- Deposit insurance schemes — Deposit protection schemes — Recovery and Resolution Plan (RRP) — Special Resolution Regime (SSR) — Regulation of banks — Credit risk — Derivatives — European Banking Authority (EBA)
(p. 115) 6 The Revision of the Credit Derivative Definitions in the Context of the Bank Recovery and Resolution Directive
6.01 Credit derivatives serve a critical function for financial institutions and the economy at large. For instance, credit default swaps allow inter alia transferring the risk of a debtor defaulting on its obligations to a third party which is more apt to assume the risk. The International Swaps and Derivatives Association (ISDA), the largest association representing the interests of the derivatives industry, provides a legal framework for the trading of most cross-jurisdictionally traded over-the-counter derivatives, which encompasses credit derivatives. The 2007 financial crisis revealed substantial weaknesses in the framework, which are more probable in the context of the Bank Recovery and Resolution Directive (BRRD).1 The reason is that the BRRD establishes a pre-insolvency regime for financial institutions, which allows competent authorities to intervene with creditor rights outside of traditional insolvency procedures. It creates a precarious mismatch, since the ISDA framework was designed with an insolvency procedure for companies in mind. The BRRD can affect credit derivatives in two ways. In the first, either the seller or buyer of the credit derivative becomes subject to a BRRD measure. In the second, the institution or obligation to which the credit derivative is referenced becomes subject to the measures. The chapter will explore the adaptation of the (p. 116) ISDA framework by means of the 2014 ISDA Credit Derivatives Definitions (2014 Definitions) to address the latter situation.
6.02 Section B will provide background information on the functioning of credit defaults swaps (Credit Derivatives or CDS).2 Section C will explore the documentation of CDS and the adjustments made during the financial crisis. Section D will analyse the BRRD from a Credit Derivatives perspective and illustrate experiences made during the financial crisis. Section E will scrutinize amendments of the 2003 Definitions in form of the 2014 Definitions. The last section will conclude the chapter.
6.03 Financial derivatives are financial instruments which provide for an immediate or future exchange of a reference value. Its price inter alia derives from the underlying reference value. Credit Derivatives are relatively simply structured derivatives. The reference value is credit risk, which is the risk that a certain entity or obligation defaults.3 Thereby the credit risk is not eliminated but transferred to an entity which is more apt to assume the risk.4 Credit Derivatives form an obligation for the seller to pay an amount to the buyer if a contractually predetermined event such as a default (a Credit Event) occurs. Credit Event is defined as: ‘An event linked to the deteriorating credit worthiness of an underlying reference entity in a credit derivative. The occurrence of a credit event usually triggers full or partial termination of the transaction and a payment from protection seller to protection buyer.’5
6.04 There are several benefits and purposes to Credit Derivatives. Credit Derivatives help transfer the risk of a referenced third party (Reference Entity) defaulting on its obligation (Credit Risk) from the buyer to the seller of the Credit Derivative. Often, the buyer is subject to the Credit Risk by either being creditor in or having invested in obligations of the Reference Entity. The CDS is referenced to the obligation establishing this relationship (Reference Obligation). There are also regulatory benefits, since employing CDS can reduce the amount of regulatory capital (p. 117) pursuant to the Capital Requirements Regulation (CRR).6 An analogy can be drawn to an insurance buyer and an insurance seller,7 albeit it does not hold from a strict legal analysis.8 The most notable difference is the missing insurable interest, that is, neither party needs to be the holder of the reference value (however, may have to deliver it upon the default of the Reference Entity as will be seen below). From an economic point of view, a Credit Derivative allows the seller to buy the credit exposure, whereas it allows the buyer to sell it. It allows financial institutions not only to manage Credit Risk but also to actively trade it.9
6.05 A CDS is a bilateral contract under which the buyer pays a periodic, fixed rate payment to the seller. In return, the seller assumes the Credit Risk by reimbursing the buyer upon occurrence of a Credit Event in the Reference Entity. CDS can be structured in different ways. The CDS can be a single or multi-name CDS such as a basket, portfolio, or index-CDS referring to a single or multiple Reference Entity, respectively. The Reference Entity can be a financial institution, a sovereign, companies, or other assets such as traditional loans to financial engineered collaterized debt obligations. The credit rating of the Reference Entity and/or its creditworthiness is essential for the calculation of the fixed payment made by the buyer since the CDS ultimately derives its price therefrom. The structure is illustrated in Figure 6.1.
6.06 Upon the occurrence of a Credit Event the buyer (or also the seller) has the right but not the obligation to trigger the Credit Event by notification. Subsequently, the CDS can be either settled in cash or physically. In the former case, the calculation agent (which can be the seller) determines the value of the obligation of the Reference Entity (Reference Obligation). The seller will usually pay the notional amount of the transaction less the market value of the Reference Obligation. In the latter case, the notification of physical settlement will be served setting out the Reference Obligation. The procedure is illustrated in Figure 6.2.(p. 118)
6.07 This section will discuss the documentation of CDS prior to the financial crisis and its initial adaptations. It illustrates that the objective of the ISDA framework is to provide standard documentation, which allows parties to make limited options to adjust to their needs and those of the transactions. The financial crisis required ISDA to address first deficiencies under the standard documentation before the introduction of the BRRD.
1. The ISDA framework
6.08 ISDA is the leading provider for multi-jurisdictional transaction documentation. The framework of the transaction is established by the 1992 or ISDA Master Agreement (MA).10 It is a standardized document which governs multiple transactions. In the schedule to the MA amendments can be made to adjust the standard documentation to the parties and the set of transactions that should be concluded thereunder. It avoids the parties’ need to negotiate in detail the complex definitions, thereby reducing substantially the costs that result from lengthy negotiations and averting costs that result from potential mistakes and conflicting provisions. Furthermore, it protects weaker or less sophisticated parties since a situation of negation may give the more sophisticated party the possibility to exploit the counterparty.11
(p. 119) 6.09 The 2003 Definitions are the building blocks for Credit Derivatives. The 2003 Definitions consist of a table of contents, an introduction and preamble, and ten articles which contain currently a set of 229 definitions. These definitions may cross-reference to or may modify other definitions. In addition, the 2003 Definitions contain six exhibits which are a set of standard forms which parties to a CDS transaction may need to use or serve.
