Source: https://www.robinskaplan.com/resources/articles/credit-default-swaps-101-a-primer-on-legal-remedies
Timestamp: 2019-04-20 23:17:25+00:00

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Prior to the current economic crisis, relatively few people had heard of credit default swaps, much less understood how they work. The extent to which credit default swaps ("CDS") have contributed to the unfolding financial maelstrom, including the demise of Lehman Brothers Holdings Inc. and the uncertainty of American International Group, Inc. ("AIG"), will be examined in the months and years to come. But for any party to a CDS, the immediate concern is knowing what rights and liabilities exist under their agreement.
A CDS is an insurance-like contract where a buyer of credit protection shifts credit risk of an underlying asset to the seller of credit protection. In a typical transaction, the "protection buyer" makes periodic payments to a "protection seller" in exchange for the latter's agreement to pay upon the occurrence of a "credit event" in respect to a "reference obligation" (such as a bond or loan). A "credit event" is the circumstance or event that triggers the actual shift in credit risk from the protection buyer to the protection seller. Typical credit events include bankruptcy, restructuring, or default, although the parties to the CDS can define their own credit events.
At the time the contract is signed, the parties to a CDS choose between two types of settlement: cash or physical. A physical settlement requires that the protection buyer deliver the obligation from the reference entity to the protection seller upon the occurrence of the credit event in return for the par amount. A cash settlement requires that the protection seller, at a credit event's occurrence, make a cash payment to the protection buyer equal to par minus the recovery rate.
(3) The market became more speculative as parties to a CDS, without any ownership interest in the underlying reference obligation, bet on whether securities would succeed or fail.
These changes occurred as the CDS market grew substantially. According to the International Swaps and Derivatives Association, the notional volume of credit default swaps outstanding in June 2008 was $54.62 trillion, up more than 58% from the notional amount of $34.5 trillion outstanding at the end of 2006. This increase is largely attributable to speculation in the market. For instance, by the end of 2007, the CDS market had a notional value of $45 trillion, while the corporate bond, municipal bond, and structured investment vehicle markets totaled less than $25 trillion-meaning that approximately $20 trillion was speculative at the end of 2007.
Despite the reach of CDS in the financial markets, the CDS market has been - to date - largely unregulated and had limited transparency. Consequently, the widespread speculation in the CDS market occurred in the absence of any oversight to ensure that protection sellers were capitalized to meet their obligations.
Why Do Companies Enter Into Credit Default Swaps?
A company might enter into a CDS for any number of reasons, including reducing credit exposure, managing portfolio cash flow, obtaining capital relief, and arbitrage. The parties to a CDS are diverse and include, among others, insurance companies, investment banks, commercial banks, and hedge funds. Quite often, these companies are both buyers of protection and sellers of protection in different CDS arrangements. And, as with any derivative transaction, parties to a CDS assume counterparty risk (the counterparty will not have the ability to pay) in addition to the credit risk of the reference entity (the issuer of the reference obligation).
The occurrence of a "credit event" as defined by the relevant CDS triggers the protection seller's obligation to make coverage payments to the protection buyers. This is not as straightforward as it sounds. Divergent interpretations of the agreement's terms, such as what is the "reference entity," the "reference obligation," or whether a "credit event" has even occurred, may cause buyers to make improper demands on the protection seller, or may lead sellers to refuse payment without legal justification. For myriad reasons, a protection buyer's demand for payment under a CDS may lead to the seller's denial - and then litigation. To date, few reported decisions address CDS disputes, resulting in limited judicial guidance in this area. It is readily apparent, however, that the language of the instrument plays a key role in determining the parties' rights and obligations.
Below is a summary of potential causes of action that parties might bring.
CDS purchasers will claim breach of contract when attempting to enforce their policies against sellers. Disputes over whether a "credit event" has occurred is often what leads to a seller's refusal to pay. If such a situation arises, the court applies basic contract law and often simply reviews the plain language of the CDS. For the purposes of legal analysis, this paper discusses New York law.
