United States: The Iheart Communications Credit Event And What It Means For The CDS Contract

Why We Still ❤ CDS

As has been the case now for three years running¹, 2016's December 20 roll date again triggered a set of novel questions for the credit default swap market, this time related to the decision by iHeart Communications, Inc. ("iHeart") to fail to pay principal on bonds held by one of its subsidiaries. Although the iHeart questions turned out to be easier to resolve than those raised in Caesars or Novo Banco (which both required External Review²), they again strained market participants' tolerance for the complexity of the product and the opacity of the process required to manage it. In this memo, we summarize the analytical issues raised by the iHeart event, consider a few market-management issues highlighted by the determinations process in this case and offer some recommendations for the design of the product going forward.

Nevertheless, we think both the product and the process, as complex and opaque as they may be, once again delivered an outcome that was predictable, swift and certain. We hope the guardians of the product keep these principles in mind as ISDA prepares to hand over administration of the product to ICE Benchmark Association.³

Despite these latest bumps, we think financial market professionals who want to see analytical effort rewarded should still find CDS worth ♥-ing.

The iHeart event generated two analytical questions under the Definitions, each sub-mitted to the International Swaps and Derivatives Association ("ISDA") Determinations Committee (the "DC") for consideration:

(1) whether a Failure to Pay Credit Event had occurred with respect to certain of iHeart's outstanding notes (the "Notes") held by Clear Channel Holdings, Inc. ("CCH"), an iHeart wholly-owned subsidiary (the "FTP issue"), and

(2) how accrued interest on the Deliverable Obligations likely to be delivered in the Auction should affect the timing of the Auction and, therefore, the Auction Final Price for CDS referencing iHeart the ("Auction Date issue").

Both issues reinforced the lesson that CDS is a highly technical product governed by objective rules and standards, not one whose performance will be determined by general views of fairness or broad market expectations. Nevertheless, as well-worn as the product is, we think the iHeart event shows there are still technical improvements to be made.

The iHeart event also expanded and tested the market's reliance on the product's unique governance structure. While the FTP issue was well-briefed and telegraphed by market participants and observers; the Auction Date issue was not. We think the difference in the way the Determinations Committee dealt with each issue suggests areas for improvement here as well.

IHEART'S TACTICAL FAILURE TO PAY

Analyzing the performance of iHeart CDS was initially challenging because of an unusual "springing lien" provision contained in certain of iHeart's outstanding debt obligations requiring the company to grant additional collateral to certain of its creditors once the outstanding principal amount of specified iHeart bonds falls below a specific level. Specifically, the "springing lien" would have been triggered if the Company had redeemed all of the outstanding Notes on December 15, 2016 as required under the relevant indenture. Prior to December 12, 2016, market participants had been speculating as to whether iHeart would retire the Notes as scheduled and allow the lien to spring. Market participants were aware, however, that enough of the Notes ($57.1 mil-lion) were held by CCH to allow iHeart to avoid that outcome if it could manage to leave the CCH-held Notes outstanding while retiring all of the Notes held by non-affiliates. (Because the cross-default threshold in iHeart's other debt obligations is $100million, this would also avoid a wider iHeart cross-default). It was not clear to market participants, however, exactly how iHeart would achieve that result. Would iHeart somehow direct payment to some beneficial owners of the Notes but not to others? Would iHeart amend the indenture to split the obligations and establish that the CCH-held Notes were not due? Would the company pursue some other tactic?

On December 13, 2016, iHeart ended the speculation when it disclosed⁴ that, although it intended to repay in full the Notes held by non-affiliated holders on December 15, 2016 as required under the indenture, it had informed CCH that it would not repay the $57.1 million of Notes held by it on the maturity date but would continue to pay inter-est on those notes as long as they remained outstanding. CCH, in turn, informed iHeart that, while it retains its right to exercise remedies under the Notes in the future, "it does not currently intend to, and it does not currently intend to request that the trustee, seek to collect principal amounts due or exercise or request enforcement of any remedy with respect to the non payment of such principal amount under the Legacy Notes Indenture."⁵ It went on to state that, in its view, the CCH-held Notes would re-main "outstanding," and the lien would not spring. In an effort to create greater certainty as to that outcome, iHeart also initiated litigation in Texas state court⁶ seeking a declaratory judgment that the CCH-held Notes were still outstanding and would re-main outstanding until cancelled or repaid.

THE CREDIT EVENT QUESTION

While the status of the springing lien remains unresolved, CDS market participants sought a quick resolution as to whether iHeart's actions nevertheless constituted a Failure to Pay under the standard CDS contract. The DC concluded on December 21, 2016 that a Failure to Pay Credit Event had occurred on December 20, 2016 with respect to iHeart as a result of a Failure to Pay in respect of the Notes held by CCH.⁷ While this was not a typical Credit Event, with an issuer clearly in default on its debt obligations generally, the decision was reached unanimously and without the need for postponement for further deliberation. This may in part have been due to the fact that the question had already been debated in public filings submitted to the DC by law firms on either side of the question⁸ —a development that has increasingly become part of the CDS determination process for questions of controversy in the market.

