Nearly three months after UK hotels and pubs group Six Continents demerged, the thorny issues that the split threw up surrounding successor companies and credit derivatives have not gone away.
In September 2002, Six Continents started weighing up how best to deal with its outstanding debt before splitting its hotels business, which was to become InterContinental Hotels Group (IHG), from its pubs and bars, now Mitchells & Butlers. In particular, IHG would have inherited £250 million ($400 million) of debenture notes maturing in 2016 secured on pub assets.
Six Continents decided to repay the debenture notes and buy back around £275 million of medium-term notes. It then used a £3 billion syndicated loan facility to finance its demerger. On separation, each of the new businesses drew on a syndicated loan of its own to repay this bridge.
So far, so simple. But in trying to organize its business split in the most effective way, Six Continents became a subsidiary of IHG. Six Continents now had little debt to speak of, with only around £18 million-worth of MTNs not signed up to the buy-back. It was correspondingly less likely to default.
So anyone who had bought credit protection on Six Continents could have found themselves out of pocket. “The fundamental fear was that they had paid for credit protection on a company that couldn’t default because its debt was sitting somewhere else,” says a credit strategist. “It’s like having bought car insurance then realizing you don’t actually own a car.”
Looking for a way around this problem, the market started to ask whether IHG and Mitchells & Butlers had succeeded to Six Continents’ debt under the relevant credit derivatives contracts. When legal opinions converged to say that, because the terms of the two new loans were so different to those of Six Continents’ old debt, neither IHG or Mitchells & Butlers was a successor company, those fundamental fears looked justified. Six Continents had no deliverables.
Selling at a loss Lenders to Six Continents who had bought protection found themselves with credit default swaps that they had to try to sell at a loss. Any traders who had looked for arbitrage between Six Continents and other hotels groups found half of their spread trade disappearing because the credit default contracts written on Six Continents did not, as they had assumed, follow Six Continents’ debt burden to IHG.
While the market felt that the economic reality of the situation was that IHG had succeeded, the swaps were unexpectedly stuck on a nearly debt-free Six Continents, and were becoming worthless.
In late January and early February, the absolute spread that Six Continents contracts were trading on dropped by around 40 basis points. “At that stage, Six Continents was a dead dog,” in the words of one lawyer.
The timing of all this was bad. On February 10, the International Swaps & Derivatives Association published its new 2003 credit derivative definitions. Their language offered no solutions to the Six Continents problem of which company, if any, would succeed. In March, Fitch reported demand for another successor supplement in the light of the impending demerger.
By June 2003, however, it seemed that the controversy had evaporated. This was largely a matter of luck. Anxious that they would be structurally subordinated if Six Continents – which is still a potentially useful financing vehicle – issued bonds, the banks that had lent to IHG asked for and got cross-guarantees between Six Continents and IHG. Suddenly, Six Continents had its deliverables, though the range of deliverables is reduced.
The broker-dealer market was suitably relieved. Spreads on Six Continents credit derivatives stopped tightening and moved back into line with other hotel names, which themselves had been tightening in the meantime.
But the key successor problem on Six Continents – what happens when a demerging company buys back its debt – is unresolved and may well be tested again on a name that is more heavily traded or appears in more CDO portfolios. Successor issues might be dormant, but they could return with a vengeance.
“From the dealers’ perspective, the first priority is certainty. The second is to have a market that invariably achieves the result that people expect so that a credit derivative they have bought tracks the right loan,” says Mark Beeston, COO of Integrated Credit Trading at Deutsche Bank. “Very few firms have any appetite for the uncertainty of legal risk in a contract,” says Beeston. Six Continents might have delivered legal certainty, but not the certainty that the market wanted, and that it still wants.
The Six Continents case leaves open the possibility in future demergers of worthless credit derivatives contracts written on shell companies. Buyers could find themselves paying a premium for nothing. Conversely, sellers could find themselves with riskier contracts written on a company with a lower rating than the original name.
One lawyer predicts that in future traders will stop quoting on demerging names rather than taking a punt on whether a new company has succeeded.
The market still needs to close the gap between the legal position and a commercially fair outcome. Tracking debt isn’t the only headache. If a name that appears in a CDO that is subject to sector concentration limits demerges, the choice of successor entity could have an impact on whether the CDO stays compliant.
Avoiding conflicts “Traders are trying to agree a reference obligation at the time of a trade to avoid conflicts over the course of the contract, especially if there is an event,” says Joe Santomo of brokers GFI. “Extra research goes into deals before they trade now.”
Another UK company, retail group Kingfisher, which is due to demerge this quarter, is confident that it will not have to buy back its debt and so will avoid becoming Six Continents II, but it has been watched carefully.
“I hope and pray that the contracts stay where the debt stays,” says one credit analyst. And German utilities group RWE is shifting debt around its group in a way that could, according to some observers, trigger a successor event.
Certainly successor language is being factored into deals. “The group of credit swap users with potentially the biggest stake in a clear resolution of successor language are those which tend to hold large negative basis positions, ie, long physical asset versus short the credit swap,” says Paul Czekalowski, European head of ICT credit structuring at Deutsche Bank. “Whilst these users are generally aware of successor language risk, their general approach is to incorporate this risk as one of a number of factors which determine the spread hurdle required to put negative basis positions on the book.”
For now, it’s unrealistic to ask for more input from ISDA as its new definitions will take at least six months to bed down. Until then, the market runs the risk of bigger losses on demerging names where the volume of notionals is far higher than it was on Six Continents. The unpredictability of these issues resurfacing on future deals makes some sort of consensus on how credit derivatives should follow debt more, not less, of a priority. If the market isn’t worried about where Six Continents leaves us, it should be.
