Credit Derivatives

Novo Banco and CDS – A Post-Mortem


In 2014, the International Swaps and Derivatives Association, Inc. (“ISDA”), published the 2014 ISDA Credit Derivatives Definitions (the “Definitions”), which updated the 2003 ISDA Credit Derivatives Definitions.[1]

One of the most significant changes in the Definitions was the inclusion of a new credit event for “Governmental Intervention.”[2]  This credit event was intended to address concerns expressed in the market that the credit event for “Restructuring” may not cover certain measures actually taken by governments to support struggling entities, especially banks.  Governmental Intervention[3] is generally defined to include actions or announcements by a “Governmental Authority”[4] that result in, inter alia, the reduction in the rate or amount of interest payable by a reference entity, an expropriation or other event which mandatorily changes the beneficial holder of the relevant obligation, or a mandatory cancellation, conversion or exchange.  This event is similar to Restructuring in certain respects (for example, the reduction in the rate or amount of interest of an obligation may trigger both events).  However, unlike Restructuring, deterioration in creditworthiness is not required to trigger a Governmental Intervention.

It did not take long for this new credit event to be probed and tested by a set of straightforward, but unusual, facts that apparently were not specifically considered by the drafters. In August 2014, Banco de Portugal, the central bank of Portugal, applied resolution measures to Banco Espírito Santo, S.A. (“BES”), a bank organized in Portugal that was experiencing distress.  These measures included a €4.9 billion rescue package for BES, and the transfer of numerous assets, liabilities and deposit-taking operations from BES to a new “good bank,” Novo Banco, S.A. (“Novo Banco”).  However, on December 29, 2015, Banco de Portugal announced the re-transfer of five senior Euro-denominated bonds (having almost €2 billion in principal) from Novo Banco back to BES.[5]  This re-transfer resulted in significant losses to bondholders, up to 90% in secondary market trading.

It was clear that Banco de Portugal constituted a “Governmental Authority” and that it had taken a binding action pursuant to its resolution law. However, irrespective of the undeniable losses suffered by creditors,[6] there was an issue as to whether the re-transfer of the bonds at issue from BES to Novo Banco affected creditors’ rights in one of the ways specified in Section 4.8(a) of the Definitions.

In accordance with the standard practice in the credit default swap (“CDS”) market, purchasers of protection asked the relevant 15-member Determinations Committee (the “Committee”) to determine whether the central bank’s actions amounted to a Governmental Intervention, hence triggering protection payments under CDS contracts.  Under the relevant rules, an 80% supermajority (12 of 15 members) is required for a Committee to decide whether or not a credit event has occurred.[7]   The Committee fell just short of the required percentage, with 11 members voting that there was no Governmental Intervention.  Although the Governmental Intervention event was generally intended to protect investors from governmental actions negatively affecting the value of obligations, the majority of the Committee concluded that the transfer of debt to another institution did not constitute a “mandatory cancellation, conversion or exchange” and did not have “an analogous effect” to the events specifically enumerated in the definition of Governmental Intervention.

Nevertheless, without the required supermajority, pursuant to the relevant rules governing Committees, the matter was referred for “external review.”[8]  External reviews of Committee decisions are quite rare and entail at least three “experts” nominated by Committee members deciding the issue.  A unanimous decision is needed to override the Committee’s original “No” vote where, as here, over 60% of Committee members voted against the occurrence of a credit event.  On February 15, 2016, the external review panel released a unanimous decision to uphold the negative determination.  In short, the panel decided that the central bank’s transfer did not constitute a mandatory cancellation, conversion or exchange of the obligations, and was not analogous to those types of event.[9]  On the latter point, the panel stated that taking a broader review of the word “analogous” would result in this clause “dominat[ing] the whole of the definition, which is inconsistent with [the] careful and detailed drafting” of the definition.[10]

In addition to seeking a determination that a Governmental Intervention had occurred, protection buyers pursued one more potential avenue for payout under the Definitions: seeking a determination that a “successor” event had occurred with respect to CDS naming Novo Banco as reference entity. A successor event occurs under the Definitions if, generally, more than 25% of the relevant obligations of a reference entity are transferred to another entity and more than 25% of the relevant obligations of the reference entity remain with the reference entity.[11]  The Committee sought additional information from Banco de Portugal and Novo Banco to determine whether this threshold had been exceeded.  After receiving this additional information, the Committee unanimously decided on March 3, 2016 that a successor event did not occur.[12]

Many industry participants believed that the Governmental Intervention was designed to protect against precisely the type of result that precipitated from Banco de Portugal’s actions.  Nevertheless, the Committee concluded, and the external review panel agreed, that the actions of Banco de Portugal did not align with the requirements of the Definitions.  Thus, one lesson from this situation is that Determinations Committees may take a formalistic view of requirements under the Definitions, regardless of the scope of losses incurred by creditors or the spirit or purpose of the language in the Definitions.  CDS purchasers should take note and not overlook the precise words of the Definitions.