In keeping with past practice, the DC did not detail its reasoning. In our view, once the facts were disclosed by iHeart, the FTP issue became straightforward. Under Section 4.5 of the Definitions, a Failure to Pay occurs when the Reference Entity fails to make a payment when and where due in accordance with the terms of the relevant Obligation. The key question in this case, then, was whether the terms of the Notes could have been considered to have been amended as a result of any agreements between, or other conduct of, iHeart and CCH, as holder of the remaining Notes, such that either the Notes were no longer outstanding or the $57.1 million was no longer due on the original due date.

On the first point, available public information continued to show that iHeart, CCH and the Notes trustee were treating the Notes as being outstanding.⁹ Had the Notes been held by iHeart itself, this might have been a more complex question, as an argument could have been made that the Notes would not be considered outstanding in bankruptcy (or, indeed, for certain other purposes); though we believe that, even then, the DC would likely have made the determination as to whether the Notes were still outstanding on the basis of a reading of the technical terms of the Notes.

On the second point, which was the one more directly argued in the Paul Weiss Memorandum and the Linklaters Memorandum, the DC apparently concluded that there was no evidence that the terms of the indenture had actually been amended, and there was therefore no reason to conclude that a Failure to Pay had been avoided. Although Linklaters argued that the agreement by CCH not to pursue remedies in respect of iHeart's non-payment should be read as a waiver of the Note holders' rights and there-fore a constructive amendment of the terms of the Notes, such forbearance agreements have never been construed by the DC as being equivalent to an amendment to the terms of the relevant obligation, except where there was an express agreement by all the relevant parties to do so.¹⁰ In this case, it appears that the DC adopted the view espoused by Paul Weiss, that a Failure to Pay could have been avoided had iHeart and the Notes trustee formally agreed to a supplemental indenture amending the maturity date of the CCH-held Notes. As iHeart's 8-K filings would have had to disclose any such amendments, the DC apparently concluded that no such amendment was made.¹¹

Footnotes

1 See, e.g., the Failure to Pay question with respect to Caesars Entertainment Corporation, available at http://dc.isda.org/cds/caesars-entertainment-operating-company-inc-4/, and the Succession Event question with respect to Novo Banco, available at http://dc.isda.org/cds/novo-banco-s-a/, both of which led to External Review.

2 Capitalized terms used but not otherwise defined in this alert shall have the meanings given to them in the 2014 ISDA Credit Derivatives Definitions (the "Definitions").

3 News Release: "ISDA Selects Benchmark Administration as Determinations Committee Secretary" (Dec. 16, 2016), available at http://www2.isda.org/news/isda-selects-ice-benchmark-administration-as-determinations-committees-secretary.

4 iHeartCommunications, Inc.'s Current Report on Form 8-K (filed Dec. 13, 2016).

5 Id.

6 Petition for Declaratory Judgment filed in iHeartCommunications Inc., f/k/a Clear Channel Communications, Inc., et al. v. The Bank of New York

n/k/a The Bank of New York Mellon Corporation, No. 2016-CI-21289 (District Court of Bexar County,

TX, Dec. 12, 2016) (hereinafter "Declaratory Judgment Petition").

7 A Failure to Pay could not have occurred any earlier than December 20, 2016 because the Definitions im-posed a Grace Period of Three Business Days where none is provided in the terms of the relevant Obliga-tion.

8 Paul, Weiss, Rifkind, Wharton & Garrison LLP, argued that the non-payment of the CCH-held Notes was a Failure to Pay(See, Paul, Weiss, Rifkind, Wharton & Garrison LLP, Memorandum submitted to ISDA Credit Derivatives Determinations Committee re iHeart Communications, Inc. Failure to Pay Credit Event (Dec. 20, 2016), available at http://dc.isda.org/documents/2016/12/iheart-pai-dec-20.pdf, hereinafter, the "Paul Weiss Memorandum"), while Linklaters LP argued the opposite (See, Linklaters LP, Memorandum submitted to ISDA Credit Derivatives Determinations Committee re iHeart Communications, Inc. Failure to Pay Credit Event (Dec. 15, 2016), available at http://dc.isda.org/documents/2016/12/iheart-pai-dec-16.pdf, hereinafter, the "Linklaters Memorandum").

9 In paragraph 76 of the Declaratory Judgment Petition, iHeart explained: "The trustee and paying agent of the [Notes] maintains records of the notes outstanding and includes the notes held by [CCH] as outstand-ing. iHeart pays interest on the notes held by its subsidiaries in the same manner as it does other outstand-ing notes. The various trustees and agents of iHeart's other debt also treat and have historically treated debt held by iHeart subsidiaries as outstanding. In addition, the [Notes] have been listed as assets on the books and records of iHeart and its subsidiaries, including the financial statements of [CCH]."

10 Indeed, the Linklaters Memorandum would seem to make arguments contrary to its author's own published views: "On the other hand, if the creditors merely agree not to enforce their rights or demand payment . . . the due date for payment will remain the same and a default will occur if payment is not made on that date." Derivatives: Law and Practice, Simon Firth (Sweet & Maxwell 2003), at Section 2.3.

11 We note, though, that if an amendment had been made to the Notes, and if (as is not difficult to imagine) it were not possible to determine whether the relevant amendment had become effective as of the instant at which the relevant payment was first due, an interpretative question as to the proper reading of Section 4.5 of the Definitions might have arisen, as it unclear whether the terms of the Obligation must be construed before or after the relevant Grace Period.

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