To assert a breach of contract claim under New York law, a plaintiff must establish: 1) the agreement's existence; 2) plaintiff's adequate performance of the contract; 3) defendant's breach of contract; and 4) damages. See Deutsche Bank AG v. Ambac Credit Prods., LLC, 2006 WL 1867497, at *9 (S.D.N.Y. 2006) (applying New York law to interpret CDS). In deciding whether a defendant breached its contract, courts examine the undisputed facts and the CDS' plain language to determine whether the situation in dispute qualifies as a "credit event" that the parties had contemplated and defined. If the transaction required multiple writings "designed to effectuate the same purpose," the court will read the documents together even if they were executed on different dates and were not all between the same parties. Id. at *10.
One of the most important components of the CDS is the definition of a "credit event." How the document defines a "credit event" will usually determine whether the protection buyer has reason to demand payment from the protection seller. Parties should also be mindful of whether their CDS contains any waivers that may affect the definition of a "credit event." For example, in Ursa Minor Ltd. v. Aon Fin. Prods., Inc., 2000 WL 1010278 (S.D.N.Y. 2000), the court found that a plain reading of the "credit event" definition and accompanying waiver language obligated the policy seller to pay under the circumstances.
Multiple transactions and assignments led to the breach of contract claim in Ursa Minor. Escobel Land Inc. ("Escobel"), a Philippine corporation, had obtained a $9,307,000 loan from Bear, Stearns International Limited ("BSIL") to construct condominiums in the Philippines. Escobel also secured a surety bond from Government Service Insurance System ("GSIS"), a Philippines government entity, which guaranteed Escobel's payment to BSIL. A GSIS representative then assigned the bond to BSIL, naming BSIL as the obligee. BSIL in turn obtained 1) a CDS from Aon Financial Products Limited ("AFP") as well as 2) an unconditional guarantee ("Guarantee") from Aon Corporation ("Aon"), together promising to pay BSIL $10 million plus expenses if GSIS failed to satisfy its obligations under the surety bond. BSIL ultimately assigned all of its rights to receive payment under the CDS and Guarantee to Ursa Minor Limited ("Ursa Minor"), who in turn assigned the CDS and Guarantee to Bankers Trustee Company Limited ("Bankers"). To reduce its own exposure, Aon entered into its own CDS agreement with Société Générale ("SG"), wherein SG agreed to pay Aon upon the occurrence of a defined "credit event." When Escobel's payment under its BSIL loan came due, Escobel failed to pay, triggering Banker's demand on GSIS. GSIS refused, arguing that the surety bond might not be enforceable against GSIS because the GSIS representative who supposedly assigned the bond to BSIL did not have the authority, and because GSIS already had canceled the bond after discovering the collateral that Escobel had offered to secure the bond was not genuine.
Due to GSIS' refusal to pay, Bankers sent a notice of default to AFP and a notice of demand to Aon. AFP, however, argued that performance under the CDS required a valid reference obligation, which had been the GSIS bond. Because GSIS claimed that the bond was invalid and/or canceled, AFP reasoned that the CDS was no longer based on a valid reference obligation, and therefore AFP need not pay Bankers. Based on AFP's argument, Aon also refused to pay, contending that AFP had not defaulted pursuant to a "credit event." In Ursa Minor, the district court disagreed, finding that AFP and Aon had breached their contracts with Bankers. By examining the CDS' plain language, the court found that nothing in the document conditioned AFP's payment on the validity of GSIS' bond, which was the CDS' reference obligation. Instead, the court held that AFP specifically had waived all defenses concerning the bond's enforceability by agreeing to cover GSIS' default "'for whatever reason or cause," even if the underlying obligation was illegal or invalid. Ursa Minor, 2000 WL 1010278, at *7. Thus, because sophisticated parties negotiated the CDS, whose terms were clear and unambiguous, the court enforced the document as written and found that AFP and Aon had breached their contracts.
The success of a party's breach of contract claim may also hinge on how the CDS at issue defines the "reference entity," which is the entity whose obligation is the subject of the swap. As seen in its post-Ursa Minor litigation, Aon realized the importance of the term's definition and how it could be the determining factor on which the court bases its decision: In Aon Fin. Prods. Inc. v. Société Générale, 476 F.3d 90 (2d Cir. 2007), Aon attempted to recoup its Ursa Minor losses by demanding payment under its own CDS with SG. Aon reasoned that if a credit event had occurred under the BSIL-Aon CDS, a credit event also must have occurred under the Aon-SG CDS. SG interpreted the contract differently and disputed that GSIS' default constituted a "credit event" under its policy with Aon.
