Introduction

The International Swaps and Derivatives Association, Inc. (ISDA) recently commissioned law firm Linklaters to conduct an independent assessment of the function, governance and membership of the Credit Derivatives Determinations Committees (the DC Review). The DC Review report was published on May 13, 2024, and is based on initial oral and written feedback primarily provided by nine DC members (both sell-side and buy-side), a law firm representing buy-side market participants, two clearinghouses, S&P and DTCC, five global regulatory authorities, and Allen & Overy as counsel to the DC Secretary.

The publication of the report opens the consultation phase of the DC Review. This alert provides a summary of the report’s main takeaways and the proposals and recommendations^[1] that are now subject to broader market consultation. We also express our initial views as to the feasibility and adequacy of some of the recommendations (in italics). ISDA is now seeking feedback from market participants to determine which of the proposals and recommendations, if any, have broad support, and ISDA has engaged Boston Consulting Group to run the consultation process (participants can visit the BCG-Expand website here to take part in the process).

Kramer Levin has been involved in virtually every issue of significance in front of the DC in the last decade, actively arguing in front of the DC on behalf of various market participants, and has represented a group of credit funds and asset managers in providing initial feedback to ISDA in the context of the DC Review.

Market participants should carefully review the recommendations and proposals made in the report and are encouraged to participate in the consultation. Greater participation (even if merely to express support for certain recommendations) is critical to improving the product. Kramer Levin expects to be actively involved in the consultation on behalf of buy-side market participants.

Speed Read – Executive Summary of Recommendations

Conflicts of Interest:

• DC Rules should allow up to three independent members of the DCs (with one acting as DC chairman).
• DC questions may be referred to an independent panel by a simple majority vote.
• Minimum standards for managing conflicts of interest should be enhanced.

DC Composition:

• DC members reduced to eight dealer and four non-dealer members, and eliminate consultative DC members.
• Lower the eligibility threshold for non-dealers, and allow non-dealer DC members to join individual (regional) DCs.

Governance:

• Establish a separate governance body with DC oversight responsibility and authority to change DC rules, in consultation with market participants.
• The governance body should have the ability to appoint independent auditors to audit DC members’ compliance procedures for managing conflicts of interest.

Representation and Transparency:

• Allow eligible market participants to submit statements of case within certain parameters, publish such statements on the DC website, and solicit feedback as to whether determination requests should disclose the identity of the submitting market participant or just the name of legal counsel.
• All material actions or decisions taken in the DC process, as well as the basis for these decisions, must be disclosed on the DC website as soon as is reasonably practical.

Funding:

• Solicit feedback regarding the appropriate funding model (e.g., by way of a transaction-based levy) for the DCs.
• Establish a working group to come up with a detailed proposal in this respect.

General Observations

Determination Process and Accuracy – The report starts from the premise that, while the current DC process can be improved, some form of determination process binding on all market participants is highly desirable, as it contributes to market confidence, enhances market stability, increases participation from market participants – leading to greater liquidity – and reduces transaction costs. Moreover, the initial feedback described in the report suggests that DC determinations are not difficult to support, creating apparent consensus that the DC’s resolutions and outcomes enjoy relatively broad support within the market.

Speed – A number of consultees have criticized both the extent of the delays and the lack of explanatory information or rationale provided by the DC in certain determination cases.^[2]Speed in reaching determinations would reduce the period during which market participants are exposed to uncertainty and related volatility generated by emerging information or rumors. The report acknowledges the need for prompt resolution of DC determination requests, but posits that speed should not be at the expense of achieving the “right answer”.

Legalistic Approach – The report fundamentally rejects another criticism of the DC process – i.e., that DC member representatives adopt an approach that is legalistic and not commercial. The report instead recognizes that DC determinations, which involve establishing the facts and interpreting and applying applicable Credit Derivatives Definitions (Definitions) to those facts, is best carried out by lawyers, and considers this to be a strength, rather than a weakness, of the DC determination process. The report notes in passing that an observable creditworthiness deterioration does not necessarily amount to a Credit Event, thus rebutting a common criticism made by market participants that may happen to fall on the wrong side of a determination. While the report emphasizes the importance of procedural rules, and that those rules are followed in practice, it also acknowledges that procedural requirements could be improved in certain respects, as per the below.