2. Confirmation as trade documentation
6.10 A CDS transaction is confirmed or evidenced in writing by a document setting out the terms of the transaction and signed by both parties (Confirmation).12 The Confirmation allows inclusion by reference the applicable definitions and any supplements (as seen below). Nevertheless, parties to a transaction can negotiate without restrictions more tailored provisions in the Confirmation (Long Form Confirmation) as opposed to Confirmations incorporating the 2003 Definitions by reference (Short Form Confirmation). In particular, in the aftermath of the 2007 financial crisis, astute market participants designed provisions that can address problems that can arise with Reference Entities that are financial institutions. Nonetheless, such individualization can lead to significant risks arising from operational inefficiency, operational risk, and reduced netting and clearing potential as well as reduced tradability of the CDS.
6.11 In order to attain more standardization resulting in a stronger framework, ISDA adjusted its Credit Derivatives framework in 2009 by publishing two supplements, the ‘2009 ISDA Credit Derivatives Determinations Committees and Auction Settlement Supplement’ dated 12 March 2009 (March 2009 Supplement, also known as the Big Bang Protocol) and the ‘2009 ISDA Credit Derivatives Determinations Committees and Auction Settlement and Restructuring Supplement to the 2003 ISDA Credit Derivatives Definitions’ dated 15 July 2009 (July 2009 Supplement). The March and July 2009 Supplements could be used as of the publication date in the respective month for new Credit Derivatives which are governed by either the 1992 or 2002 MA. Moreover, ISDA gave parties the possibility to incorporate the March and July 2009 Supplements into the terms of (p. 120) each Protocol Covered Transaction on the condition that both parties agreed to it.13 Most notably the March 2009 Supplement could be opted into by means of the Big Bang Protocol.14 The supplements are the hereto most significant amendments to the 2003 Definitions.
6.12 The March 2009 Supplement introduced the Credit Derivatives Determinations Committee (DC).15 Five regional DCs are created by the Supplement, one for each of the following regions: Americas, Europe, Australia/New Zealand, Asia (excluding Japan), and Japan.16 Those DCs will determine whether a Credit Event or a Succession Event has occurred, and whether certain instruments or obligations are eligible for delivery to a seller following a Credit Event, or for inclusion in an auction. With the introduction of the DC, these matters will be determined by the DCs and their determinations will be binding for all the parties to a transaction which has incorporated the March 2009 Supplement. The DC can also for example determine the Cash Amount by way of an auction. Previously the parties to the CDS contract had to determine the Credit Event themselves. Moreover, the calculation agent (which was traditionally the seller) determined the Cash Amount.
6.13 In addition, the March 2009 Supplement amended the 2005 auction procedure for the determination of the value of the settlement of the CDS (Cash Amount). This amount is calculated differently if the CDS is settled in cash or physically and the financial crisis posed significant challenges. Upon occurrence of a Credit Event the buyer needs to submit the Reference Obligation, which in the case of physical settlement is hence referred to as Deliverable Obligation. The Deliverable Obligation needs to fall within certain categories and have certain features. For instance it needs to be transferable and fulfil certain conditions, which will be explored below.
6.14 The determination of the Cash Amount is in either case problematic or subject to errors. A problem that could occur in the determination of the Cash Settlement Amount by the calculation agent could be that it does not reflect the fair value of the Reference Obligation. In particular, before the insolvency of a financial institution the quoted prices are highly volatile and hence the valuation problematic—such that the buyer incurs the risk of not being reimbursed for his losses in full. (p. 121) The determination of the Physical Settlement Amount can also be problematic. The price of a Reference Obligation may not reflect the fair market value as a consequence of excessive demand or a market squeeze or if the Reference Obligations are expropriated as will be seen below or they just stop trading.
6.15 The March 2009 Supplement attempted to rectify these deficiencies by introducing a procedure for the determination of the cash amount by means of an auction (Auction Settlement Amount) which is organized under the auspices of the DC. With the introduction of the March 2009 Supplement the auction settlement process will be standardized and it will have the parties agreeing in advance to participate in the auction process for all classes of CDS, except for a few classes that are explicitly excluded.17 The DC will determine for every auction certain auction-specific terms, as well as Deliverable Obligation terms and a list of Deliverable Obligations to be valued in the auction. The auction resembles the cash settlement procedure in so far as the calculation agent is replaced by the auction. Hence, the determination of the value is made for a category of Reference Obligation by the auction consisting of multiple financial institutions that give quotes under the supervision of the DC (Auction Final Price). In other words, the auction does not consider particular Reference Obligations that have been used for some CDS trades. This procedure can be implemented in existing CDS trades by means of aforementioned Big Bang Protocol irrespective of the initially chosen form of settlement—as long as both parties agree and both forms of settlement continue existing for new trades.
6.16 Although all the Credit Derivatives are governed by the 2003 Definitions and Supplements, the majority of CDS contracts traded are standard contracts. These contracts mostly make reference to the Credit Derivatives Physical Settlement Matrix in their Confirmations.18 The ‘Credit Derivatives Physical Settlement Matrix’ dated 29 May 201219 prescribes a set of Reference Entities or Obligations and a selection of applicable Credit Events and subsequent measures. For instance if in the Confirmation a standard European corporate is selected as Reference Entity and the Confirmation incorporates by reference to the Matrix inter alia a set of Credit Events and settlement method can be found. If the Credit Derivatives Physical Settlement Matrix as amended from time to time is chosen to apply (p. 122) to the Credit Derivative under the governing Confirmation, aforementioned Supplements do not need to be referenced. In case of any conflicting provisions the terms set out in the Confirmation prevail.
