August 5, 2019 BARRON’S 29
Debtissuersaretakingstepstorestrictfunds’useofcreditdefaultswapsto
“manufacture”corporatedefaults. By Mary Childs
Hedge Funds’ CDS
‘Games’ May Be Ending
IN RECENT YEARS, SOME HEDGE FUNDS HAVE USED
credit default swaps to “manufacture” corporate
defaults,aimingforahandsomeprofitinthepro-
cess.Butthatmaybecomemoredifficultascorpo-
rations erect roadblocks to stop them.
Theswaps—financialproductsdesignedtohelp
mitigate credit risk—pay out to holders if issuers
missdebtpayments,fileforbankruptcy,orundergo
anyother“creditevent.”Butsomeissuers,arguing
thatthefunds’actionsareabusive,areworkingto
tightenlanguageindebtcontractstorestrictlend-
ers’ behavior.
Whilethehistoryofmanufacturedcreditevents
goesbackto2006,fundsrampedupthepracticein
recentyearsafterGSOCapitalPartners,a Black-
stone Group (ticker: BX) hedge fund, cajoled
Spanishgamingcompany Codere (CDR.Spain)into
skippinganinterestpaymentonaloanthatGSO
owned, triggering a CDS payout to GSO.
GSO tried to engineer a credit event by home
builder Hovnanian Enterprises (HOV), but stood
downafterahedgefundthathadsoldtheCDSsued.
Inanothersituation,hedgefundChathamAsset
Management encouraged publisher McClatchy
(MNI) to stop issuing debt by an entity to which
itsCDSweretied,“orphaning”thecontractsand
sending the value plummeting.
TheCommodityFuturesTradingCommission,
whichgovernspartoftheCDSmarket,observed
14 manufactured credit events in the past 2½
years,comparedwithjustsixinthedecadeended
in 2016, former chairman Christopher Giancarlo
said on a July 10 CFTC podcast.
Inadifferenttypeofsituation,AureliusCapital
Management claimed telecom-services provider
WindstreamHoldings (WIN)wasindefaultdue
toayears-oldcovenantbreach.InFebruary,after
a courtruledinAurelius’favor,Windstreamfiled
for bankruptcy protection.
The“silverlining”totheWindstreamdebacleis
that“borrowersarekeptontheirtoesbythepros-
pectofvigorouscovenantenforcementbycreditors,”
CovenantReviewanalystIanWalkerwroteinMay.
Andnow,theyarealsoontheirfeet,takingsteps
to prevent lenders from getting the best of them.
Companiesare“usingdebtdocumentsasaprophy-
lactic tool to avoid the consequences suffered by
Windstream,”analystsatFitchRatingswroteina
June report.
Issuershavetrieddifferentapproaches,includ-
ing disenfranchisement provisions in loan docu-
ments that disqualify any net-short lender—one
whosepositionmightmotivateittopushthebor-
rowerintodistress—fromvotingitsinterests.Such
lenders must disclose their status.
Issuersarealsotighteningtimelimitsoncredi-
torobjectionstoactions,somethingthatgenerally
wasn’tproscribedinthepast. ClearChannelOut-
door Holdings (CCO) and Builders FirstSource
(BLDR) have recently written language giving
debtholderstwoyearstoobject,inwhatXtractRe-
searchcalls“contractuallyshortenedstatutesoflim-
itations,”orSOLs.Somedocumentsnowmandate
alonger“defaultcureperiod”—moretimefortheis-
suer to fix a problem or ask lenders to waive a
breach.Another:uppingtheproportionoflenders
who can declare a default.
Whenfacility-servicescompanyAlliedUniver-
sal issued debt in June, it wrote in a disenfran-
chisementprovisionandanSOL. NexstarMedia
Group (NXST)and Grubhub (GRUB)issueddebt
recently with SOLs and extended cure periods.
SiriusComputer’sJunedebtissuewas“thefull
monty,” wrote Xtract’s Valerie Potenza. Terms
barrednet-shortlendersfromvotingasstakehold-
ersnormallydo,andgaveSiriuspowertotransfer
their holdings to a third party or to Sirius.
Hedgefundshaven’ttestedthenewdealterms,
andtheymaynotwork.Therearestructuralchal-
lenges: Issuers can’t disenfranchise bondholders
due to regulations, for example, so that new lan-
guage “fails to capture the very type of conduct
thatledtoWindstream’sbankruptcy,”Fitchwrote.
Preventing all future loophole exploitation is
nearly impossible, Potenza says.
“People always come up with some innovative
waytoworkaroundaprovisionthatseemsinsur-
mountable,” she tells Barron’s. “It could be any
structure, if somebody sees an opening.”
CovenantReviewsaysthatthefixesriskover-
shooting.“Iftheseattemptscontinuetoproliferate
andmutate,theymaythreatengood-faithcovenant
enforcementbycreditorsthatarenotplayingCDS
games,”analystRossHallockwroteinaJunenote.
Representatives for Aurelius, GSO, and Chat-
ham declined to comment.
Although low interest rates have made debt
agreements a playground for creativity, they’re
generallyprettyexplicit;mostbehavioriscodified.
But CDS are relatively new and were built to be
more malleable than other instruments.
What’smore,theyfallawkwardlybetweentwo
regulators:TheSecuritiesandExchangeCommis-
sion oversees single-name CDS; the CFTC, CDS
indexes.MostCDSuserstradeboth,oftenpaired.
The two agencies don’t always collaborate seam-
lessly, which has created confusion.
Regulatorsandmarketparticipantsworrythat
CDScreativityundermineswhattrustremainsina
productmanyblameforthefinancialcrisisanda$6
billionlossat JPMorganChase (JPM).Lettingthe
most aggressive investors push rules might scare
those who just want to hedge credit risk.
“Our focus on these strategies is sharpening,
andintensifying,”Giancarlosaidonthepodcast.
Low interest
rates have
made debt
agreements
a playground
for creativity,
but they’re
generally
pretty explicit;
most of
their behavior
is codified.
But CDS are
relatively
new and were
built to be
more malleable
than other
instruments. Tara Jacoby