Decision Time for the ISDA

Decision Time for the ISDA 2019 Narrowly Tailored Credit Events Protocol

The Situation: The International Swaps and Derivatives Associations, Inc. ("ISDA") is in the process of amending its credit derivatives documentation to address concerns market participants and regulators have raised regarding narrowly tailored credit events ("NTCEs").

The Result: Following up on the Narrowly Tailored Credit Event Supplement ("NTCE Supplement") it published in July 2019, ISDA published the ISDA 2019 NTCE Protocol ("NTCE Protocol") on September 16, 2019, which should enable parties to efficiently amend many of their outstanding credit default swaps ("CDS").

Looking Ahead: Market participants have less than a month to decide whether or not to adhere to the NTCE Protocol.

September 16, 2019, marks the opening of the public adherence window for the NTCE Protocol. Unless the October 14, 2019, cutoff date is extended, parties to uncleared CDS have less than a month to decide whether or not to adhere. The NTCE Protocol is expected to amend all outstanding corporate CDS between adhering parties as of January 13, 2020, ("Implementation Date") by incorporating the terms of the NTCE Supplement to the 2014 ISDA Credit Derivatives Definitions ("Definitions") into those transactions. This Commentary provides a brief background on NTCEs, the NTCE Supplement, and the NTCE Protocol.

NTCEs are defaults that are significant enough to trigger credit events on CDS referencing a company ("Reference Entity") but narrow enough to avoid impairing the company's debt. They typically involve an agreement between the Reference Entity and a party that has bought CDS protection on it ("Protection Buyer"). The Protection Buyer extends financing to the Reference Entity on favorable terms and the Reference Entity commits to default on a debt payment, allowing the Protection Buyer to profit on CDS purchased from third parties. NTCEs date back to the 2013 refinancing of Spanish gaming company Codere, but it was the 2017 refinancing of home-builder Hovnanian Enterprises that really caught the attention of the industry and its regulators.

Hovnanian's refinancing was novel in that it included both an agreement to withhold bond interest payments (which was expected to trigger a credit event) and the creation of new original issue discount ("OID") debt (which was expected to amplify the payout upon that credit event). Shortly after the financing was announced, a CDS seller sued both Hovnanian and the Protection Buyer that financed it on market manipulation grounds. The payment default (and resulting credit event) never actually occurred, as the parties reached a settlement just before the relevant cure period lapsed, but not before both ISDA's Board of Directors and the CFTC voiced concerns regarding NTCEs and their impact on the CDS markets. Other regulators would soon join the chorus.

The industry's response was the NTCE Supplement, which ISDA published in July 2019 following consultations it commenced in March and May 2019. The NTCE Supplement amends two provisions of the Definitions: the definitions of "Outstanding Principal Balance" in Section 3.8 and "Failure to Pay" in Section 4.5.

Outstanding Principal Balance has been modified to address concerns about parties conspiring to create OID debt in order to enhance CDS payouts upon a credit event. The revised definition provides two ways to discount the overstated face amount of such debt for CDS purposes. First, it specifies that any bankruptcy or insolvency law that would have the effect of reducing the principal balance of an obligation for bankruptcy claim purposes can also be applied in the CDS context, even when the Reference Entity is not bankrupt or insolvent. Second, when no such laws are applicable, it calls for obligations issued for less than 95% of their stated principal amount to be automatically haircut though a mechanism called "Fallback Discounting."

The change to Failure to Pay was intended to address NTCEs by introducing a "Credit Deterioration Requirement" for that credit event. If the Credit Deterioration Requirement is applicable, a payment default "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." This concept, which has roots in the definition of "Restructuring" (a standard credit event in most of the world but not the Americas), may very well discourage the future use of NTCEs, but it also may inject subjectivity and uncertainty into Failure to Pay determinations.

The NTCE Supplement will apply to all standard uncleared CDS that are entered into on or after the Implementation Date, and it is expected that CCPs will modify their rules so that the NTCE Supplement's terms will also apply to all cleared CDS entered into after that date. The NTCE Protocol is a way for parties to amend their existing CDS with other adhering parties so that the NTCE Supplement will also apply to those trades following the Implementation Date.

There are several variables for parties to consider when deciding whether or not to adhere to the NTCE Protocol, including the direction and composition of their portfolios and the potential for basis or liquidity issues to arise following the Implementation Date, so parties should not hesitate to seek advice of counsel.

Three Key Takeaways

  1. The terms of the NTCE Supplement are expected to apply to all standard corporate CDS entered into after the January 13, 2020, Implementation Date.
  2. Parties must decide before October 14, 2019, whether they want those terms to also apply to their outstanding uncleared CDS.
  3. Given the tight timeframe and complexity of the issues, market participants should not hesitate to seek advice of counsel.


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