Thames Water creditors have had a torrid time of late amid a mad dash to shore up the company’s finances before it runs out of money next month. A clutch of investment banks with derivatives exposure to Thames appear less concerned, despite the beleaguered UK utility owing around £1.3bn on a series of complex hedging transactions.
That’s because the Thames saga is fast becoming another case study in one of the secret weapons in the derivatives playbook: that swap counterparties typically rank above all other creditors, shielding them from potential losses that other lenders face when companies run into trouble.
Legal experts say this decades-old practice should protect JP Morgan, Bank of America and the other banks that struck derivatives contracts with Thames, as well as swap providers to other troubled companies like Southern Water. The question is whether their privileged status may yet be challenged by disgruntled bond and loan holders – or even the UK government – if Thames’ position as a private company becomes untenable.
In the more immediate future, all eyes will be on Thames' derivatives counterparties and their legal representatives to see if they back a proposed £3bn bailout plan to keep the company afloat.
“It is not unusual that derivatives rank at the upper end of a company’s capital structure, often above senior secured debt," said Paul Bagon, a partner at law firm Reynolds Porter Chamberlain. "In the event of the insolvency of an issuer, such structures give derivative holders a senior ranking against other noteholders and a better prospect of recovery.”
Thames is the UK’s largest water provider – and the most highly leveraged. It has increasingly struggled to service its £17.4bn pile of secured debt, forcing it to seek £3bn in emergency funding.
Those bailout negotiations have brought into focus the roughly £1.3bn that Thames owes to banks on the other side of inflation and interest rate swaps it has entered over the years. Southern also has £1.6bn in swap liabilities.
Using derivatives to lock in future interest payments on floating-rate debt is standard procedure for corporate treasurers. On top of that, many utilities take advantage of their revenues moving in line with inflation by transforming some debt into inflation-linked bonds, which typically lowers a company’s overall cost of financing.
Large exposures
Almost 60% of Thames’ debt was linked to inflation as of October, according to Moody’s, partially driven by its derivatives positions. Those derivatives have effectively added to Thames' debt load, pushing conventional lenders further down the pecking order.
"If a company only has a small portfolio of hedges, then the mark to market of those might not be substantial and so a bond or loan holder wouldn’t be that worried about their subordinated position in the capital stack," said Jackie Bowie, head of EMEA at consultancy firm Chatham Financial.
"But, as we found during the financial crisis, hedging liabilities can be very large – especially if you’ve got longer-dated hedging in place. If I was a lender to a company, I would be paying a lot of attention to what the mark-to-market liability of a company’s hedges could be."
Although swap exposures can be large, particularly if markets have moved significantly since the contracts were agreed, banks providing these hedges are careful to put in place defences to protect themselves if the worst happens and a company faces collapse.
Chief among them is demanding their derivatives receive a super-senior ranking in a company’s capital structure, meaning they are first to be repaid in an insolvency. Most banks refuse to provide hedges without such provisions and will want them to be enshrined in the company’s intercreditor agreement – a legal document that all its creditors have access to.
Wild cards
So far, the super-senior status of Thames’ derivatives counterparties appears intact, allowing banks to breathe easily. Its proposed £3bn bailout facility will rank above Class A and B debtholders, but below derivatives liabilities. However, that hasn’t stopped banks from organising themselves and seeking advice.
Banks including JP Morgan and Bank of America, which hold swaps with Thames, have engaged law firm Simpson Thacher to represent them. Morgan Stanley also has exposure to Thames – although a modest one, sources said. Spokespeople for the three banks declined to comment.
Swap counterparties may be wary of challenges to their position if rival creditors look to identify potential legal ambiguities in the intercreditor agreement. Such a situation arose 10 years ago when creditors to the owners of "The Gherkin” in the City of London successfully argued that their £396m loan facility shouldn’t be subordinate to the £140m that BayernLB was owed under an interest rate swap agreement with the owners of the landmark building after they breached loan terms.
“That’s a good example of a firm having a very large derivatives exposure that was attacked by the lenders,” said a derivatives lawyer at a London firm. “The derivatives ranked senior, but there was essentially a loophole within the intercreditor agreement that the lenders attacked to try to force a different interpretation.”
Full-blown nationalisation would also introduce a wild card for Thames’ derivatives providers, given uncertainty over how the government would treat those claims, lawyers said.
Future restructuring
Even if no challenges arise, the presence of the derivatives within Thames’ capital structure will probably still complicate debt restructuring talks because there would be more self-interested stakeholders involved wanting to extract value from the company.
“Generally, senior holders within capital structures should fair better under a debt restructuring but the devil is always in the detail – in particular the interpretation and operation of any intercreditor agreement," said Bagon. "In contested restructurings, creditors will jostle for position and as a consequence the final outcome of a restructuring tends to be case-specific.”
According to Bowie, the debt restructurings that took the longest in the aftermath of the 2008 financial crisis were for debtors that had large hedges in place.
“Even if the hedging were pari passu, it would still make the debt restructuring more complex because you've got another secured creditor in the mix that needs to be settled,” she said. “It just creates a whole other layer of claims, more complex calculations, and it’s much harder to understand how much of a haircut a swap provider would take versus what a lender would be prepared to take.”
Additional reporting by Christopher Spink and Aileen Suresh