Composition of the DCs and Conflicts of Interest

The report notes the apparent decreased interest by both sell-side and buy-side market participants in becoming DC members, as only three out of the five buy-side member seats and eight or nine (depending on the DC) out of the 10 sell-side member seats are currently filled.

Resources, Risks and Costs – This decrease in interest is primarily due to DC membership requiring a significant investment of time and resources (including procedurally in order to manage conflicts of interest), which is acutely felt by buy-side members in particular. In addition, the function comes with perceived legal and reputational risk associated with the mere prospect of facing even unfounded litigation or regulatory investigations. Dealers have also complained about the costs associated with DC membership.

Impact of Perceived Risks – The report insists that, to date, concerns around potential litigation or regulatory investigations, or potential criticisms faced by DC members for expressing a minority view or vote on the DC, do not appear to have affected the decisions reached by the DC. However, it seems inevitable that in at least some instances, a minority of DC members may have held an alternative view that not only did not prevail but, due to a lack of transparency, was also not articulated to the market.

Conflicts of Interest

Despite the amendments made to the DC Rules in 2016 to address conflicts of interest, consultees expressed some persistent concern that DC members often hold positions that stand to be economically impacted by the outcome of DC questions, which may lead to the perception that they are voting their book. In that respect, the report clearly stated that “the market must have confidence in the assertion that financial interests have no role in decision-making. It is not enough to say (even with justification) that the right decisions have been taken.”

This is also an issue of primary concern to regulators who emphasized that the lack of regulatory intervention to date should not imply that they are happy with the status quo. The report highlighted that this is an aspect of the DC process that presents the greatest risk, because it could lead to a collapse in market confidence and/or regulatory intervention, requiring immediate remedial action (on which the report did not elaborate).

The following approaches were considered to improve market confidence and perception in this area and are part of the main recommendations submitted for consultation:

1. Independent DC Voting Members – This model would involve appointing one or more voting individuals having requisite legal qualifications but no affiliation with any organization holding CDS positions. Three such members of the DC is viewed as an ideal number, as it would collectively provide that group with veto power. One such member could chair the DC meetings to relieve the DC ecretary or DC counsel of that charge. The report suggested that retired judges would be suitable, especially as chairs, since they would add credibility as figureheads of the DCs and have experience synthesizing complex information and (critically, we believe) listening to alternative views. Such a figurehead could then be seconded by other independent financial market legal experts and supported by other DC members and their knowledge of the market. While such an approach would entail additional costs, as further discussed below, this is unlikely to be significant in the context of the DC process.

Experts in financial markets and debt instruments with the requisite legal skills could be a good alternative to retired judges, as long as they are not conflicted. Authoritative figures in that group exist and would likely bring the same amount of credibility to the process. This would include legal experts who have previously acted as external reviewers in the few instances where a DC supermajority was not achieved.^[3]

2. Independent Panel – This model would involve referring determination requests to a separate panel of independent lawyers, because the DC would perceive either a lack of factual clarity or legal uncertainty about the interpretation of the Definitions. Referrals would be discretionary and decided by the DC without voting on the issue.

While the main perceived benefits of such an approach are independence and decision-making speed, some consultees expressed reservations that it would be extremely difficult to find individuals with the requisite level of knowledge and commercial background that the current DC member representatives possess, which could in turn compromise the quality and accuracy of determinations. The report noted that those issues could be addressed by having the DC summarize the points at issue and the arguments for or against a particular outcome, which would be publicly disclosed.

A variation on this theme would mandate such a panel for material determinations such as credit and succession events, but this approach was ultimately not recommended.

