US loan market seeks to block CDS manipulation

NEW YORK, May 13 (LPC) — U.S. companies are trying to prevent speculative investors from calling default events on leveraged loans to secure payouts under credit default swaps ( CDS) at the expense of other lenders as investor activism increases.

Companies are trying to tighten loan documentation to prevent aggressive investors from elevating programs that benefit their CDS holdings above the interests of borrowers or other lenders.

The move to add tougher new language to the documents follows two high-profile US court cases involving homebuilder Hovnanian and telecommunications service provider Windstream.

The changes would limit CDS holders’ ability to call a default, either removing their right to vote on creditor decisions or preventing them from holding a loan, sources said.

CDS does provide debt insurance. Investors, who may own a company’s loan, bond or both, buy CDS contracts that provide protection against a negative credit event, including a default or bankruptcy filing.

If the contract is triggered, the seller of CDS will pay the buyer the difference between par – 100 cents on the dollar – and the determined value of the debt.

The proposed loan modifications are designed to tackle activist debt investors with CDS and “may prevent the activist investor from suing the company to accelerate debt primarily to favor their CDS position and not the debt they owns,” said Fabien Carruzzo, a partner at the law firm. Kramer Levin.

Although the goal of the proposals is to protect the US$1.2 trillion leveraged loan market, the proposals are expected to meet some resistance from more aggressive investors.


Hovnanian and Blackstone Group’s GSO Capital Partners were the first to receive a lawsuit. Solus Alternative Asset Management filed a lawsuit last year after GSO helped arrange a financial package that would bar the builder from making its next interest payment.

This created a “default” credit event that allowed buyers with CDS protection, including GSO, to receive payment on their contracts, according to a 2018 article by attorneys Kramer Levin.

Solus and GSO agreed to settle the matter at the end of May 2018 and Hovnanian made the interest payment which he skipped on May 1, 2018, according to a press release.

Windstream filed for bankruptcy in February after a court ruled in favor of Aurelius Capital Management, which alleged that a 2015 spin-off of the company’s telecommunications network assets breached its agreements with bondholders.

American companies are trying to prevent similar situations from happening in the future. Preventing CDS holders from buying loans by adding them to disqualified lender lists is one option.

These lists typically consist of funds, institutional investors, and even competitors with whom borrowers prefer not to share private information, or are banned for reasons such as past activism.

“From a business perspective, they don’t want their lenders going into lending with a program that’s not going to fit their (plans),” said Jessica Reiss, head of covenant research. loan from Covenant Review. “The company doesn’t want to feel like it can’t work with its lenders.”

Ideally, a disqualified list should be as narrow as possible to avoid impacting lenders’ ability to sell or exit positions, Reiss said.

Another proposed documentation would bar CDS owners from participating in lender votes, which would prevent them from calling or enforcing a default, sources said. This would not prevent a CDS holder who holds the bond from calling a bond default.

This option would not affect liquidity as it would not restrict trading, but it relies on the honor system, which could require each lender to certify to the agent and the borrower before a vote that they does not hold a net short position, a source said. .


The US Commodity Futures Trading Commission (CFTC) has criticized the so-called fabricated defaults, saying they undermine the integrity of the CDS market.

“Market participants and their advisors are advised that in the event of Manufactured Credit Events, the (CFTC) will carefully consider all measures available to help ensure market integrity and combat manipulation or fraud involving CDS, in coordination with our regulatory counterparts as appropriate,” the regulator said in April 2018.

In March, the International Swaps and Derivatives Association (ISDA) announced that it was changing its definitions of CDS to address closely matched credit events.

ISDA’s CDS proposal is a simple solution that requires deterioration in the underlying entity’s credit for the CDS to be triggered. This creates some uncertainty about the outcome, which is designed to deter a fabricated default strategy, Carruzzo said.

“If you only have a 50/50 chance of a strategy working, being determined as a true credit event, you may be hesitant to do this because you’re not sure you can monetize the contract,” did he declare. (Reporting by Kristen Haunss. Editing by Tessa Walsh and Michelle Sierra)

Priscilla C. Carnegie