[1] The implementation date for the updated Definitions was September 22, 2014.

[2] For a more complete description of the changes to ISDA Credit Derivatives Definitions, click here.

[3] “Governmental Intervention” is defined in full, as follows:

(a) “Governmental Intervention” means that, with respect to one or more Obligations and in relation to an aggregate amount of not less than the Default Requirement, any one or more of the following events occurs as a result of an action taken or an announcement made by a Governmental Authority pursuant to, or by means of, a restructuring and resolution law or regulation (or any other similar law or regulation), in each case, applicable to the Reference Entity in a form which is binding, irrespective of whether such event is expressly provided for under the terms of such Obligation:

(i) any event which would affect creditors’ rights so as to cause:

(A) a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals (including by way of redenomination);

(B) a reduction in the amount of principal or premium payable at redemption (including by way of redenomination);

(C) a postponement or other deferral of a date or dates for either (I) the payment or accrual of interest, or (II) the payment of principal or premium; or

(D) a change in the ranking in priority of payment of any Obligation, causing the Subordination of such Obligation to any other Obligation;

(ii) an expropriation, transfer or other event which mandatorily changes the beneficial holder of the Obligation;

(iii) a mandatory cancellation, conversion or exchange; or

(iv) any event which has an analogous effect to any of the events specified in Sections 4.8(a)(i) to (iii).

Definitions, §4.8(a) (emphasis added).

[4] The term “Governmental Authority” includes, inter alia, any de facto or de jure government (or agency, instrumentality, ministry or department thereof), any court, tribunal administrative or other governmental, inter-governmental or supranational body and any authority or other entity designated as a resolution authority or charged with the regulation or supervision of the financial markets of the “reference entity” or some or all of its obligations.  Definitions, §4.9(b).

[5] It appears from Banco de Portugal’s announcement of the measure that it specifically selected these bonds because they were “intended for institutional investors.” See Banco de Portugal, Banco de Portugal approves decisions that complete the resolution measure applied to BES (December 29, 2015) (available at: Among other things, the central bank stated that “[t]he selection of the above-mentioned bonds was based on public interest and aimed to safeguard financial stability and ensure compliance with the purposes of the resolution measure applied to Banco Espírito Santo, S.A. This measure protects all depositors of Novo Banco, the creditors for services provided and other categories of unsecured creditors.” Id.

[6] Some US$430 million in net protection payments would be triggered if it was determined that a credit event had occurred.

[7] ISDA supported a decision of a Governmental Intervention having occurred, arguing that the re-transfer of the bonds at issue constituted a “conversion or exchange” or had “an analogous effect” to an exchange, and that a negative determination “would lead to an illogical outcome.” See ISDA Determinations Committee Request, Has a Governmental Intervention Credit Event occurred with respect to Novo Banco, S.A.? (December 30, 2015) (available at Specifically, ISDA argued as follows:

A decision that a Governmental Intervention has not occurred would lead to an illogical outcome where holders of the Transferred Bonds suffer a near complete economic loss for the arbitrary reason that they are institutional investors, but this loss is not mitigated by their CDS protection despite paying a higher premium for protections against the risk of governmental interventions.  This outcome will further diminish CDS’s efficacy as a tool to hedge credit risk and further erode confidence in the product. . . .  This action is taken under the “bail in” regime that the European banking regulators seek to implement, and is precisely the type of governmental intervention risk that the Definitions were designed to cover.

[8] Specifically, Section 4.1(a) of the 2014 ISDA Credit Derivatives Determinations Committees Rules (available at provides that “[a]ny DC Question relating to DC Resolutions to be made by Supermajority under . . . 3.1(c) (Credit Event Resolution) . . . shall be referred to the external review process described in this Section 4 (External Review) . . . if a Convened DC . . . holds a binding vote on, but is unable to Resolve by a Supermajority, such DC Question.”

[9] Among other things, the panel pointed to the use of the word “transfer” elsewhere in the Definitions and concluded that “it would seem . . . that the draftsman has deliberately decided not to include the expression of ‘transfer’ as an event within the definition of a [Governmental Intervention].”  Novo Banco External Review; Decision and Analysis of the External Review Panel of the ISDA EMEA Determinations Committee with respect to DC issue Number 2015123002 pursuant to Section 4 of the 2016 ISDA Credit Derivatives Determination Committees Rules, at 4 (February 15, 2016) (available at

[10] Id. at 6.

[11] Definitions, at §2.2(a). More specifically, in this case, if the Committee concluded that BES succeeded to more than 25% of Novo Banco’s relevant obligations but more than 25% of relevant obligations remained with Novo Banco, then the CDS would be divided accordingly into new CDS transactions with each of BES and Novo Banco, respectively, as the reference entity. See id. at §2.2(a)(iv) and 2.2(n).

