Exchange-Traded Solvency Derivatives

Background of Credit Default Swaps

Credit default swaps have traditionally been used to transfer the credit risk inherent in bonds, loans and other credit instruments, without disturbing the structure or legal ownership of the underlying asset. These contracts are privately negotiated and traded, if at all, in the OTC market. In a typical credit default swap, the buyer of protection pays a fee in exchange for the seller of protection contracting to make a payment in the event that the reference entity suffers an agreed upon credit event during the term of the contract. Qualifying credit events typically include a bankruptcy filing, restructuring, moratorium and failure to satisfy a particular obligation.

History of Credit Event Contracts

On Oct. 17, 2006, the CME requested authorization from the CFTC to offer CECs. (Copies of the application, amendments, supporting materials and objections can be obtained at www.cftc.gov.). The request was initially met with staunch opposition from the Chicago Board Options Exchange ('CBOE'), which argued that CECs are not futures but rather options based upon securities, thereby making CECs a security. In response, the CME explained that CECs are not securities because: 1) the buyer of a CEC does not acquire an ownership interest in the Reference Entity or any of its securities; 2) a CEC is not based on the value of any security issued by the Reference Entity; and 3) the seller of a CEC undertakes no obligation to deliver a security or to make a payment based on the value of any security. Moreover, the CME asserted that, unlike in the case of options, parties to a CEC are committed to specific actions.

The CME's original application sought approval of a contract that provides for a payment in the event of a bankruptcy, obligation acceleration, obligation default, failure to pay, debt repudiation, moratorium or restructuring as defined by the ISDA. However, in response to the CBOE's objection, the CME filed an amended application in which it scaled back the definition of a qualifying credit event to solely the bankruptcy of the Reference Entity.

On Jan. 31, 2007, the CFTC granted the CME's amended application and thereby authorized the CME to issue and trade CECs. The CME thereupon announced that it would launch the first three CEC products in March 2007. However, on March 7, 2007, the CME announced a modified plan under which it would initiate its foray into the trading of solvency derivatives through its contemplated introduction of an indexed product tied to the likelihood of bankruptcy filings by a group of 32 companies, as opposed to a single Reference Entity.

In response to the authors' inquiry, the CME's spokesperson indicated that the CME decided to delay the introduction of CECs tied to a single Referenced Entity. Hence, whether and when the CME will ultimately launch a single Referenced Entity solvency derivative is presently unknown.

Meanwhile, contemporaneous with the submission of its objection to the CME's application for approval of CECs, the CBOE filed an application with the Securities and Exchange Commission seeking authorization to offer a similar credit event product that is designed to pay out when specific companies become the subject of a bankruptcy petition. Thus, it appears that one or more exchanges will offer and trade single reference entity credit default derivatives in the near future.

Description and Purpose of CECs

CECs are designed to merge the benefits of OTC credit default swaps with the benefits of exchange-traded futures by offering a standardized, exchange-traded, centrally cleared and guaranteed credit default swap contract. The CME acts as an intermediary to all related transactions and takes an initial margin from both sides of the trade to act as a guarantee.

The CME's offering of CECs will eliminate many of the risks associated with OTC solvency derivatives, such as the risk of counterparty default and unreliable pricing. In addition, CECs will eliminate the need to negotiate the terms of a private credit default swap, streamline accounting practices and thereby reduce transaction expenses. Hence, the introduction of CECs is expected to not only appeal to existing derivatives traders, but to expand the market to new traders. It is this projected expansion of usage that creates the expectation that CECs will have a dramatic impact on the restructuring community.

Material Definitions

The CME defines a 'credit event' (i.e., an event that triggers a payment obligation on the contract) as the bankruptcy of a Reference Entity. 'Bankruptcy' is defined as a filing under the United States Bankruptcy Code of: 1) a voluntary petition by the Reference Entity that has not been dismissed by the expiration date of the CEC; or 2) an involuntary petition against the Reference Entity with respect to which an order of relief has been issued by the court prior to the expiration date of the contract. Thus, while a CEC offers many benefits previously unavailable in the OTC market, the CME's definition of a qualifying credit event is significantly narrower than the definition of a credit event in a typical OTC credit default swap.

