Credit Funds: Credit Default Swaps in the Distressed Limelight

In this Ropes & Gray podcast, Alyson Gal, Matt Roose and Jill Kalish Levy discuss recent developments in loan and bond documentation in response to market concerns with how credit default swaps may affect the likelihood of defaults being triggered under the underlying debt instruments, including the advent of so called “net-short holder” provisions. As the backdrop to the market concerns that are leading to these provisions, we discuss two recent situations, Hovnanian and Windstream, as examples of transactions where the fact that market participants held CDS protection or, conversely, were CDS protection sellers, affected how events played out. We then review the various “net-short holder” provisions in loan documents and indentures seen to-date, and discuss how the market response to these concerns continues to evolve.

Jill Kalish Levy: Hello, and thank you for joining us today for this Ropes & Gray podcast, the latest in a series of podcasts aimed at credit funds. My name is Jill Kalish Levy and I am counsel in the finance group at Ropes & Gray. I have with me here today Alyson Gal, a partner in the finance group, and Matt Roose, a partner in the business restructuring group. Both Alyson and Matt represent lenders in all types of situations, including in the context of new issuances and restructuring existing issuances.

We are here to talk about the advent of some new provisions that have started appearing in certain loan documents and bond indentures in reaction to some recent situations involving credit default swaps. These provisions include “net-short” provisions, which provide for, among other things, the disenfranchisement of investors deemed “net-short holders” by the relevant document.

Alyson, can you tell us a bit more about what this is and where it all started?

Alyson Gal: Sure, Jill, I’d be happy to. It’s great to be here with you today to discuss these new developments. So far, the provisions that we’ll be talking about have only appeared in a few deals, and they’re still quite controversial.

Truth be told, there’s been lots of chatter in the finance world for a long time about issues that arise when investors hold both credit default swaps, or CDS, and loans or notes of the same or a related issuer. People have talked about potential issues that can arise when parties to CDS contracts try to influence transactions involving the issuers referenced under the CDS.

But that issue stopped being hypothetical with two recent cases: Hovnanian and Windstream. Matt, can you walk us through what happened in Hovnanian?

Matt Roose: I’d be happy to do that and I’m excited to be joining you and Jill today to talk about net-short provisions. The basic facts of Hovnanian are as follows: In 2018, Hovnanian Enterprises, a home building company, was in financial distress and was trying to refinance its existing notes. Hovnanian was approached with a very attractive financing package by a market participant which, as it happened, owned CDS protection on loans issued by the company. As part of the financing package, it was contemplated that Hovnanian would first acquire, through a subsidiary, and then intentionally default on, a subset of their bonds, which would trigger a payout under the CDS contracts held by the financing source.

After the transaction became known to the market, another market participant, a protection seller of Hovnanian CDS exposure, sought to enjoin the deal. The case eventually settled out of court, but it’s been the subject of a fair amount of discussion in the market, since it cast in sharp relief the potential for transactions to be structured with at least a partial goal of achieving a certain result under CDS contracts.

Jill Kalish Levy: Thanks, Matt. When it happened, Hovnanian drew attention to whether CDS should pay out if an issuer intentionally triggers a default with the cooperation of a CDS protection buyer and more generally how investors with differing economic interests will approach a company. I think the case would have gotten even more attention had it been actually decided by a judge instead of settled outside of court. The Windstream case and subsequent bankruptcy filing have also raised concerns about how CDS is impacting the market, albeit with a very different set of facts. Alyson, maybe you can tell us a bit about Windstream?

Alyson Gal: Yes, sure. Windstream had very different facts than Hovnanian, and has triggered a whole other set of proposed drafting responses, but from an investor’s perspective, it cast a bright light on a lot of the same issues.

In Windstream, Aurelius Capital Management had accumulated $300 million of Windstream notes and reportedly ten times that amount in Windstream-related CDS protection. Aurelius then asserted that a purported sale-leaseback transaction that had been completed two years prior created an event of default under its notes, which would have the effect of triggering the CDS protection. And in fact, a court has agreed with that assertion, so it’s hard to say there was anything wrong with what happened there. Aurelius called a default, and Windstream challenged the default notice in court. The court upheld Aurelius’ position and Windstream consequently filed for bankruptcy.

CDS protection sellers later sought to block Aurelius from tendering its notes at the Windstream CDS auction on the basis that pending equitable subordination claims against Aurelius should disqualify it from participation, but ISDA rejected that challenge and instructed the auction to proceed.

Matt Roose: So Hovnanian and Windstream, despite having very different facts, both showed the conflicted motivations of holders of debt that are also buyers of CDS protection, particularly where those holders are “net-short”, i.e., they hold CDS protection with greater notional amounts than their exposure to the underlying debt. I know I have been getting a lot of calls from clients who want to understand the facts of these cases and more importantly, how they can protect themselves from either situation happening to them in their investments. Alyson, how are you seeing the market respond, particularly to the Windstream facts?

