A group of funds, led by Solus Alternative Asset Management, is seeking to prevent a deal between GSO Capital Partners and Hovnanian Enterprises which has the potential to fundamentally undermine trust in credit derivatives. A federal court is due to hear arguments today, but regardless of the outcome market participants say change is needed.

Hovnanian is widely understood to be considering missing a bond payment in order to deliberately trigger certain CDS held by GSO. In return, GSO would provide Hovnanian with cheap financing - a "rigged" loan at 5% for nine years, much lower than market rates.

Solus and others allege that this is not just morally dubious, but illegal. Solus has asked that the court prevent GSO and Hovnanian from completing any deal which relies on Hovnanian voluntarily defaulting on debt that it is able to repay.

"If true that there is a deliberate design to trigger a CDS credit event when in fact the company is capable of making the relevant payment, then that would go against the spirit of the system of credit protection," says Assia Damianova, special counsel at Cadwalader, Wickersham & Taft.

Solus had also offered financing to Hovnanian, which was turned down in favour of the offer from GSO. It has therefore been suggested that Solus' objections are the product of sour grapes, although GSO has been involved in a similar situation before.

"Market participants are drawing similarities to Codere in 2013. In that case, GSO offered to refinance Codere's debt in exchange for the company making an interest payment late. Codere went - briefly - into default," says Damianova.

She continues: "The difference is that Codere was in genuine financial distress. Hovnanian's bonds are trading near par so, while the company may not be entirely healthy, it does not appear to be in distress. Deterioration in creditworthiness is a condition for a restructuring credit event occurring, but this situation shows how it might be a useful condition to a failure to pay credit event."

In the Hovnanian case, what is proposed is a simple credit event whereby coupon will not be paid, with creditworthiness not considered. Although it may be unpalatable to many in the CDS market, for Hovnanian itself the deal with GSO makes financial sense.

While Solus has elected to have its objections heard by a federal court, there are limited protections. Had the dispute happened in Europe, there may have been better regulatory coverage.

"In Europe we have the new Market Abuse Regulation, which specifically applies to financial instruments (including derivatives) the price/value of which depends on or has an effect on the price or value of securities traded on trading venues. Of course, a complaint to the relevant regulator about any potential distortions will take time to be investigated and in that time the credit event would occur, so the immediate available tools may still be rather limited," says Damianova.

Considering the relevant lack of protection that this case has highlighted, there have been calls to amend the ISDA Credit Derivatives Definitions in order to tighten loopholes. Safeguards might be required regardless of the court's ruling.

"It may be time to redraft credit definitions in such a way that credit events take into account if the relevant occurrence is a 'manufactured' credit event. The difficulty would lie with (i) having good evidence and public information about the background of such occurrence and (ii) perhaps the current logic of the Credit Derivatives Definitions that credit events occur regardless of certain 'defences' such as lack of authority, illegality, change of law or exchange controls," says Damianova.

Proving any wrongdoing is difficult because of course negotiations between GSO and Hovnanian - or their equivalents in a future case - are private. While GSO might struggle to justify its generous financing offer, a credit event is itself a very black and white matter and any background circumstances are, currently, irrelevant to resolving whether one has or has not occurred.

If these issues are not addressed, Damianova warns that "the danger is that market participants might become more reluctant to trust or use credit derivatives". She adds: "A Hovnanian credit event would have been difficult to foresee - you cannot be expected to assume that the reference company will be persuaded to miss a payment on its debt by a third-party - and what is more, after such blip, that the company is likely to actually improve in its performance because of the cash injection, while, at the same time, still having a 'cheapest to deliver' bond that may be used to drive down recoveries in the valuation process used to determine CDS losses."

JL