6.17 This section will discuss the BRRD from a Credit Derivatives perspective and discuss the need for the adaptation of the definitions. Credit Derivatives, as has been seen above, attempt to protect a creditor from the default from an obligor, which is traditionally linked to insolvency. The BRRD establishes a pre-insolvency regime that endows competent and resolution authorities with powers to interfere with creditor rights outside of insolvency. In fact, it provides measures that can be used to prevent the insolvency of a distressed financial institution. The financing of the measure should be borne by the shareholders and creditors of the financial institution. It may result in the write down of shares and subordinated obligations such that the institution may be recapitalized and continue as a going concern. Creditors of senior obligations may be unaffected by the measure. But also the form of the Reference Obligation may vary due to the interference in the contractual rights, which has consequences for the settlement of the transaction.
1. Overview of the BRRD
6.18 The BRRD measures cannot be captured neatly by the 2003 Definitions.20 The BRRD introduces a set of early intervention measures, applied if the financial condition of the financial institution is rapidly deteriorating,21 and resolution measures, applied if the preconditions set out in article 32 BRRD et seq are met, viz. that the ‘institution is failing or likely to fail’.22 Those measures will assist indirectly in the stabilization of distressed financial institutions and funding of the recapitalization or resolution measures. According to article 37(3) BRRD the measures are the:
(i) sale of business measure;
(ii) transfer to a bridge institution measure;
(iii) transfer to an asset management vehicle measure; and
(iv) bail-in measure.
6.19 A true innovation is the latter measure, which raises multiple challenges. The bail-in measure is an instrument that imposes losses and the costs of the resolution (p. 123) of the distressed financial institution on not-exempted creditors.23 The BRRD stipulates that under the measure the resolution authority or court should be able to cancel liabilities owed by the financial institution, modify or change the form of a liability owed by the bank, for example by way of a conversion of debt into equity, and provide that a contract under which the financial institution has a liability is to have effect as if a specified right had been exercised by it (Bail-in Measure). However, certain types of liabilities will be excluded from the Bail-in Measure, as for example covered deposits, secured liabilities including covered bonds, and inter-bank liabilities with an original maturity of less than seven days. Furthermore, resolution authorities will have the power to exclude liabilities from the Bail-in Measure on a discretionary basis.
6.20 Moreover, most European Member States have transposed or are in the process of implementing a regime which can give effect to the Bail-in Measure. The most commonly used Credit Events are Bankruptcy and Restructuring under the 2003 Definitions, which, as will be seen, do not address the situation of restructuring while in resolution.24
2. Bankruptcy and Restructuring under the 2003 Definitions
‘Bankruptcy’ means the Reference Entity (a) is dissolved …, (b) becomes insolvent or is unable to pay its debts …, [or which tries to capture a wider array of situations] (f) seeks or becomes subject to the appointment of an administrator, provisional liquidator, conservator, receiver, trustee, custodian or other similar official for it or for all or substantially all its assets.
6.23 Albeit less prominent, section 4.2(h) 2003 Definitions attempts to capture all situations with a similar effect to the preceding events. Bankruptcy is initiated for instance upon commencement of an insolvency procedure or, more importantly for financial institutions, the revocation of the banking licence. The problem arises in the determination whether and at which point in time a similar event is reached, in particular, when the financial institution is only in resolution. Given that it is for the DC to determine, there is no comprehensive guidance, and because the number of experiences with such situations is limited, substantial uncertainty arises. Therefore, it has been questioned whether Bankruptcy is of relevance for financial institutions. For instance Schuyler Henderson stated: ‘[t]his event is geared towards normal corporate reference entities and has proved not (p. 124) entirely satisfactory when applied to institutions in a regulated industry, such as banks’.25
‘Restructuring’ means that, with respect to one or more Obligations … any one or more of the following events … is announced (or otherwise decreed) by a Reference Entity or a Governmental Authority in a form that binds all holders of such Obligations, and such event is not expressly provided for under the terms of such Obligation …: (II) a reduction in the amount of principal or premium payable at maturity or at scheduled redemption dates.
6.25 Restructuring was not clearly applicable as a number of specified restructuring events need to occur. For instance nationalization or expropriation would have the effect of causing such a reduction; nonetheless, the absence of the amendment of the terms of the Obligations makes the applicability uncertain.26
6.26 For instance in the context of expropriation of equity and subordinated obligations during the nationalization of SNS Bank NV and its holding company SNS REAAL NV—the fourth-largest financial institution and insurance group in the Netherlands—Restructuring was challenged. In this case, the Dutch Minister of Finance exercised for the first time the powers given to him by the Dutch Intervention Act.27 The reason is that expropriation is not contemplated as a limb of Restructuring. Nonetheless, the DC decided that a Restructuring had occurred on 20 March 2013.28 On a purposive construction the DC determined that a Restructuring within the meaning of limb (a)(ii) occurred, that is a reduction in principle, albeit there had been a present considerable uncertainty as to whether the expropriated obligations were actually cancelled and the multiple holder requirement was not satisfied, since the Dutch state became the sole holder of the obligations.