To resolve the issue, the Second Circuit compared how the BSIL-Aon CDS and the Aon-SG CDS each defined what could constitute a "credit event." The appeals court ultimately determined that the risk contemplated by the former contract was not the same risk contemplated by the latter. Specifically, "the risk transferred to Aon and the risk transferred by it were not necessarily identical." Aon Fin. Prods., 476 F.3d at 96. In fact, "there is...no reason to assume that the risk transferred to Aon was precisely the risk that it transferred or sought to transfer to SG." Id. at 99.
The Aon Fin. Prods. court also examined how the Aon-SG CDS defined the "reference entity." In that contract, the "reference entity" was the "Republic of Philippines and any successors." Aon contended that "any successors" encompassed any agency of the state, including GSIS, and therefore GSIS' failure to pay was equivalent to the Republic of Philippines's failure to pay, which would qualify as a credit event. But the Second Circuit again disagreed, finding that GSIS was a separate juridical entity from the Republic of Philippines. Thus, while the Aon-SG CDS did promise payment by the seller when the reference entity did not pay, the "reference entity" definition did not include GSIS. GSIS' failure to pay, therefore, did not constitute a credit event, and Aon could not compel SG's payment.
As demonstrated by the cases summarized above, if a contract's terms are unambiguous, then courts generally will look only to its plain language and will "give effect to the contract as written." Aon Fin. Prods., 476 F.3d at 96. Depending on whether the document's plain language supports their argument, however, both plaintiffs and defendants may contend that the court should look to extrinsic evidence. While typically the best evidence of the parties' intent is the contract itself, if the policy arguably contains ambiguity, then courts may consider extrinsic evidence "to ascertain the correct and intended meaning of a term or terms." Eternity Global Master Fund Ltd. v. Morgan Guar. Trust Co., 375 F.3d 168, 177-78 (2d Cir. 2004) ("Eternity Global II"). Where a contract includes ambiguous terms but was negotiated by counsel for sophisticated parties, courts should interpret such unclear language "to realize the reasonable expectations of the ordinary businessperson." Ursa Minor, 2000 WL 1010278, at *7.
Whether a court finds a contract's terms to be ambiguous or not depends on its de novo reading of the document. For example, in Eternity Global Master Fund Ltd. v. Morgan Guar. Trust Co., 2003 WL 21305355 (S.D.N.Y.) ("Eternity Global I"), Eternity Global Master Fund Limited ("Eternity Global") purchased Argentine bonds and hedged its risk with credit default swaps with Morgan Guaranty Trust Company of New York and JP Morgan Chase Bank (collectively "Morgan"). When the Argentine government announced a "voluntary debt exchange" under which domestic debtholders could exchange their debt for loan instruments with lower yields and longer maturities, Eternity Global claimed that the Argentine's debt "restructuring" constituted a credit event and demanded payment from Morgan. The Southern District of New York granted defendants' motion to dismiss, finding that Argentina's "voluntary debt exchange" did not meet the definition of an "Obligation Exchange," which would trigger payment, as defined in the CDS. Eternity Global I, 2003 WL 21305355, at *5. Instead, the contract defined an "Obligation Exchange" as "the mandatory transfer...of any securities, obligations or assets..." (emphasis provided). Id. Plaintiff attempted to argue that "mandatory" should encompass circumstances that are "economically coercive," but the trial court, in reviewing the Black's Law Dictionary definition of "mandatory," found that the word's plain meaning did not permit such a reading. Since the district court reasoned that Eternity Global chose to exchange its obligations for lower-interest secured loans, it held that defendants had not breached the CDS and dismissed the case.
On appeal, the Second Circuit stated that the dictionary definition did not account for what "mandatory transfer" means in the context of that particular industry. Finding Eternity Global's argument that "mandatory" includes an obligation exchange achieved by "economic coercion" to be plausible, the appeals court then looked to the credit derivative trade's background customs, practices and usages for clarification. Because the Second Circuit determined that the term "mandatory transfer" may have been more open-ended in the industry than Morgan contended, the court reversed the district court's dismissal and remanded for further discovery and, if necessary, resolution before a trier of fact. Eternity Global II, 375 F.3d at 186.
