When Blackstone’s GSO Group came up with a debt restructuring plan for New Jersey-based building firm Hovnanian earlier this year, the debt exchange was dependent on manufacturing a cheapest-to-deliver security that would produce a bumper pay-out on the firm’s CDS from a default that was also part of the plan.
The scheme drew harsh criticism and was seen as an outrage – a threat to the integrity of the CDS market itself.
Although GSO is a master of the art, such behaviour – dubbed “net short debt activism” – is far from isolated. It involves building up a long position in the debt of a company in order to assert a default that will trigger CDS pay-outs from a larger short position. Still smarting from the bad publicity surrounding the Hovnanian default, the CDS market is now braced for further reputational damage from another such situation.
Hedge fund Aurelius, which has a long history of debt activism, has been fighting a lengthy battle in the US with rural internet services provider Windstream, alleging that a sale leaseback of its fibreoptic cable network in 2015 violated debt terms in place to preserve assets for noteholders. It claims the sale leaseback constitutes an event of default and is understood to have built up a large short position in the debt in the expectation that the CDS will consequently be triggered.
A decision on the case is now imminent. If the ruling supports the hedge fund’s position, it could trigger cross defaults on $5.7 billion of Windstream debt.
If the ruling in the case goes Aurelius’s way, this will be a second big blow to the reputation of the CDS market in a year
The telecom firm has conducted a $1.6 billion debt exchange in order to dilute Aurelius’s position – a move that the latter has also challenged, claiming that there is a prohibition on new debt.
Interestingly, Elliott Management, one of the most widely known activist debt funds, is on the other side of this fight, and agreed to the debt exchange. Windstream has refinanced $3.4 billion of its $6 billion debt pile in the last two years.
If the ruling in the case goes Aurelius’s way, this will be a second big blow to the reputation of the CDS market in a year. The furore precipitated by the Hovnanian restructuring prompted the Commodity Futures Trading Commission (CFTC) to observe on April 24 that such manufactured defaults could amount to market manipulation and that they severely damage the CDS market. The announcement was carefully timed to appear shortly before Hovnanian missed a payment on its bonds on May 1.
Net short debt activism is highly lucrative when it works, however, and many distressed debt funds have profited handsomely from time spent trawling through deal documents to find potential anomalies. It will take more than stern words to rein in such activities. The CDS market needs to step up its response.
Isda needs to prohibit the manufacture of both cheapest-to-deliver obligations and transactions with affiliates intended to trigger a default. It must also hope that the Windstream case goes against Aurelius in order to avoid another deluge of negative headlines hitting the single-name CDS market.