6.27 Even in situations in which a Credit Event has been determined to have occurred, there are a number of additional challenges. In 2013 the framework with the (p. 125) March 2009 and July 2009 Supplements was subject to extensive examinations. After the determination that the expropriation constituted a Restructuring, the main problem was the valuation of the ceased Deliverable Obligation, which leads to a reflection of its characteristics, specifically, the payout of the CDS is dependent on the recovery value of the Deliverable Obligation.29
6.28 Since, in the case of expropriation, the Deliverable Obligation ceases to exist it can no longer be delivered. The BRRD can have other similar effects, such as (i) moving the Reference Obligation to another entity whereby the obligation is no longer an obligation of the CDS Reference Entity (i.e. the CDS contract could become orphaned) or (ii) the conversion of the Reference Obligation to equity, a perpetual bond, another receipt of rights, or even a non-financial instrument. Therefore, such impairment has the effect of ceasing equally the Deliverable Obligation. For the purpose of settlement alternative Reference or Deliverable Obligations can also be used. However, in the case for instance of SNS REAAL Bank NV all subordinated obligations ceased to exist, thereby the closest Reference Obligations that could be used were senior. This situation of senior recovery is uneconomic for the buyer as it leads to a lower recovery rate. For instance the recovery rate for buyers of CDS with SNS REAAL Bank NV as Reference Entity was 85 per cent. The problem is illustrated in Figure 6.3.
6.29 Another challenge for the framework was the conditions of the 2003 Definitions for the Obligation and the conflicts with the regulatory reform. For instance, a precondition for the settlement under the 2003 Definitions as Supplemented is that the contractual terms of the Obligation do not provide for a contingent possibility of a write-down or conversion of debt into equity (Not Contingent).30 In the (p. 126) context of the BRRD, financial institutions are required to have sufficient obligations they can bail-in. Consequently, the financial institution has to issue obligations which may become subject to the bail-in measure as stipulated in article 45 et seq BRRD together with article 54(6) CRR.31 The applicable prospectus liability regimes of the Member States require that such knowledge of inherent risks that are material for the purpose of assessing the obligation is disclosed. Pursuant to article 54(1)(b) CRR if applicable the provisions of the obligation may specify the triggering events and the rate of either (i) conversion or limit (ii) or range, in other words the terms expressly provide for contingent elements (and hence would not be eligible Reference Obligations for the purpose of Credit Derivatives).
6.30 But also in cases where there is a pure disclosure of the risk of being subject to bail-in, the Not Contingent condition may be violated. It has been suggested that a distinction can be drawn between (i) pure ‘disclosure of risks’ that may affect an investor’s rate of return … [and a] (ii) contractual agreement between the issuer and the holder of the instrument as to the conditions under which the amount would be reduced’.32 Statutory bail-in does not involve a negotiation concerning the terms of the issuance.
6.31 Another condition of the Deliverable Obligation is that it is not subordinated in priority of payment to any other subordinated obligation of the Reference Entity (Not Subordinated). Subordination means according to section 3.13 2003 Definitions:
a contractual or similar arrangement providing that (i) upon liquidation … or winding up of the Reference Entity claims of the holders of the Senior Obligation will be satisfied prior to the claims of the Subordinated Obligation or (ii) the holders of the Subordinated Obligation will not be entitled to receive or retain payment in respect of their claim against the Reference Entity at any time that the Reference Entity is in … default under the Senior Obligation.
6.32 Uncertainty arises when the bail-in instrument is applied to senior Obligations before subordinated Obligations. The BRRD requires that the resolution authority should give due regard to the credit hierarchy; however, due to technical problems or better suitability of a more senior tranche the BRRD gives the resolution discretion to disregard the requirement.33
6.33 This section will introduce the new Credit Derivatives framework in light of the foregoing discussion. The ISDA Credit Derivatives framework has revealed precarious deficiencies for the operation of CDS. In particular, with regard to the BRRD and attempts of some market participants to counter these deficiencies, ISDA has, in consultation with its members and the market, developed a new set of standards. This section will concentrate on the innovations if financial institutions are used as Reference Entities and become subject to a BRRD measure. The adjustment is divided into a new credit event and the conditions for the Deliverable Obligation. This section first provides background information on the ISDA 2014 Credit Definitions. The second part will explore the aforementioned new credit event and the third the revised conditions for the Deliverable Obligation.
6.34 The experienced deficiencies resulted in the creation of an ISDA working group consisting of members of ISDA’s Credit Steering Committee (Committee) in May 2012. It was charged with proposing amendments to the 2003 Definitions in order to ensure the ‘safe and efficient functioning of the credit derivatives market’.34 In May 2013 the Committee released its first proposal setting out amendments to the 2003 Definitions so as to address the challenges expected to arise from the BRRD to ISDA members in conjunction with the ISDA Credit Derivatives Market Practice Committee. Later in July 2013 the main areas of change were first published, followed by a more concrete proposal in November 2013. It was finalized in the form of the 2014 ISDA Credit Definitions (2014 Definitions).
6.35 The 2014 Definitions, as well as other ISDA definitions, are not just a set of definitions but also include calculation methods and consequences of certain events. The 2014 Definitions are divided into: (a) methods for the calculation of the premia to be paid by the buyer; (b) methods for the determination of the Reference Entity and if applicable the successor; (c) requirements for triggering the CDS, in particular with respect to the Credit Events, Reference Entities, and assets that can be subject to a CDS; and (d) methods for the determination of a successor entity if a resolution measure has been applied to the Reference Obligation.
6.36 The 2014 Definitions codified for the first time the term financial institution, which had before been within the aforementioned matrix (Financial Reference (p. 128) Entity Terms).35 It limits the scope of the amendments and innovations related to the BRRD to financial institutions. It is not only relevant for the determination of any successor but also creates classes of seniority, namely senior, subordinated, and further subordinated. Thereby, it recognizes the complex capital structure of financial institutions and prevents measures against a certain class of obligations triggering (unexpectedly) other CDS referenced to other obligations. Moreover, the aforementioned Not Subordinated criteria is addressed by requiring that subordinated and not-subordinated debt obligations are traded and documented separately. Hence the application of a resolution measure to a subordinated debt obligation would not affect not-subordinated debt obligations and vice versa. Furthermore, it prevents that the discontinuation, for example, due to expropriation such as in the case of SNS, of a subordinated tranche may result in a substantially higher auction price than that for a not-subordinated debt obligation. In case of transferring the debt obligation, the determination of a Credit Event is also just considered within the initially negotiated seniority level.
