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Cashing in on insolvency

One lawyer describes the number of credit default swaps out there as 'the real evil.'
|Written By Mark Cardwell

Insolvency lawyer Sylvain Vauclair likes to compare the negotiations that take place between creditors of big corporate debtors before they go into proceedings to implement a restructuring plan to a high-stakes poker game. “The premise of the whole solvency thing is that there’s never enough money for everybody,” says Vauclair. “People struggle to get the biggest piece of the pie.”

Though each case is unique, the traditional goal — and often the outcome — of these bargaining donnybrooks are agreements that avoid value-decreasing bankruptcy filings and, ultimately, save companies. But the advent of credit default swaps (CDSs) has added a whole new dimension to an already complex game in recent years. “They’re like an ace or a wild card up a creditor’s sleeve,” says Vauclair, a partner in McCarthy Tétrault LLP’s Montreal office and co-leader of the firm’s national bankruptcy and restructuring group. “If a creditor is holding CDSs, they may have a lot more to gain from the company’s failure than its survival.”

A seemingly innocuous financial tool when it was developed and approved in the United States a decade ago, CDSs are basically unregulated insurance contracts in which investors pay premiums in return for payouts that are triggered by specified events — in this case a default or trade down in the difference of an investment. “Essentially, they are side bets on the performance of the U.S. mortgage markets and the solvency of some of the biggest

financial institutions in the world, a form of legalized gambling that allows you to wager on financial outcomes without ever having to buy stocks and bonds and mortgages,” journalist Steve Kroft explained during an episode of TV news show 60 Minutes that looked into CDSs (the best of the dozens of exposés that can be seen or heard on the subject on the Internet or from economic experts —

Issued in untold quantities for unknown amounts, CDSs are believed to be an important component of the glue holding together many hundreds of trillions of dollars worth of deals between big banks, insurance companies, and multinational corporations around the world. The result has been the creation of a massive and complex web of people and companies that secretly insure each other, and which became part and parcel — some say the cause — of last year’s global financial meltdown. As a result, CDSs are now seen as a mainstay in an arsenal made up of what Warren Buffett calls financial weapons of mass destruction.

As the economic fallout from that meltdown continues, creditors around the world who have insured themselves against — or speculated in favour of — a company’s bankruptcy by buying CDSs may, depending on the wording of their contracts and the solvency of CDS issuers like AIG, be tempted to protect their own interests by thwarting restructuring efforts and cashing in. For their part, uninsured creditors and banks faced with making massive payouts on those same CDSs are working desperately to support a company’s efforts to rebuild.

The result, as insolvency professionals in Canada and elsewhere who are involved in those efforts are discovering, is that it is becoming increasingly difficult to distinguish friends from foes around the negotiating table. “There’s no question that [CDSs] have had an impact in the context of restructuring cases we’ve been involved with,” says Rob Chadwick, a corporate lawyer and partner at the Toronto office of Goodmans LLP and a member of the firm’s corporate restructuring group. “CDS[s] are clearly now a key issue in restructuring in Canada.”

Chadwick has worked on many of the recent big restructuring and refinancing files his firm has been involved with, including the $32-billion, third-party asset backed commercial paper, the US$1.4-billion refinancing of AbitibiBowater, the US$1.2-billion recapitalization of Tembec, and the billion-dollar-plus restructurings of corporate behemoths like Quebecor, Smurfit-Stone, and Canwest. He suggests the key to successful recapitalization efforts is finding common goals or issues around which debt holders can coalesce. “You need to understand the key drivers of your creditor group,” he says. “As an insolvency lawyer, that’s part of my job.”

That task, however, has become more difficult — even impossible — in some cases where debt holders have either bet against companies or tried to hedge their investments by buying CDSs, which results in them having strong incentives to thwart the efforts of traditional stakeholders to reach restructuring agreements that will save companies in distress. “They don’t tell you they have them [but] it becomes obvious they are following different strategies than other creditors,” says Chadwick.

