iHeartCommunications, 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 discuss auction details related to the timing of the iHeart Auction on January 4, 2017.  Under Section 3.2(d) of the DC Rules, the DC may amend the Credit Derivative Auction Settlement Terms by a Supermajority vote and only after a public comment period, unless a Supermajority resolves to allow such amendment without a public comment period.
 
 
 
On that basis, we believe that if any amendment to the Credit Derivative Auction Settlement Terms for iHeart were to occur in relation to the date on which the Auction will be held, the DC must first consider and, if necessary, allow for public comment as to the below concerns.
 
 
 
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, the DC received two comments with respect to timing of the Auction (the “Auction Timing Statements”) noting that iHeart’s 14% senior notes due 2021 (the “14% Notes”), which are expected to be the cheapest to deliver of the Deliverable Obligations, are approaching their next interest payment date scheduled to occur on February 1, 2017.  On that basis, the Auction Timing Statements requested that the DC set the Auction Date such that the Auction Settlement Date would occur on or shortly after February 1, 2017 (i.e., on or shortly after the next interest payment date of the 14% Notes) to minimize potentially skewed auction results.  The essence of the concerns raised in the Auction Timing Statements was that unless the DC sets an Auction Date and Auction terms that permit delivery of Bonds under Representative Auction-Settled Transactions after payment of the upcoming semi- annual coupon on the 14% Notes on February 1, 2017, there could be “the possibility of confusion over who is entitled to payment of the accrued interest and how the accrued should be factored into the Auction Final Price.”
 
 
 
We respectfully disagree.  For the reasons stated below, holding the Auction on or about February 1 would not result in confusion with respect to accrued interest on the 14% Notes but rather, would create an inappropriate windfall for protection buyers (“PBs”) to the detriment of protection sellers (“PSs”) in a manner inconsistent with the expectation that the DC should act in an impartial manner that neither favors or advantages either buyers or sellers of protection.
 
 
 
One of the Auction Timing Statements argues that if participating bidders submit bids for the Deliverable Obligations that reflect the likelihood of payment and expected receipt of interest on the 14% Notes, the Auction Final Price would be artificially inflated due to the considerable accrued interest component reflected in the bids.  This simply makes no sense.  The 14% Notes have already been trading for several years.  Market participants are fully aware of the trading and settlement dynamics of the 14% Notes.  The semi-annual coupon on the 14% Notes is a common feature of corporate bonds.  Like other corporate bonds, the 14% Notes are quoted clean but settlement always includes accrued interest.  There is no reason the Auction Final Price should not reflect how the 14% Notes are actually traded. 
 
 
 
A CDS is identical to a forward sale by the PB of the reference obligation at its face value: (i.e., as if it was a default free bond) on the occurrence of a credit event.  The PB has the right to receive the face value of the reference obligation at a future undetermined date.  The PS, who agrees to buy forward the obligation as if it were default free, will require to be compensated for the potential payout it will have to face in the event of a default.  The PS, in exchange for the premium payment, has a cash outflow equal to the face value of the bond but has actual exposure equal to the post-default market value of the bond.  That is, the recovery value implicit in the CDS (i.e. the value of the reference obligation after the credit event) is set entirely on the value the PS is able to obtain from the bond following the settlement of the CDS.  This is how physically-settled CDS operate. 
 
 
 
The Auction process is intended to eliminate the need for physical delivery by uniquely establishing the recovery value for the reference obligation and ensure equal payoffs across CDS buyers.  The Auction process is not intended to result in a price that would significantly differ from the price for comparable physically settled CDS.  For that reason, the suggestion in one of the Auction Timing Statements that the 2014 Definitions must be amended to require that PSs pay accrued interest to PBs is not only unnecessary, but represents a misreading of the 2014 Definitions. 
 
 
 
Section 3.12 of the 2014 Definitions reflects the fact that the Outstanding Principal Balance of Deliverable Obligations ordinarily does not include accrued interest unless the parties enter into a non-standard CDS and so otherwise elect.  In other words, where “Exclude Accrued Interest” applies, which is the standard election, only the principal amount of the obligation is included in determining the Outstanding Principal Balance.  It is not grossed up to reflect accrued interest (and hence the quantity of obligations that needs to be delivered does not increase).  In other words, a PB does not have to increase the amount of the Deliverable Obligation by the amount of unpaid interest and the PS does not have to reimburse the PB for such unpaid interest.  This has nothing to do with the recovery value of Deliverable Obligations.  The Final Price of a Reference Obligation under the 2014 Definitions is based on the market value at which the Reference Obligation is trading post default, i.e., its recovery value.  To the extent the market believes that a holder of a defaulted bond will be able to recover accrued and unpaid interest, it will be so reflected in the recovery value.[2]  The 2014 Definitions could have made a distinction between how the value of a defaulted bond versus a performing bond is determined post Credit Event, but they do not.
 
