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Reprinted from the Futures & Derivatives Law Report. Copyright © 2008 Thomson Reuters/West. For more information about this publication please visit www.west. thomson.com
December 2008
nVolume 28
nIssue 11
Comparing Credit Default
Swaps to Insurance
Contracts:
Did the New York State
Insurance Department
Get It Right?
B y S h E r r I V E N O k U r , M A T T h E w M A G I D S O N , A N D A D A M M . S I N G E r
Sherri Venokur is a Member of the Firm; Matthew Magidson and Adam M. Singer are Counsel, Lowen-stein Sandler, PC.
On September 22, 2008, the New York State Department of Insurance announced that it would be regulating certain credit default swaps as insurance contracts. On November 20, 2008, the department made another announcement, this time stating that, although certain credit default swaps did constitute insurance contracts, the insur-ance department would “delay indefinitely its application of New York Insurance Law to CDS … .”1 During the two-month period
between the two announcements, bar asso-ciation committees, trade assoasso-ciations and the various market participants in the vast credit default swap market struggled with the anticipated scope and consequent rami-fications of the insurance department’s regu-lation of credit default swaps as insurance. This article will discuss whether the New York State Department of Insurance has properly categorized certain credit de-fault swaps as insurance. It will describe
the credit default swap product, how it is used by financial market participants and how it is documented, cover the regulatory treatment of credit default swaps, both as “security-based swap agreements” under the Commodity Futures Modernization Act of 2000 and under various rulings by the New York State Department of Insur-ance, discuss the market view that credit default swaps are not insurance, and then set forth the differences between credit de-fault swaps and insurance.
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Editorial Board
© 2008 Thomson Reuters/West. This publication was created to provide you with accurate and authoritative information concerning the subject matter covered, however it may not necessarily have been prepared by persons licensed to practice law in a particular jurisdiction. The publisher is not engaged in rendering legal or other professional advice, and this publication is not a substitute for the advice of an attorney. If you require legal or other expert advice, you should seek the services of a competent attorney or other professional.
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STEPhEn W. SEEMER
Publisher, Thomson/Legalworks
CaRRIE a. PETERSEn
Publication Editor, Thomson/West
RIChaRD a. MILLER
Editor-in-Chief, Prudential Financial 751 Broad Street, 21st Floor, Newark, NJ 07102
Phone: (973) 802-5901 Fax: (973) 802-2393 E-mail: richard.a.miller@prudential.com
MIChaEL S. SaCkhEIM
Managing Editor, Sidley Austin LLP 787 Seventh Ave., New York, NY 10019 Phone: (212) 839-5503
Fax: (212) 839-5599 E-mail: msackheim@sidley.com
PaUL aRChITZEL
Alston & Bird Washington, D.C.
GEoFFREy aRonoW
Heller Ehrman LLP Washington, D.C.
ConRaD G. BahLkE
OTC Derivatives Editor Weil, Gotshal & Manges New York, NY
RhETT CaMPBELL
Thompson & Knight LLP Houston, TX
anDREa M. CoRCoRan
Promontory Financial Group Washington, D.C.
W. IaIn CULLEn
Simmons & Simmons London, England
WaRREn n. DavIS
Sutherland Asbill & Brennan Washington, D.C. SUSan C. ERvIn Dechert LLP Washington, D.C. RonaLD h. FILLER Lehman Brothers New York, NY EDWaRD h. FLEISChMan Linklaters New York, NY DEnIS M. FoRSTER New York, NY
ThoMaS LEE haZEn
University of North Carolina at Chapel Hill
DonaLD L. hoRWITZ
One Chicago Chicago, IL
PhILIP MCBRIDE JohnSon
Skadden Arps Slate Meagher & Flom Washington, D.C.
DEnnIS kLEJna
MF Global New York, NY
RoBERT M. MCLaUGhLIn
Katten Muchin Rosenman New York, NY
ChaRLES R. MILLS
Kirkpatrick & Lockhart Washington, D.C.
DavID S. MITChELL
Fried, Frank, Harris, Shriver & Jacobson LLP New York, NY
RIChaRD E. naThan
Los Angeles
PaUL J. PanTano
McDermott Will and Emery Washington, D.C.
FRank PaRTnoy
University of San Diego School of Law
GLEn a. RaE
Banc of America Securities LLC New York, NY
kEnnETh M. RaISLER
Sullivan & Cromwell New York, NY
RIChaRD a. RoSEn
Paul, Weiss, Rifkind, Wharton & Garrison LLP New York, NY
kEnnETh M. RoSEnZWEIG
Katten Muchin Rosenman Chicago, IL ThoMaS a. RUSSo Lehman Brothers New York, NY hoWaRD SChnEIDER MF Global New York, NY STEPhEn F. SELIG
Brown Raysman Millstein Felder & Steiner LLP New York, NY
PaUL UhLEnhoP
Lawrence, Kamin, Saunders & Uhlenhop Chicago, IL
EMILy M. ZEIGLER
Willkie Farr & Gallagher New York, NY
Introduction
Circular Letter No. 19 (2008) (the “Circular Let-ter”), issued by the New York State Department of Insurance (the “NYS Insurance Department”) on September 22, 2008, outlines “best practices” for financial guaranty insurers and includes specific recommendations regarding the provision by fi-nancial guaranty insurers of policies covering their affiliates’ payment obligations under credit default swap (“CDS”) transactions (“CDS Transactions”). In the Circular Letter, the NYS Insurance Depart-ment stated that a CDS Transaction “is an insur-ance contract when it is purchased by a party who, at the time at which the agreement is entered into, holds, or reasonably expects to hold, a ‘material interest’ in the referenced obligation.”2
Two months later, on November 20, 2008, the NYS Insurance Department issued a First Sup-plement to Circular Letter 19 (2008) (the “First Supplement”), stating that the NYS Insurance Department would “delay indefinitely its appli-cation of New York Insurance Law to CDS …
.”3 According to the First Supplement, the NYS
Insurance Department’s decision to refrain from regulating CDS at this time is based on the initia-tives announced on November 14, 2008, by the President’s Working Group on Financial Markets “to strengthen oversight and transparency and to create a centralized market infrastructure for the over-the-counter derivatives market, including credit default swaps … .”4
NYS Insurance Department Superintendent Eric Dinallo, however, has not retreated from his view, as stated in the Circular Letter, that a CDS Transaction is an insurance contract when the buyer has or expects to have a material interest in the subject of the transaction. This statement represents both an expansion of the common un-derstanding of what constitutes insurance and a reversal of how prior NYS Insurance Department opinions have been interpreted by the market-place.