Another case where the court took into account industry practice to interpret an ambiguous term is Deutsch Bank AG v. Ambac Credit Prods., LLC, 2006 WL 1867497 (S.D.N.Y. 2006). There, the CDS required that upon a credit event's occurrence, the plaintiff deliver the reference obligation (bonds issued by a third party) to the policy seller before the seller had a duty to pay. While neither party disputed that a credit event had happened, plaintiff delivered the bonds weeks after they were due, and defendant refused payment. Because the contract at issue both defined when the bond delivery must occur as well as referred to standard industry terms that provided a highly detailed timeline for buyers to follow, the district court allowed Deutsche Bank to introduce evidence of industry customs on whether CDS sellers commonly were flexible with respect to delivery dates. While given the opportunity to present extrinsic evidence on industry practice, plaintiff ultimately failed to provide an industry expert who could establish that common practice in the field allowed for an unlimited time period by which buyers could deliver their reference obligations.
In addition to breach of contract, protection buyers may also have a claim for breach of the implied covenant of good faith and fair dealing. Under such covenant, which is implicit in all contracts, each promisor must exercise good faith regarding "any promises which a reasonable person in the position of the promisee would be justified in understanding were included." Deutsch Bank, 2006 WL 1867497, at *16, citing to Dalton v. Educ. Testing Serv., 87 N.Y.2d 384, 389 (1995). The implied covenant of good faith and fair dealing, however, can only impose obligations consistent with the contract's mutually agreed upon terms and cannot add any substantive provisions not included by the parties. Deutsch Bank, 2006 WL 1867497, at *16. When bringing such a claim, therefore, parties must be careful to plead facts and present evidence that do not simply reiterate its breach of contract argument. Nor should claimants attempt to void a condition expressly included in the policy with this claim. As the Deutsch Bank court explained, "if a contractual term applies, a plaintiff cannot replace a failure to show a breach of contract by referring to the implied covenant."
Another claim that parties may consider bringing when a CDS dispute arises is one for fraud. To prove fraud under New York law, a plaintiff must show that: 1) the defendant made a material false representation; 2) with which the defendant intended to defraud the plaintiff; 3) the plaintiff reasonably relied upon such representation; and 4) the plaintiff suffered damages as a result of this reliance. Eternity Global I, 2003 WL 21305355, at *2. Moreover, "for a fraud claim to survive alongside a breach of contract claim, a plaintiff must either: (i) demonstrate a legal duty separate from the duty to perform under the contract; or (ii) demonstrate a fraudulent misrepresentation collateral or extraneous to the contract; or (iii) seek special damages that are caused by the misrepresentation and unrecoverable as contract damages." Id.
Parties making fraud charges should also be aware of heightened pleading requirements. While the district court applied New York state law in determining whether Eternity Global had established all the elements of fraud, it also required plaintiff to plead the claim with particularity as the Federal Rule of Civil Procedure 9(b) demands. Specifically, the district court explained that when charging common law fraud, a party must also 1) detail the statement or omissions that the claimant contends are fraudulent; 2) identify the speaker; 3) describe when and where such statements or omissions were made; and 3) explain why the statements and omissions were fraudulent. Id. And despite Rule 9(b)'s lower standard for scienter, fraud claimants must still allege facts that "give rise to a strong inference of fraudulent intent." Id. at *3. To establish such intent, a plaintiff can either plead facts to show the defendant had both motive and opportunity to commit fraud, or allege facts that demonstrate strong circumstantial evidence of conscious misbehavior or recklessness. Id. As seen in Eternity Global I and affirmed in Eternity Global II, conclusory allegations about a defendant's intent are insufficient to make a claim for fraud.
Plaintiff in Eternity Global also brought a claim for negligent misrepresentation, whose requisite elements include showing that: 1) because of a special relationship, defendants had a duty to give correct information; 2) defendants made a false representation that they should have known was incorrect; 3) defendants knew that plaintiff desired the supplied information for a serious purpose; 4) plaintiff intended to rely and act upon such information; and 5) plaintiff reasonably and detrimentally relied on that information. See Eternity Global I, 2003 WL 21305355, at *3. In making a negligent misrepresentation claim, parties must plead facts demonstrating that defendants were not merely making promises of conduct or results in the future but, instead, made present misrepresentations of existing fact. As evidenced by Eternity Global's failed negligent misrepresentation claim, claimants cannot merely accuse defendants of making representations about future events without providing additional details on how such statements were false at the time they were made.