2. Governmental Intervention Credit Event
a) Exploring Governmental Intervention
6.38 Due to potential divergent transpositions amongst Member States and globally, the Committee wanted to define bail-in as broadly as possible. The new Credit Event was introduced under section 4.8 2014 Definitions as ‘Governmental Intervention’. It stipulates that:
(a) ‘Governmental Intervention’ means that, with respect to one or more Obligations … any one or more of the following events occurs as a result of action taken or an announcement made by a Governmental Authority pursuant to, or by means of, a restructuring and resolution law or regulation (or any other similar law or regulation), in each case, applicable to the Reference Entity in a form which is binding, irrespective of whether such event is expressly provided for under the terms of such Obligation:
6.39 In summary, Governmental Intervention is triggered in case a governmental authority36 publicly announces or applies a resolution measure interfering with the Reference Obligation or a third party which guarantees the Reference Obligations under an existing recovery and resolution law or regulation.37 The introduction of a law such as the BRRD implementation acts in the respective jurisdiction or laws that facilitate the execution of the BRRD measures (with potentially adverse consequences for certain creditors) would hence not trigger CDS. Governmental Intervention would have the requirement that the financial institution experience some form of distress requiring intervention, however it is not inextricably linked to creditworthiness such as Restructuring.
b) Distinction Restructuring and Bankruptcy
6.40 In contrast to Restructuring, the Government Intervention does not have the same preconditions. First, Restructuring requires that all creditors of the Reference Obligation are bound by the measure taken against the institution, whereas Governmental Intervention requires that only the measure is binding. Secondly, the Restructuring requires that the terms of the obligation do not provide for the occurrence of the event, that is the aforementioned Not Contingency (p. 130) requirement. The clarification of the occurrence of a Credit Event needs to be complemented by a rationalization of the Not Contingent condition. The challenges the Not Contingent condition caused for the certainty of whether the Reference (or Deliverable) Obligation (in case of Physical Settlement) would lead to the deletion of the clause in the Deliverable Obligation Characteristics in section 3.14(b) 2014 Definitions.38 In particular, these have been deemed necessary as all obligations of financial institutions can be expected to either have an explicit provision or risk disclosure which stipulates the occurrence of a conversion of the obligation into equity or any other form of receivable. Furthermore, Governmental Intervention contemplates, in contrast to Restructuring expropriation, a change in the beneficial owner, mandatory cancellation, and conversion or exchange.
6.41 Governmental Intervention should not be understood as an umbrella term for all resolution measures under the BRRD. Other Credit Events such as Restructuring will still find application. This subsection will develop these circumstances and assess the proficiency of the 2014 Definitions to address the new situations that result from the application of the BRRD.
6.42 The BRRD requires competent authorities to ensure the resolvability of financial institutions before they suffer distress in Chapter II, Title II of the BRRD. Should the financial institution experience distress, competent authorities are required to intervene according to Chapter II, Title III of the BRRD. Such situations in which the financial condition of the financial institution is rapidly deteriorating may infringe upon inter alia capital requirements.
6.43 The resolution authority may request for instance changes to the capital or organizational structure or its products and services offering if it identifies a substantive impediment for resolution.39 The reorganization and a potential separation of some obligations with a consequent transfer to an assuming entity may qualify as a Credit Event.40 The main difference between resolvability and early intervention is that under management measures the latter provides also that a temporary administrator can be appointed.41
6.44 Governmental Intervention or Restructuring does not capture such a situation. The mere measure does not constitute a Governmental Intervention or Credit Event. It requires also that some form of adverse implications for creditors as enumerated under section 4.8 2014 Definitions materializes. For the same reason, Restructuring would not be invoked (s. 4.7 2014 Definitions).
(p. 131) 6.45 Bankruptcy is a conceivable Credit Event in case of Early Intervention. The reorganization for the resolvability does not lead to the commencement of insolvency procedures against the financial institution or revocation of the banking licence.42 In fact, it seems rather disproportionate and could have adverse consequences for the financial market.43 The mere transfer of assets and liabilities to another entity does not result in an event that could constitute Bankruptcy.44 It was submitted that the appointment of a temporary administrator pursuant to article 29 BRRD who replaces the management of the financial institution may trigger a Bankruptcy Credit Event.45 The reason is that the temporary administrator can morph into a special manager pursuant to article 35 BRRD if the financial condition continues to deteriorate despite the early intervention measures. The special manager can execute decisions without requiring the consent of creditors that would be required by ordinary management.46 Therefore, the appointment of a temporary manager, which qualifies as a ‘similar officer’, could invoke Bankruptcy.47
6.46 As previously mentioned, there are strong requirements with respect to the Deliverable Obligations. The Deliverable Obligations are of essential importance as they are required for the calculation of the Auction Settlement Amount. Since the BRRD and in particular the bail-in measure can significantly alternate the form of the Deliverable Obligations the requirements need to be satisfied.
6.47 The Not Contingent condition is relaxed. Under section 3.11 2014 Definitions the term ‘Permitted Contingency’ is introduced which allows the incorporation of provisions that result in the reduction of the payment obligation of the Reference Entity. It allows inter alia that the provisions (i) provide for the transfer of assumption of the Reference Obligation, (ii) can cause the subordination, and (iii) specifically allow the application of the Bail-in Instrument as long as it is initiated by a Governmental Intervention. Hence, Governmental Intervention no longer requires an analysis of the terms of the debt obligations.48
(p. 132) 6.48 In order to facilitate resolvability, the BRRD stipulates that debt instruments that are governed by the laws of a third country or are within the jurisdiction of a third country should contain clauses to the effect that investors submit themselves to the measures of an EU competent authority.49 It should prevent financial institutions from issuing debt governed by the laws of a third country or through foreign subsidiaries in order to prevent the obligation from becoming subject to bail-in. In addition, contractual recognition prevents further complications such as litigations from investors in third countries. It is clear that the inclusion of the contractual recognition clause (in existing debt instruments) exposes investors to significant risk without providing benefits.
