Worldwide: "The Net Short": U.S. And European High-Yield Covenant Trends In Response To Net Short Activism

Background

On February 15, 2019, the U.S. District Court for the Southern District of New York issued its ruling in the case of Aurelius Capital Master, Ltd. ("Aurelius") against Windstream Services, LLC ("Windstream"). The origins of the case date back to April 2015, when one of Windstream's affiliates spun off and, subsequently, leased back some of its real estate and other assets. Two years after that transaction, Aurelius, a fund that purchased a controlling position in Windstream's 6.375% Senior Notes due 2023 (the "2023 Notes"), challenged the transaction, alleging that the sale and leaseback was not permitted under the 2023 Notes indenture, and issued a notice of acceleration related to the 2023 Notes. The district court ruled in favor of Aurelius, stating that the transaction resulted in an event of default under the 2023 Notes indenture and that Aurelius' notice of acceleration was valid. This meant that Windstream was consequently in default under a number of its other debt instruments, by virtue of cross-default or cross‑acceleration provisions in those instruments, and faced an immediate liquidity crisis with no access to financing to fund its business operations. As a result, on February 25, 2019, Windstream filed for Chapter 11 bankruptcy, despite the fact that at the time it had no operational failures.

It has been generally understood that, at the time it brought its suit against Windstream, Aurelius held credit default swaps ("CDS"), creating a net short position in Windstream's debt. For a typical noteholder with a net long position in a note¹, especially one that is structurally-, lien- or payment-subordinated in the capital structure, the issuer's bankruptcy would generally be viewed as undesirable because of the risk that potential recoveries under the note could be significantly lower than par (or the amount the holder paid to purchase the notes). In contrast, noteholders with a net short position in a note would arguably operate under an opposite set of economic incentives because the CDS would pay out if the reference entity (such as Windstream, in the case of CDS protection on the 2023 Notes) experiences an adverse credit event (such as, among others, a payment default or bankruptcy filing, as in the Windstream case). As such, a net short noteholder may not be interested in negotiating with an issuer and its group to find ways to avoid bankruptcy if any issues arise during the term of the notes.

The use of CDS-driven investment strategies by certain credit investors that benefit from an issuer's credit event has the potential to upend the historically aligned incentives of all noteholders in a particular class of an issuer's debt. Windstream was only the latest in a number of CDS-driven debt defaults by corporate issuers, from the Spanish gaming company Codere in 2013 to the homebuilder Hovnanian in 2017 (which also resulted in litigation that was finally settled in 2018).² Consequently, there has been a growing awareness among participants across the loan, high-yield and derivatives markets of the need to effectively address the potential impact of CDS, or similar instruments, on both issuer-creditor and intercreditor relationships and on the credit markets, generally.

On September 19, 2019, the Chairmen of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission, along with the Chief Executive of the U.K. Financial Conduct Authority, issued an Update to June 2019 Joint Statement on Opportunistic Strategies in the Credit Derivatives Market, where the agencies outlined concerns about continued pursuit of various opportunistic strategies in the credit derivatives markets, including "manufactured credit events", and their potential adverse impact on the "integrity, confidence and reputation of the credit derivatives markets, as well as markets more generally".³ The agencies emphasized that they "expect firms to consider how the aforementioned opportunistic strategies may impact their businesses and to take appropriate action to mitigate market, reputation and other risks arising from these types of strategies". The agencies "look forward to further industry efforts to improve the functioning of the credit derivative markets and welcome continuing engagement with market participants".⁴

While potential legislative responses to the issue remain possible, loan and high-yield bond market participants have presently endeavored to address the issue by introducing two main types of contractual restrictions in debt documentation:⁵

In this note, we examine the key terms and mechanics of these provisions and provide an overview of the trends and changes in their formulations over 2019 in the U.S. and European high-yield bond markets. These formulations continue to develop and have not yet been widely tested on the U.S. or European markets.

Net Short Disenfranchisement

In 2019, the NSD provision was included in the final terms of a small, but growing number of U.S. high-yield offerings, generally those involving private equity sponsor-owned companies. This provision was also introduced in the preliminary terms of a couple of European high-yield offerings during 2019, although it was retained in the final terms of only one of the offerings (i.e., following the completion of the marketing process and discussion of the proposed terms between the issuer and investors).⁶

The NSD provision may include several important variations, which drafters should be aware of to ensure that the provision, if incorporated in high-yield bond deals, strikes the right balance between protection of the issuer and net long noteholders against net short activism without overreaching in its scope such that the overall liquidity in the notes is negatively affected.

1 A noteholder's hedging strategy with respect to a specific bond or an issuer may employ short positions in CDS or another type of security, and this type of hedging activity has generally been viewed as standard by the market.

2 Note that, unlike Windstream, Codere and Hovnanian involved a "manufactured default", whereby net short activists cooperate with, and encourage the issuer, which is an otherwise solvent company, to deliberately default on its debt, thereby triggering a credit event and pay‑out under CDS purchased against the reference security.

See Update to June 2019 Joint Statement on Opportunistic Strategies in the Credit Derivatives Market, available at https://www.sec.gov/news/ public-statement/update-june-2019-joint-statement-opportunistic-strategies-credit-derivatives (Sept. 19, 2019). See also Joint Statement on Opportunistic Strategies in the Credit Derivatives Market, available at https://www.sec.gov/news/press-release/2019-106 (June 24, 2019).

4 We briefly note that there have already been certain changes in the derivatives markets aiming to address some issues with the so-called "narrowly tailored credit events" or "manufactured defaults". Specifically, on July 15, 2019, the International Swaps and Derivatives Association ("ISDA") published the 2019 Narrowly Tailored Credit Event Supplement (the "NTCE Supplement") to the 2014 ISDA Credit Derivatives Definitions. The NTCE Supplement amends two key definitions relating to the "narrowly tailored credit events", which are events that are significant enough to trigger credit events under a CDS contract leading to its settlement, but narrow enough to avoid actually impairing the creditworthiness or financial condition of the company on which the credit event is determined (the "Reference Entity"). In particular, the NTCE Supplement amends the definition of a "Failure to Pay" by introducing a "Credit Deterioration Requirement". If this requirement is specified as applicable in the relevant CDS contract then a failure to make due payment "shall not constitute a Failure to Pay if such failure does not directly or indirectly either result from, or result in, a deterioration in the creditworthiness or financial condition of the Reference Entity". See 2019 Narrowly Tailored Credit Event Supplement to the 2014 ISDA Credit Derivatives Definitions, available at https://www.isda.org/book/2019-narrowly-tailored-credit-eventsupplement- to-the-2014-isda-credit-derivatives-definitions. CDS parties can effectively apply the NTCE Supplement to their existing contracts by adhering to the ISDA 2019 NTCE Protocol, which was published on September 16, 2019. See ISDA 2019 NTCE Protocol, available at https://www.isda.org/protocol/isda-2019-ntce-protocol. The NTCE Supplement will apply to uncleared CDS (except where the transaction references a sovereign Reference Entity) that are entered into on or after the implementation date (set for Jan. 27, 2020). Cleared trades are not covered by the NTCE Supplement and are instead addressed by equivalent amendments to the central clearinghouse's rulebook.

5 While comparable structures have also been introduced in the U.S. and European loan markets, this publication primarily focuses on the trends seen in the U.S. and European high-yield markets.

6 We have already seen the NSD provision appearing in the preliminary terms of at least one European high-yield offering in January 2020.

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