iHeart Communications, Inc.

 
To: ISDA Credit Derivatives Determinations Committee (Americas)
  
Re:  iHeartCommunications, Inc. Auction Date
  
This statement is submitted in connection with a general interest question as to the timing of the Auction Date for the Auction to be held with respect to iHeartCommunications, Inc. (“iHeart”).[1]  On December 23, 2016, the ISDA Credit Derivatives Determinations Committee (Americas) (the “DC”) stated that it had heard concerns about a substantial coupon payment due by February 1, 2017 and that certain market participants had raised concerns about the impact on the Auction if settlement of Representative Auction-Settled Transactions were to occur prior to this date.  As a result, the DC said that it “therefore anticipates holding the Auction on or after February 1, 2017, consistent with the provisions of Section 3.2(d) of the DC Rules to avoid prejudice to buyers or sellers compared to Physical Settlement.”  We understand the DC is scheduled to continue its discussion as to the timing of the iHeart Auction on January 6, 2017. 
 

Under Section 3.2(b)(i) of the DC Rules, “the Auction Date shall be the third Relevant City Business Day immediately preceding the 30th calendar day after the Credit Event Resolution Request Date” which, in the case of iHeart, would be January 13, 2017.  However, on January 4, 2017, memorandum # 2017010401 was published (the “Jan 4 Memo”).  The Jan 4 Memo argues that, based on the “buy-in” provisions of Section 9.7 of the 2014 Definitions, because a potential Buy-in Date could not occur until February 1, 2017, such date represents the appropriate date for the setting of the Auction Date.  The Jan 4 Memo argues that such an outcome is required so that the Auction Date mirrors what would likely have taken place if Physical Settlement applied. 
  
We wholeheartedly agree that the intention of the Auction mechanics is to mirror, to the extent possible, the outcome that would arise in a corresponding Physical Settlement.  However, we strongly disagree that such mirroring requires that the Auction Date be based on a theoretical Buy-in Date (if any) that might occur in Physical Settlement.  Such a conclusion is a misreading and misunderstanding of the history of the buy-in provisions and the role that those provisions play in physically settled CDS.
  
If a CDS is physically settled, a protection buyer (“PB”) must deliver a Notice of Physical Settlement to the protection seller (“PS”) within 30 calendar days of the Event Determination Date, (the NOPS Cut-off Date which the Jan 4 Memo states is January 19, 2017).  This would result in a Physical Settlement Date of January 24, 2017.  The Buy-in Date if there were to be one, would be not less than 5 Business Days later.  However, this is of no relevance.
 
The buy-in procedures did not exist in the original 1999 iteration of the credit derivatives definitions.  The physical settlement process worked smoothly in the early days of CDS where CDS were mainly used for hedging.  Then, the value of CDS did not typically exceed the outstanding amount of the underlying obligation covered by the CDS.  As the CDS market grew situations where CDS notional value exceeded the value of the underlying obligation became more frequent.  In those cases, following the occurrence of a Credit Event, a PB who did not already hold the underlying bonds required for delivery in order to comply to physical settlement, had to buy them on the secondary market creating the potential for artificial price pressure (i.e., a short squeeze).  In order to avoid short squeezes, the 1999 definitions also allowed for a cash settlement election (to be made at the time of entering into the CDS) whereby the payment to PBs was determined as the difference between the nominal and the market value of the Reference Obligation.  In contrast to Physical Settlement, Cash Settlement puts the exposure to changes in the price of the distressed bonds subsequent to contract liquidation on PBs. 

To address the problems that were arising with Physical Settlement, the 2003 definitions added a buy-in mechanic that allowed PSs to source Deliverable Obligations in circumstances where a PB failed to make the required delivery.  The buy-in process is intended to create additional time to source Deliverable Obligations and partially alleviate short squeeze issues.  The buy-in process assured that PBs would not be left with a valueless CDS because of lack of availability of Deliverable Obligations, but, at the same time, was intended to incentivize PBs to do everything possible to source the required Deliverable Obligations.  A PS exercising its buy-in rights, unlike a PB, would have no incentive to source the cheapest to deliver Deliverable Obligation.  A PB that foregoes sourcing its own Deliverable Obligations faces the possibility of a lower payout under the buy-in mechanics.
  
Unfortunately, the buy-in mechanics proved insufficient to address short squeezes.  As the market continued to grow and CDS became efficient instruments for taking credit views, it became evident that with the notional size of CDS frequently exceeding the volume of issued bonds, there was increasing risk of failed trades due to the market trying to buy and sell the same bonds multiple times in order to settle their CDS.  
  
For investors without physical positions, cash-settling their CDS was preferable.  However, even with Cash Settlement, obtaining quotes for distressed securities can be quite difficult, since liquidity dries up rapidly following a Credit Event.  For this reason, in order to increase the transparency of the settlement process, and address failed trades, beginning in 2005, the market developed credit event auctions.  By mid-2009 auction settlement had become the standard settlement mechanism for CDS contracts.
  
The auction process as noted, is intended to create transparency and replicate the physical market as much as possible and, at the same time, establish a market-wide price.  An auction process that works as intended creates transparency, efficiency and, most importantly, eliminates the types of short squeezes that the original physically settled markets were experiencing and that the buy-in mechanics had attempted to address.  Auction pricing in effect allows bonds to trade at the same price as the cash settlement price so that basis is always settled at par.  In other words, the auction process does not need to and should not reference a buy-in process.  The Auction eliminates the need for a buy-in.  The buy-in process would, in effect, represent a failed auction. 
  
Additionally, the buy-in process does not result in a date certain as is suggested by the Jan 4 Memo.  The Jan 4 Memo states that the Buy-in Date could not occur until February 1, 2017 and, therefore, the Auction Date should be on or after February 1, 2017 as well.  However, this fails to reflect the fact that Section 9.7 of the 2014 Definitions provide that a PS can exercise its right to close out all or a portion of a Credit Derivatives Transaction on any date following the expiration of five Business Days following the Physical Settlement Date.  This means that even if PBs exercised their ability to delay physical delivery, that right would expire on January 31, 2017, before the scheduled interest payment date on iHeart’s 14% notes.  Further, there is no way of knowing if PBs would exercise that right and, if they did, what date, if any, PSs would establish as a Buy-in Date.  That is, the Buy-in Date is an unknown date and could occur at any time in the future on a date that, in the determination of the PS, would be most advantageous to the PS in order to minimize the size of its payout.
  
The Jan 4 Memo implies the Buy-in Date is a date certain and, on that basis, is the appropriate date to be used for the Auction Date.  The NOPs Cut-off Date is a date certain.  The Physical Settlement Date is a date certain as well.  The Buy-in Date is not a date certain and, accordingly, a hypothetical Buy-in Date cannot serve as a reference point for the Auction Date.
 
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 We confirm that a copy of this statement may be provided for information purposes only to the members of any Credit Derivatives Determinations Committee convened under the DC Rules in connection with the iHeart Communications, Inc.  General Interest Question to consider the issues discussed herein, and that it may be made publicly available on the ISDA Credit Derivatives Determinations Committee website.  We accept no responsibility or legal liability in relation to its contents.
 

[1] Capitalized terms used but not otherwise defined herein shall have the meanings set forth in the 2014 ISDA Credit Derivatives Definitions (the “2014 Definitions”) or the 2016 ISDA Credit Derivatives Determinations Committees Rules (January 20, 2016 version) (the “DC Rules”).