We believe that the proposal to add independent members to the DC is far superior than a referral to separate panels for the very same reasons specified in the report, but specfically because we think it will be difficult to find individuals with the requisite amount of expertise who are not conflicted and willing to serve on such a panel. Also, we firmly believe that market participants, who understand the product and are inherently interested in its efficacy, should have a preponderant say in determinations, with the adequate number of guardrails. A compromise whereby questions are sent to some version of external review when the DC so elects (but with a lighter process with no exchange of briefs or other procedural burden) might be more appropriate.

3. Enhancing protections against conflicts of interest in DC Rules (see below)

DC Composition

Most consultees also indicated that increased buy-side participation on the DCs was desirable. The main recommendations made in the report and subject to consultation to that effect include:

• Lowering the requirement of outstanding notional amount for single-name CDS positions (across the previous twelve months) from $1 billion to $100 or $200 million
• Allowing applications by market participants throughout the year instead of just once per year^[4], and
• Allowing potential members to join individual DCs rather than all DCs, which could also promote determination expediency

The report also recommends that the number of DC members should be adjusted to reflect the current number of dealer members, and the current proportion (50%) of dealer vs. non-dealer members remain the same,^[5]irrespective of any independent DC members that may be added. The report also recommends doing away with the appointment of consultative (non-voting) dealer and non-dealer DC members, which only make sense where there is a surplus of interested market participants.

Enhanced Conflict Management Procedures

The current rules covering conflicts of interest require that a DC member have written policies and procedures in place to manage conflicts of interest and, among other things, guarantee a minimum level of independence of the DC representative or decision-maker from the business people (especially those in charge of the pricing, trading and marketing of credit derivatives at the DC member).

Nevertheless, the DC rules do not prohibit discussions from taking place between the DC representatives and other individuals in the DC member’s organization who are excluded from acting as decision-makers. DC representatives may thus be aware of their respective firm’s net economic position. They can also freely discuss the underlying credit with business colleagues on the desk – precisely the information capable of influencing a decision (whether deliberately or due to unconscious bias) – and still cast a vote on the DC. In such a case, protection against conflicts of interest would merely rely on the integrity of the decision-maker and their ability to avoid undue influence.

While the report notes that most DC members have policies and procedures containing stricter requirements, and DC members are generally incentivized to support an accurate determination outcome (because setting a bad precedent could work against the organization’s future interests), the risk of being influenced, consciously or unconsciously, remains. Regulators also pointed out that the DC Secretary does not audit compliance with applicable requirements, and ultimately no market participant has any way of knowing whether a particular DC member complies with the standards.

In essence, the report notes that this is a matter of perception as “the question is not merely whether the decision-making process has been influenced but whether the market can be confident of this.”

The report suggests that those issues could be addressed by DC members adhering to a code of conduct that sets a higher minimum standard than the one required under the DC Rules. Under the new standards, an individual who is a DC decision-maker must have no awareness of the member firm’s net position in CDS contracts (or other information that could give rise to an inference of bias). This person would also be prohibited from discussing questions before the DC with individuals on the desk.

While such a code of conduct would set a higher standard for managing conflicts, implementation could be a challenge for buy-side DC members, which are generally smaller firms, making it difficult to ensure that information barriers are respected. In such case, the report acknowledges that promoting increased buy-side participation should not come at the cost of properly managing conflicts, and thus endorses the possibility for recusals on conflict-of-interest grounds (which is an “other” recommendation not subject to consultation but to be discussed at a later date),^[6]along with corresponding changes to quorum provisions.

DC Questions

Abstract Requests and Lack of Information Provided – The report recognizes that the requirements that must be satisfied to submit a DC Credit Event Question are materially less onerous than in circumstances where a Credit Event Notice and a Notice of Publicly Available Information have been provided. As a consequence, a DC Credit Event Question can be asked at a very high level of abstraction^[7]and without sufficient information being provided to enable the relevant DC to form a conclusion on the point. Also, while the DCs are under no obligation to independently research, investigate or supplement any information, in practice they often do seek out additional information to help them reach a determination. This, in turn, results in a considerable amount of work and potential delays (depending on the circumstances), which may leave market participants in the dark as to what is happening at the DCs.