[12] See ISDA EMEA Credit Derivatives Determinations Committee, Statement (March 3, 2016) (available at: It appears that, in addition to Novo Banco’s €7.35 billion of outstanding senior debt, the European Central Bank had provided Novo Banco with some €7 billion in loans. Therefore, €2 billion of re-transferred bonds constituted less than 25% of Novo Banco’s aggregate obligations at the time.

Greece Triggers Credit Event and Raises Questions for Sovereign CDS


On March 9th, the ISDA Determinations Committee for Europe unanimously concluded that The Hellenic Republic (Greece) had triggered a restructuring “credit event” under credit default swap (“CDS”) contracts in connection with the exchange of its debt with private creditors.  The committee’s determination was based in large part on the imposition and use by Greece of retroactive “collective action clauses” (“CACs”) on bonds governed by Greek law which bound all holders of such debt to the decisions of a supermajority.  In accordance with the 2003 ISDA Credit Derivatives Definitions, a restructuring credit event (whether due to a reduction of coupon, extension of maturity or other specified change) is not triggered unless the restructuring “occurs in a form that binds all holders.”

When it was first announced in October 2011, the Greek debt exchange appeared to be carefully structured to avoid a credit event by making the exchange with private investors voluntary.  However, as Greece’s economic situation deteriorated (or became more apparent) in the months that followed, private investors became more reluctant to participate, which precipitated the imposition of the CACs.  The final debt exchange deal with private investors, which is intended to help reduce the Greek debt load from 165 percent of GDP in 2011 to below 120 percent by 2020, resulted in a real loss of some 74% on bond holdings.[1]  On March 19th, ISDA held an auction for the Greek bonds and established a recovery rate of 21.5%, resulting in net payouts of some €2.89 billion (i.e., 78.5% of the approximately €3.7 billion net notional amount of protection out of some €80 billion in gross CDS notional).

Despite many commentators’ concerns, the settlement of CDS contracts in the wake of the determination of a Greek credit event did not lead to broader market turmoil and has been widely viewed as a success.[2]   Nevertheless, the CDS market’s experience in connection with Greece’s credit event, and other developments, have generated substantial apprehension and raised several questions regarding the future of the sovereign CDS market.  One of these questions is whether the sovereign CDS product, as it currently exists, can be too easily circumvented.  Specifically, many market participants expressed dissatisfaction when it became apparent that the Greek debt exchange, as it was originally proposed, would not trigger a credit event due to its “voluntary” nature, arguing that such a comprehensive restructuring should trigger protection payments under CDS contracts.  Although a credit event was eventually triggered, the confusion regarding the circumstances under which a credit event would occur in the case of a sovereign debt restructuring has led to calls to modify the relevant ISDA definitions to deal with similar situations in the future.[3]

Another concern has been voiced regarding the bonds deliverable in the ISDA settlement auction itself.  Specifically, auction bidders were primarily able to bid only on the new Greek law governed bonds issued in the Greek debt exchange, because the old bonds (other than international law governed bonds) generally had been retired and no longer existed at the time of the auction.  There was concern that the price of these new bonds, which necessarily looked to Greece’s risk profile after the extinguishment of debt through the bond exchange, would be higher than the price of the original bonds which, in turn, would lead to a lower CDS recovery rate.  Fortunately, and somewhat fortuitously, the price for the new bonds closely approximated the level of loss sustained by private sector investors.

Another concern is the potential impact of the European Union’s recent ban on “naked” sovereign CDS, which came into effect on March 25th, but will apply beginning November 1, 2012.  The ban, which includes certain exemptions, will be overseen by the European Securities and Markets Authority (“ESMA”).  However, the draft guidance published by ESMA[4] regarding the ban raises questions regarding how determinations of violations will be made.  For example, it appears that the ban could cover “cross border” situations where a market participant seeks to hedge exposure in a sector of one sovereign (e.g., Italian banks) by purchasing protection against the default of another sovereign (e.g., Cyprus).  The existence of the ban itself, and any confusion caused by the breadth of its potential enforcement, may lead some market participants to exit the sovereign CDS market.

[1] On April 25th, the Greek finance ministry announced that 96.9% of debt held by private bondholders (some €199 billion out of a total €205.5 billion) had been exchanged.

[2] Indeed, it remains to be seen whether the potential settlement of CDS contracts for a sovereign for which there are far larger volumes would lead to market panic and present systemic risk.  The approximately €3.7 billion net notional amount of CDS contracts on Greece at the time of its credit event is dwarfed by the current net notional amount of CDS contracts on other sovereigns, including approximately €22 billion on France and between €18-20 billion on each of Italy, Germany and Brazil.

[3] On a related note, the future involvement of clearinghouses in making determinations regarding CDS contracts (including whether credit events have occurred) has also become a recent topic of market discussion.