6.49 Next to the Bail-in Instrument, the Reference Obligations may be fully or partially transferred to a third entity, for example another financial institution or an especially created entity such as a bridge institution or an asset management vehicle. Another measure under the BRRD is the provision of a guarantee for the distressed financial institution pursuant to article 92(a). The conditions for entities assuming all of or partially the Reference Obligations or guaranteeing the Reference Entity and/or Obligation (Successor) are defined in section 2.2 2014 Definitions. Under the 2003 Definitions the concept of indirect Successor has been utilized. In light of the BRRD this has been amended to a ‘provider of a relevant guarantee’. Interestingly, the 2014 Definitions also take account of the fact that the transfer may be effected while in resolution50 and may be repeated, resulting in the transfer to another successor institution, such that debt obligations may be located at several institutions.
6.50 This repeated transfer or transfer to various institutions can result in problems when determining the ultimate Successor. Because of this reason, the 2014 Definitions modified the methods to determine the Successor as follows.51 There are now three scenarios. In the first scenario, if at least 75 per cent of the Reference Obligations and relevant guarantees (if applicable) are assumed by a third institution, this institution will become the Successor.52 The ninety-day period remains in such a situation; however, for the determination of the overall Successor such period is no longer relevant.53 The reason is that a further transfer within the ninety-day period may not be recognized by the market resulting in the CDS becoming ‘orphans’. The abolition of the time window also allows the recognition of a gradual transfer. The applicable due date is in all situations the date of the transfer. In the second scenario, less than 75 per cent but more than 25 per cent are transferred to a third institution. In this scenario there can be several successors for the purpose of the 2014 Credit Definitions. In the last scenario, if less than 25 per cent are transferred and the distressed institution continues to exist, no succession occurs.
(p. 133) 6.51 The Successor may have a different risk profile than the original Reference Entity. Since the economic reality may differ significantly, the terms of the CDS may have to be adapted, which could result in tedious negotiations. Therefore, ISDA empowers the calculation agent to adapt the terms such that the economic reality is maintained.54
6.52 Under the 2014 Definitions there are a number of adjustments to the restructuring settlement mechanism. The calculation of the Settlement Amount changed fundamentally. The 2014 Definitions contain the newly introduced article V (General Terms Relating to Settlement), article VI (Terms Relating to Auction Settlement), revision to article VII on the Cash Settlement, and substantial modification of article VIII on the Physical Settlement. This is a codification of the 2009 Supplements on the settlement into the 2014 Definitions but it also introduced new specifications for the settlement method that should be taken as a reference amount.
6.53 The BRRD can affect the outstanding principal balance55 of a Reference Obligation ex post facto. This is problematic however, since the Recovery Amount under a CDS is computed by taking the difference between (i) the recovery value of the obligations that have been subject to the Bail-in Instrument with an outstanding principal balance that is equal to the CDS’s notional amount and (ii) the notional amount of the Reference Obligation. Therefore, the 2014 Definitions provide that this can be delivered at its original nominal value prior to the resolution measure pursuant to section 8.12(b). In the latter case the 2014 Definitions stipulate that if the conversion proceeds cannot be delivered, the CDS should settle at a pre-determined fixed Cash Settlement Amount of 100 per cent in favour of the buyer. In other words, the new Settlement Method is a hybrid between Cash and Physical Settlement whereby the method is predominantly the Cash Settlement Method while having a predefined Reference Obligation in favour of the buyer.
6.54 Under the BRRD the Reference Obligation can be subject to the Bail-in Instrument, with adverse effects for the recovery rate. For instance, in a physical settlement auction it would not be possible to deliver the Reference Obligation, since it is converted or expropriated. In the former case the 2014 Definitions provide that this can be delivered at its original nominal value prior to the resolution measure pursuant to section 8.12(b). In the latter case the 2014 Definitions stipulate that if the conversion proceeds cannot be delivered, the CDS should settle at a pre-determined fixed Cash Settlement Amount of 100 per cent in favour of the buyer. In other words, the new Settlement Method is a hybrid between Cash and Physical Settlement whereby the method is predominantly the Cash Settlement Method while avoiding the problems that were experienced at the SNS auction.
6.55 Measures under the BRRD can amend the form of the Deliverable Obligation, which results in the inability to settle following a Credit Event. For instance either the Deliverable Obligation has been converted into equity, which did not constitute a Deliverable Obligation under the 2003 Definitions, or written-down such that there is no actual obligation that can be delivered. The settlement method under the 2014 Definitions is an auction, which suggests that less importance should be given to the form of the Deliverable Obligation. However, the concept of what constitutes such obligation remains essential for the auction process determining the reference price at which the Credit Derivatives will be settled. The 2014 Definitions provide that if a Governmental Intervention Restructuring Event occurred, the Deliverable Obligations can be delivered irrespective of its form. The delivered amount should equal the relevant amount of the Deliverable Obligation that has been converted. In such situations the buyer will be reimbursed in full.
6.56 In the 2003 Definitions the form of the Deliverable Obligation immediately prior to the measure would have been relevant to determine the actual Deliverable Obligation, nevertheless, given that certain obligations cease to exist only similar obligations would be deliverable, as seen in the case of SNS in partial repayment.
