Municipal Derivatives

English Supreme Court Brings an End to Dexia-Prato Swap Dispute

On January 18 the English Supreme Court refused to grant Comune di Prato (“Prato”), an Italian local authority with responsibility for the municipality of Prato in Tuscany, permission to appeal a 2017 decision of the Court of Appeals in favor of Dexia Creditop SpA (“Dexia”), Prato’s swap counterparty.[1] This decision brings to an end a long-standing dispute that was one of many involving swaps entered into by Italian municipalities between 2001 and 2008, when the onset of the financial crisis triggered defaults and brought increased scrutiny to the derivatives market.[2]

The decision of the Court of Appeals, together with the determination by the Supreme Court not to allow further appeal, may provide greater certainty as to the narrow scope of Article 3(3) of the Rome Convention, particularly in respect of derivatives agreements documented under standard documentation that are governed by English law. READ MORE

Detroit Commences the Largest Chapter 9 Ever – What’s Next*


On July 18, 2013, the City of Detroit, Michigan became the largest city to file for rehabilitation under Chapter 9 of the United States Bankruptcy case.  Detroit, through its financial manager, is seeking to restructure approximately $18 billion in accrued liabilities, including unsecured debt and other liabilities of $11.5 billion, and secured obligations—including swap obligations—of $7.3 billion.  READ MORE

LIBOR Manipulation and Municipal Derivatives


On July 6th, the Serious Fraud Office of the United Kingdom announced an investigation into alleged manipulation of the London interbank offered rate (“LIBOR”), which is the benchmark rate referenced in hundreds of trillions of U.S. dollars of securities, loans and transactions, including interest rate derivatives having some US$350 trillion in outstanding notional amount.

In June, U.S. and U.K. regulators agreed to a US$450 million settlement with Barclays plc in connection with allegations relating to the manipulation of LIBOR.  Since the announcement of that settlement, dozens of civil lawsuits have been filed against dealers.  Many of those filing suit are municipal issuers that receive LIBOR-based payments under interest rate swaps with dealers, typically related to their variable rate debt obligations.  These issuers argue that suppression of the LIBOR rate has led to artificially low amounts being calculated on the floating rate legs of their swaps, resulting in losses. READ MORE

City of Milan Settles with Banks in Derivatives Fraud Case


The City of Milan, Italy, has reached a settlement relating to a dispute involving fees charged by four foreign banks relating to the sale of derivatives.  The City had entered into swaps with each of UBS AG, Deutsche Bank AG, JPMorgan Chase & Co. and Depfa Bank PLC that were linked to, among other things, a €1.68 billion bond issued by the City.  On April 27, 2009, Italian financial police, acting on the order of a judge, seized assets (including the banks’ stakes in certain Italian companies, real estate assets and bank accounts) valued at approximately €476 million from the four banks in connection with an investigation into whether the banks fraudulently received some €100 million in fees which were not properly disclosed.  Subsequently, on March 17, 2010, public prosecutors formally charged the four banks, as well as eleven bankers and two former city officials, with fraud in connection with these transactions.[1]

Under the terms of the €455 million settlement deal, the banks reportedly will unwind the transactions and pay to the City the current mark-to-market of the swaps, with a substantial discount.  In exchange, the City agreed to release certain seized assets and drop claims for damages in a civil suit it had brought.  The City also agreed to withdraw as a plaintiff in the related criminal suit, although that case is continuing in the Italian courts.  The banks did not admit any responsibility in connection with their fees as part of the settlement

[1] For additional information regarding these transactions and the related investigation, click here and here.

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.” READ MORE

Standardization of Muni CDS


On March 5th, ISDA published the 2012 ISDA U.S. Municipal Reference Entity Supplement to the 2003 ISDA Credit Derivatives Definitions (the “March 2012 Supplement”), which is intended to standardize credit default swaps referencing U.S. municipal issuers or obligations as the reference entity or reference obligation (“muni CDS”) with credit default swaps referencing corporate and sovereign CDS.  The March 2012 Supplement generally applies to muni CDS certain industry standards that became applicable to corporate and sovereign CDS through the 2009 ISDA Credit Derivatives Determinations Committees, Auction Settlement and Restructuring Supplement to the 2003 ISDA Credit Derivatives Definitions, which was adopted by the vast majority of the market through the “Big Bang Protocol.”[1] At the time the Big Bang Protocol was implemented, the market focus was on standardizing the terms of the corporate and sovereign CDS sectors, which were much larger in comparison.  Since that time, the trading volume of the muni CDS market has grown significantly, as has market interest in trading products that are liquid, fungible (generally, easier to offset with one another), and have the characteristics necessary for central clearing.

