Potential Impact of Economic Sanctions Against Russia on CDS

The broad economic sanctions imposed by the US, UK, EU, Switzerland, Singapore, Japan and other countries against Russia and Russia's counter measures both have and will continue to have severe consequences on the world economy and financial markets. Not the least of such impact will be felt on the credit default swap ("CDS") markets. This is an unprecedented and fast-evolving situation, with daily developments potentially changing the analysis relevant to CDS. Here we set out a summary of the relevant US sanctions and a number of questions that CDS market participants should consider.

US Sanctions Relevant to CDS

In April 2021, the US Office of Foreign Asset Control ("OFAC") issued Executive Order 14024 ("EO 14024"), "Blocking Property with Respect to Specified Harmful Foreign Activities of the Government of the Russian Federation",¹ still effective today, which authorizes sanctions against persons designated by OFAC. As a result, all of the designated persons' property an interests in property that are or come within the United States or that are or come within the possession or control of any US person are blocked, and US persons are prohibited from doing business with these institutions unless authorized by OFAC.

Pursuant to OFAC's 50% Rule, all entities that are owned 50% or more by any of the designated entities are also blocked pursuant to EO 14024. In addition, FAQ 980 makes it clear that these SDN-related prohibitions apply to both US and non-US persons.

OFAC has also issued several Directives under EO 14024, each with its own scope, target, and specific prohibitions. For example –

Directive 1A ("Directive 1A") "Prohibitions Related to Certain Sovereign Debt of the Russian Federation" effectively prohibits US financial institutions from participating in the primary market for Ruble- or non-Ruble-denominated bonds issued after June 14, 2021, and secondary market for such bonds issued after March 1, 2022, in each case by the Central Bank, National Wealth Fund or the Ministry of Finance of the Russian Federation.

Directive 3 ("Directive 3") "Prohibitions Related to New Debt and Equity of Certain Russia-related Entities", prohibits "transactions in, provision of financing for, and other dealings in" new debt of longer than 14 days maturity and new equity of identified entities or their property or interest in property issued after March 26, 2022, or 30 days after the designation of the entity, if later. In FAQ 989, OFAC suggested that modifications to the terms of existing debt on or after the relevant effective date would be considered new debt for these purposes.

Directive 4 ("Directive 4"), "Prohibitions Related to Transactions Involving the Central Bank of the Russian Federation, the National Wealth Fund of the Russian Federation, and the Ministry of Finance of the Russian Federation", prohibits persons acting within U.S. jurisdiction from performing any transaction “involving” the Central Bank of Russia, the National Wealth Fund of the Russian Federation and with the Russian Ministry of Finance, including transfers of assets to these entities or foreign exchange transactions on their behalf. The new FAQs emphasize that Directive 4’s prohibitions apply to both direct and indirect transactions involving the Central Bank of the Russia, the National Wealth Fund of the Russian Federation, or the Russian Ministry of Finance, and that US persons should be on the alert for nonroutine foreign exchange transactions that may indirectly involve the Central Bank.

OFAC has issued a number of general licenses permitting certain activities involving designated persons or their property, including General License 10A ("GL 10A") which authorizes, through May 25, 2022, transactions that are ordinarily incident and necessary to the wind down of derivatives contracts entered into prior to 4 pm on February 24, 2022 that (i) include certain identified Russian entity and their 50%-owned subsidiaries as a counterparty or (ii) are linked to the debt or equity of such entity. GL 10A also permits transactions that would otherwise be prohibited under Directive 4 that are ordinarily incident and necessary to the wind down of derivatives contract, repurchase agreements or reverse repurchase agreements entered into prior to March 1, 2022, that include the Russian Central Bank, national Wealth fund or Ministry of Finance as a counterparty.

Are new CDS Transactions on Russian Reference Entities Prohibited?

In the case of CDS referencing Russian sovereign debt, while Directive 1A does not refer to "derivatives transactions", it does prohibit participation in the "secondary market" in sovereign debt issued after March 1, 2022, which likely covers derivatives. The expansive prohibition under Directive 4 may also be interpreted to cover derivatives if such instruments indirectly involve entities targeted by Directive 4 (currently - the Russian Central Bank, National Wealth Fund or Ministry of Finance).