6.57 In light of the BRRD and with hindsight regarding the SNS case, ISDA overhauled significantly its framework for Credit Derivatives with reference to financial institutions. The 2014 Definitions introduced the Governmental Intervention Credit Event that should capture the new pre-insolvency measures particular to financial institutions. It is a significant extension of the possible events compared to Restructuring and significantly alleviates the preconditions to be triggered. Furthermore, the Deliverable Obligation conditions have also been significantly alleviated with respect to the new intervention powers of resolution authorities to interfere with and alternate the form of debt obligations. The amendments were suggested to be primarily designed with view to the bail-in measure. In other words, Governmental Intervention is not an umbrella provision capturing all measures that can be exercised pursuant to the BRRD. Restructuring and Bankruptcy remain relevant Credit Events for financial institutions.
6.58 Credit derivatives are essential financial instruments in today’s financial markets and for the real economy. During the 2007 financial crisis, the market for Credit Derivatives was severely affected not least because of uncertainties about the operability of the framework; however, it is on the verge of recovery. The reason is, in particular, the possibility to separate the Credit Risk of an obligation and transfer (p. 135) it to a market participant more apt to assume the risk. The effect is also recognized by regulators, which requires less regulatory capital if these instruments satisfy certain conditions.
6.59 The 2007 financial crisis tested the contractual framework of credit derivatives and revealed some substantial problems if financial institutions are used as Reference Entities, in particular, uncertainty with respect to the applicability of the Credit Events and deficiencies in the existing settlement method. The expropriation of Reference Obligation caused precarious problems. This problem is likely to become more prominent in the context of the BRRD and its resolution measures.
6.60 ISDA created under the 2014 Definitions new Credit Events that can specifically address the new resolution measures. It amended the Restructuring Credit Event, by clarifying the definitions or by changing the circumstances in which a restructuring can occur, and it introduced the provision on Governmental Intervention in order to include it among the new resolution powers under the BRRD. It further clarified the disclosure of the Bail-in risk and the challenge for the fulfilment of the Not Contingent Condition. It is not breached if the contingency is an effect of the Governmental Intervention.
6.61 The 2014 Definitions came into effect on the CDS roll date in September 2014.56 As of this implementation date parties can begin conforming transactions with the 2014 Definitions. It is required that parties to an existing transaction incorporate the 2014 Definitions by way of a protocol or, for new transactions, reference the 2014 Definitions into the Confirmation. The overall success of the 2014 Definitions depends on the language of the Obligation and the finalized wording of the BRRD and its transposition and/or implementation into national legislation. Another factor for the success of the 2014 Definitions is the pursued method of resolution and the complexities arising for resolution authorities in a multi-jurisdictional setting. Nevertheless, experience indicates the 2014 Definitions can be welcomed which is also suggested by the revitalized CDS market.
6.62 It can be concluded that the introduction of the Governmental Intervention, the codification of the Financial Reference Entity, the revised Deliverable Obligations, and Auction Settlement Adaptations provide a robust Credit Derivatives framework. The existing Credit Events have, however, not become obsolete but have been further concretized and adapted to the BRRD. The changes can be applauded as they provide the market with the necessary certainty and weather the ISDA framework for the BRRD.(p. 136)
1 Council Directive 2014/59/EU establishing a framework for the recovery and resolution of credit institutions and investment firms and amending Council Directive 82/891/EEC, and Directives 2001/24/EC, 2002/47/EC, 2004/25/EC, 2005/56/EC, 2007/36/EC, 2011/35/EU, 2012/30/EU, and 2013/36/EU, and Regulations (EU) No. 1093/2010 and (EU) No. 648/2012, of the European Parliament and of the Council (BRRD).
2 Other derivatives not analysed herein are credit linked notes, CDS swap options, contracts for difference, total return swaps, credit spread derivatives, and portfolio trades such as synthetic credit default obligations (CDOs).
5 International Swaps and Derivatives Association (ISDA), Derivatives consulting group glossary (2010) <www.isda.org> accessed 10 March 2015. Credit Event is defined in s. 4.1 2013 Definitions. It should be noticed that Credit Event is not defined by reference to the governing laws of the parties but defined broadly to cover multiple jurisdictions.
8 Opinion prepared for the ISDA by R Potts QC, Erskine Chambers on 24 June 1997. An abstract by P Harding, A Practical Guide to the 2003 ISDA Credit Derivatives Definitions (Euromoney Books 2004) 19 is at time of writing not publicly available.
9 Zerey, ‘§8 Credit Default Swaps/Vertragsgestaltung’, above n 4, 198.
10 ISDA Master Agreement 1992 and ISDA Master Agreement 2002, available at <http://www.isda.org/publications/isdamasteragrmnt.aspx> accessed 10 March 2015.
11 Nonetheless, it has been suggested that the ISDA standard set of documentation may favour the protection of sellers since these have been the authors of the documentation. ISDA has also been reported as exercising substantial regulatory power and has been involved in lobbying thereby favouring the protection of sellers, see S Listokin-Smith, ‘Meta-regulation of OTC Derivatives Contracts Post-reform’ (2013) 21(2) Journal of Financial Regulation and Compliance 188 and C Scott and J Biggins, ‘Public-private Relations in a Transnational Private Regulatory Regime: ISDA, the State and OTC Derivatives Market Reform’ (2012) 13(3) European Business Organization Law Review 309. Nonetheless, the benefits of standardization outweigh potential conflicts of interests; the regulatory support and the interaction with law making contributes expertise and therefore helps in clarifying potential misinterpretations, see T Cleary, ‘Financial Derivatives and the Anti-deprivation Principle’ (2011) 26(8) Journal of International Banking Law and Regulation 379.
12 Individual trades that should be part of a governing Master Agreement are incorporated by means of Confirmations. These contain the specifications of the individual trade and can for instance be obtained for Credit Derivatives incorporating 2003 Credit Definitions, available at <www.isda.org/publications/docs/EXHIBIT-A-to-2003-ISDA-Credit-Derivatives-Definitions.doc> accessed 10 March 2014; Günter Reiner, ISDA Master Agreement (C.H. Beck, München 2013) 294–303.