 
 
As indicated in the Auction Timing Statements, the Depository Trust Company (“DTC”) will make an interest payment to the holders of the 14% Notes as of the interest payment date of February 1, 2017 without reference to the record date set forth in the indenture.  Again, this is standard market practice for corporate bonds cleared through DTC.  An Auction Date does not have to occur after February 1 simply to avoid confusion.  An Auction Final Price that incorporates accrued and unpaid interest on the 14% notes will be consistent with quoted and settled prices for the 14% notes and will properly reflect their recovery value.  This would not distort the settlement for other related products.  Trying to structure the Auction in such a way that intentionally ignores the interest feature of the 14% Notes would do exactly that.
 
 
 
Allowing for adjustment to the timing of the Auction to take into account the interest payment date for the 14% Notes would be an explicit departure from the objectives of the DC and would allow PBs to manipulate the auction process in order to maximize their payment.  As noted in the Auction Timing Statements, there are numerous examples of adjustments to the Auction timing mechanics.  However, such adjustments to Auction terms have been to address market disruptions and “impossibilities” but not for the purpose of addressing the economic relationship between PBs and PSs.  See for example:
 
 
 
·         Isolux Corsán Finance (IC Finance)--DC accelerated Auction timetable (in particular, the settlement period following the Auction Date was shortened) to ensure that it was completed before a restructuring plan was implemented.  This assured a fair result by allowing the Auction to be completed while the deliverable debt was still available.
 
·         Ukraine Repudiation/Moratorium Credit Event--Auction timeline was accelerated to enable recipients of Ukraine bonds under Representative Auction-Settled Transactions to receive the bonds in time to take part in the exchange offer and consent solicitation if they wanted to.  Any bonds whose holders had agreed to take part in the exchange offer and consent solicitation process prior to the Auction could not be delivered into the Auction.
 
·         Norske Skog--Auction took place over two months after the Credit Event occurred.  This was an unusually long gap, but was caused by issues with determining the Deliverable Obligations and in particular trying to find the Intercreditor Agreement.  
 
·         Thomson--Auction occurred four months after the Restructuring Credit Event.  Deliverables comprised a revolving credit facility and an unknown number and size of private notes for which very little information was publicly available.  Additionally, Thomson was in the process of implementing a debt-for-equity restructuring plan, to which some bondholders had adhered.  It took the DC a considerable amount of time to agree on an initial list of deliverables and the Auction process could not have occurred smoothly had the DC not delayed the Auction.
 
The types of complications or impossibilities described above do not exist here.  The only reason to manipulate the timing of the iHeart Auction to avoid the 14% Notes interest payment date is an economic one.  We believe that what is really underlying the argument that the Auction cannot be held until after February 1 is the fact that the 14% Notes carry an unusually high coupon and they are still performing.  If the 14% Notes reflected the realities of our current low interest rate environment, we doubt that anyone would have even objected to the timing for the iHeart Auction.  This is nothing more than a desire on the part of PBs to keep the 14% Note interest payment and increase their payout under the Auction by lowering the Final Auction Price.  It is unlikely that the DC would be asked to depart from this norm if the coupon in question was not so high.
 
 
 
Accrued interest is included in the value for all corporate bonds, whether defaulted or current.  If iHeart had actually defaulted on all of its outstanding debt on Dec 15th , the 14% Notes would have traded with the market assigning some value for the 5 months of accrued interest (reflected as a higher claim in bankruptcy).  Defaulted bonds with similar recoveries often trade at different prices based on accrued interest.  In this situation, because the 14% Notes still pays a cash coupon, the dirty price will drop the full 6 points of accrued immediately following the next interest payment date.  The “solution” of delaying the Auction will not normalize this situation and result in a typical defaulted bond auction; it will actually be worse for PSs than a true defaulted bond scenario. 
 
 
 
A delay only serves to expose all iHeart CDS to unnecessary and unanticipated market risks.  This Auction should not be different from other Auctions in that, as noted above, the Auction Final Price always reflects an expectation of interest payment through accrued but unpaid interest claims embedded in the deliverable obligation.  Accordingly, PSs expect the recovery value to reflect accrued but unpaid interest that is embedded in a Deliverable Obligation. 
 