[4] ESMA’s draft technical advice on possible Delegated Acts concerning the regulation on short selling and certain aspects of credit default swaps (EC) No XX/2012) (15 Feb 2012).

Greece Inches Closer to Triggering a Credit Event


With an enormous €14.5 billion bond maturing on March 20th, Greece continues to negotiate with its private sector investors on the reduction of approximately €100 billion of its total €350 billion of debt. Agreement with these investors is intended to reduce the country’s debt from 160% of GDP to 120% of GDP by 2020 and is required in order for Greece to secure from the European Union and International Monetary Fund the second installment of bailout funds, approximately €130 billion, necessary for the country to avoid default. However, the negotiations have been complicated and, perhaps, compromised, not only by Greece’s economic deterioration, but also, at least to some extent, by the involvement of smaller private investors who have purchased Greek debt—and, in some cases, credit default swap (“CDS”) protection on Greece—since the deal was announced in October 2011. At that time, the expectation was that approximately 90% of debt holders would voluntarily agree to the terms of the restructuring, which generally entailed an exchange of existing debt for new, longer-dated bonds. There is now concern that, as currently contemplated, significantly fewer debt holders will voluntarily agree to the proposed terms of the restructuring. One reason for this appears to be the purchase (at a deep discount) of large amounts of Greek debt from banks by funds and others more insulated from political and other pressures to accept a restructuring. This has resulted not only in a decline in debt holders willing to participate in an exchange of debt, but also in the tougher negotiation of terms for the new debt.

The main sticking point in the discussions with private investors has been the coupon of the new debt. In a meeting in Brussels on January 23rd, the euro zone finance ministers rejected the private investors’ proposal that the new debt bear an average coupon of 4%. The Institute of International Finance, which represents the private investor banks and funds, had previously indicated that the 4% offer reflected the investors’ limit for an acceptable restructuring, as investors effectively were being asked to accept a real loss of approximately 70% on their debt (i.e., a reduction of some 50% of the face amount of debt, coupled with a lower coupon, longer maturity and other terms).[1] Even with such a deep haircut, certain observers (including Standard & Poor’s, which rates Greece at “CC”) remain skeptical as to whether a deal with private investors would constitute sufficient debt relief in light of the outlook for the country’s GDP, absent the much larger public sector of investors also taking a haircut.[2]

If Greece is unable to negotiate terms with private investors that are acceptable both to those investors as well as the euro zone ministers authorizing the release of bailout funds (and, of course, actually implement additional austerity measures reflecting several billions of euros in savings),[3] Greece likely will be unable to repay maturing debt as early as March 20th.[4] This would trigger a credit event under CDS contracts, and possibly precipitate Greece’s exit from the euro. Although the net uncollateralized payments that would be owed on Greek CDS are highly unlikely, in and of themselves, to present systemic risk, there is concern that a Greek default would severely shake financial markets.

Even if a deal is reached with private investors and the bailout funds are released, Greece appears to have inched closer to potentially triggering a credit event under CDS contracts. One reason for this is that the holdouts will have to be paid in full, gobbling vast amounts of liquidity and making a hard credit event in the future more likely. Alternatively, Greece could force all holders to accept a restructuring of debt by imposing (since Greek law governs most of the existing bonds) a retroactive collective action clause,[5] which would bind all holders to the decisions of some supermajority. The imposition of a collective action clause would be difficult for debt holders to challenge through a lawsuit, as such an action would likely have to be brought in Greece. However, that alternative is far from ideal, as use of such a clause would almost certainly result in a Restructuring credit event being triggered under the 2003 ISDA Credit Derivatives Definitions.

Until now, the Greek debt restructuring has been intentionally and carefully structured in a way that would not result in the triggering of a credit event under CDS transactions. Specifically, a Restructuring credit event (whether due to a reduction of coupon, extension of maturity or other specified change) is not triggered unless the event “occurs in a form that binds all holders” (emphasis added).[6] Certain market participants have argued that, formalities notwithstanding, the CDS product is simply not providing the contemplated protection, as the market expectation was that such a comprehensive restructuring would indeed trigger protection payments.[7] There have been market calls for revisiting the Restructuring credit event or, perhaps, adding a “soft” restructuring event that could be triggered in similar situations in the future. Nevertheless, any future credit derivatives market changes would not impact outstanding transactions, which are bound by existing terms.

[1] However, debt holders may be eligible for an enhanced payout in the event of an economic recovery. An offer of billions of dollars in short-dated bonds from the euro zone’s temporary rescue mechanism (known as the European Financial Stability Facility) has also been discussed as a potential “sweetener” for private investors.

[2] On a related note, the European Central Bank (the “ECB”) has indicated a willingness to forgo profits on its €40 billion Greek bond portfolio, which was expected to pay €55 billion at maturity, hence further reducing the Greece’s debt burden. The ECB is not able to take losses on its bonds, as this would be viewed as providing monetary financing of Greek government debt, which may be impermissible under relevant treaties.

