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Updates to Credit Default Swap Terms: Too Little, Too Late?

Credit default swaps became notorious financial instruments and symbols of financial engineering run amok during the 2007-8 financial crisis.  Once worth over $60 trillion a year, the credit default swap market has shrunk significantly, but it is still worth nearly $10 trillion a year. ((Inaki Aldasoro & Torsten Ehlers, The Credit Default Swap Market: What a Difference a Decade Makes, BIS Quarterly Rev., Jun. 2018, at 1, 2.))  A credit default swap is a financial derivative contract that pays out when a party defaults on their debt obligations, similar to insurance on someone else defaulting on their debt. ((Justin Kuepper, Credit Default Swap (CDS) Definition, Investopedia (last visited Mar. 13, 2019), https://www.investopedia.com/terms/c/creditdefaultswap.asp. ))  Last year, there was a large-scale controversy that roiled the credit default swap market in the United States; the dispute called into question the continuing existence of the market and highlighted concerns about the financial instruments. ((See generally Solus Alt. Asset Mgmt. LP v. GSO Capital Partners L.P. No. 18 CV 232, 2018 U.S. Dist. LEXIS 13961 (S.D.N.Y. Jan. 29, 2018).))

Beginning in 2017, a construction company called Hovnanian Enterprises was struggling economically and having trouble refinancing its debts on favorable terms. ((Id. at 8-9.))  GSO Capital Partners L.P., a fund that provides financing to distressed companies, came to the rescue. ((Id. at 9.))  GSO proposed a plan to Hovnanian: in return for providing favorable financing terms to Hovnanian, Hovnanian would agree to default on some of its debt. ((See id. at 11-12.))  The transaction would be a partial default, enough to trigger GSO owned credit default swaps on Hovnanian debt, but not enough to force Hovnanian to default on most of its debt in a larger scale debt default. ((Id. at 10-11.))  Hovnanian would have otherwise been able to pay its debts, so the failure to pay would have been manufactured primarily to trigger credit default swaps. ((Gabriel T. Rubin & Andrew Scurria, How Regulators Averted a Debacle in Credit-Default Swaps, Wall St. (Jul. 8, 2018), https://www.wsj.com/articles/how-regulators-averted-a-debacle-in-credit-default-swaps-1531047600.))  This limited default was designed to benefit both GSO and Hovnanian, but unsurprisingly, other parties were less than thrilled with the transaction. ((Id.))

After learning about the pending transaction., Solus Alternative Capital Management, the hedge fund supplying GSO with the credit default swaps on Hovnanian debt, sued for an injunction under various portions of the Securities Exchange Act of 1934 and tortious interference. ((Solus Alt. Asset Mgmt. LP v. GSO Capital Partners L.P. No. 18 CV 232, 2018 U.S. Dist. LEXIS 13961 (S.D.N.Y. Jan. 29, 2018) at 2.))  Solus Capital’s request for a preliminary injunction was denied due to lack of irreparable harm. ((Id. at 23.))  The denial of the preliminary injunction caused grave concern in the credit default swap markets. ((Rubin supra note 8.))  With forewarning of the situation, the Commodities Futures Trading Commission (“CFTC”) attempted to intervene to prevent the transaction from going through. ((Id.))  The CFTC went as far as to issue a warning statement about the transaction on its website raising concerns that the transaction could be considered market manipulation. ((The Commodity Futures Trading Commission (CFTC) Divisions of Clearing and Risk, Market Oversight, and Swap Dealer and Intermediary Oversight, Statement on Manufactured Credit Events by CFTC Divisions of Clearing and Risk, Market Oversight, and Swap Dealer and Intermediary Oversight (Apr. 24, 2018), https://www.cftc.gov/PressRoom/SpeechesTestimony/divisionsstatement042418?mod=article_inline.))

The transaction was resolved between the parties privately before the default was triggered, ((Rubin supra note 8.)) but the proposed structure of the transaction left many questions about the future of the credit default swap market.  Seeking to fill the void, the International Swaps and Derivatives Association (“ISDA”) has proposed changes to what should trigger a credit default swap contract. ((Christopher Whittall & Natalie Harrison, CDS Tweaks Aim to Boost Credibility of US$8trn Market, NASDAQ, (Mar. 11, 2019), https://www.nasdaq.com/article/cds-tweaks-aim-to-boost-credibility-of-us8trn-market-20190311-00671.))  Instead of merely failing to make a payment, companies may now also be required to experience financial deterioration which is designed to prevent any future manufactured defaults. ((Id.))  The new terms are not set to be mandatory, but will instead try to nudge all market participants to the new standards. ((Benjamin Bain, Silla Brush & Sridhar Natarajan, Wall Street Titans Cut Deal to Clean Up Shady CDS Trades, Bloomberg,(Mar. 6, 2019), https://www.bloomberg.com/news/articles/2019-03-05/wall-street-titans-said-to-cut-deal-to-clean-up-shady-cds-trades?srnd=premium.))

The ISDA changes are an interesting proposal, ((See Whittall supra note 16.)) and the changes could have probably solved the Hovnanian dispute, but the wording changes still leave the possibility of exploitation in the credit default swap market.  The Hovnanian dispute exposed deep questions around the moral hazard issues that are present in the credit default swap market and its relation to insurance principles.  One fundamental idea of insurance is that it should not be beneficial to trigger the insurance, and instead insurance should only be used as method to prevent loss and manage risk.  The extent to which credit default swaps function as insurance, as opposed to financial derivatives designed to allow betting on companies defaulting on their debt, is questionable, but in cases where credit default swaps are intended to function as risk mitigation against debt defaults further changes to the market may be warranted.

Instead of attempting to tweak the ISDA language for future credit default swap contracts, a larger change may be advisable.  A clearer rule should be formulated by market participants to eliminate manipulative transactions, or governmental regulation should be considered as a possible solution. One option that ISDA may wish to consider is some sort of good faith standard for companies that are attempting to trade in the credit default swap market.  If ISDA changes prove inadequate, which seems possible, the CFTC may also wish to issue updated regulations on credit default swaps and market manipulation.  A strong rule out of the CFTC could help to give the market confidence and help the image problem that faces credit default swaps.