Gavel at the keyboard
Non-capital markets: 15 lawyers debated the significance of the size of a single letter to decide the fate of $600m of derivatives

The $8tn market for credit-default swaps enables financial institutions to hedge their debt portfolios while allowing sophisticated investors to place bets on the creditworthiness of companies.

It is also a market where 15 lawyers debating the significance of a lower-case “o” decided the fate of $600m worth of derivatives this week.

CDS are akin to insurance contracts, protecting against the risk that a company does not repay its debts. Crucially, though, the contracts are not legally classed as insurance, allowing them to be freely traded by institutions that have no exposure to the debt concerned.

This is an important distinction: you would never be allowed to buy life insurance on another person, for obvious reasons. And while a life insurance contract is simple to settle — a person is either alive or not — the shades of grey in the health of companies make credit derivatives much more unpredictable.

This combustible combination means that one thing is certain, however: controversy is never far away.

The latest storm centres on VodafoneZiggo’s CDS. These derivatives crashed in value this month after traders realised that the Dutch telecoms company had wound down the unit that previously housed its bonds back in March 2018, moving the debt to a new entity.

This seemingly mundane reorganisation meant that CDS buyers were essentially holding insurance policies on a company that no longer existed, evoking the adage about contracts not being worth the paper they were written on.

None of this would have mattered if someone had flagged the switch to supervisors within 90 days. But nobody noticed — for the better part of a year. That is more than an embarrassment for a market supposedly filled with sophisticated participants. It meant that those who had bought the VodafoneZiggo CDS stood to lose hundreds of millions of dollars.

To the uninitiated, this probably seems very silly. It appears logical that the CDS contracts should really reference the new VodafoneZiggo entity.

But when things go wrong in the CDS market, buyers and sellers have to turn to one of the industry’s so-called “determinations committees” for adjudication. These panels are made up of in-house lawyers from 10 banks and five fund managers, who vote on how the contracts should be interpreted.

CDS contracts have a clause allowing a transfer to take place even if the 90-day window is missed, but only if a new entity “assumes all of the obligations” of the old one. Given one of the defining characteristics of the legal profession is pedantry, the lower-case “o” on the fifth quoted word stuck out like a sore thumb to CDS lawyers.

Normally, the word “obligation” is capitalised in CDS documentation, meaning it refers strictly to a relevant set of bonds. The lack of a capital letter in this clause could mean the term refers to any potential obligation, such as tax liabilities.

In the VodafoneZiggo case, the committee ruled the $600m of CDS could be transferred to the new entity because although there were lower-case “o” obligations left behind, they were deemed “immaterial”.

To many, it was a rare victory for common sense. Others were left puzzled by a panel that usually follows the letter of the law now conceding that its interpretation was “probably different to the English legal meaning”.

“They’ve never fudged the documents before,” says one hedge fund manager. “It’s the uncanniest thing I’ve ever seen.”

For the banks that were the biggest holders of VodafoneZiggo’s CDS, it was a happy fudge, with cynics pointing out that the majority of seats on the committee were held by the banks’ lawyers. The committees have always insisted that they are independent, as their legal representatives sit safely behind internal Chinese walls at the banks.

Yet the fact that many market participants took a cynical view shows how a string of sharp-elbowed trades in recent years have shaken faith in the market.

Last year saw a high-profile furore over “manufactured defaults”, a controversial practice pioneered by Blackstone, where companies are offered financial sweeteners to default in a way that triggers a windfall on their CDS.

The more recent bankruptcy of Sears was marred by a spat between hedge funds looking to influence the level of payouts on the US retailer’s CDS.

While this Sears dispute has now been resolved, some of the retailer’s creditors are trying to subpoena the parties involved — including Cyrus Capital, a US hedge fund — to shed light on how the CDS truce was struck.

Cyrus has also been hit with a legal complaint from the bankruptcy estate of Norske Skog, a Norwegian paper company that was the subject of a contested CDS trade in 2016 involving the US hedge fund and Blackstone.

The real-world consequences of seemingly abstract derivatives bets are forcing lawyers for bankrupt companies to wake up to the CDS market. While that could ultimately stem some of the controversial goings-on in the CDS market, don’t expect surreal episodes in which hundreds of millions dollars can ride on the meaning of a lower case “o” to end anytime soon.

robert.smith@ft.com

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