Dealers in the U.S. and Europe will accept different forms of reference entity guarantees in credit derivatives contracts under the International Swaps and Derivatives Association's 2003 Credit Derivatives Definitions. Although ISDA sought a global standard for guarantees, a consensus to adopt a proposed compromise did not emerge. Instead, ISDA approved a more basic supplement. Dealers in New York determined it was appropriate to trade on Qualifying Affiliate Guarantees only, due to the legal uncertainty of enforcing upstream and sidestream guarantees. While aware of the legal considerations, European dealers did not want to limit the range of credit protection products they could offer.
Treatment Of Guaranteed Obligations Under
The 2003 Definitions
The 2003 definitions clarify the treatment of guarantees provided by a reference entity, as well as the related underlying obligations, in credit-efault swaps, an issue that was not addressed directly in the 1999 Credit Derivatives Definitions. The 2003 definitions delineate which obligation and deliverable obligation categories and characteristics apply to guarantees and which apply to their related underlying obligations.
Under the 2003 definitions, the determination of whether a credit event may occur with respect to a guarantee depends on whether the guarantee is a Qualifying Guarantee. If the parties specify "All Guarantees Applicable" in their confirmation, then a credit event may occur with respect to a guarantee without regard to the relationship between the reference entity and the underlying obligor and the guaranteed obligation may be delivered in settlement. If, on the other hand, they specify "All Guarantees Not Applicable," then a credit event may occur only with respect to guarantees provided by a reference entity to its downstream affiliate, "Qualifying Affiliate Guarantees," and only those guarantees and their underlying obligations may be delivered.
Modifications To The Definitions Supplement
In the 2003 definitions, the term Qualifying Affiliate Guarantees includes a 50% affiliation threshold for a Downstream Affiliate, which threshold is evaluated at the time of the relevant credit event or the delivery date. In the definitions supplement, affiliation is determined as of the date of guarantee issuance, reflecting the consensus that share ownership is more reliably determined at issuance, through offering materials, than at a later date.
The definitions supplement amends Section 2.23 of the 2003 definitions to eliminate the requirement that a Qualifying Guarantee not be subordinated to any unsubordinated borrowed money obligation of the underlying obligor. Thus, unless the parties choose "Not Subordinated" as an obligation characteristic, an obligation guaranteed by the reference entity may qualify as an obligation even if, at the time a credit event occurs, that underlying obligation is subordinate to the unsubordinated borrowed money obligations of the underlying obligor. Parties may exclude such underlying obligations as obligations by specifying "Not Subordinated" in their confirmations.
The 2003 definitions provide that both the Qualifying Guarantee and the underlying obligation must satisfy each of certain listed obligation characteristics and deliverable obligation characteristics if those characteristics are specified by the parties. The definitions supplement amends that provision to clarify that if the parties specify "Not Subordinated," that choice will apply both to the guarantee given by the reference entity and to the underlying obligation.
Finally, the definitions supplement modifies the "Multiple Holder Obligation" requirement for a restructuring credit event so that its consent threshold does not apply to bonds. Under the 2003 definitions, a restructuring is not a credit event unless the relevant obligation meets the definition of "Multiple Holder Obligation"--that is, it is held by more than three unaffiliated holders at the time of the event and the consent of at least two thirds of the holders was required for the restructuring. This modification was deemed necessary because Eurobonds, which comprise a majority of the European debt market, frequently require less than a two-thirds vote for a restructuring.
Implementation
Parties may make use of the definitions supplement by including language that indicates the extent to which their agreement is subject to the "2003 ISDA Credit Derivatives Definitions, as supplemented by the May 2003 Supplement to such Definitions."
This week's Learning Curve was written by Sherri Venokur, special counsel, and Jamila Roos, associate in the commodities and derivatives practice group, specializing in derivatives at Stroock & Stroock & Lavanin New York.