[3] On February 9th, Greek leaders announced that the major parties had reached a deal on reforms and austerity measures (including budget cuts worth an estimated €3.3 billion) needed to obtain the bailout funds. This follows the February 6th announcement of the lay-off of 15,000 civil service workers.

[4] Note, however, that concern has been raised that the bond maturing on March 20th has a seven-day grace period, during which CDS protection may expire.

[5] Note that, beginning January 2013, it appears that euro zone governments will be required to include collective action clauses into new government bond issues having a maturity greater than one year pursuant to the terms of the permanent €500 billion bailout fund agreed to at an EU summit on January 30th.

[6] Note that parties to virtually all CDS contracts are bound to the decisions of the regional Determinations Committee as to whether a “credit event” has occurred (among other things), hence minimizing the potential for legitimate individual action by disaffected market participants.

[7] Despite this insecurity, based on the results of its most recent quarterly survey of European fixed-income investors, Fitch Ratings announced on February 8th that most investors continue to view sovereign CDS as a useful hedging tool.

IRS Issues Proposed Regulations Addressing CDS and Section 1256 Swap Exclusion


On  September 15th, the U.S. Treasury Department issued proposed regulations that would add credit default swaps and non-financial index derivatives to a revised definition of “notional principal contracts.”  The proposed regulations also provide guidance on the definition of swaps and similar agreements within the meaning of section 1256(b)(2)(B) of the Internal Revenue Code of 1986.  For a complete description of the proposed regulations in a recent Orrick Client Alert, please click here.

Federal Reserve Bank Publishes Report on CDS Market


On September 27th, the Federal Reserve Bank of New York published a staff report, titled An Analysis of CDS Transactions: Implications for Public Reporting (the “Fed Report”). The Fed Report analyzed three months of global credit default swap (“CDS”) transaction information (i.e., May through July 2010) and presents findings on market composition, trading dynamics and level of standardization. Among other things, the Fed Report was intended to contribute to the development of public reporting requirements and data collection in derivative industry reform efforts.

During the three-month investigation period, the Fed Report found that there were 292,403 transactions (including both single-name and index trades)[1] on 1,554 corporate and 74 sovereign reference entities. Of these, approximately two-thirds were single-name CDS transactions, the vast majority of which were on corporate names. The Fed Report further found that only some 3% of corporate names were “actively traded” (i.e., traded an average of at least 10 times per day during the period) and that CDS transactions tended to be traded in standard notional sizes, with corporate single-names most frequently traded in the $/€5 million mode and indices typically traded in modes of $10 million and $/€25 million. Both single-name and index transactions were most frequently traded in 5-year maturities. Also, 63% of all CDS transactions were between the 14 major over-the-counter derivatives dealers (the “G14”), with the remainder between G14 dealers and end users. Overall, G14 dealers acted as protection sellers 85% of the time and as protection buyers 78% of the time. The Fed Report determined that, on a daily basis, an average of some 3,000 single-name trades were executed for $25 billion of notional value and an average of some 1,450 index trades were executed for $74 billion of notional value.

Based on its examination of this and other trade data, the Fed Report made several conclusions, including that: (i) a high degree of product and trading practice standardization exists in the CDS market (with respect to contractual terms,[2] as well as notional sizes and maturities); (ii) there was no clear differentiation in trade sizes between CDS that were eligible for clearing at the time of investigation and those that were not, suggesting that there may be no reason to treat the two sets of transactions differently for trade reporting rule purposes; and (iii) large customer CDS trades are not hedged by dealers entering into offsetting trades using the same instrument soon thereafter, suggesting that requiring same-day reporting of CDS trading activity may not disrupt same-day hedging activity by dealers (since little such activity occurs),[3] although regulators should gauge the impact such reporting may have on dealers gradually trading out of positions.

[1] The Fed Report observed 57 distinct credit indices, with Europe iTRAXX and CDX North American Investment Grade collectively accounting for 40% of the index market.

[2] Indeed, the report found that, of the single-name contracts it examined, 92% had a fixed coupon and 97% had fixed quarterly payment dates.

[3] As noted in the Fed Report, the dealer community has expressed concern that public knowledge of large transactions (including perhaps through the real-time reporting requirements contemplated by the Dodd-Frank Act) creates the risk that others in the market will front-run dealer attempts to offset those transactions, hence increasing the cost of hedging.

Appellate Court Decides CSX Total Return Swap Case


On July 18th, the U.S. Court of Appeals for the Second Circuit (the “Second Circuit”) issued its long-awaited opinion in CSX Corporation v. The Children’s Investment Fund Management (UK) LLP, et. al.[1] The issue that made the case so closely-monitored by derivatives market participants was whether, and under what certain circumstances, a total return receiver (i.e., the “long” party) under a cash-settled total return equity swap should be deemed to be the “beneficial owner,” for purposes of Section 13(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”),[2] of the underlying shares its counterparty (i.e., the “short” party) purchases to hedge its position.

