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Hedge fund Solus sues GSO, Hovnanian over CDS ‘manipulation’

Hedge fund Solus Alternative Asset Management sued homebuilder Hovnanian Enterprises Inc. and Blackstone Group's GSO Capital Partners, accusing them of manipulating the market on insurance tied to Hovnanian's debt.

According to Solus, GSO was close to suffering "massive" losses after betting that Hovnanian would default on its debt. The only way for GSO to avoid the losses was if the homebuilder defaulted on existing debt and issued a certain type of new debt, Solus claimed. Because that was unlikely to occur, GSO bribed Hovnanian to do so, Solus said in the complaint.

Solus said the illegal scheme could cost it and other sellers of Hovnanian credit default swaps — which investors use as a hedge against defaults — hundreds of millions of dollars. "And the integrity of the CDS market — which is predicated on the expectation that companies seek to avoid payment default, not to accept illicit payments to default intentionally — will be irreparably damaged," Solus said.

The suit in New York state court seeks a court ruling blocking GSO and Hovnanian from entering into any transaction that includes a commitment by Hovnanian to voluntarily default on debts it could otherwise pay. It comes after Hovnanian said it's accepting a financing package offered by GSO over the objections of a rival hedge fund group.

A Blackstone representative said the lawsuit was without merit.

Hovnanian said the company acted "properly at all times and that any attempt to block this transaction will not be successful."

Hovnanian had already warned in a regulatory filing that its decision to back the GSO plan opens it to legal challenges.

The parties are scheduled to appear in court on Jan. 25.

The conflict revolves around GSO's lending proposal that hinged on the builder agreeing to default on some obligations. That would allow GSO to profit from its CDS holdings.

The refinancing plan from GSO calls for a Hovnanian affiliate to buy back a $26 million piece of the company's 8% 2019 bonds, while most of the remaining notes are being replaced with new debt. A condition on the new notes prevents the affiliate from paying interest on the bonds it holds prior to maturity. Failure to pay interest could be construed as a default that triggers the credit-default swaps.

GSO began purchasing hundreds of millions of dollars worth of swaps on Hovnanian debt starting in late 2016, while Solus was buying the homemakers' bonds and selling credit protection, according to the lawsuit. The market's confidence in Hovnanian's ability to meet its obligations "steadily improved" over the first half of 2017 and the company announced the refinancing of more than $700 million in July, according to the complaint.

"Rather than accept that it had made a misguided wager against Hovnanian and its ability to pay its debts, GSO embarked on a fraudulent scheme with Hovnanian to pervert the normal operation of the CDS market," Solus said in the suit.

Peter Grauer, chairman of Bloomberg LP, the parent of Bloomberg News, is a non-executive director at Blackstone.