Pricing and Settlement

The prices of CECs are expected to fluctuate based upon traders' expectations of whether the Reference Entity will become a debtor in bankruptcy. CECs call for a final cash settlement which is binary in character and fixed in advance of listing and does not vary in relation to the price of any obligation issued by the Reference Entity. In the absence of a credit event, the final settlement price of the contract will be established at zero. However, if a credit event exists as of the final settlement date, the final settlement price equals the product of the final settlement rate applied to the notional value of the contract.

Impact on Restructuring Community

In the event that the CME proceeds with its offering of CECs, these products will have a profound impact upon the ability of Reference Entities to achieve their restructuring objectives.

Secured Lender Considerations

CECs will offer secured lenders increased opportunities to hedge credit risks and protect themselves from unexpected default losses arising from their borrowers' failure to repay loans in accordance with their terms. While there exist other strategies for hedging such credit risks, CECs ostensibly will allow lenders to plan more accurately and with greater efficiency.

In addition, CECs offer lenders the ability to spread risk to other lenders (and/or speculators holding opposite expectations) without having to sell participations in their loans to other lenders that may insist upon receiving control over the credit and thereafter utilizing different collection strategies. Thus, CECs provide a hedge strategy that enables secured lenders to maintain tighter control over the administration of their loan portfolios.

Moreover, given that CECs are exchange-traded contracts, they provide greater transparency into the Reference Entity's financial health, as well as a financial indicator by which lenders may assess the value and liquidity of their own loan portfolios and the accuracy of their underwriting analyses.

Furthermore, by providing lenders with a direct financial interest in whether or not a borrower files a bankruptcy petition in order to address restructuring needs ' as opposed to restructuring out of court ' CECs could influence a lender's willingness to grant concessions to its borrower and the structure of such concessions. For example, a lender that has purchased a CEC has a financial incentive to actively enforce the terms of its lending agreement with a Reference Entity and to refuse to waive an event of default thereunder or grant any requested concessions or financial accommodations. Once in default, the lender could pressure the Reference Entity to file for bankruptcy or foster the filing of an involuntary bankruptcy petition against the Reference Entity prior to the expiration of the lender's CEC. The authors express no view as to whether such conduct violates applicable law and caution readers to fully consider this issue before adopting this strategy.

Even short of that, a lender that purchased a CEC will want to account for the possible payment on its CEC when underwriting a credit decision associated with the administration of a loan to a Reference Entity. Thus, a credit analysis that indicates that the lender is likely to achieve a higher recovery if the lender forecloses on its collateral and receives a payment on its CEC is likely to convince the lender to refuse to grant a borrower's requested concession(s) related to its loan.

Similarly, a lender holding a CEC associated with a distressed borrower may insist that its acceptance of any concessions be tied to the borrower's filing of a bankruptcy petition within a particular timeframe, so that the lender can collect payment on its CEC. For example, a lender may tie its willingness to provide further financing or consent to a proposed restructuring or pre-packaged plan of reorganization on the borrower's filing of a bankruptcy petition within the duration of the lender's CEC.

In addition, because CECs are exchange-traded products with greater liquidity than OTC derivatives, a secured lender will have greater flexibility to sell its CEC. This liquidity should expand the secured lender's workout options and possibly even create a beneficial investment strategy by allowing a secured lender to sell its CEC at a high price tied to the market's expectation that the Reference Entity is likely to become bankrupt. Indeed, there may be circumstances in which a secured lender may wish to grant financial concessions to a Reference Entity that would allow the Reference Entity to stave off bankruptcy and yet still permit the secured lender to sell its CEC on the exchange for a high price.

Finally, secured lenders that become aware of the intention of its borrower, or that of a possible borrower, to file a bankruptcy petition may purchase CECs based upon this information under the belief that the anti-fraud and insider trading jurisdiction of the SEC does not extend to CECs. Again, the authors express no view as to the legality of this approach.

Debtor Considerations

The availability of CECs should expand the ability of Reference Entities to tap a wider capital market and at better rates, inasmuch as potential lenders will have increased opportunities to efficiently hedge their credit decisions.

