A central policy concern since the onset of the Greek debt crisis in 2010 has been whether sovereign debt restructurings trigger credit default swaps (CDS). CDS are insurance-like financial products whereby a protection seller agrees to pay the protection buyer in case of a credit event on a reference entity (in this case Greece) in return for a premium over a defined period of time. The legal framework for CDS transactions is largely standardized. More than 90 percent of CDS transactions are based on the ISDA Master Agreement. As a mechanism for creditors to hedge against the default of a debtor, CDS are financial instruments to redistribute risk (or, according to their defenders, to shift risk onto those entities willing and capable of better bearing such risks). Over the last two decades, CDS on sovereign debtors became increasingly common.
Greece’s debt restructuring in February/March 2012 was the first to be implemented under the umbrella of a large number of CDS (more than 2.5 billion Euros in net terms). During the implementation phase of the Greek restructuring in March 2012, several interested market participants raised the question whether the Greek restructuring triggered an obligation for the sellers of CDS on Greece to pay. The Determinations Committee (DC) of the International Swaps and Derivatives Association (ISDA) for Europe, Middle East and Africa, the body established by ISDA and given decision-making power under the ISDA documentation to rule on credit events, found that a restructuring credit event was triggered on March 9 2012. The parties to CDS have agreed by contract that a credit event occurs only if the competent DC has said so.
As the Greek restructuring in February/March 2012 demonstrated, the consequences of such expert determinations by DCs can be momentous in financial terms not only for the parties to CDS transactions themselves, but also for the broader public and for taxpayers. A case in point is the Austrian bank KA Finanz, the bad bank split off from Kommunalkredit, the comparatively small Austrian lender to municipalities previously owned by Dexia that the Austrian government nationalized at the height of the global financial crisis. KA Finanz had taken over about 500 million Euros of CDS on Greece from Kommunalkredit. As a result of the payouts following the March 9 decision, the Austrian government had to inject another 1 billion Euros into the bank in order to stave off its collapse.
DCs recruit their members from among financial institutions and investment managers, which will often have positions on either side of CDS transactions. In view of their composition and the considerable practical importance of their decisions, concern has arisen that DC members may be tempted to “vote their own book” – i.e. to reach credit determinations in part based on whether the firm is on the buying or selling side of CDS for a particular reference entity. For instance, two members of the Steering Committee of the Institute of International Finance which negotiated the restructuring of Greek debt on behalf of private creditors of Greece, are voting members of the DC for Europe (BNP Paribas and Deutsche Bank). They were net sellers of CDS protection on Greece, meaning that both institutions had to pay out to protection buyers when the credit event occured. Given these concerns about independence of DCs and the right to a fair trial in civil matters under Article 6 of the European Convention, it is an open question whether competent domestic courts could in effect review decisions and potentially overturn decisions of DCs.
The ISDA Master Agreement provides:
“With respect to any suit, action or proceedings relating to any dispute arising out of or in connection with this Agreement (“Proceedings”), each party irrevocably (i) submits
(1) if this Agreement is expressed to be governed by English law, to (A) the non-exclusive jurisdiction of the English court if the Proceedings do not involve a Convention Court and (B) the exclusive jurisdiction of the English courts if the Proceedings do involve a Convention Court; or
(2) if this Agreement is expressed to be governed by the laws of the State of New York, to the non-exclusive jurisdiction of the courts of the State of New York and the United States District Court located in the Borough of Manhattan in New York City.”
How do the responsibilities of DCs relate to the otherwise competent national courts? The ISDA Master Agreement does not explicitly address the relationship between the technical determinations of DCs and national courts. Unlike courts, their decision-making power does not derive from a constitutional or legislative grant of authority to adjudicate disputes. The basis for DC’s decision-making power is contractual – the mechanism for independent determination of whether a credit event occurred is voluntarily agreed by the parties to CDS transactions. It is debatable whether DCs exercise jurisdiction in a formal sense. One could view their decision-making as a pure expert determination, that does not involve the application of law to fact patterns. However, the difficulty associated with this view is that DCs apply the contractually agreed credit events to different fact patterns, and reach quasi-judicial decisions (even though they provide little reasoning). In this respect, the DC process is similar to arbitration.
Unlike in arbitration or litigation, however, there are no parties in the DC process. It is a procedure with only one actor – a relevant market participant who submits a request for determination to the DC. Even though the ISDA documentation is silent on this question, DC decisions are de facto final and binding upon a whole class of protection buyers and sellers of the reference entity concerned. As a result, the DC decisions radiate far beyond the sphere of the financial market participant that submitted the original request. The decision has implications for a wide range of protection buyers and sellers, who are not represented in the proceedings before the DC. One could analogize the role of DCs to those of credit rating agencies that involve analysts reaching a reasoned view on the creditworthiness of a corporate or sovereign issuer. In contrast to credit ratings agencies that rate issuers on the basis of financial and political criteria, however, DCs reach their decisions on the basis of legal rules set out in the ISDA documentation – in this important respect they exercise jurisdiction over disputes arising out of the ISDA Master Agreement.
Since their establishment in 2009, no affected market participant thus far has asked a national court to review a DC decision. In case of evidence that conflicts of interest had an effect on the decisions of DCs or if DCs fail to operate in accordance with the agreed contractual terms, review by the competent national courts is a distinct possibility. It is unlikely that DCs are the final arbiter on questions of law.