Normally this blog only covers litigation in United States courts between counterparties to a derivatives contract. However, I wanted to step out for a second to cover litigation in a different venue – in front of the International Swaps and Derivatives Association (ISDA) Determinations Committee. That committee recently made a decision that may cause counterparties to regret giving the ISDA such authority. The committee decided on March 1, 2012 that there had been no default on Greek debt and thus holders of credit default swaps (CDS) on Greek debt would not receive payment.
Before discussing the decision I wanted to describe how things worked previously. There was a very similar case filed in 2002, regarding Argentina’s debt exchange. That case, Eternity v. Morgan, was blogged here. There the parties had entered into CDS on Argentine debt, and they disagreed about whether Argentina’s 2001 debt exchange constituted a default (specifically a restructuring credit event) entitling the protection buyer to receive payment. Back then there were no ISDA Determinations Committees and so the parties had to resolve the question in New York Federal District Court. The court ruled that since the exchange was “voluntary” there was no default. Eternity appealed, and the Second Circuit Court of Appeals overturned the decision, stating that the bonds received in the exchange “undeniably provide a lower return over a longer maturity than the original bonds.” Although that alone does not reveal whether the exchange was voluntary, the Appeals Court reminded the District Court that there may have been economic coercion and raised a number of other questions. The Appeals Court sent the case back to the District Court for further deliberations. The case was settled in late 2006, before the District Court could issue a new opinion.
As demonstrated above, one problem with letting the courts answer these questions is that courts disagree with each other. Different courts can have different answers, and there is no uniformity. Another problem is that the process took years, and if the derivatives market is going to grow things have to move much more quickly. Ideally, parties would know whether a default had occurred near instantaneously and such a determination would affect all CDS whose payoffs were conditioned on the default.
In response to this wish for a quick and uniform answer, in 2009 the ISDA created the “Auction Hardwiring” a.k.a. the “Big Bang Protocol” framework. This new regime provided for a quick and automated settlement of derivatives contracts. Among other things, it created the Determinations Committees which would issue binding decisions on various questions, including whether a credit event had occurred. The committee would be made up of the ten largest dealers and five largest non-dealer users of derivatives. Auction Hardwiring would be incorporated into ISDA contracts created after 2009, and parties to previous contracts were allowed to incorporate it via amendment. Of course parties were free to ignore this change, and to write their own derivatives contracts subject to the prior regime. But the new regime was highly popular as virtually all members of the derivatives community signed up for it.
Thus far, there were no notable decisions by the committee (although there were controversial decisions and numerous split votes). However, their decisions on March 1 raised a stir. For example, see this article “If Greece Isn’t a ‘Credit Event,’ What Is?” by Richard Quest and the article “Greece and Credit Default Swaps: Bucking the ISDA Cartel” by derivatives expert Janet Tavakoli.
Moving on to the details of those decisions, decision no. 2012022401 decided whether Greece’s debt exchange with the European Central Bank (ECB) constituted a restructuring credit event. In preparation for the transactions that would give Greek bondholders less than they were owed (i.e. a “haircut”), Greece did a debt exchange with the ECB to shield the ECB from the haircut. The committee ruled that this effective subordination was not a credit event. In decision no. 2012022901 the committee said that the Greek debt exchange offer of February 24, 2012 was also not a credit event.
The precise questions submitted to the committee are provided below, but I cannot provide the committee’s explanation for their decisions because no such explanation was released. The committee’s decisions are communicated as a vote tally (which in this case was 15-0 on both questions). When deciding whether a credit event had occurred in the Eternity v. Morgan case discussed above, the courts issued long and well articulated opinions. However here there is only yes or no answer which can potentially make the decision seem a bit capricious and, more importantly, does not provide guidance to parties who want to predict how the committee will rule in the future.
As additional events occur the committee could issue a ruling declaring a default. Some expect this to happen when Greece uses the Collective Action Clause (CAC) to force holdout bondholders to accept the exchange. A CAC states that as long as some majority (e.g. 70%) of creditors agrees to modify the debt agreement, such modification will be forced upon the holdouts. This induces holdout bondholders to exchange their old debt for new debt, because after the old debt is modified via the CAC, it will have the same terms as the new debt. However, the old debt will be illiquid. Thus between the modified old debt and the new debt, you might as well take the new debt. It is seemingly coercive upon the holdouts and so an amendment of Greek debt pursuant to the CAC is expected to be a credit event. But even if such a default decision is made, it leaves lingering questions as to why the events that have occurred thus far were not a default. Thus the decisions raise serious questions about the value of ISDA documented CDS as a hedging tool.
Documents excerpted below:
· Question No. 2012022401 posed to the ISDA Credit Derivatives Determinations Committee for Europe, the Middle East and Africa, Feb. 27, 2012
· Question No. 2012022901 posed to the ISDA Credit Derivatives Determinations Committee for Europe, the Middle East and Africa, Feb. 27, 2012