 
 
We believe that significant arguments can be made that iHeart manipulated the payment of its debt to avoid defaulting on debt held by third parties while, at the same time, manufacturing a default on iHeart’s 5.5% notes due 2016 held by Clear Channel Holdings, Inc (“CCH”), a wholly-owned subsidiary of iHeart.  While we understand that the decision as to the occurrence of a Failure to Pay Credit Event has already been made by the DC, we nevertheless believe that the facts giving rise to this Credit Event were contrived.  As noted by Linklaters in its submission to the DC, if CCH had waived its rights to receive payment on the 5.5% notes it held or had otherwise agreed with iHeart to defer the payment date for those notes, then there could not have been a failure to make payments when and where due. 
 
 
 
In any event, because iHeart’s purported default only occurred with respect to its 5.5% notes held by CCH, we believe the iHeart situation is more akin to the first step of a multi-part restructuring that will allow iHeart to retire certain debt while keeping other performing debt outstanding.  We understand that because only the 5.5% notes held by CCH were subject to the payment delay, a Restructuring Credit Event did not occur given that not all holders of 5.5% notes were affected.  However, neither the market nor CDS terms expect a voluntary debt restructuring that does not satisfy the requirements of a Restructuring Credit Event to instead be deemed to constitute a Failure to Pay Credit Event.
 
 
 
Typically, in the case of a Failure to Pay Credit Event, it would be expected that all of the relevant obligations of the Reference Entity would be in default.  This is not the case for iHeart nor what it intended by treating the 5.5% notes held by CCH differently from the ones held by third parties.  In true default scenarios reflected by a Failure to Pay Credit Event, there would not likely be a difference among similarly ranked defaulted obligations other than with respect to the amount of accrued and unpaid interest.  That is because the market would expect that that the default would apply to all of the issuer’s outstanding comparable debt.  On the other hand, in a restructuring it is impossible to predict all potential outcomes.  Some debt may continue to exist as performing debt without modification while other debt may have substantially different terms or may cease to be outstanding all together.  As a result, there can be wide disparities in pricing among Deliverable Obligations.  A CDS that covers a Restructuring Credit Event under which the PS is potentially forced to pay out on an event that is not a full default, would presumably require a higher premium to reflect such potential disparities.  iHeart CDS were not priced and sold on that basis.
 
 
 
Again, as noted above, if an across the board default had actually occurred, all of iHeart’s debt would be valued as of the default date based on the market’s assessment of recovery which would take into account accrued and unpaid interest through the default date.  This is how the market assesses and values CDS that cover Failure to Pay Credit Events.  Such CDS do not typically contemplate nor need to price the fact that, notwithstanding the payment default, all of the issuer’s debt that could be delivered into the Auction is performing debt while the only debt that is purportedly in default is held by the issuer’s own subsidiary and will not even be deliverable into the Auction.
 
 
 
Since the 2014 Definitions Implementation Date a number of questions have been submitted to DCs alleging that the CDS market is being manipulated in some way, and demanding that the relevant DC determine a question in a particular way to preserve the integrity of the CDS market or ensure that CDSs work in the way intended.  However, the DC has consistently decided that it cannot be swayed by such statements and can only base its determinations on the wording of the CDS documents and the relevant facts.  Any manipulation that occurs is a market abuse matter and therefore subject to the relevant market abuse laws and regulations.
 
 
 
Given the absence of clear facts that we believe should have precluded declaring a Failure to Pay Credit Event, allowing a change to the iHeart Auction timeline based on the 14% Notes interest payment would constitute an explicit departure from the DC’s policy of refusing to condone or tacitly support market manipulation not supported by the facts before it.  Allowing certain protection buyers to manipulate the Auction process in order to maximize their payout smacks exactly of such disdained market manipulation.  This does not preserve the integrity of the market.  It does the opposite.
 
 
 
We agree that where Auction Settlement applies, the DC has some discretion as to the terms of the Auction.  We also appreciate that the iHeart situation is raising complex questions for the DC.  However, this all boils down to a simple fact:  Any change in Auction timing to benefit protection buyers will have an equal and offsetting impact on protection sellers.  The DC simply cannot act to favor only one side of the market.  Therefore, we believe that the DC should maintain DC Rules Default Auction Date of January 13, 2017, as would be expected under the DC Rules. Otherwise, the DC must amend the he Credit Derivative Auction Settlement Terms pursuant to Section 3.2(d) of the DC Rules to neutralize the impact of the February 1 interest payment to eliminate the otherwise one-sided treatment that will be afforded to PBs.  This could be accomplished by, among other things, (i) requiring that all deliverable debt be valued as of the default date of the 5.5% notes regardless of the other Auction Settlement Terms or (ii) determining that the 14% Notes will not constitute a Deliverable Obligation.
 
 
 
 
 
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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”).

[2] In fact, Section 3.7 of the 2014 Definitions provides that any principal only component of a Bond from which some or all of the interest components have been stripped is an Excluded Deliverable Obligation.