Alyson Gal: I’ve been getting similar questions, Matt. In the wake of Windstream, private equity sponsors and their portfolio company borrowers, as well as the loan and bond markets generally, have responded to the “net-short” problem with a host of new provisions intended to address the issue. The shorthand term for these provisions, collectively, is “net-short provisions,” but practically speaking, the provisions have very different iterations and nuances and continue to evolve. Also, it should be noted that most agreements still don’t have these provisions because they remain controversial on all sides.

Jill Kalish Levy: Are the loan and bond markets incorporating the same kinds of changes to address this issue?

Alyson Gal: Well, in the loan market, the initial response to the net-short issue has been to seek to disenfranchise net-short holders. Certain credit agreements now say that lenders who, as a result of themselves or their affiliates holding interests in CDS and similar instruments, have a net-short position with respect to the loans, have no right to vote for or against any amendment or waiver relating to the loans, nor can they direct the administrative agent or any lender to take any action under the loan documents. Some agreements provide that any lender that submits a notice of default to the administrative agent must make a representation that it is not a net-short lender.

The most recent “net-short” innovation which has been proposed in certain credit agreements is to count net-short lenders as disqualified lenders. That allows the borrower to force a net-short lender to sell its loans at par or, more drastically, at the lesser of par and the amount it paid to purchase the loans. In these cases, the net-short lender does not receive interest.

Jill Kalish Levy: Wow, these provisions seem to show very strongly that net-short lenders are not welcome in a syndicate of lenders. Has there been as strong a reaction in the bond market? What are you seeing in indentures and offering documents to reflect this new area of focus for market participants?

Alyson Gal: Bond markets have included some of the same provisions as loan markets. For example, certain recent bond indentures require directing bondholders to represent that they are not net-short holders. I’ve even seen two indentures, Sirius Computers and Core & Main, go so far as to include the ability to “yank” net-short bondholders at the lesser of par and the most recent quoted price for the debt, though it’s hard to imagine such below-par yank provisions getting much traction in the market.

Matt Roose: Yes, it’s fair to say that the bond markets have had an equally strong response where the provisions have been adopted. In direct response to Windstream, I have seen several recent indentures that require events of default to be asserted within two years of their occurrence, provided the event was reported publicly or directly to bondholders. This would prevent parties with an intent to assert a default from buying debt and CDS referencing the same issuer, and then asserting an event of default long after the default occurred. Part of what was controversial in Windstream was that the default that was alleged to have occurred had taken place before Aurelius was even an investor and was publicly reported. A shortened statute of limitations would give parties a smaller window in which to call a default against the issuer.

Alyson Gal: Yes, that’s exactly right. Indentures are going beyond loan documents in other ways, too. The same indentures that included a shortened statute of limitations (for example, Allied Universal, Axis, Nexstar, Grubhub) also provide that cure periods for defaults may be extended or stayed by the issuer if the issuer demonstrates that the notice of default was submitted by a net-short holder, or stayed by a judge if the cause of the default is the subject of litigation. This new provision would potentially have prevented the swift bankruptcy filing we saw in Windstream shortly after the court decided the case, since it allows an issuer an opportunity to fix a default that is being called as a means for a net-short holder to collect on its CDS protection.

Jill Kalish Levy: That makes sense from the perspective of an issuer and a minority noteholder. In addition to the actual legal provisions in loan documents and indentures, I’ve started to see issuers include risk factors in offering documents which are clearly directed at net-short holders, warning potential investors that other investors may seek to financially benefit by triggering defaults. Other risk factors point out possible decreases in liquidity due to the new net-short holder provisions and the theoretically reduced investor pool that could result.

Matt Roose: Yes, I’ve seen those as well. Ultimately, the cumulative goal of these new provisions are to take influence away from the net-short holders, on the theory that investors who stand to gain more from a default than from the loans or bonds being in good standing should not be able to impact the outcome of an amendment or restructuring process, to provide mechanisms by which net-short investors can be removed from the investor pool without unduly profiting from their actions, and to provide mechanisms to make it more difficult for issuers and borrowers to be brought down by long-stale defaults.

Jill Kalish Levy: That all makes sense. Given all that we have explored here, do you expect more documents to start incorporating net-short provisions as time goes on?

Alyson Gal: It’s really hard to say. Parties on all sides are continuing to consider the impact of these cases and of these new provisions, and where they fall out on the question of whether to include them. So the market response to the perceived issues created by net-short holders continues to evolve. Provisions addressing these issues are far from uniform, are by no means widely accepted and are definitely a work in progress. But issuers are clearly taking these issues seriously and many are seeking to address them in their documents when they have the leverage to do so. As such, it does seems likely that there will be long-standing changes in loan and bond documentation as a result of these issues, though the exact form that these changes will take remains to be seen.

Jill Kalish Levy: Alyson and Matt, thank you so much for joining me for this discussion. For more information on the topics that we discussed or other topics of interest to the credit funds community, please visit our website www.ropesgray.com. And, of course, if we can help you navigate any of the topics we discussed today, please don't hesitate to get in touch. Stay tuned for future podcasts on the latest developments in this space, and thank you for listening.