05 Apr Credit Default Swaps and Bankruptcy
In a series of papers – the most recent a chapter in Greg N. Gregoriou’s and Paul U. Ali’s Credit Derivatives Handbook: Global Perspectives, Innovations, and Market Drivers (McGraw-Hill 2008) – Seton Hall Professor Stephen J. Lubben has argued over the past year or so that credit default swaps (CDS’s) will change the negotiation dynamic of large Chapter 11 cases.
An understanding of Lubben’s argument requires at least a rudimentary understanding of what CDS’s are and the purpose they serve. As discussed by a brief article appearing in the March 5, 2009 edition of The Economist, “[a] CDS works like a fire-insurance policy: the holder pays a regular premium, but if the house burns down there is a big payoff. With CDSs, the payoff is triggered by a default – and filing for Chapter 11 [does] indeed trigger some CDSs.”
Against this conceptual background, Lubben argues that where the holder of a CDS is better off with with a default on the debt underlying the swap than it is waiting for the debt to pay out, the dynamics of debtor-creditor negotiation before and during Chapter 11 will change. In particular:
– CDS’s could impede the negotiation of workouts, pre-arranged or pre-negotiated Chapter 11 plans, as creditors with a vested interest in the debtor’s failure either refuse to negotiate or – worse yet – actively seek the company’s demise.
– CDS’s may shorten the timeframe for workout negotiations or promote the increased use of involuntary bankruptcy filings.
In a helpful post offered last month on the academically-oriented bankruptcy blog “Credit Slips,” John Marshall Law School Professor (and fellow “Credit Slips” blogger) Jason Kilborn points readers to the March 5 Economist article and suggests further that the CDS market may incentivize claims trading amongst speculators betting on the debtor’s failure:
[W]hat if high-risk investors (speculators?) buy CDS[‘s], banking on a corporation’s default (akin to “naked short selling” of a company’s stock) [?] This explosive situation comes to a head if the borrower company attempts a reorganization. Now you’ve got very dedicated and often aggressive investors hoping for your failure! [With] enough riding on the CDS paying out, one can easily imagine a CDS holder offering to buy a blocking position (34%) of the unsecured debt of a company attempting reorganization – which the CDS holder can probably do for a song in light of the pending reorganization (and the payout on the CDS will almost inevitably be more than a plan promises to unsecureds). I’ve heard lots of grousing among judges wanting to know how certain “creditors” voting unsecured claims came to own those claims – now I understand why these judges want that info and what scary info they might find if the question is answered. I presume the “not in good faith” votes of CDS holders voting down a reasonable reorg plan could be equitably subordinated or classified (rejected). What a nightmare for debtor’s counsel! All that work to then have your plan fail because investors with no real skin in your game tank your deal so they can collect the equivalent of hazard insurance on your failure.
Precisely how – and under just what circumstances – CDS’s will affect the negotiation dynamics that for years have been a staple of reorganizations remains to be seen. Lubben suggests that under some circumstances, the holders of CDSs may, in fact, still retain an interest in seeing the debtor succeed. Kilborn himself points to recent developments in the case of LyondellBasell, the Dutch petrochemicals giant whose American unit, Lyondell Chemicals, commenced Chapter 11 proceedings in January: According to the March 7 Economist article, “some CDS holders want to force the debtor’s European parent to default, bringing in the complications of a cross-border reorganization. That would so complicate the case that the chance of a total meltdown – and a payout on the CDS – would spike, so DIP lenders have ponied up just to avoid that eventuality.”
Regardless of the ultimate outcome, this formerly esoteric and little-understood corner of the bond market appears to be having a very practical, real-world effect on larger Chapter 11 cases.