In the case of CDS referencing Russian Corporates, the broad prohibition under Directive 3, "transactions … or other dealings in", indicates that a CDS referencing the relevant new debt may prohibited. In order to ensure the legality of a CDS referencing old debt, it may be necessary to expressly exclude the prohibited new debt from being or becoming an Obligation or Deliverable Obligation. In the event of an old debt being modified and thus becoming new debt, it may be necessary to exclude such modified debt excluded from the CDS as well.

When Will a Credit Event Occur?

Credit Events under a Russian Sovereign CDS include the following:

• Failure to Pay – after the expiration of the relevant Grace Period, the failure to make a payment (over $1 million) when and where due, in accordance with the terms of the Obligation
• Obligation Acceleration – Obligation has become due and payable before it would otherwise have been due and payable as a result of, or on the basis of, the occurrence of a default other than a failure to pay
• Repudiation/Moratorium – both (i) an officer of the Reference Entity or a Government Authority (A) disaffirms, disclaims, repudiates or rejects or challenges the validity of, Obligations (over $10 million) or (B) declares or imposes a moratorium, standstill, roll-over or deferral, whether de facto or de jure, with respect to an Obligation, and (ii) a failure to pay or restructuring occurring within 60 days or on the next payment date
• Restructuring – with respect to an Obligation (over $10 million), a reduction in interest, principal or premium, postponement of a payment date, a subordination or a change in the currency of payment to any currency other than CAD, JPY, CHF, GBP, EUR or USD, in each case in a form that binds all holders and occurs as a direct or indirect result from a deterioration of creditworthiness or financial condition of the Reference Entity

Credit Events under a Russian Corporate CDS include Bankruptcy of the Reference Entity, Failure to Pay and Restructuring.

The Obligation referenced in the definitions of Credit Events must be a bond or loan that satisfies certain Obligation Characteristics – including Not Domestic Currency (i.e., payable in a currency other than the Ruble), Not Domestic Law (i.e., governed by non-Russian law), and Not Domestic Issuance (i.e., not issued primarily in the Russian market). This generally means that any failure by the issuers to make payments on Ruble bonds, including as a result of a Central Bank prohibition on such payments to foreign investors as recently reported,² should not trigger a Credit Event under the CDS.

Foreign currency-denominated obligations, however, still may not meet the Obligation Characteristics. To the extent any bond or loan permits, by its terms, payment in currencies (such as the Ruble) other than the currency (such as US Dollars) denominating the obligation,³ the bond or loan is not considered "payable" in a currency other than the Ruble, and therefore does not meet the Obligation Characteristic of "Not Domestic Currency".

If payment defaults occur on non-Ruble denominated, non-Russian law-governed bonds issued in foreign markets, as reported with respect to USD sovereign bonds for example,⁴ then a Failure to Pay could be triggered if those bonds qualify as Obligations under the CDS and the contractual payment requirements, such as time, place and amount (including currency), are not met.

The market is also considering on another question – whether, and if so how, a Russian government decree permitting Russian entities to make debt payments in Rubles to holders from countries that have imposed sanctions on Russia regardless of the underlying obligation terms, as the Kremlin has apparently issued,⁵ would affect the analysis of a Credit Event. More details will be needed regarding the decree and how it will be implemented. The answer may also partially depend on whether the bond terms permit the obligor to pay in Rubles, assuming of course that those bonds are determined to be "Not Domestic Currency".

It is therefore important to examine the terms of the debt instruments to ascertain, among other things, whether the obligor is permitted to make payments in Rubles, and the precise time and place mechanics of payments, as well as any announcement by the Russian government or the reference entity as to the Obligations.

What Debt Will Be Deliverable Obligations?

The settlement of a CDS requires the delivery (in the case of physical settlement) or pricing (in the case of cash settlement) of bond or loans that the meet Deliverable Obligation Characteristics, including Not Domestic Law and Not Domestic Issuance. Deliverable Obligations must also be payable in a Specified Currency – currencies used in the G7 countries.

The Credit Derivatives Determinations Committee has determined that a non-Ruble-denominated bond which by its terms permit payment in Ruble would not satisfy this Deliverable Obligation Characteristics. With respect to bonds the terms of which do not permit alternative payment currency, if USD-denominated obligations are paid in Rubles as a result of the government decree, it may raise an issue as to whether the government decree has made the obligations "payable in Rubles", and therefore whether they still meet this Deliverable Obligation Characteristics.

