United States: Unconventional CDS Credit Events: Hovnanian Enterprises

Introduction

Over the past few years, a number of issuers in financial distress and their investors have used refinancing and restructuring strategies that capitalize on credit default swap (CDS) contracts written on the issuer, as reference entity, to achieve a better economic outcome. These strategies take various forms but most commonly involve the triggering of the CDS contract via a failure-to-pay credit event. The ensuing monetization of the CDS contracts for the benefit of CDS protection buyers enables them to extend financing to the reference entity on more favorable terms. At the same time, the relatively low failure-to-pay threshold of $1 million in the standard CDS contract enables CDS contracts to be triggered without hitting cross-default thresholds across the reference entity's capital structure. Failure-to-pay credit events of this type are "unconventional" because they result from voluntary rather than unavoidable payment defaults.

Until recently, the two most prominent examples of these unconventional credit events occurred with respect to Codere SA and iHeart Communications Inc.1 The CDS market on K. Hovnanian Enterprises Inc. has now taken center stage. On Jan. 29, 2018, Judge Laura Taylor Swain of the U.S. District Court for the Southern District of New York denied a preliminary injunction sought by Solus Alternative Asset Management against Hovnanian and GSO Capital Partners LP to restrain a prospective refinancing transaction involving an unconventional credit event with respect to Hovnanian.2

This article addresses the CDS-related structuring in Hovnanian and the legal issues in the Hovnanian litigation, which is ongoing. In a companion piece, we provide an analysis of the state of the CDS market following these unconventional credit events, the viability of these strategies moving forward and the possible implications for the CDS market with their proliferation.

The Hovnanian Restructuring

The court described Hovnanian as "a large construction firm that 'designs, constructs and markets, and sells residential properties' [that] 'suffered serious financial losses as a result of a recession and collapse of the homebuilding market in the United States' between 2007 and 2011." 

On Feb. 1, 2018, Hovnanian closed a series of transactions to restructure and refinance some of its debt maturing 2019 with significant financing provided by GSO. One component of these transactions involved the tender of $170 million of Hovnanian's 8% senior notes due November 2019 (the 2019 notes) in exchange for $155 million in cash, $90.6 million of new 13.5% unsecured notes due 2026 (the New 2026 notes) and $90.1 million of new 5% unsecured notes due 2040 (the New 2040 notes). In addition, GSO agreed to provide Hovnanian a 5% term loan in the amount of $132.5 million (with an additional $80 million available as a delayed draw) to refinance Hovnanian's 7% notes due August 2019, and a $125 million revolver available to refinance Hovnanian's existing $75 million secured term loan and for general corporate purposes.

As part of the exchange offer, Hovnanian's subsidiary, K. Hovnanian at Sunrise Trail III (Sunrise), agreed to purchase and maintain the outstanding $26 million of the 2019 notes expected to be tendered in the proposed exchange of the 2019 notes for the New 2026 notes and the New 2040 notes. Moreover, the indenture for the New 2026 notes and the New 2040 notes prohibits Hovnanian from making the interest payment due on the 2019 notes held by Sunrise on the next interest payment date in May 2018. A default on the May 2018 interest payment in the amount of $1.04 million may result in a failure-to-pay credit event determination by the ISDA Credit Derivatives Determinations Committee (ISDA DC), although no such determination has yet been made. This, in turn, would entitle CDS protection buyers (including GSO if it maintains the CDS positions it disclosed as part of the litigation) to receive payments on their Hovnanian CDS contracts.

Comparison to Codere and iHeart

The Hovnanian restructuring incorporates elements of both Codere and iHeart. The transaction is analogous to Codere because Hovnanian's agreement to default under the 2019 notes held by Sunrise is apparently designed, in part, to draw value from the CDS market that will be used, indirectly, to provide value to Hovnanian through favorable financing terms obtained from GSO. As in iHeart, the interest payment that will be missed is on an obligation owed not to street investors, but rather to an affiliate of the reference entity.

Unlike both Codere and, to a certain extent, iHeart, Hovnanian is not a distressed entity, considering the current prices of its publicly traded debt obligations. However, Hovnanian has made it clear that it has a significant and relatively urgent need to refinance its 2019 notes, and due to certain restrictions in its other debt obligations, it cannot fund the refinancing with otherwise available cash. To obtain financing at more favorable rates than would typically be available to it in the market, Hovnanian turned to a more complex refinancing strategy with GSO, central to which is a CDS credit event.

The Hovnanian restructuring also injects a wholly new component with the issuance of the New 2040 notes. These notes provide long-term flexibility to Hovnanian, among other benefits, but with their relatively low 5% rate of interest and extended maturity, they are likely to be the obligation in Hovnanian's capital structure trading at the lowest level. If so, and to the extent a failure-to-pay credit event is determined to have occurred, we would expect the payments on the CDS contracts to be primarily based on the trading price of that obligation.3  While it is difficult to predict the level at which New 204 Notes will trade at the time of the credit event, if current trading prices remain somewhat consistent, they would have the effect of increasing the return to CDS protection buyers on their CDS contracts, generating value for GSO through its CDS positions. Some of the value received by GSO then would be passed on to Hovnanian in the form of the favorable financing terms it receives from GSO.