14 See SK Henderson, ‘Credit Derivatives and the “Big Bang” Part 2’ (2010) 3 Journal of International Banking and Financial Law 187 and SK Henderson, ‘Credit Derivatives and the “Big Bang” Part 1’ (2010) 1 Journal of International Banking and Financial Law 94.
15 There are five regional Determination Committees, i.e. Europe, Middle East and Africa (EMEA); Americas; Japan; Asia (excluding Japan); and Australia and New Zealand. Market participants make up its composition; however, its articles vary. Consequently, its procedures, composition with voting and non-voting members as well as global and regional members varies.
16 K Koppelman, S Tirrell, and C Ayotte-Brennan, ‘The Continuing Evolution of Credit Derivatives: ISDA Publishes 2009 Supplement and Protocol’, above n 13.
18 See Credit Suisse, ‘A Guide to Credit Events and Auctions’, available at <https://doc.research-and-analytics.csfb.com/docView?language=ENG&source=emfromsendlink&format=PDF&document_id=803733390&serialid=FWHCx3yCrSE3FoEvAbEKa6fRKhqLoKs0jL1gR5W2Dfs%3D> accessed 10 March 2015.
19 See ISDA Credit Derivatives Physical Settlement Matrix, available at <http://www.isda.org/c_and_a/docs/Credit-Derivatives-Physical-Settlement-Matrix-20140922.xlsx> accessed 10 March 2014.
24 G Reiner, ISDA Master Agreement, above n 12, 170–3.
25 S Henderson, Henderson in Derivatives (2nd edn, LexisNexis 2010), 144; Similarly Simon Firth stated that ‘[d]espite the breadth of the provision, it may require adaptation to reflect any specific local insolvency law procedures in the Reference Entity’s jurisdiction. For example, regulatory interventions, which in some jurisdictions may be a precursor to the winding-up of a regulated bank or investment firm, would not be covered’, S Firth, Derivatives Law and Practice  RN 16.094.
26 Similar, the Credit Events Obligation Acceleration, Obligation Default and Failure to Pay are contingent on the actual default or acceleration. Thus, they would be triggered once the default materialized and after the due grace period.
27 Dutch Intervention Act (Wet bijzondere maatregelen financiële ondernemingen); for background information on the Act see P Rank and B Bierman, ‘International Briefing on the Netherlands’  7 Journal of International Banking and Financial Law 455.
28 ISDA, Determinations Committee Decision, available at <http://dc.isda.org/documents/2013/03/decision-20032013.pdf> accessed 10 March 2014 and ISDA, ISDA EMEA Credit Derivatives Determinations Committee: SNS Bank Restructuring Credit Event (2013) News Release, available at <http://dc.isda.org/documents/2013/03/determinations-committee-sns-bank-n-v-restructuring-credit-event.pdf> accessed 10 March 2015.
30 Pursuant to s. 2.20(b)(i) the condition is defined as the Deliverable Obligation having at all times ‘an outstanding principle balance … that pursuant to the terms … may not be reduced as a result of the occurrence or non-occurrence of an event or circumstance (other than payment)’. Under the 2014 Definitions this is no longer applicable. The absence under the 1992 and 2002 Definitions as Supplemented may be interpreted as a failure to opt into the Not Contingent condition, however the predominant view is that parties need to opt out. See the controversial decision Nomura International Plc v Credit Suisse First Boston International  EWHC 160 (Comm) where it was held that parties need to opt in as the absence allowed the buyer to submit convertibles bonds. See JC Zerey, ‘Credit Default Swaps/Vertragsgestalltung’ in JC Zerey (ed.), Finanzderivate: Rechtshandbuch (3rd edn, Baden-Baden, Nomos 2013) for a short discussion (in the German language).
32 Lu and Clark, ‘The Imperfect Hedge’, above n 20, 95 et seq.
33 Art. 48 BRRD; see art. 3(3) RTS EBA FINAL Draft Regulatory Technical Standards on criteria for determining the minimum requirement for own funds and eligible liabilities under Directive 2014/59/EU, EBA/RTS/2015/05 dated 3 July 2015.
34 International Swaps and Derivatives Association (ISDA), 2014 ISDA Credit Derivatives Definitions (2014), available at <www.isda.org> accessed 10 March 2015.
35 The 2005 Matrix Supplement published by ISDA on 7 March 2005. It aimed at harmonizing different sorts of Reference Entities and jurisdictions such as to find common Credit Events, criteria for the Deliverable Obligation, eligible options in the 2003 Definitions.
36 Pursuant to s. 4.9(b) 2014 Definitions ‘Government authority’ means: (i) any de facto or de jure government (or any agency, instrumentality, ministry, or department thereof); (ii) any court, tribunal, administrative, or other governmental, inter-governmental, or supranational body; (iii) any authority or any other entity (private or public) either designated as a resolution authority or charged with the regulation or supervision of the financial markets (including a central bank) of the Reference Entity or some or of all of its obligations; or (iv) any other authority which is analogous to any of the entities specified in Sections 4.9(b)(i) to (iii). With regard to Cross Default the 2014 Definitions stipulate that such Governmental Intervention affecting subordinated obligations will not trigger another Credit Event for senior obligations pursuant to s. 2.20(f)(iv) 2014 Definitions.
44 The residual institution should be wound-down pursuant to national insolvency laws (art. 37(7) BRRD), which requires the insolvency application by the resolution authority and the respective permission.
47 Reiner, above n 24, 31 et seq.
48 It was questionable whether the introduction of a BRRD-related risk factor into the prospectus could constitute a breach of the non-contingency rule. The uncertainty places issuers of debt in a precarious situation, whereby they may face on the one hand investor litigation and on the other reduce the marketability of their debt instruments.
56 ISDA, ISDA 2014 Credit Derivative Definitions to go live in September (3 February 2014) <http://www2.isda.org/news/isda-2014-credit-derivatives-definitions-to-go-live-in-september>.