ISDA rules against credit event for Novo Banco bond transfer

The continuing difficulties of applying credit default swaps have recently been highlighted by the experience of a failed Portuguese bank, Banco Espirito Santo (“BES”) and its successor “good bank” Novo Bank.

Despite the fact that the 2014 ISDA Credit Derivative Definitions (the “Definitions”) included a new credit event for public bailouts, the ISDA Determination Committee (the “DC”) decided that a retransfer of bonds from Novo Banco to BES will not amount to a “Government Intervention” or other credit event. This decision was confirmed on February 15, 2016 by a group of external experts. This means that not only the bonds will be worthless, but also any credit default swaps linked to the bonds, as ISDA rules had transferred the swaps to Novo Banco – although the DC has yet to determine whether these swaps should now be transferred back to BES.

Background – Insolvency of BES and Transfer of Credit Default Swaps to Novo Banco

BES filed for insolvency in 2014 and most of its assets were transferred to Novo Banco (the “good bank”), leaving behind most of its liabilities in BES. In August 2014, the DC decided that since more than 75% of BES debt had been transferred to Novo Banco, a succession event had occurred under the Definitions. This meant that all credit default swaps linked to BES were transferred to Novo Banco as the new reference entity. As a result, any credit default swaps relating to the bonds remaining with BES would be worthless.

Retransfer of bonds to BES

However, in November 2015, ECB stress tests concluded that there was a €1.4 billion capital shortfall in Novo Banco. In order to raise more capital and under pressure to make the good bank attractive for early sale, the Bank of Portugal (“BoP”) decided that certain bond issues should be transferred back to BES. This retransfer took place on December 29, 2015. The date may have been chosen to avoid the new rules that came into force in the EU on January 1, 2016 under the Bank Recovery and Resolution Directive. These new rules allow central banks to apply bail-ins to all categories of creditors. It is likely that the BoP wanted to rely on the powers of Portuguese law to decide which obligations to transfer rather than be beholden to new EU regulations.

One of the most controversial aspects of retransfer is the basis on which particular bonds were chosen. Only 5 out of 52 BES bonds were selected and it appears that the BoP wished to avoid retransferring retail bonds on the grounds that disrupting the general public could affect Novo Banco’s future retail banking business. It also avoided bonds created offshore, possibly as a result of a December 2014 decision by the BoP. This decision excluded a loan arranged by Goldman Sachs to BES from BoP’s earlier decision in August 2014 to transfer the liabilities of BES to Novo Banco. English law governed this loan and Goldman Sachs asked the English courts to confirm that responsibility for the loan had been transferred to Novo Banco under the BoP’s August decision. The court ruled that it had jurisdiction under English law to consider the matter and held that, in accordance with English law, the loan had been transferred to Novo Banco(1). Although the English court’s decision could effectively be ignored by Portugal, it is understandable that BoP wished to avoid further challenges.

DC Decision on “Government Intervention”

The holders of the transferred bonds asked the DC to decide whether the retransfer of the bonds constituted a credit event within the meaning of the Definitions. In early January 2016, the DC decided by an 11 to 4 majority that this was not a credit event. It did not fall within the definition of “governmental intervention” (under section 4.8 of the Definitions) which requires either:


a) a reduction in interest or capital,

b) a coupon or redemption deferral…or

c) the subordination of obligations;

(ii) an expropriation of obligations;

(iii) compulsory cancellation, conversion or exchange; or

(iv) any event which has an analogous effect to any of the events in (i) through (iii).

Following the ruling against a credit event, an external review by an agreed panel of experts had to be arranged in accordance with ISDA rules. The panel has now unanimously decided that the DC decision was correct. She concluded that it was undisputed that the retransfer was not an event covered by (i) or (ii). The only questions were whether (iii) or (iv) applied. Subparagraph (iii) did not apply: it was not a cancellation because the obligations continued to exist, nor a conversion into another form of obligation (such as a debt in shares), or an exchange because that would require a cancellation of the bonds and their replacement by the issuance of new bonds on different terms.

The panel considered that the crucial question was whether the catch-all paragraph (iv) was broad enough to include the transfer. He decided to prefer a narrow interpretation in order to preserve as much certainty as possible in section 4.8. In the committee’s view, events of analogous effect should only apply to events that were functionally identical to those of the rest of the article but which, for some technical reason, fell outside the scope of the defined terms.

A new succession event?

A new DC decision is now required on whether the retransfer of bonds is itself a succession event. The question to be answered is whether the retransfer of bonds means that more than 25% of BES’ original liabilities now accrue to BES. If so, the CD may decide that the credit default swaps should be split between the two banks. A decision on the matter has now been postponed until the end of April 2016 in order to allow further information to be provided on the active and passive situation of Banco Novo.


The DC clarified that for credit default swaps to be paid following a government intervention credit event, a simple transfer of obligations from one reference entity to another will be insufficient, even if this has the effect of depriving bonds of their economic value. Government intervention requires a significant change in the terms of the bonds that deprives bondholders of all their legal rights.

Bondholders’ hopes now rest on whether the CD will agree to credit default swaps also being transferred back to BES along with the bonds.

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