However, the flipside is that the availability of CECs could hinder a Reference Entity's ability to achieve an out-of-court restructuring or refinancing, particularly if the parties from which consent is needed are the holders (whether as buyer or seller) of CECs tied to the Reference Entity. For example, creditors holding the seller position in a CEC may: 1) reject any restructuring or refinancing proposal that is tied to a bankruptcy filing and/or 2) condition their acceptance of such a proposal on the requirement that a bankruptcy filing would not be made until after the expiration of its CEC. In contrast, creditors holding the buyer position in a CEC may: 1) reject any restructuring or refinancing proposal that is not predicated upon a bankruptcy filing; and/or 2) condition their acceptance of such a proposal on the requirement that a bankruptcy filing would be made prior to the expiration of its CEC. Thus, if possible, a Reference Entity should seek to determine whether its largest creditors are parties to such a CEC.

One approach to this problem entails the Reference Entity negotiating for a covenant in its credit agreements that obligates its lenders to disclose the existence of any CEC that it or an affiliate owns or thereafter purchases related to the Reference Entity. Armed with this knowledge, the Reference Entity can structure its affairs and any possible bankruptcy filing in a fashion that is most likely to achieve the concessions that it seeks from its lenders that hold applicable CECs.

An alternative approach calls for the Reference Entity to negotiate limitations on the ability of its creditors to purchase an applicable CEC. While this may result in the diminished availability of financing and/or less favorable credit terms, such a prohibition may, among other things, eliminate the risk that the creditor's motivation in obtaining a payment on its CEC will cause it to reject concessions or restructuring proposals that it might otherwise accept in the absence of its CEC.

Unsecured Creditor and Third Party Considerations

CECs offer unsecured creditors of a Reference Entity, such as trade vendors, many of the same benefits that make CECs attractive to secured lenders.

Like secured lenders, unsecured creditors can purchase CECs to hedge their exposure to a Reference Entity. For example, a vendor that is contemplating extending significant trade credit to a Reference Entity could efficiently purchase a CEC to protect against the risk that a bankruptcy filing by the Reference Entity will result in a loss on such extension of credit. Similarly, a trade vendor that has not received timely payment on its sales invoices may also subsequently purchase a CEC, and thereby hedge its risk at a time when the risk of loss is even greater. The fact that CECs are exchange-traded products will enable trade vendors to quickly, efficiently and anonymously purchase hedge protection that is less likely to be available in the OTC market. Indeed, sellers of private solvency derivatives are highly unlikely to offer such a contract at a time when the Reference Entity is delinquent on its accounts payable, and those that do, even assuming they can be identified, are likely to charge considerably higher prices for such protection.

Unsecured creditors may also benefit indirectly from the availability of CECs. For example, those trade vendors that do not purchase CECs can use the pricing of CECs to gauge a Reference Entity's financial health and thereby determine whether to extend trade credit to a Reference Entity and the terms thereof. In addition, a Reference Entity that seeks to avoid triggering a credit event on its secured lender's CEC may be willing to borrow money from other lenders at higher rates in order to stave off the need to file for bankruptcy prior to the expiration of its secured lender's CEC, as doing so may increase the Reference Entity's negotiating leverage with its secured lender.

Conclusion

While it is difficult, if not impossible, to fully anticipate the scope and impact of the forthcoming introduction of CECs on the restructuring community, it is abundantly clear to the authors that those members of the restructuring community that fail to account for these impacts could squander a variety of strategic and practical opportunities. As a result, the authors encourage readers to actively monitor the CME's introduction of CECs and to account for the same in their credit and restructuring analyses.

Todd L. Padnos, a member of this newsletter's Board of Editors, is a partner in the San Francisco office of LeBoeuf, Lamb, Greene & MacRae LLP. He concentrates his practice in the areas of bankruptcy, business reorganizations, workouts, and commercial litigation. He may be reached at 415-951-1140 or [email protected]. Brett J. Kitei is a bankruptcy associate in the firm's San Francisco office.

In the last ten years, the credit derivatives market has grown from its infancy to approximately $26 trillion of notional value according to the International Swaps and Derivatives Association, Inc. ('ISDA'). The most highly utilized type of credit derivative, the credit default swap, is used by investors to bet on a company's creditworthiness or hedge a position in a fashion that protects against the company's failure to make a payment or satisfy other terms.

To date, credit default swaps have been issued only in private transactions and traded solely in the over-the-counter market ('OTC') by large, sophisticated investors. Thus, while the proliferation of credit default swaps has had an impact upon distressed companies, the lack of a standardized, exchange-traded credit default swap has limited the scope and magnitude of this impact.

