language: “For the purposes of Section 3.8(a)(iii)(B), ‘applicable laws’ shall include any bankruptcy or insolvency law or other law affecting creditors’ rights to which the relevant obligation is, or may become, subject.” 
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