The March 2012 Supplement generally subjects muni CDS to the resolutions of the ISDA Determinations Committees, mandatory auction settlement processes and “look-backs” on credit events and succession events by incorporating the Big Bang Protocol.  Among other things, through the March 2012 Supplement, muni CDS transactions have been brought under the jurisdiction of the existing ISDA Determinations Committee for the Americas, which is the body that, inter alia, determines whether a credit event or succession event has occurred.  Moreover, the auction mechanism for determining the “final price” of assets in connection with a credit event has been hardwired into muni CDS contracts, with cash settlement becoming the standard settlement method.  Also, the Determinations Committees Rules have been amended in connection with muni CDS, such that: (i) holding an auction is mandatory where at least 3 dealers (as opposed to at least 5 dealers for corporate and sovereign CDS) are parties to 300 or more trades; and (ii) if one of the top 6 dealers by trading volume in single-name muni CDS and the Markit MCDX index (i.e., an index comprised of 50 U.S. municipal credits, encompassing both general obligations and revenue obligations) fails to participate in an auction, then that dealer will be removed from the Determinations Committee for purposes of making muni CDS determinations.

To further facilitate the standardization of the muni CDS product, the dealer community has modified certain trading conventions in conjunction with the March 2012 Supplement, including providing for standardized fixed coupons of 100 basis points and 500 basis points, which is the same convention used for North American corporate names.  All provisions of the March 2012 Supplement became effective on April 3rd, except for those relating to the look-back periods, which will become effective on June 20, 2012.  However, the terms of the March 2012 Supplement also became applicable to muni CDS entered into prior to April 3rd if the counterparties thereto both elected to adhere to the 2012 ISDA U.S. Municipal Reference Entity CDS Protocol.  Over 100 market participants signed up to this protocol during the period for adherence, which opened on March 5th and closed on April 2nd.

The March 2012 Supplement should make muni CDS more liquid and encourage trading.  From initial data, it appears that the enhanced standardization has indeed succeeded in increasing muni CDS trading volumes.  In fact, shortly after the terms of the March 2012 Supplement took effect on April 3rd, it was reported that trading volume in the Markit MCDX index increased to between $2 to 3 billion from a pre-standardization norm of between $500 million to $1 billion.  Despite this marked increase in trading activity, some have cautioned that a large and vibrant muni CDS market could make it easy for speculators to zero in on an issuer perceived as struggling, sharply impacting that issuer’s borrowing costs.

[1] For more information on the Big Bang Protocol, please click here.

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. READ MORE

Italian Court Orders Disclosure of Swap Settlement


In a ruling published on September 26th, an Italian court ordered the disclosure of the terms of a settlement between the city of Cassino and J.P. Morgan Chase & Co. (“JPM”), notwithstanding a confidentiality provision in the settlement agreement between the parties. According to reports, the city had entered into an interest rate swap in 2003 with a Bear Stearns entity (which JPM purchased in 2008) under which the city paid a LIBOR-based floating rate and received a fixed rate in connection with some €22 million of debt. As interest rates increased, the city found itself owing a large termination payment to JPM.

It is not clear whether governmental officials fully understood the implications of the transaction at the time of its execution. Indeed, the sophistication of— and risk disclosure and representations made by dealers to—government decision-makers in connection with swaps has been a global concern in the wake of the financial crisis and has led to calls for additional protection of public entities.[1] (In Italy alone, according to Bank of Italy data, some 300 municipalities reportedly had negative marks-to-market on swaps totaling close to €1 billion as of March 2011.) As a result, legislators have engaged in efforts to reform the governmental swap market both in the United States and in Europe, including through the implementation of financial reforms such as the Dodd-Frank Act.[2]

[1] As we have previously reported (see DMIR March 2010 and DMIR May 2009), in March 2011, four banks, eleven bankers and two former city officials were charged with fraud in connection with derivatives transactions entered into by the city of Milan, Italy.

[2] For example, in March 2010, the Italian Senate Finance Committee unanimously approved a proposal that would restrict the use of derivatives by municipalities (see DMIR March 2010). For additional information on the protections afforded to governmental entities and other “special entities” entering into swaps under the Dodd-Frank Act, please see DMIR July 2010 and Orrick Alert: Derivatives Regulation Reform and Provisions Affecting Governmental Entities in the Dodd-Frank Act.

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).

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.