Clarification Regarding Information To Be Submitted – The report noted a consensus among the consultees that the DC rules should clarify what information must be provided when a DC Credit Event Question is submitted. Equally, there was agreement that the information requirements should not be as onerous as what is required for a Notice of Publicly Available Information (PAI).^[8]This is because a DC Credit Event Question may not (unlike a PAI) lead to settlement, and the DC may consider the information to be influential enough even though it does not constitute a PAI. That said, the PAI requirement should be retained for the purpose of defining the key elements of each Credit Event (as it provides a degree of certainty about the minimum evidentiary standards that must be satisfied).

Checklist for DC Questions – The report recommends that the DC Rules provide a checklist of the elements that must be confirmed, whether PAI is required or whether it is sufficient to provide other eligible information instead (and elements that do not need to be confirmed at all, such as applicable grace periods). This checklist should be completed by the requestor, who should confirm if PAI or other Eligible Information is being provided in support of each element (and in such case stating the document and page reference where the information can be found), or whether certain elements can be specifically inferred from the information provided.^[9]

This approach would uncover any gaps in the required information, in which case the question should not be considered by a DC and, instead, be treated as inoperative, and so disclosed on the DC website. The DC Secretary should have authority to make such a determination, with the ability to refer the matter to a DC in cases of doubt. Of course, if additional information addressing existing gaps later becomes available, the question could then be accepted for deliberation.

While the authority that would be given to the DC Secretary is not particularly objectionable, some parameters should be provided to make sure that its discretion is adequately exercised and, in the case of doubt, the matter is referred to the DC. 

If the DC agrees to deliberate a Credit Event request but forms the view that there is insufficient evidence to reach a conclusion that a Credit Event has or has not occurred, the report recommends that the DC should have the option to make a “not proven” determination,^[10]indicating that the DC is unwilling to conclude, on the basis of the information provided, that a Credit Event has occurred due to the lack of sufficient reliable evidence. The current options in that case are not palatable: a no Credit Event determination is unattractive because it implies that a Credit Event has not occurred; a dismissal would enable market participants to trigger bilateral settlement; and deferring determination injects uncertainty and creates the impression that the DC is not operating efficiently.

The report notes that the DC should not be responsible for obtaining or researching additional or missing information. In that respect, we believe that DC members may have access to eligible information that could supplement any information provided by the requestor, and if such information qualify as Eligible Information, we see no downside in using it as part of the process.

All recommendations made in respect of DC questions are “other” recommendations not subject to consultation but to be discussed at a later stage.

Statements of Case (supporting a specific outcome)

The report addressed whether market participants should be permitted to submit statements of case supporting a specific outcome as to whether an event (such as a Credit Event) has occurred. Since the DC elected – without any market consultation – to discontinue its practice of publishing such statements on its website, there was uncertainty as to whether, and by how many DC members, such submissions were considered.

The report made it clear that if such statements are accepted,^[11]they should be publicly disclosed to market participants on the DC website. Thus, the current practice of not disclosing such statements should be discontinued as inconsistent with general principles of procedural fairness.

The report recognizes that the alternative is between (i) not receiving any statement at all (other than the checklist discussed above) or (ii) receiving and publishing such statements and providing other market participants a short period to respond.

Consultees expressed mixed views on this approach. In addition to arguing that the quality of arguments may not be consistent and would threaten to turn the DC website into a blog, a concern was raised that market participants may use such statements to move markets with a view to obtaining a more palatable price (e.g., in connection with an unwind).

We understand that negative views expressed by consultees on the admissibility of such statements are likely to come from certain DC members who may not have fully appreciated how damaging the current practice has been for the product in terms of the perceived lack of transparency, especially in terms of process and independence of the DCs.

However, the report maintains that it would be desirable for market participants to have the opportunity to advance arguments in favor of or against a specific outcome, given both the economic implications of determinations and the need to ensure that the DCs retain the confidence of the market. Allowing statements of case is also seen as a means of reassuring market participants not represented on the DC that their views will be taken into account. Also, arguments that DC members have sufficient expertise to be able to understand all the relevant arguments were not found to be persuasive, as “it is in the nature of difficult cases that they sometimes involve arguments that would not otherwise have been thought of.”