The Solus Action

As with any bilateral market, for all the economic benefit this transaction presents for Hovnanian and, presumably, GSO, there is a converse loss for CDS protection sellers. One CDS protection seller, Solus Alternate Asset Management LP, filed a complaint against both GSO and Hovnanian in New York federal district court. The Solus complaint alleged Solus will suffer monetary losses if the ISDA DC determines that a failure-to-pay credit event occurs following the planned May 2018 interest payment default. But Solus also suggests that the transaction could result in irreparable harm to the CDS market generally.

In the first instance, Solus sought an injunction to block the exchange offer for the 2019 Notes. The court denied Solus' request, citing the availability to Solus of monetary damages and the ability of ISDA to craft solutions addressing problems in the CDS market generally.4 With the denial of the requested injunction, the Solus action will transition to a traditional litigation process of responsive pleadings, motion practice, discovery and possibly a full trial.

The complaint, on which Solus must now proceed on the merits, alleges a number of causes of action against GSO and Hovnanian. 

  • Market Manipulation

Solus accuses Hovnanian and GSO of violating Section 10(b) of the Securities Exchange Act of 1934 and related Rule 10b-5 by manipulating both the price of CDS contracts and the price of Hovnanian's outstanding bonds. In this regard, a single-name CDS is a security for purposes of anti-fraud rules of the federal securities laws.

To establish market manipulation, Solus will have to prove that GSO and Hovnanian engaged in a fraudulent or deceptive course of conduct. A classic claim of market manipulation typically rests on the creation of a perception of market activity where none exists, or of pricing generated artificially by deceptive practices rather than free market forces. Solus will likely be battling uphill in this respect. The terms of the restructuring have been disclosed, and their effects on the pricing for Hovnanian debt and CDS contracts that reference the Hovnanian debt are the predicable outcome of the known features of those instruments. 

  • Disclosure Claims

The Solus complaint makes a further allegation under Section 10(b) and Rule 10b-5 that Hovnanian failed to properly disclose the benefits of the transaction to GSO. As with its market manipulation claim, Solus will be encountering a relatively high bar. Even if Hovnanian has not expressly articulated the CDS drivers for the transaction, the market has clearly understood them.  With no harm and no undisclosed facts (as opposed to perceived motivations), it is difficult to see where Solus goes with this claim, other than perhaps to obtain some additional disclosures from the issuer.

  • Tortious Interference

Finally, Solus falls back on a claim of tortious interference by Hovnanian and GSO with Solus' CDS contracts or (under Solus' amended complaint) its business relationships. Tortious interference has historically proven to be a difficult claim on which to succeed, as pursuing one's own economic interest is not tortious, notwithstanding that there may be an adverse consequential impact on contractual or business relationships of a third party. Particularly here, where the CDS contracts will pay off only if the ISDA-DC determines that a credit event has occurred in accordance with the terms of the contracts, it would seem difficult to establish that the defendants have engaged in tortious conduct.  

Conclusion

Hovnanian, together with GSO, has taken a strategy pioneered in Codere and iHeart and further refined it to extract value from CDS protection sellers in order to facilitate a comprehensive refinancing. An adverse ruling in the Solus case on the merits could put the brakes on this strategy, but Solus would seem to have a difficult road ahead to prevail in the case. At this stage, if the court's ruling on the request for injunctive relief is any indication, it is a fair bet that the court will not choose to wade into an area of private contract in which the expertise resides with the ISDA and the ISDA DC, which have tools at their disposal to correct perceived inequities and inefficiencies.  

In the companion article, we explore various policy and market considerations regarding unconventional credit events following the renewed focus on these tactics in the Hovnanian case. ISDA will likely need to address these considerations if it is determined to implement marketwide changes to constrain financial restructuring strategies predicated on the engineering of a failure-to-pay credit event.

Footnotes

1  For a discussion of the unconventional credit events with respect to those reference entities, together with an analysis of the resulting strategic implications, see article here.

Solus Alternative Asset Management LP v. GSO Capital Partners L.P., No. 18 CV 232-LTS-BCM (SDNY Jan. 29, 2018).  Kramer Levin is not involved in the Hovnanian litigation, but the authors' article iHeart and Other Unconventional CDS Credit Events was cited by the court in its decision.

3 The New 2040 notes are trading at 32.276 as of March 26, 2018. Another Hovnanian obligation (the 2% notes due 2021) is trading around 82.082  as of March 26, 2018. All other debt is trading near par as of March 26, 2018.

4 See the authors' article suggesting a number of changes to the standard ISDA CDS contracts that might be adopted to address perceived challenges to the CDS market from unconventional credit events.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions