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8 July 2013
Say the word 'derivatives' and normal people look blank and switch off. Even lawyers tend to glaze over when faced with more than a fleeting moment engaged in derivatives banter. But if you put credit derivatives and workouts together, it's another matter entirely. The combination creates a fizz, not dissimilar to the reaction seen when chemists mix sodium with water.
Although credit derivatives are a relatively new financial instrument, their sudden prevalence means that banking lawyers can hardly afford to ignore them. This has become only too obvious in the current economic climate, which is seeing a whole host of banking lawyers turn their attention to restructuring.
Derivatives in workouts are causing menacing problems; and when in-house lawyers come across difficulties, external advisers are being drafted in to come to their rescue. Predictably, the expertise is coming from the magic circle, where Allen & Overy, Clifford Chance and Linklaters in particular are making a name for themselves.
Credit derivatives provide banks with a way to offload the risk of lending. The risk is taken on by a second bank, which will be forced to pay out should it be proved that a credit event has taken place. Although legally this is not classed as insurance, in effect it is very similar.
All this sounds very simple until you put it in the context of a workout. When a company decides to restructure its debt, its relationship with the bank offsetting the risk of the lender suddenly takes on a new significance. Assuming that a credit event has taken place, the lender is assured of payment and to all intents and purposes is cut out of the equation.
But the lender is the middleman in the transaction, which means that the borrower is often unacquainted with the bank selling the lender protection. Understandably, negotiating with an unknown party has its difficulties. Obviously, the problem is accentuated if the lender has bought credit derivative protection from more than one bank.
Other difficulties arise when a syndicate of banks is asked to agree to a proposal. A bank with a credit derivative agreement will not want to lose its cover, which invariably means the bank will end up acting in its own interest rather than in the interest of the syndicate. In fact, in some circumstances lenders want to manufacture default situations and will try to agree a solution which triggers the credit derivative.
In a current high-profile restructuring, despite opposition from the rest of the syndicate, one bank asked to be left on its own as the sole lender under the original agreement so that it could claim its credit derivative. In the end the bank was prevented from doing so, but not before it had created serious hiccups.
There is also huge scope for lawyers to get involved in establishing when a credit event has taken place. All the documentation for credit derivatives is undertaken by the International Swaps and Derivatives Association (ISDA), which leaves the bankers and lawyers free to argue the interpretation. Like in the cases on material adverse change (MAC) clauses, it is not always clear-cut.
With only a handful of firms equipped to deal with these issues, there could be some concern that magic circle firms have a tool they can use to consolidate their hold on the workouts market. No doubt they would like this to be the case, but at the moment credit derivative capability is being seen as a bonus - something that might trigger a pitch in a firm's favour.
But perhaps it is an area that all firms with serious banking practices should consider. And consider sooner rather than later, before it has pulling power that cannot be disputed.
Restructurings are hitting the headlines at the moment, so maybe this is an opportunity for derivatives to get the attention they deserve.