CSX Corp. (“CSX”) had attempted to enjoin two hedge funds (collectively, the “Funds”) from voting their shares in a proxy contest to elect certain candidates to its board of directors. CSX claimed that the Funds acted together as a “group” and should have been deemed to have beneficially owned, in the aggregate, more than 5% of CSX’s stock, both outright and as long parties to cash-settled total return equity swaps with various banks. As such, the Funds should have disclosed that they had formed a “group” that owned more than 5% of CSX’s shares, as required by the Exchange Act. The U.S. District Court for the Southern District of New York (the “District Court”) concluded that: (i) the Funds failed timely to disclose that they had formed a “group” (based on evidence that the Funds communicated regarding their efforts to exert control over CSX and taking “concerted action”); and (ii) one of the Funds failed timely to disclose that it was the beneficial owner of more than 5% of CSX’s shares (based on evidence that it had violated Rule 13d-3(b) under the Exchange Act by engaging in a “plan or scheme” to evade Section 13(d) disclosure requirements).[3] However, the District Court did not conclude definitively that the Funds, as long parties to the equity swaps, obtained beneficial ownership in the shares acquired by their counterparties as hedges. The District Court also refused to enjoin the Funds from voting their shares because they had disclosed their share ownership for a sufficient period of time prior to the vote.

The Second Circuit only considered the issues concerning a “group” violation of Section 13(d)(3) with respect to the CSX shares owned outright by the Funds, without regard to any beneficial ownership they might have acquired as long parties to the equity swaps. As to that issue, the Second Circuit remanded the case to the District Court to make findings as to whether the Funds specifically formed a “group” for the purpose of “acquiring, holding, voting or disposing” of CSX shares owned outright and, if so, the latest date by which such a group was formed. The Second Circuit found that “[o]nly if such a group’s outright ownership of CSX shares exceeded the 5 percent threshold prior to the filing of a section 13(d) disclosure can a group violation of section 13(d) be found.”

The Second Circuit also affirmed the District Court’s denial of the voting injunction sought by CSX. However, significantly for the derivatives market, the Second Circuit did not address the issues that “would require decision as to the circumstances under which parties to cash-settled total-return equity swap agreements must comply with the disclosure provisions of section 13(d),” noting that the panel was divided on numerous issues relating to the treatment of equity swaps.[4]

[1] 2011 WL 2750913 (2d Cir. July 18, 2011).

[2] Section 13(d) generally requires that a party acquiring, directly or indirectly, the beneficial ownership of more than 5% of certain classes of equity securities, within ten days of such acquisition, send to the issuer of the securities and to each exchange where the securities are traded, and file with the Securities and Exchange Commission (the “SEC”), a statement containing certain specified information and such additional information as the SEC may prescribe as necessary or appropriate in the public interest or for the protection of investors.

[3] See CSX Corp. v. The Children’s Inv. Fund Mgmt., 562 F. Supp. 2d 511 (S.D.N.Y. 2008).

[4] Nevertheless, in a concurring opinion, one member of the panel stated that:
any agreement or understanding between long and short swap parties regarding: (i) the purchase of shares by the short party as a hedge; (ii) the sale of such shares to the long party when the swaps are unwound (as in settled-in-kind equity swaps); or (iii) the voting of such shares purchased by the short party, would cause the shares purchased as a hedge and any shares owned by the long party to be aggregated and counted in determining the 5 percent trigger.

2011 WL 2750913, at *27 (Winter, J., concurring).

Sovereign Bailouts and CDS Restructuring Triggers


On July 21st, the International Monetary Fund and European Union agreed to a second bailout package for Greece amounting to some €109 billion, subject to the beleaguered country implementing structural reforms and meeting specified fiscal targets. This is in addition to the €110 billion package launched in May 2010. For investors in the private sector, the new plan involves a voluntary restructuring of Greek debt, whereby investors voluntarily elect to exchange existing debt into four instruments. This exchange will result in a 21% net present value loss on private investor debt holdings (assuming a 9% discount rate) and an extension of the average debt maturity from six years to 11 years. The private sector contribution to the plan is estimated to be worth some €37 billion, with a target of 90% of private investors participating.

Rating agencies have indicated that they intend to treat the plan as a “selective” default. However, as discussed in greater detail below, the voluntary nature of the private sector involvement means that credit default swaps (“CDS”) are not able to trigger based on the plan.[1] This, in turn, has called into question the value of credit default swaps, at least with respect to sovereign reference entities.