The report thus recommends that statements of case be permitted and, to alleviate concerns raised by some consultees, the report proposes a number of parameters, in that such submissions should:

• Exclusively discuss the issue before the DC (with no allegation of impropriety or litigation threats)
• Be limited in length
• Be prepared by outside counsel to deter frivolous filings and reduce the number of submissions
• Include representations as to the accuracy of the statement and the public nature of the information provided, and
• Disclose the identity of the persons making the submission

Anonymity of the Requestor

The report recognizes that fully anonymous submissions enable market participants to avoid disclosing their net trading positions and (in particular) enable dealers to more freely raise questions that may be perceived as adversarial by their customers. However, it also mentions that disclosure would deter market participants from making frivolous submissions, taking extreme positions or making statements that might be regarded as manipulating markets (though market movements per se were not retained as problematic). Rather than disclosing the identity of the market participant advancing the argument, merely disclosing the identity of outside counsel could potentially be a good compromise. While expressing a preference for the former approach, the report recognizes differing views in that respect and submits both alternatives to wider consultation.

This is another area where we would diverge with the preference expressed in the report. A balancing of interests should be applied with respect to anonymity. Protecting the market against frivolous requests, while legitimate and laudable, should be measured against the detrimental impact of disclosing the full identity of market participants in terms of publicizing their investment strategies and attracting undue attention from the market and potentially regulators. Also, in many cases, market participants who raised valuable requests for the market, would not have done so if their identity was fully disclosed. Those interests, we believe, should prevail, especially since there are a number of other ways to address frivolous or adversarial requests. Market manipulation should not factor into this analysis because regulators already have access to the identity of market participants submitting a DC request. 

DC Questions Acceptance and Standard

The report endorses the proposal of establishing criteria that, if satisfied, would guarantee that a question submitted would be taken up by the DC. This is desirable to ensure the DCs are taking a consistent approach in deciding which questions to entertain. The report also supports the view that the DC Rules should make it clear which governing law the relevant DC is required to consider when making contractual interpretations (which would depend on the region in question) and recommends that a document be prepared to provide guidance to the DCs about principles of interpretation under English and New York law. Also, because questions or facts are determined by the DCs on the balance of probabilities, an evidentiary standard under New York law (as the governing law of the DC Rules) should be adopted. This may encourage the DCs to adopt a less risk-averse approach. Finally, the report would allow conversations outside of DC meetings between DC members and legal advisers appointed by the DC.

All these recommendations are part of the “other” recommendations not subject to consultation, but to be addressed separately.^[12]

Transparency

Process Transparency – The report recommended certain procedural changes to improve transparency. Any material step taken in the DC process must be disclosed on the DC website as soon as it is reasonably practical. This includes a requirement for the DCs to publicly state their reason for not deliberating a specific issue or for adjourning a meeting, if this is caused by a lack of sufficient information.

Decision-making Transparency – In response to certain comments made by buy-side market participants, the report found there to be strong arguments in favor of requiring the DC to provide the reasons for all material decisions that are made. This would reassure market participants that the DCs properly considered the matter, and would promote consistency in the decision-making process, and it may also improve the quality of decisions. Explanatory statements should be sufficiently detailed so that market participants are able to understand the basis for them. The report also stated that the DC should be open to criticism on account of their determinations and recognized the additional work this would entail for the DCs, which the report viewed as part of the DCs’ role.

Governance

Based on broad support among the consultees, the report recommends establishing an independent governance body to oversee the DCs, which would in turn enhance accountability. Even if there is overlap between DC members and members of a governance body, individuals comprising the governance body would bring a wider skill set and perspectives from market participants to the table, enhancing their ability to identify issues and changes needed for the DC determination process. This governing body would report periodically to market participants and would have the authority to make changes to the DC Rules, in consultation with the DCs. The details of the governance committee (such as its composition, responsibilities and processes) will need to be separately considered, but the report makes clear that each of the main groups of market participants (including the buy-side, with a specific buy-side subcommittee) should be adequately represented.

