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US loan market seeks to block CDS manipulation

NEW YORK, May 13 (LPC) - US companies are trying to stop speculative investors from calling events of default on leveraged loans to get payouts under Credit Default Swap (CDS) contracts at the expense of other lenders as investor activism rises.

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

The move to add tougher new language to documents follows two highly publicized US court cases involving homebuilder Hovnanian and telecom service provider Windstream.

The changes would curb CDS holders’ ability to call a default, either by removing their right to vote on creditor decisions, or by blocking them from owning a loan altogether, sources said.

CDS effectively provides insurance for debt. Investors, that may own a company’s loan, bond or both, buy CDS contracts which offer protection against a negative credit event including a default or bankruptcy filing.

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

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

While the aim of the proposals is to protect the US$1.2trn leveraged loan market, the proposals are expected to meet some resistance from more aggressive investors.


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

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

Solus and GSO agreed to settle the case in late May 2018 and Hovnanian made the interest payment that it skipped on May 1, 2018, according to a news release.

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

US companies are trying to stop similar situations arising in the future. Barring 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 that borrowers prefer not to share private information with, or are barred for reasons including previous activism.

“From a company perspective, they don’t want their lenders coming into the loan with an agenda that won’t align with their (plans),” said Jessica Reiss, head of loan covenant research at 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 their positions, Reiss said.

Another documentation proposal would ban CDS owners from participating in lender votes, which would stop them from calling a loan default or enforcing it, sources said. It would not impede a CDS holder that owns the bond from calling a bond default.

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


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

“Market participants and their advisors are advised that in instances of manufactured credit events, the (CFTC) will carefully consider all available actions to help ensure market integrity and combat manipulation or fraud involving CDS, in coordination with our regulatory counterparts, when appropriate,” the regulator said in April 2018.

In March, the International Swaps and Derivatives Association (ISDA) said it was amending its CDS definitions to address narrowly tailored credit events.

ISDA’s CDS proposal is a simple fix which requires credit deterioration at the underlying entity for the CDS to be triggered. This creates some uncertainty around the outcome, which is designed to deter a manufactured default strategy, Carruzzo said.

“If you only have a 50-50 chance a strategy will work, that it will be determined to be a true credit event, you may hesitate to do it because you are not sure you can monetize the contract,” he said. (Reporting by Kristen Haunss. Editing by Tessa Walsh and Michelle Sierra)