CDS protection payments are triggered (subject to the satisfaction of certain other conditions) upon the occurrence of a “credit event,” including a “Restructuring.” Under the 2003 ISDA Credit Derivatives Definitions, which govern virtually all CDS transactions, a Restructuring is generally defined to include: (i) a reduction in either the interest rate or amount of interest or principal payable on an obligation; (ii) a postponement or other deferral of the payment of interest or principal on an obligation (including an extension of maturity); (iii) a change in the ranking or priority of payment of an obligation, resulting in its subordination; or (iv) a change in the currency of the obligation to other than a permitted currency.[2] However, any such event must “occur[] in a form that binds allholders” (emphasis added) of an obligation for a Restructuring to take place. The exchange of privately-held debt under the plan will be voluntary, and so, will not be binding on all holders.

The triggering of Greek CDS, if it were to occur, would be highly unlikely to have systemic implications.[3] Nevertheless, it appears that the rescue plan was intentionally structured to not result in a CDS credit event, perhaps to dissuade continued speculation in European sovereign CDS.[4] Certain commentators have argued that the restructuring plan has flipped market expectation on its head and have questioned the continued value of sovereign CDS. However, others insist that CDS products continue to work as contemplated, pointing out that private investors electing not to participate in the voluntary restructuring that continue to hold the original debt remain protected against a “hard” credit event (such as a payment failure or mandatory restructuring) under CDS contracts where they have bought protection. The International Swaps and Derivatives Association, Inc., the primary industry group for the derivatives marketplace, has indicated that it intends to gauge market sentiment in the wake of these developments and may explore changes to the definition of Restructuring.[5]

[1] Despite the controversy surrounding the Greek plan, it is sufficiently clear that this is the case under the existing regime governing CDS transactions. Indeed, as of the date of this publication, not one market participant has even bothered to ask the relevant regional determination committee (i.e., the committee charged with making certain decisions for CDS transactions with respect to reference entities in Europe) to decide whether a Restructuring credit event has occurred with respect to Greece in connection with the plan.

[2] Note that three separate types of this credit event exist: standard Restructuring (known as “Old R”); Modified Restructuring (known as “Mod R”); and Modified Modified Restructuring (known as “Mod Mod R”). Unlike Mod R and Mod Mod R, Old R does not limit the maturity of what a buyer of protection may delivery in connection with a credit event. Old R typically applies to CDS having Western European sovereigns as reference entities.

[3] As of July 1st, according to data from Depository Trust & Clearing Corporation, the aggregate net exposure for sellers of credit protection on Greek sovereign debt CDS was $4.8 billion (or just 1% of the government’s outstanding debt), without taking into account any recovery value or collateral. Moreover, the vast majority of CDS exposure is collateralized, either partially or fully.

[4] European governments have long been concerned about the economic implications of speculation in sovereign CDS markets. For additional information on this topic, please see DMIR March 2010.

[5] See Katy Burne, Swaps Group Weighs Revamp of Triggers on Default Insurance, Wall Street Journal (Aug. 3, 2011).

European Commission Probes Banks Over CDS


On April 29th, the European Commission (the “EC”), the executive body of the European Union, announced it had opened two antitrust investigations in connection with the credit default swap (“CDS”) market. In the first probe, the EC is investigating whether 16 U.S. and European banks that deal in CDS and Markit, the primary provider of financial information for CDS, have colluded and/or have abused their collective dominance in an effort to control financial information on CDS. The banks being investigated give most of the pricing, indices and other essential data for the trading of CDS only to Markit. The focus of the investigation is on whether this practice is the consequence of collusion or abuse of their collective dominance and has the effect of restricting access to the raw data from other information service providers. The investigation will also look into whether Markit’s license and distribution agreements are abusive and impede competition in the CDS information services market.

In the second probe, the EC is investigating nine U.S. and European banks in connection with agreements the banks entered into with ICE Clear Europe (“ICE”), the leading clearinghouse for CDS, when they sold an independent derivatives clearinghouse, named The Clearing Corporation, to ICE. In particular, the investigation is examining whether provisions in these agreements for preferential fees and profit sharing arrangements for the banks created an overpowering incentive for the banks to exclusively use ICE as a clearinghouse, effectively locking them into the ICE system to the detriment of competitor clearinghouses and leading other CDS market participants to also clear trades through ICE.

Decision on SEC’s First Insider Trading Case Involving Credit Default Swaps


On June 25th, a federal district court judge ruled against the Securities and Exchange Commission (SEC) in U.S. regulators’ first lawsuit alleging insider trading of credit default swaps (CDS).  On May 5, 2009, the SEC had charged a portfolio manager at hedge fund investment advisor Millennium Partners L.P. (Millennium) and a bond and CDS salesman at Deutsche Bank Securities Inc. (DBSI) with insider trading.  The SEC’s complaint alleged that the bond salesman became privy, through his employment at DBSI, to confidential information concerning the restructuring of an upcoming bond issuance by VNU N.V. (VNU), a Dutch media holding company, and passed that information on to a Millennium portfolio manager, who traded CDS based on that information.  DBSI was the lead underwriter for the bond issuance.