Another key Deliverable Obligation Characteristics applicable to bonds is Transferable, i.e., transferable to institutional investors without any contractual, statutory or regulatory restrictions.

The Directive 1A-imposed regulatory restriction on transactions in certain debt obligations means that US financial institutions cannot participate in the secondary market in, and therefore cannot receive, Russian sovereign bonds issued after March 1, 2022. Similarly, under Directive 3, if the Reference Entity of a CDS is one of the identified Russian entities (or their 50% affiliates), or guarantees the debt of such an identified entity or affiliate, the debt issued or guaranteed by the Reference Entity, if issued or modified after March 26, 2022, may be subject to the prohibitions and a US financial institution may not transact or deal in them. These restrictions raise a serious question as to whether the new debt is Transferable and eligible to be Deliverable Obligations.

If no instrument meets the Deliverable Obligation Characteristic for a CDS, then the CDS may be "orphaned", and the protection buyer may not receive the protection for which it is in dire need. Even if there are Deliverable Obligations, the severe dissipation of liquidity, particularly if more restrictions are imposed under sanctions, may affect the price of the Deliverable Obligations and the settlement process of a CDS.

How Will CDS Settlement Work?

After the occurrence of a Credit Event, standard CDS transactions will be cash settled at a price obtained through an Auction. As part of the Auction, market orders (in the form of physical settlement requests) and limit orders from potential sellers and buyers of Deliverable Obligations are matched to form hypothetical physically-settled CDS trades under which Deliverable Obligations will be delivered in exchanged for payments at the final price of the Auction. The final price, in turn, will be the highest, or lowest as the case may be, price at which all market orders are filled. It is, therefore, essential that Deliverable Obligations be available for the CDS Auction, and participation in the Auction be adequate on both sides of the market.

The US sanctions have made some allowance for wind-down transactions in the otherwise prohibited transactions in debt issued by the Russian Federation or the identified Russian entities within a short window. For example, GL 10A may temporarily permit transactions in the debt of certain entities in a wind-down of derivatives transactions. However, the price at which parties are willing to buy the debt in an Auction would presumably still reflect the short duration of such permission. Indeed parties' willingness to buy these instruments at all may be severely limited as a result of the expansive sanctions.

If demand for the Deliverable Obligations is insufficient in the Auction, the final price could be determined at zero, and protection buyers could receive par payments. Conversely, if insufficient Deliverable Obligations are sold into the Auction, the final price could be 100%, eliminating a buyer's CDS protection. Protection buyers with outstanding Russian sovereign or corporate CDS would therefore presumably endeavour to acquire Deliverable Obligations for delivery into an Auction following a Credit Event, which is highly likely to occur if the sanctions continue apace. If no Auction is held or if an Auction fails to produce a final price, then the fallback settlement method would apply, and protection buyers will need to physically deliver the Deliverable Obligations in exchange for protection payments.

Conclusion

The economic sanctions continue to evolve, as is Russia's voluntary or involuntary response. What is permitted to transfer but illiquid today may be prohibited and illegal tomorrow. It is therefore critical that CDS parties continue to follow new developments in the sanctions regimes and Russia's counter-measures, while at the same time examine the terms of the debt instruments on which possible Failure to Pay, Restructuring or other Credit Events might occur to anticipate the likely scenarios and the potential fallout. A protection buyer who needs to ensure that it does not lose the protection as a result of settlement failure should consider acquiring bonds or loans that satisfy the Deliverable Obligation Characteristics in preparation for settlement.

Authors: Julia Lu, Partner, Alexander Dmitrenko, Partner

<sub>1. Executive Order 14024, available here.
2. Russia Bans Coupon Payment to Foreigners on $29 Billion in Bonds - Bloomberg (March 1, 2022).
3. Seee Credit Derivatives Determinations Committee decision, available at Credit Derivatives Determinations Committee » The Russian Federation (cdsdeterminationscommittees.org).
4. Analysis: Ukraine war raises spectre of Russia's first external debt default | Reuters (March 3, 2022).
5. Russia Permits Payments to Foreign Bondholders, but Only With Rubles – Wall Street Journal (March 6, 2022).</sub>