March 1, 2021

DealBook: When a Bankruptcy ‘Event’ Doesn’t Mean Bankruptcy

A subsidiary of Energy Future Holdings operates a natural gas plant in Dallas. Aurelius Capital said the Texas power company is in default on a loan.Matt Nager/Bloomberg NewsA subsidiary of Energy Future Holdings operates a natural gas plant in Dallas. Aurelius Capital said the Texas power company is in default on a loan.

In finance and law, bankruptcy is understood to mean a process for resolving financial distress, like those under the United States Bankruptcy Code or the Companies’ Creditors Arrangement Act in Canada. State law assignments for the benefit of creditors could also been seen as a bankruptcy process under this definition.

In common parlance, bankruptcy is often used more casually, to mean something like broke or insolvent.

Which version, then, would you expect would apply to a bankruptcy trigger in a credit default swaps contract?

You might be surprised.

Section 4.2 of the 2003 International Swaps and Derivatives Association’s credit derivatives definition lists seven categories that could set off a bankruptcy credit event and thus a payout from a protection seller. There is also an eighth category that picks up any event that is analogous to the first seven. The precise language is set forth in the document below.

Take a close look at Part (b) of Section 4.2, which provides that

Bankruptcy means a Reference Entity . . . becomes insolvent or is unable to pay its debtors or fails or admits in writing in a judicial, regulatory or administrative proceeding or filing its inability generally to pay its debts as they come due.

Not exactly polished English grammar, but corporate lawyers are rarely rewarded for that.

Now, one credit default swap protection buyer wants to argue that the phrase “becomes insolvent” means that a bankruptcy credit event involves bankruptcy in the colloquial sense of the work.

The issue involves Aurelius Capital Management, no novices in the world of distressed debt world, which, one can surmise, holds lots of credit default swaps that reference the Texas Competitive Electric Holdings Company.

The Texas Competitive Electric Holdings Company is not a public company, but a subsidiary of two reporting companies. And in a recent registration statement, one of those parent companies said this as part of its discussion of the “risk factors” associated with the registration:

Analyses of TCEH’s business indicate that the principal amount of its outstanding debt exceeds its enterprise value.

Aurelius Capital has asked the International Swaps and Derivatives Association committee that considers these matters to rule that the “becomes insolvent” language in part (b) means insolvency in a balance sheet sense of the word, and that, among other things, the above registration statement language constitutes an admission that the Texas Competitive Electric Holdings Company is insolvent on that basis.

In short, Aurelius Capital wants to say there has been a bankruptcy credit event, without any actual bankruptcy or similar proceeding.

This could have major implications for the broader market for credit default swaps. Among other things, it would seem that if this interpretation is adopted, any company with negative shareholder equity on its books has also triggered the credit default swap contracts that reference it.

That includes a lot of companies, including some that have reasonably good share prices, which presumably reflect the possibility of a brighter future. For example, AMR, parent company of American Airlines, reported assets of $25 billion and liabilities of $29 billion on its 2010 10-K filing.

Has it also triggered a bankruptcy credit event? If so, how do we explain current credit default swap prices, taken from Bloomberg, which show price of about $2,400?

If there has been a credit event, the credit default swap prices should equal the payout on the credit default swap because the buyer would essentially be buying the right to the payout. Of course, one doubts there would be any sellers in such a situation.

Other major companies with negative book equity — based on their most recent 10K as reported on Bloomberg Law — include Ford, Clorox, Cablevision Systems, Lorillard and Moody’s (irony noted).

If all of these have experienced credit events, the credit default swap market is in for some major dislocation.

This is but one reason why Aurelius Capital’s argument can’t be right, no matter how clever and seemingly plausible it is in the abstract. More generally, their proffered reading of Part (b) really makes no sense in the broader context of Section 4.2, which is entirely focused on bankruptcy in the legal and financial sense of the word.

Rather, it seems to me that Part (b) is really trying to capture something like the criteria that would support filing an involuntary bankruptcy petition under Section 303(h) of the Bankruptcy Code. That makes Part (b) consistent with the other elements of Section 4.2.

The drafting is awkward, but does it make any sense to generate a credit default swap based on a financial condition that is not tied to any actual default? Clearly there is no hedging reason for such a thing, and even on the speculative side it seems unlikely that such a provision would be buried deep within the definition of bankruptcy.

All of this is no doubt behind the International Swaps and Derivatives Association’s decision on Thursday that no bankruptcy credit event had occurred.

Here’s betting that the International Swaps and Derivatives Association amends this provision in the next round of credit default swap definitions.

International Swaps and Derivatives Association’s credit events definitions

Stephen J. Lubben is the Daniel J. Moore Professor of Law at Seton Hall Law School and an expert on bankruptcy.

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