The Sears bankruptcy case made headlines this month in the complex world of credit default swaps (CDS).  A credit default swap is a contract pursuant to which the seller receives payment from a buyer in exchange for which the seller must compensate the buyer in the event of a default or other specified credit event.  On November 9, in what it openly admitted was an attempt to take advantage of the abundance of default protection issued in the days leading up to its bankruptcy filing, Sears sought permission to auction certain “medium-term notes” (MTNs) that were issued by Sears Roebuck Acceptance Corp. (“SRAC”) prior to the petition date and held entirely by affiliates of Sears.[1]

To understand how the Debtors might use the CDS market to drive up the value of the MTNs despite the fact that they are not themselves buyers of credit protection requires an understanding of the process by which buyers of default protection are made whole.  As explained in the Motion, SRAC is the “Reference Entity” under certain credit default swaps. The commencement of the bankruptcy cases was a “credit event” requiring sellers of credit protection to pay buyers of credit protection an amount (a “Settlement Amount”) equal to the notional amount of the credit protection purchased times a percentage equal to 100% minus the value (the “Recovery Percentage”) of certain qualifying obligations of Sears and its affiliates, such as the MTNs (such difference, the “Loss Percentage”).

The Motion continues, “[u]nder the terms of the CDS, the Loss Percentage and, therefore, the Settlement Amount, will be determined at an auction (the “Auction”) conducted by the International Swaps and Derivatives Association (“ISDA”) in which buyers of credit protection who so desire can sell qualifying obligations of the Company, and sellers of credit protection who so desire can purchase qualifying obligations of the Company, at a price determined at the Auction. Whether or not a buyer or a seller of credit protection participates in the Auction, buyers are entitled to receive, and sellers are obligated to pay, the Settlement Amount on the CDS to which they are a party. The Auction ensures that a buyer of credit protection who wishes to receive no less than the full par amount of the bonds for which it has purchased credit protection is able to do so by selling its bonds into the Auction and receiving the Recovery Percentage of the par amount of its bonds at the Auction, and then receiving the Loss Percentage thereof from its seller of credit protection, for a total of 100%. Sellers of credit protection are motivated to participate in the Auction, too, because the higher the price they pay at the Auction, the lower the Settlement Percentage that they have to pay on the CDS. Thus, sellers of credit protection are likely to purchase qualifying obligations at the Auction at a price higher than they would be willing to pay outside the Auction.”

“Because sellers of credit protection are likely to pay relatively high prices at the Auction, buyers of credit protection, who are eligible to sell qualifying obligations into the Auction, frequently will compete in the days leading up to an Auction to find qualifying obligations that they can sell at the Auction for top dollar. This competition drives up the price of qualifying obligations, like the MTNs, in order to tender them into the Auction. The specter of the Auction creates a demand for the MTNs and confers a value that is greater than a value derived simply from the collectability of the MTNs and their relative priority in the Debtors’ capital structure. Although the Debtors are not eligible to sell the MTNs directly into the Auction because they are not buyers of credit protection, they can benefit from the spike in the price of the bonds immediately before the Auction by selling the MTNs to entities that are. Consequently, there is an opportunity for the Debtors to monetize their interest in the MTNs at a favorable price—an opportunity that likely will be gone after the Auction is concluded.”[2]

On November 14, Cyrus Capital Partners, L.P. (“Cyrus”) objected to the Motion.[3]   While the Objection was ostensibly filed by Cyrus in its capacity as a creditor, the firm has been reported to be a seller of protection against a Sears default.[4] By “flooding the market with cheap SRAC debt,”[5] the Debtors would be increasing the pool of defaulted securities for which sellers of credit protection like Cyrus would have to cover the Loss Percentage determined at the Auction, providing all the incentive that Cyrus or any other seller of protection would need to oppose the maneuver.

The Objection argues that the sale of the MTNs is not in the best interests of the SRAC bankruptcy estate because, among other things, the proposed sale “completely ignores any discussion of whether SRAC has (or has investigated whether it has) any defenses, claims, counterclaims, setoff or other rights or interests that would permit SRAC to challenge the amount, validity, priority or enforceability of the MTNs against SRAC and its estate.”[6]   

The Objection also raises the specter of gamesmanship and manipulation by parties seeking to leverage swap protection with carefully timed issuances and sales of affiliate-held securities.  “The sale of legacy intercompany claims by certain Debtors at the expense of another Debtor under these unregulated circumstances necessarily will introduce an entirely new and unknown creditor constituent into the cases—and in particular, into SRAC’s capital structure. This exercise, if permitted, may have significant implications for plan structure negotiations and creditor voting rights, as well as introducing the potential for gamesmanship using all of the various types of intercompany claims that exist between and among Debtors. Allowing certain Debtors to transform massive “insider” claims to massive third party claims in this manner could have far-reaching implications for the ultimate resolution in these (and other) cases.”[7]

Notwithstanding the concerns raised in the Objection—particularly the troubling implications of allowing the subject of credit protection to openly attempt to manipulate the CDS market in which it is not itself a direct participant—Judge Drain approved the Motion. [8]

Importantly, however, as a result of a last-minute agreement between Cyrus and the Debtors, the approval order stated that the “MTNs are not being sold free and clear of any Liens or Claims of SRAC, including, without limitation, any counterclaim, defense or right of setoff, held or that may be asserted by SRAC or its estate, and nothing in this Order shall impair or prejudice in any way any rights, claims, or defenses that SRAC or its estate may have in connection with the MTNs.”[9] This language may constitute a partial victory for Cyrus.  At a minimum, it preserves for later resolution any defense to payment of the MTNs that SRAC (or its estate / creditors) might wish to assert in the future.   But, perhaps more significantly, one market commentator has observed that “the inclusion of that language could increase the odds that a panel of derivative traders will exclude the notes from a separate auction that will determine the payout on some $400 million of swaps on Sears” and may drive down demand for the notes.[10]

Because the Approval Order was entered following withdrawal of the Cyrus Objection, and because no other party objected to the Motion, the Debtor’s request was unopposed and the Court did not have occasion to prepare a written opinion.  Future attempts by defaulting issuers to leverage the CDS market may call on Courts to examine more fully some of the difficult questions that were raised but ultimately left unanswered in the Sears case.  

[10] “Cyrus's Last-Minute Change to Debt Sale May Cost Sears Millions,” Bloomberg, November 20, 2018.  Available at:  https://www.bloomberg.com/news/articles/2018-11-20/cyrus-s-last-minute-change-to-debt-sale-may-cost-sears-millions