Recently, the Chicago Mercantile Exchange ('CME') obtained approval from the Commodity Futures Trading Commission ('CFTC') to offer the first ever standardized, exchange-traded, centrally cleared and guaranteed product available to the credit derivatives market. These instruments, called credit event contracts ('CECs'), are intended to provide a transparent and liquid means of acquiring protection against the filing of a bankruptcy case by or against a single company (the 'Reference Entity'). Trading through a central counterparty such as the CME should remove many of the risks, difficulties and expenses associated with trading credit default swaps. Thus, the availability of CECs is likely to foster further expansion of the credit derivatives market and will undoubtedly have a significant impact upon future corporate restructurings.

Background of Credit Default Swaps

Credit default swaps have traditionally been used to transfer the credit risk inherent in bonds, loans and other credit instruments, without disturbing the structure or legal ownership of the underlying asset. These contracts are privately negotiated and traded, if at all, in the OTC market. In a typical credit default swap, the buyer of protection pays a fee in exchange for the seller of protection contracting to make a payment in the event that the reference entity suffers an agreed upon credit event during the term of the contract. Qualifying credit events typically include a bankruptcy filing, restructuring, moratorium and failure to satisfy a particular obligation.

History of Credit Event Contracts

On Oct. 17, 2006, the CME requested authorization from the CFTC to offer CECs. (Copies of the application, amendments, supporting materials and objections can be obtained at www.cftc.gov.). The request was initially met with staunch opposition from the Chicago Board Options Exchange ('CBOE'), which argued that CECs are not futures but rather options based upon securities, thereby making CECs a security. In response, the CME explained that CECs are not securities because: 1) the buyer of a CEC does not acquire an ownership interest in the Reference Entity or any of its securities; 2) a CEC is not based on the value of any security issued by the Reference Entity; and 3) the seller of a CEC undertakes no obligation to deliver a security or to make a payment based on the value of any security. Moreover, the CME asserted that, unlike in the case of options, parties to a CEC are committed to specific actions.

The CME's original application sought approval of a contract that provides for a payment in the event of a bankruptcy, obligation acceleration, obligation default, failure to pay, debt repudiation, moratorium or restructuring as defined by the ISDA. However, in response to the CBOE's objection, the CME filed an amended application in which it scaled back the definition of a qualifying credit event to solely the bankruptcy of the Reference Entity.

On Jan. 31, 2007, the CFTC granted the CME's amended application and thereby authorized the CME to issue and trade CECs. The CME thereupon announced that it would launch the first three CEC products in March 2007. However, on March 7, 2007, the CME announced a modified plan under which it would initiate its foray into the trading of solvency derivatives through its contemplated introduction of an indexed product tied to the likelihood of bankruptcy filings by a group of 32 companies, as opposed to a single Reference Entity.

In response to the authors' inquiry, the CME's spokesperson indicated that the CME decided to delay the introduction of CECs tied to a single Referenced Entity. Hence, whether and when the CME will ultimately launch a single Referenced Entity solvency derivative is presently unknown.

Meanwhile, contemporaneous with the submission of its objection to the CME's application for approval of CECs, the CBOE filed an application with the Securities and Exchange Commission seeking authorization to offer a similar credit event product that is designed to pay out when specific companies become the subject of a bankruptcy petition. Thus, it appears that one or more exchanges will offer and trade single reference entity credit default derivatives in the near future.

Description and Purpose of CECs

CECs are designed to merge the benefits of OTC credit default swaps with the benefits of exchange-traded futures by offering a standardized, exchange-traded, centrally cleared and guaranteed credit default swap contract. The CME acts as an intermediary to all related transactions and takes an initial margin from both sides of the trade to act as a guarantee.

The CME's offering of CECs will eliminate many of the risks associated with OTC solvency derivatives, such as the risk of counterparty default and unreliable pricing. In addition, CECs will eliminate the need to negotiate the terms of a private credit default swap, streamline accounting practices and thereby reduce transaction expenses. Hence, the introduction of CECs is expected to not only appeal to existing derivatives traders, but to expand the market to new traders. It is this projected expansion of usage that creates the expectation that CECs will have a dramatic impact on the restructuring community.

