Participants in credit default swap (CDS) market know that moral hazards may arise when the parties to CDS contracts seek to influence transactions involving the companies referenced under the CDS. This risk is exponentially more pronounced when reference entities succumb to such influence. The controversy involving the home builder, Hovnanian Enterprises, Inc. (Hovnanian), has renewed market participants’ concerns that the fundamental assumptions underlying CDS as a hedging tool are no longer valid. CDS market participants should take no comfort from the federal court’s ruling in the Hovnanian case last week, which shows courts will be unsympathetic to the plight of CDS market participants and are reluctant to enjoin an issuer from creating a credit event to obtain restructuring financing from a capital provider that benefits from the credit event.
In this client alert, RK&O partners Julia Lu and Gregory G. Plotko summarize the Hovnanian case and offer several key take-aways regarding its likely impact on the CDS market and the rights of creditors in similar circumstances.