Plaintiffs may also claim equitable estoppel in a CDS dispute. Under New York law, a plaintiff making such a claim must demonstrate that defendants: 1) engaged in "conduct which amounts to false representation of concealment of material facts"; 2) intended that plaintiff would act upon such conduct; and 3) knew of the real facts. Deutsche Bank, 2006 WL 1867497, at *17. The claimant also must show that 1) it did not know or have the means to know the true facts; 2) it relied on the conduct of the party to be estopped; and 3) it changed its position to its prejudice. Id.
As previously recounted, in Deutsche Bank, the plaintiff unsuccessfully attempted to justify its late delivery of the CDS reference obligation to the policy seller by pointing to industry practice. Using a different tactic, Deutsche Bank also tried to argue that the defendants should be estopped from refusing delivery of the subject bonds because they had made certain statements leading the plaintiff to believe that late delivery was acceptable. The Deutsche Bank court did note that the parties submitted evidence during the bench trial showing that defendants' employees had made remarks to plaintiff's employees indicating that delivery of the bonds one to two days after the conversation at issue took place would be acceptable. The district court, however, held that defendants' remarks in no way could be interpreted to mean that the reference obligation could be delivered four weeks later. Deutsch Bank, 2006 WL 1867497, at *17.
A seller of protection's strongest defense may be challenging whether certain condition precedents in the CDS occurred such that payment under the CDS is required. While other condition precedents may exist (especially given that every CDS is a unique contract), a typical CDS contract will require 1) that a "credit event" occurred as defined within the CDS, 2) that the buyer of protection notifies the seller of protection of the "credit event" with a "credit event notice" (often times supported by publicly available information), and, 3) in cases involving physical settlement, that the buyer of protection delivers the reference obligation to the seller of protection. If the buyer of protection fails to fulfill any of these conditions provided for in the CDS, the seller of protection will not be required to make payment under the CDS.
As discussed above, an illustrative case involving this issue is Aon Fin. Prods. Inc. v. Société Générale, 476 F.3d 90 (2d Cir. 2007). The Second Circuit noted that "[t]he terms of each credit swap independently define the risk being transferred." And after reviewing both credit default swaps, the court held that the "risk transferred to Aon and the risk transferred by it were not necessary identical." Whereas the credit default swap between Bear Stearns and Aon expressly included a failure to pay by GSIS as a credit event, the credit default swap between Aon and SG contained protection against "a condition. . . resulting from any act or failure to act by the government of the Republic of the Philippines. . . or any agency. . . thereof. . . that has the effect of. . . causing a failure to honour any obligation. . . issued by the government of the Republic of the Philippines." The court, therefore, held that a "credit event" pursuant to the Aon-SG CDS did not occur and, as a result, that SG did not need to make any payment.
Depending on the facts of the case, buyers of protection (or brokers, bond issuers, hedge funds, etc.) may have misrepresented, or failed to disclose, material information regarding the value of the reference obligation. Sellers of protection price a CDS, and ultimately enter into the contract, based on the quality of the reference obligation. Many reference obligations are corporate or municipal bonds where the seller of protection can determine the strength of the reference obligation by being well-acquainted with the reference entity. Other reference obligations, however, may be structured investment vehicles, such as asset-backed securities, mortgage-backed securities, and collateralized-debt obligations, which have no known reference entity and are difficult to value. And as recent financial events reveal, many of these structure investments have lost tremendous value or defaulted because they were tied to collateralized subprime mortgages. In a CDS case, it is important to determine whether the protection buyer disclosed all material risks associated with the underlying reference obligation to the protection seller. While courts hold that bare nondisclosure is not a defense, courts generally hold that failure to disclose material facts, even innocently, will preclude specific performance or provides grounds for rescission.
