Credit Default Swaps – those largely unregulated “side bets” over the likelihood of specific companies defaulting on one or more of their credit obligations, which were all the rage during the beginning of the decade - have become, in light of the 2008 financial crisis, “the financial instrument that scholars, journalists, government officials and even some prominent financiers love to hate.”
The problematic impact of CDS’s on firms in financial distress – and their separate treatment under existing securities “safe harbors” in the US Bankruptcy Code – have likewise provoked further commentary and calls for reform from the insolvency community (some of which has been covered in various posts on this blog, and which is summarized here).
But despite the furor over much-maligned CDS’s, not everyone is casting aspersions.
Last week, Seton Hall’s Michael Simkovic and Davis Polk’s Benjamin Kaminetzky released a paper arguing that CDS pricing at the time of a credit event (such as a loan made in connection with an LBO) can – when combined with other market information about a company’s debt securities – provide important indicators of a company’s solvency at the time of that transaction.
Though it requires 58 pages (plus 12 pages of appendices) to develop, Simkovic’s and Kaminetzky’s basic premise is relatively simple:
Fraudulent transfer analysis is too often susceptible to manipulation by self-interested experts, and too prone to after-the-fact “second guessing” by bankruptcy courts, to be consistently reliable and predictable. Efficient securities markets are the best contemporaneous guides to the solvency of a debtor with publicly traded debt. As a result, bankruptcy courts attempting to determine the solvency of a debtor at the time of an alleged fraudulent transfer should use contemporaneous credit-market data as a (or as the) key indicator of the debtor’s solvency.
The idea is more than an abstract concept: Simkovic and Kaminetzky cite two relatively recent decisions in which bankruptcy courts applied public-market analysis to determine the debtor’s solvency and the resulting avoidability of a fraudulent transfer, each using equity market valuations contemporaneous with the time of the transfers. Simkovic and Kaminetzky extend this approach, arguing that credit-market instruments and their derivatives – such as credit yield spreads and CDS pricing - provide a more reliable indication of solvency than the debtor’s equity.
The idea of employing public market data is of limited use in cases where the debtor is closely held – or where public credit-market data is not readily available. But Simkovic’s and Kaminetzky’s research represents yet another recent and important effort by scholars to impose greater uniformity and predictability on the question of whether a debtor is – or has become – insolvent as a result of a pre-bankruptcy transfer for less-than-equivalent value (for another approach to the same general problem, see an earlier post here).
In light of the extensive, highly-leveraged financing that took place between 2004 and 2007 – and the correspondingly high anticipated default rates when that same debt matures over the next several years – Simkovic’s and Kaminetzky’s work also renews the focus on an important question, directly relevant to any inquiry into an alleged fraudulent transfer:
What did the participants in an allged fraudulent transfer – and all of those responsible for due diligence regarding that transfer – believe about the debtor’s present or resulting solvency at the time the transfer was made? And what (if anything) was the basis for their belief?