Credit events are a serious business. With billions of dollars at stake via credit default swaps on many of the large companies that enter the default radar, the International Swaps and Derivatives Association’s Credit Derivatives Determinations Committee can’t afford to have any gray areas clouding the legitimacy of its decisions. And with Aurelius Capital, a distressed credit hedge fund with USD2.4 billion in assets under management, requesting earlier this week that the CDC take a vote on whether or not Texas Competitive Electric Holdings should be considered bankrupt, at least a handful of market participants are beginning to wonder if and how client relationships and/or proprietary positions within the Committee may or may not influence a vote. After all, the acceptance of Aurelius’ request marks only the second time since the Committee was formed that a public request from an end user for a formal vote has been accepted by the Committee.
The question, says one derivatives lawyer in New York, is whether or not business interests can or will factor into a credit event determination in the future, especially considering Aurelius’ accepted request has been heavily covered in the media and others may follow suit. “Hedge fund clients are calling me and asking if this is going to become a trend,” said the lawyer. “Are other hedge funds holding large debt positions in faltering companies going to start blitzing the CDC with vote requests? What if this practice extends to some of the biggest and most powerful end users?” If so, says the lawyer, ISDA should begin considering laying out explicit guidelines to govern conflicts of interest, both with respect to client relationships and proprietary positions in the underlying.
As for ISDA, a spokesman cited the public nature of the CDC’s votes and the necessity for a supermajority as ensuring the integrity of the process. For a credit event to be called, 12 out of the 15 members of the Determinations Committee need publicly to vote in favor of an event. ISDA does not currently have any explicit language dealing with the possibility for conflicts of interest, said the spokesman.
Of the 15 voting members in the Americas, 10 are dealers and five are among the biggest end users in the business. Of these voting members, BlackRock Fund Advisors holds the ninth most TCEH debt at USD159 million via issued bonds, while PIMCO Advisors LP holds USD64 million worth, 30th on the list of bondholders according to Bloomberg. Whether or not any of the voting members have relationships with Aurelius or TCEH could not be gleaned.
Some feel strongly that CDC members would never risk their reputations by voting their economic interests. “In this business, reputation is everything,” said the founder of corporate credit hedge fund manager in San Francisco, Calif. “Most of these businesses, especially the funds, are built on the legitimacy of their names. I really don’t think any of them would risk doing anything as shady as voting for a credit event just because they had a large holding in the underlying debt.”
This assessment appears true enough, at least in this case. Perhaps in keeping with the namesake of the requesting fund, the CDC summarily issued a 15-0 “thumbs-down” decision reminiscent of a Roman emperor sentencing a defeated gladiator to death. No credit event, they said, and judging by personal discussions it appears they were right. But what about next time? Will the Coliseum crowd continue to back Joaquin Phoenix if it appears personal interests have compelled the Emperor to snuff out Russell Crowe? Hollywood tells us no.