Material Definitions

The CME defines a 'credit event' (i.e., an event that triggers a payment obligation on the contract) as the bankruptcy of a Reference Entity. 'Bankruptcy' is defined as a filing under the United States Bankruptcy Code of: 1) a voluntary petition by the Reference Entity that has not been dismissed by the expiration date of the CEC; or 2) an involuntary petition against the Reference Entity with respect to which an order of relief has been issued by the court prior to the expiration date of the contract. Thus, while a CEC offers many benefits previously unavailable in the OTC market, the CME's definition of a qualifying credit event is significantly narrower than the definition of a credit event in a typical OTC credit default swap.

Pricing and Settlement

The prices of CECs are expected to fluctuate based upon traders' expectations of whether the Reference Entity will become a debtor in bankruptcy. CECs call for a final cash settlement which is binary in character and fixed in advance of listing and does not vary in relation to the price of any obligation issued by the Reference Entity. In the absence of a credit event, the final settlement price of the contract will be established at zero. However, if a credit event exists as of the final settlement date, the final settlement price equals the product of the final settlement rate applied to the notional value of the contract.

Impact on Restructuring Community

In the event that the CME proceeds with its offering of CECs, these products will have a profound impact upon the ability of Reference Entities to achieve their restructuring objectives.

Secured Lender Considerations

CECs will offer secured lenders increased opportunities to hedge credit risks and protect themselves from unexpected default losses arising from their borrowers' failure to repay loans in accordance with their terms. While there exist other strategies for hedging such credit risks, CECs ostensibly will allow lenders to plan more accurately and with greater efficiency.

In addition, CECs offer lenders the ability to spread risk to other lenders (and/or speculators holding opposite expectations) without having to sell participations in their loans to other lenders that may insist upon receiving control over the credit and thereafter utilizing different collection strategies. Thus, CECs provide a hedge strategy that enables secured lenders to maintain tighter control over the administration of their loan portfolios.

Moreover, given that CECs are exchange-traded contracts, they provide greater transparency into the Reference Entity's financial health, as well as a financial indicator by which lenders may assess the value and liquidity of their own loan portfolios and the accuracy of their underwriting analyses.

Furthermore, by providing lenders with a direct financial interest in whether or not a borrower files a bankruptcy petition in order to address restructuring needs ' as opposed to restructuring out of court ' CECs could influence a lender's willingness to grant concessions to its borrower and the structure of such concessions. For example, a lender that has purchased a CEC has a financial incentive to actively enforce the terms of its lending agreement with a Reference Entity and to refuse to waive an event of default thereunder or grant any requested concessions or financial accommodations. Once in default, the lender could pressure the Reference Entity to file for bankruptcy or foster the filing of an involuntary bankruptcy petition against the Reference Entity prior to the expiration of the lender's CEC. The authors express no view as to whether such conduct violates applicable law and caution readers to fully consider this issue before adopting this strategy.

Even short of that, a lender that purchased a CEC will want to account for the possible payment on its CEC when underwriting a credit decision associated with the administration of a loan to a Reference Entity. Thus, a credit analysis that indicates that the lender is likely to achieve a higher recovery if the lender forecloses on its collateral and receives a payment on its CEC is likely to convince the lender to refuse to grant a borrower's requested concession(s) related to its loan.

Similarly, a lender holding a CEC associated with a distressed borrower may insist that its acceptance of any concessions be tied to the borrower's filing of a bankruptcy petition within a particular timeframe, so that the lender can collect payment on its CEC. For example, a lender may tie its willingness to provide further financing or consent to a proposed restructuring or pre-packaged plan of reorganization on the borrower's filing of a bankruptcy petition within the duration of the lender's CEC.

In addition, because CECs are exchange-traded products with greater liquidity than OTC derivatives, a secured lender will have greater flexibility to sell its CEC. This liquidity should expand the secured lender's workout options and possibly even create a beneficial investment strategy by allowing a secured lender to sell its CEC at a high price tied to the market's expectation that the Reference Entity is likely to become bankrupt. Indeed, there may be circumstances in which a secured lender may wish to grant financial concessions to a Reference Entity that would allow the Reference Entity to stave off bankruptcy and yet still permit the secured lender to sell its CEC on the exchange for a high price.

Finally, secured lenders that become aware of the intention of its borrower, or that of a possible borrower, to file a bankruptcy petition may purchase CECs based upon this information under the belief that the anti-fraud and insider trading jurisdiction of the SEC does not extend to CECs. Again, the authors express no view as to the legality of this approach.

Debtor Considerations

The availability of CECs should expand the ability of Reference Entities to tap a wider capital market and at better rates, inasmuch as potential lenders will have increased opportunities to efficiently hedge their credit decisions.

However, the flipside is that the availability of CECs could hinder a Reference Entity's ability to achieve an out-of-court restructuring or refinancing, particularly if the parties from which consent is needed are the holders (whether as buyer or seller) of CECs tied to the Reference Entity. For example, creditors holding the seller position in a CEC may: 1) reject any restructuring or refinancing proposal that is tied to a bankruptcy filing and/or 2) condition their acceptance of such a proposal on the requirement that a bankruptcy filing would not be made until after the expiration of its CEC. In contrast, creditors holding the buyer position in a CEC may: 1) reject any restructuring or refinancing proposal that is not predicated upon a bankruptcy filing; and/or 2) condition their acceptance of such a proposal on the requirement that a bankruptcy filing would be made prior to the expiration of its CEC. Thus, if possible, a Reference Entity should seek to determine whether its largest creditors are parties to such a CEC.

One approach to this problem entails the Reference Entity negotiating for a covenant in its credit agreements that obligates its lenders to disclose the existence of any CEC that it or an affiliate owns or thereafter purchases related to the Reference Entity. Armed with this knowledge, the Reference Entity can structure its affairs and any possible bankruptcy filing in a fashion that is most likely to achieve the concessions that it seeks from its lenders that hold applicable CECs.

An alternative approach calls for the Reference Entity to negotiate limitations on the ability of its creditors to purchase an applicable CEC. While this may result in the diminished availability of financing and/or less favorable credit terms, such a prohibition may, among other things, eliminate the risk that the creditor's motivation in obtaining a payment on its CEC will cause it to reject concessions or restructuring proposals that it might otherwise accept in the absence of its CEC.

Unsecured Creditor and Third Party Considerations

CECs offer unsecured creditors of a Reference Entity, such as trade vendors, many of the same benefits that make CECs attractive to secured lenders.

Like secured lenders, unsecured creditors can purchase CECs to hedge their exposure to a Reference Entity. For example, a vendor that is contemplating extending significant trade credit to a Reference Entity could efficiently purchase a CEC to protect against the risk that a bankruptcy filing by the Reference Entity will result in a loss on such extension of credit. Similarly, a trade vendor that has not received timely payment on its sales invoices may also subsequently purchase a CEC, and thereby hedge its risk at a time when the risk of loss is even greater. The fact that CECs are exchange-traded products will enable trade vendors to quickly, efficiently and anonymously purchase hedge protection that is less likely to be available in the OTC market. Indeed, sellers of private solvency derivatives are highly unlikely to offer such a contract at a time when the Reference Entity is delinquent on its accounts payable, and those that do, even assuming they can be identified, are likely to charge considerably higher prices for such protection.

Unsecured creditors may also benefit indirectly from the availability of CECs. For example, those trade vendors that do not purchase CECs can use the pricing of CECs to gauge a Reference Entity's financial health and thereby determine whether to extend trade credit to a Reference Entity and the terms thereof. In addition, a Reference Entity that seeks to avoid triggering a credit event on its secured lender's CEC may be willing to borrow money from other lenders at higher rates in order to stave off the need to file for bankruptcy prior to the expiration of its secured lender's CEC, as doing so may increase the Reference Entity's negotiating leverage with its secured lender.

Conclusion

While it is difficult, if not impossible, to fully anticipate the scope and impact of the forthcoming introduction of CECs on the restructuring community, it is abundantly clear to the authors that those members of the restructuring community that fail to account for these impacts could squander a variety of strategic and practical opportunities. As a result, the authors encourage readers to actively monitor the CME's introduction of CECs and to account for the same in their credit and restructuring analyses.

Todd L. Padnos, a member of this newsletter's Board of Editors, is a partner in the San Francisco office of LeBoeuf, Lamb, Greene & MacRae LLP. He concentrates his practice in the areas of bankruptcy, business reorganizations, workouts, and commercial litigation. He may be reached at 415-951-1140 or [email protected]. Brett J. Kitei is a bankruptcy associate in the firm's San Francisco office.