Credit derivatives are supposed to reduce risk not add to it. But the restructuring of UK electronics company Marconi is proving that the documentation of credit swaps is not as reliable as banks would hope.
Lawyers are unsure whether the company’s $4 billion workout should trigger Marconi swaps. At issue is whether a non-binding agreement to restructure counts as a credit event under definitions written by the International Swaps&Derivatives Association that are used as the basis for most deals.
Patrick Clancy, a lawyer with Shearman&Sterling and ex-director of WestLB, says: “The aim of credit default swaps is that the protection buyer can get out when things go wrong. If it cannot, the market is not working. That has to be an error in the documentation.”
If bankers cannot settle their contracts when a company agrees to a non-binding workout, they could find their credit protection expires before they cash in. Should they be forced to wait until the restructuring takes effect, they could even find the underlying company’s bonds and loans are exchanged for securities that protection buyers cannot deliver under their swaps. “Then they really would be stuffed,” says a UK lawyer.
Since Marconi struck a deal with creditors late in August, agreeing to replace debts with cash, bonds and equity, the company has been heavily traded in the credit swap market. Now the creditors that bought protection want to call in their money. But their lawyers cannot agree whether the banks can do so or not. Law firm Linklaters says the proposed restructuring counts as a credit event. Clifford Chance, another law firm, says it does not.
For now, the banks are doing nothing, each waiting to see if others will try to settle their swaps. One senior counsel at a leading investment bank says: “Everyone knows there are these credit derivatives out there. Everyone knows the law firms have different views. My own view is that Linklaters has the better argument, but I am not without my doubts.”
A credit event can usually be called if a company fails to pay interest on its debts, strikes a deal to restructure obligations or is about to become insolvent. In Marconi’s case the company’s bankers have waived interest payments. And the non-binding restructuring agreement does not trip swap contracts.
How delicate is the trigger?
Linklaters, which has been representing various creditors, argues that a credit event has occurred under the third criteria – imminent bankruptcy. This can be triggered if, in Isda’s words, a company takes action in furtherance of an arrangement for the benefit of creditors, meaning action to avoid going bankrupt. This argument has not been used before.
Linklaters’ head of derivatives, Simon Firth, says: “Marconi has made it quite clear that it has a particular objective which the company must achieve if it is to survive.” A press release describing the proposed restructuring is enough to trigger the contracts, he says. “Nothing in the swaps documentation requires the action to be in the form of an application to court or other formal legal steps.”
Clifford Chance, which has advised Marconi on its restructuring, disagrees. The firm is understood to believe that talking with creditors is not enough to trigger the clause. The firm’s lawyers say the company must take a formal step, such as seeking court approval of its plan, to trip the agreements.
Other derivatives specialists say it is wrong to declare a credit event on the basis of bankruptcy. The clause was written so protection buyers could settle contracts should a company be heading for unavoidable insolvency. In Marconi’s case this is not clear, they say.
Bankers will be hoping Linklaters is right. When credit swaps are settled, the protection buyer usually hands over bonds to its counterparty in return for payment – physical settlement. But if the restructuring goes ahead before banks serve credit notices on counterparties, their bonds and loans will be swapped for mostly equity. Shares cannot be delivered to a counterparty under the Isda rules.
Firth says: “If a bank held notes worth $100 million, which were exchanged for new bonds worth $10 million plus equity, the bank would have $10 million to deliver and would have lost 90% of its protection.”
Shearman&Sterling’s Clancy adds: “This raises the question of whether there should be a fall-back to cash settlement written into contracts, something that is not standard at the moment.” Cash settlement would mean protection buyers could claim money equivalent to the lost value of their bonds rather than delivering the securities to the counterparty.
Isda remains unflappable. Kimberly Summe, its general counsel, says: “The fact we are not getting calls about this means things are proceeding normally.” The clause under which Linklaters is claiming a credit event on Marconi has been removed from the most recent version of Isda’s definitions, she says. But the same problems that have arisen in relation to Marconi apply to all contracts written before the November rule changes.
Some commentators are unconvinced the new rules are an improvement. Linklaters’ Firth says: “The rating agencies like the new definitions because the scope of the ‘taking steps’ clause is unclear and, arguably, it kicks in too early. It is too sensitive. But in a case like Marconi the clause is a necessary trigger. Otherwise a credit event might come too late and investors would have nothing to deliver under their contracts.”
Rob Mannix (rmannix@iflr.com) is the editor of Euromoney’s sister publication, International Financial Law Review.