Without naming names, he adds he has personally been involved in cases in which bond holders who stood to make 15 or 20 cents on the dollar from a restructuring also possessed CDSs that would pay them 100 cents on the dollar if they were triggered in the case of a filing. “At the end of the day,” says Chadwick, “they may prefer to see the company fail.” Because Canada doesn’t have a large number of companies, particularly outside Toronto and Calgary, that are big enough to seek and obtain financing on the world derivatives market, and because the financial crisis hasn’t ravaged our economy the way it has the U.S., the impact of these so-called negative-basis trades has been much worse south of the border. There, Moody’s Investors Service projects business defaults will more than triple in 2009, reaching numbers not seen since the 1930s.

A Bloomberg news story in early March neatly portrayed the potential that CDSs have to derail efforts aimed at restructuring such high-profile American corporate icons as Ford Motor Co. and Six Flags, which notably owns La Ronde amusement park in Montreal. Investors, the article explained, had the opportunity to buy Six Flags bonds at 20.5 cents on the dollar and CDSs at 71 cents. If the company defaults, creditors would receive face value of the debt, minus costs.

According to a note issued by high-yield strategists at Citigroup in February, a $10-million purchase of credit default swaps in Six Flags would yield a profit of six percentage points — or a cool $600,000 — if the company failed. “Before you had to worry mostly about where you were [in a company’s capital structure],” Matthew Eagan, an investment manager at Boston-based Loomis Sayles & Co., which manages $7 billion in high-yield assets, told Bloomberg. “Now, you have to consider the possibility that you might have this large holder of CDS incentivized to see it go into bankruptcy.”

It is this gambling against companies that might otherwise be nursed back to health by conscientious creditors that most rankles Rick Orzy, a senior partner and co-leader of the national bankruptcy and restructuring practice of Bennett Jones LLP. He represents mostly public and private placement bond holders in large insolvency cases — like Nortel Networks, Quebecor World, Stelco, Parmalat, and Teleglobe — as well as in international restructurings. He says the very essence of CDSs encourages people to bet on stocks and security even though their investment isn’t in jeopardy. “The difference [between] CDSs and insurance is that insurance covers you in a loss while a CDS pays out by an event that you yourself can cause,” he says. “And insurance companies have to have capital to cover the policies they issue. But people are allowed to write CDSs with no regulation and collect huge fees without ever being able to cover it. It’s absurd.”

While lamenting the fact that CDSs “motivate shareholders in the wrong way — and people have to realize there [are] lots of these things out there, which I think is the real evil,” Orzy says, although he doesn’t believe the sky is falling because of them. “There are always people around a negotiating table who are motivated by their own economic agendas [and] there [are] lots of situations — like with people selling short stock — that create these kinds of perversities,” he tells Canadian Lawyer. “And don’t forget, what goes around comes around. If you look at the 10 biggest insolvencies in the last few years, the same half-dozen big holders — mutual funds, insurance companies, etc. — have been involved in almost all of them. If one has CDSs and takes a ridiculous position that causes big losses to the others, well, hey, maybe next time it’ll be their turn. So you can get them to temper their positions.”

Rob Chadwick agrees. And in addition to the human dimension that is always involved in efforts aimed at finding solutions to restructuring companies — a process he likened to a merry-go-round with different stakeholders jumping on and off according to their interests — he says there are also technical ways in which CDSs can be defused before they scuttle a negotiating process. “A lot depends on the terms [and] how a CDS is written,” he says. Sometimes, too, he adds, the value of CDSs — especially those written by conduits like the companies that wrote commercial paper — are questionable. And in some cases CDSs are bought by other stakeholders who want to improve their positions or simply save the process. “There’s no doubt CDS[s] have made things more complicated because they add another variable to an already complicated process,” says Chadwick. “But it’s like anything else. People are adapting and learning to live with them.”