According to the complaint, based on confidential information from the bond salesman, the portfolio manager purchased CDS protection on VNU, then profited $1.2 million by closing out his positions after the public announcement was made regarding the issuance and the price of CDS on VNU surged.  In making its case, the SEC pointed to the fact that, while discussing the VNU restructuring, the two switched from their recorded work telephones to their mobile telephones, which demonstrated that they knew what they were doing was improper.  Neither DBSI nor Millennium were accused of any misconduct by the SEC.  For a more detailed description of the SEC’s claims, please click here.

The defendants first argued that the SEC lacked jurisdiction to bring the case because CDS are private contracts, not securities.  Following a civil bench trial, the judge disagreed.  The judge pointed out that the SEC has antifraud enforcement jurisdiction over “securities-based swap agreements,” which are agreements for which “a material term is based on the price, yield, value or volatility of any security or any group or index of securities, or any interest therein.”  Id.  The judge decided that the material terms of the CDS contracts at issue were, in fact, based on the price, yield, value, or volatility of VNU’s securities and, therefore, constituted securities-based swap agreements over which the SEC had antifraud enforcement jurisdiction.

However, the judge also ruled that information exchanged in the telephone calls between the two presented by the SEC as evidence did not adequately demonstrate that they had engaged in insider trading.  In fact, in his decision dismissing the case, the judge stated that there was no evidence to support either the SEC’s attempt to attribute “nefarious content” to the calls between them or that the bond salesman had any motive to provide inside information to the portfolio manager.

Crisis in Greece Leads to Renewed Calls for CDS Regulation


Greek Prime Minister George Papandreou urged global action to curb speculation in credit default swap (“CDS”) transactions, particularly those relating to sovereign debt. During a visit this month to the United States, Papandreou said: “We need clear rules on shorts, naked shorts and credit default swaps. I hope there will be a positive response from this side of the Atlantic to bring this initiative to the G20.” At a joint news conference with German Chancellor Angela Merkel in Berlin on March 5th, he also referred to CDS as a “scourge” that threatened the Greek and global economies. Merkel added: “Credit-default swaps, where you insure your neighbor’s house just to destroy it and make money from it, that’s exactly what we have to curb.”

Fear of contagion from Greece’s fiscal troubles have led to concern across the European Union, particularly in the eurozone. In an effort to calm market concern over its spending, the Greek government passed extreme austerity measures in early March, including a sharp cut in civil servant entitlements and an increase in the value-added tax rate. These measures are intended to result in savings of some €4.8 billion. But Greece remains in desperate need to access the capital markets as well, as it must roll over €53 billion of its approximately €300 billion of debt this calendar year, €20 billion of it by the end of May. The sixteen eurozone members remain divided on whether—and how—to assist Greece. Concerns exist over the prospect of their failure to provide standby loans or other support to Greece, which could harm the credibility of the Euro if Greece instead seeks support from the International Monetary Fund. Additional pressure for a solution was put on eurozone members by the March 24th downgrade of Portugal’s debt rating to “AA-” from “AA” by Fitch Ratings.

As the Greek debt crisis has unfolded, the country’s borrowing costs have skyrocketed. On March 4th, the country issued €5 billion of heavily-oversubscribed 10-year bonds at 6.25%, or approximately twice the rate payable on German bunds. Papandreou and some commentators blamed this 300 basis point premium over the German benchmark, at least in part, on speculators buying protection through CDS contracts. The purchase of such protection by speculators effectively bets on a default on debt which, in turn, drives up CDS premiums and reinforces the market perception that Greece will indeed default; this negative market perception is reflected in the borrowing costs of bonds issued. Of course, the primary driver of Greece’s high bond rate is the inherent risk of its ability to repay its debt.

Despite substantial industry efforts to increase standardization and transparency for CDS in the wake of the AIG crisis,[1] the product remains viewed by certain vocal critics as a major contributing factor to the financial meltdown that should be subject to stricter regulation, or even outright ban. Indeed, the Greek crisis has led to renewed calls for regulation and bans of the product across Europe, including by Jose Manuel Barroso, the European Union Commission President. This spotlight shines on CDS as comprehensive financial reform legislation continues to be considered by federal legislators in the United States and in the European Union.

[1] CDS transactions were subject to condemnation by politicians and the media alike in connection with the AIG crisis in the fall of 2008. Among other things, this crisis led to a short-lived effort by New York State insurance regulators to make certain CDS transactions (i.e., those under which buyers of protection own the underlying asset on which protection is written) subject to insurance regulation (see Client Alerts: September 2008 and November 2008). More recently, the New York Senate released draft legislation this month under which, among other things, certain credit protection sellers would need to be licensed as providers of “credit default insurance.” It is not clear whether this proposed legislation would be redundant with (or be precluded by) any final federal regulation of CDS.