Every CDS requires the buyer of protection to formally notify the seller of protection that a "credit event" occurred before the seller is ever required to make a payment under the contract. And if the CDS involves a physical settlement, the buyer of protection must also deliver the reference obligation to the seller of protection before any payment is required. If the purchaser unreasonably delays notifying the seller of the credit event or delivering the reference obligation, a court may deny a buyer's attempt to recover under the CDS. This is especially true if the protection seller can prove that its rights would be substantially and negatively affected. Depending on the court, however, the protection seller may also need to prove that the facts and circumstances indicate that the protection buyer intended to abandon its rights under the contract.
In cases involving CDSs, the protection seller's rights could be substantially harmed if the value of the reference obligation significantly declines as the plaintiff delays notifying the seller that a credit event occurred. For instance, if the protection buyer unreasonably delays notifying the protection seller that a credit event occurred, and the value of the reference obligation further decreases, then the protection seller in a cash settlement case will be forced to make a larger payment. And in a physical settlement case, the protection seller will inherit the reference obligation valued at a lower dollar amount than it would have been valued if the protection buyer timely delivered the reference obligation.
The defense of waiver also may be available to a CDS litigant. The decision in VCG Special Opportunities Master Fund Ltd. v. Citibank, No. 08-01563, 2008 WL 4809078 (S.D.N.Y. November 5, 2008) instructs that a party to a CDS can unintentionally waive a claim by its post-dispute conduct.
In that case, the plaintiff hedge fund, VCG Special Opportunities Master Fund Limited ("VCG"), sold a CDS to defendant Citibank, N.A. ("Citibank") whereby VCG agreed to pay Citibank a "Floating Payment" up to $10 million if specified credit events occurred. VCG deposited $2 million as collateral against the risk of VCG's default on its obligation to make the Floating Payment.
The parties disagreed about whether the CDS permitted Citibank to demand additional collateral. Nonetheless, less than one month after the CDS was executed and over the weeks that followed, Citibank demanded, and VCG paid, additional collateral approaching the amount of $8 million. Although VCG believed that it was not obligated to make the payments demanded, it continued to make the collateral payments for fear that it would be declared in technical default. The parties ultimately ended up in litigation. Among its claims, VCG argued that the CDS did not support Citibank's demand for additional collateral. The court rejected the claim, holding that because VCG's posted the disputed collateral and continued to accept Citibank's payments under the CDS, VCG had waived its right to challenge the demands for additional collateral.
Protection sellers may also be excused from liability under a CDS if there was a mistake as to a basic assumption when the CDS was formed and that mistake had a material effect on the agreed exchange of performance. This defense, however, is discretionary in nature, and courts would likely not void the contract if the CDS allocated the risk of a mistake to the defendant. In VCG Special Opportunities Master Fund Limited (discussed above), the court held that the defendant's mistaken understanding about its obligations under a CDS did not relieve it from its contractual obligations. Finding that the protection seller, VCG, was a sophisticated hedge fund and that the CDS language was clear, the court held that VCG's failure "to review carefully the terms of the parties' agreement" defeated its claim for rescission.
Courts may also weigh whether enforcement of the CDS would be particularly harsh on the defendant and whether the other party had reason to know of the mistake. As an example, this defense may come into play when the protection seller and the protection buyer both believe the reference obligation is secured by mortgages or other assets that roughly equal the value of the reference obligation (e.g., bond, loan, ABS, MBS, CDO). If the reference obligations are not actually secured by mortgages or assets, or the mortgages are not secured by property or buildings as described in the mortgage documents, or some other mistake exists as to the nature of the reference obligation, the CDS could be voidable by the seller.
Not surprisingly, there is a groundswell of support to bring oversight and transparency to the CDS market. While it remains to be seen precisely how this will be accomplished, the momentum is toward creating a CDS central counterparty, which would step in to ensure that CDS obligations are met irrespective of a breach by either party. The Federal Reserve, the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission each support creating a central clearinghouse, and at this writing bills are pending in both houses of Congress that would substantially regulate the market. One such bill now circulating in the U.S. House Agricultural Committee would not only require most CDS trades to go through a central clearinghouse, it would also address the problem of speculation in the market by prohibiting parties from entering into a CDS unless they have a direct exposure to financial loss from the underlying credit event. While the political will may not ultimately support that particular measure, the CDS market will undoubtedly experience a sea-change in the coming year as new regulations and oversight, in whatever form they may take, emerge.

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