The report also recommends that there be independent audits of the policies and procedures applied by DC members to address conflicts of interest.

Both recommendations are subject to consultation.

The DC Secretary

The report acknowledges that there is concern that certain aspects of the DC process lack transparency, and it gives the DC Secretary a degree of discretion, but a change in the DC Secretary’s role or its use of counsel is not desirable. However, the DC rules could be clearer about the capacity in which legal services are provided, provide a non-exclusive list of the types of legal services that may be sought by the DCs and make it clear that any such advice is provided to the DCs, rather than to the DC Secretary.

Funding

The report addresses the inequities and shortcomings of the current funding model, which relies on the contributions of the dealer DC members. It is pointed out that only the dealer DC members shoulder the costs of a decision-making process that benefits all market participants. When this is coupled with decreasing dealer participation on the DCs, this may compromise the effectiveness of the DCs in the long term. The challenge is to find a funding model that both achieves a more equitable sharing of costs and can be implemented in practice.

A levy on individual transactions would ensure that costs are borne by all market participants in proportion to their CDS contracts. The charge could apply to cleared transactions; however, this would not capture the uncleared market. Alternatively, the charge could apply at the trade warehouse level, but this is somewhat complicated to implement. Most buy-side members indicated they would be supportive of such a model. Alternatively, funding could continue to be provided by the dealers only, but expanded to a broader range of market participants, such as index market makers.

Recognizing the need to address operational and other issues, the report recommends that views on the appropriate funding model be sought as part of the consultation and that a working group be formed to put together a detailed proposal.

Admissibility of Private Information

The report addresses the issues relating to the private debt documentation, including in light of recent events in the market and determinations in the context of Vue International Bidco plc, and more broadly in the context of the Credit Event, CDS auction and successor determinations. However, because those issues are wider than the operation of the determination process, the reports recommends that they be addressed as part of a wider product review.

DC Website

The report notes the website could be improved, and points out that eligible information should be able to be added to an existing request such that an up-to-date position is clearly visible on the website.

Consultation and Timing

As noted in the Introduction, Section 15 of the report contains the key recommendations to be put forward for consultation, which we have summarized in the "Speed Read" section. Appendix 2 of the report sets forth a number of other recommendations to be addressed separately at a later date.

The consultation will remain open until July 26, 2024.

^[1]_{These recommendations have also been summarized at the end of the report, with the key recommendations to be put forward for consultation by market participants listed in Section 15, and various other recommendations to be addressed as part of a separate exercise listed in Appendix 2.}

^[2]_{This would most recently include the delays observed in Vue International Bidco plc (see here).}

^[3]_{As the report notes, PRIME Finance has published a list of individuals with legal expertise and experience of the financial markets, broken down by jurisdiction.}

^[4]_{This particular proposal is to be discussed at a later date as part of Appendix 2.}

^[5]_{This would result in DCs having eight dealer DC members and four non-dealer DC members.}

^[6]_{See paragraph five of Appendix 2 of the report.}

^[7]_{This was the case in the context of the Bankruptcy Credit Event request in Credit Suisse in 2023, accessible here, where the requestor was not required to identify or describe the particular facts supporting that the specific prong of the Bankruptcy Credit Event was satisfied, and the information submitted ran over a thousand pages.}

^[8]_{As defined in Section 1.35(a) of the Definitions, PAI is information confirming relevant facts to a Credit Event that has been put forth by certain credible sources, e.g., either recognized financial news publications or persons/entities acting in an official capacity (e.g., an agent or trustee), or the Reference Entity itself, or information made publicly available by a regulatory or judicial body.}

^[9]_{See paragraph two of Appendix 2 of the report.}

^[10]_{See paragraph two of Appendix 2 of the report.}

^[11]_{We understand even by a few members on the applicable DC.}

^[12]_{See paragraph three of Appendix 2 of the report.}

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