A Failure to Pay Credit Event allows a CDS buyer to be paid the protection payments when the Reference Entity fails to make a required payment on its debt obligation. Until recently, the credit default swap market embraced the commonsense assumption that any future payment defaults would be solely a product of a Reference Entity’s declining creditworthiness. Based on this assumption, CDS protection sellers provide protection buyers with hedges against this credit risk.
That foundational assumption has been challenged by two well-known examples – Codere S.A. in 2013 and Hovnanian Enterprises Inc. in 2018. Both cases illustrated the ability of a CDS buyer to obtain a windfall under its CDS when it offered valuable consideration to the Reference Entity itself to cause a Failure to Pay Credit Event.
Market participants are now searching for an amendment to the CDS Definitions that will minimize the risk of similar schemes resulting in Failure to Pay Credit Events. In this client alert, RK&O partner Julia Lu proposes distinguishing between categories of Failure to Pay Credit Events and applying different rules to the resulting categories.