Milbank LLP Alternative Investments partner John Williams, who leads the firm’s Derivatives practice, was recently featured in a Risk.net article titled “Market Set to Reject SEC’s Anti-Fraud CDS Rules…Again.”
The article discusses how new US regulatory proposals designed to combat the potential for fraud and manipulation in single-name credit default swaps (“CDS”) instead risk stifling the CDS market. The proposed Securities and Exchange Commission (“SEC”) rules discussed are designed to avoid manufactured credit events of recent years where hedge funds engineered payouts of CDS contracts, by flagging traders building up large single-name positions. In response to this proposed regulation, Mr. Williams commented, “I’m convinced that this rule, if enacted as printed, would be the death of corporate CDS.”
This new rule states that any action that “affects the value of cash flow, payments or deliveries” would be subject to this additional review to determine if it is fraudulent, including actions that affect the amount of collateral posted, which changes regularly based on the swap’s market value, according to the SEC. Mr. Williams said, “This rule is taking actions that are perfectly legal with respect to underlying instruments – loans, bonds, other credit instruments – and causing those same actions to be potentially illegal if you also hold CDS. You would have to evaluate whether the action you’re taking with the cash instrument will have the effect of creating an unexpected change in the value of the CDS.” With the possibility of an expensive legal investigation, Mr. Williams predicts that “General counsels are going to say to traders: ‘Don’t do the CDS trade. Do whatever you’re going do with the underlying instrument, but don’t do the CDS trade.’”
According to the SEC’s explanation, the rules attempt to prohibit any market manipulation by punishing negligent behavior where a trader “reasonably should know that a statement was false or misleading.” The article notes, “those that hold both the CDS and the underlying bonds would face the most scrutiny.” Mr. Williams believes this environment will “effectively be toxic and therefore much too expensive from a regulatory risk standpoint to be involved in any kind of cash market activity – any direct loan origination, any restructuring, any ad hoc committee – while also holding the CDS position” and that “It makes more sense to completely take off the table the idea that attempted manipulation is actionable. Any rule that goes as far as capturing attempts is inherently problematic.”
Led by Mr. Williams, Milbank coordinated the efforts of a coalition of nine buyside firms who proposed and worked with ISDA to revise the rules of the standard corporate CDS contract to give the ISDA Credit Derivatives Determination Committee the tools to make balanced judgments that are necessary with respect to the occurrence or non-occurrence of Credit Events. This resulted in the creation and adoption of the Narrowly Tailored Credit Event Supplement.