Admittedly, CDS Transactions and insurance contracts are very similar, and most newspaper and magazine articles attempt to explain CDS
Transac-tions by using examples and terms from the insur-ance context: the buyer makes premium payments to the seller and receives a payment from the seller if a covered event occurs. Historically, however, the two products have been distinguished by the fact that insurance requires the buyer to have an “insurable interest” in the subject of the insurance,
e.g., the house or car, as well as proof of loss
in-curred by virtue of the occurrence of the covered event.5 CDS Transactions do not require the buyer
to have an interest in the Reference Entity or an Obligation of the Reference Entity6 and, thus, do
not condition the seller’s payment to the buyer upon the buyer’s proof of loss by virtue of the oc-currence of a Credit Event. For this and other rea-sons — undoubtedly including an understandable reluctance on the part of the NYS Insurance De-partment to assume responsibility for regulating a global financial product — the NYS Insurance De-partment’s Office of General Counsel (“OCG”) is-sued an opinion, dated June 16, 2000, stating that a CDS Transaction is not insurance if the seller’s payment to the buyer “is not dependent upon the buyer having suffered a loss … .”7
Given the current market turmoil and the blame that the CDS product has taken for the near col-lapse of the global financial markets, it is not surprising that the NYS Insurance Department stepped in to fill what was perceived as a regula-tory vacuum with respect to CDS Transactions. At this time, there seems to be unanimous agree-ment among the Federal Reserve, the Securities and Exchange Commission and the Commodities Futures Trading Commission, as well as the NYS Insurance Department, that regulation of CDS Transactions should be at the federal level.
Credit Default Swap Basics
A credit default swap is a bilateral contract between a buyer of protection (“Buyer”) and a seller of protection (“Seller”) with respect to an obligation (usually a bond or loan) of a particular entity, called the Reference Entity. The Buyer pays a periodic fee to the Seller, and, if a certain speci-fied “Credit Event” occurs, then the Seller is re-quired to make a payment to the Buyer by means
of either physical settlement or cash settlement. In a physical settlement transaction, the Buyer de-livers to the Seller an obligation of the Reference Entity that has certain specified characteristics (a “Deliverable Obligation”) in exchange for the
face amount of the Deliverable Obligation.8 In a
cash settlement transaction, the payment from the Seller to the Buyer is the difference between the face amount of the Reference Obligation and its current market value.
CDS Transactions are documented using stan-dardized contracts and incorporating definitions published by the International Swaps and De-rivatives Association, Inc. (“ISDA”). Most CDS Transactions are evidenced by an ISDA-based con-firmation, which incorporates the ISDA Master Agreement entered into between the parties and the 2003 ISDA Credit Derivatives Definitions.
how Market Participants Use Credit
Default Swaps
Parties may enter into CDS Transactions to gain or reduce exposure to credit risk. Credit exposure can be gained by the Seller of CDS protection with-out the initial cash with-outlay required when purchasing a bond or making a loan. In addition, a CDS Buyer can reduce exposure to a credit risk without actu-ally selling the relevant loan or bond. This unique feature of CDS allows banks to purchase CDS pro-tection in order to reduce their exposure to certain borrowers or industries without jeopardizing their customer relationships. For example, if a bank cus-tomer requests a $100,000,000 loan, and the bank is only willing to assume $50,000,000 in credit ex-posure to its customer, then, instead of referring the customer to a competitor or syndicating the loan, the bank could loan the entire $100,000,000 to its customer and buy CDS protection on the loan as the Reference Obligation in the Notional Amount of $50,000,000.
As the CDS market developed, its uses expand-ed to include: (A) obtaining increasexpand-ed access to credit markets (bonds and loans are limited to the actual amount issued or borrowed by the underly-ing credit, but CDS has no parallel limitation); (B) the creation of new kinds of credit exposure not otherwise available in the market9; (C)
arbitrag-ing perceived pricarbitrag-ing inefficiencies in the capital structure of an issuer or between issuers; and (D) managing regulatory capital requirements (and potentially taking advantage of different capital requirements for banks versus insurance compa-nies). In addition, a CDS Buyer may be seeking to terminate or offset another trade on the same or similar Reference Entity or Reference Obligation that it entered into as Seller, if the cost to termi-nate the first trade would exceed the present value of the future premium payments on the second trade (the same is also true for a CDS Buyer enter-ing into a second trade as CDS Seller).
Of all the additional uses of CDS Transactions noted above, only the diversification of credit ex-posure is a substitute for financial guaranty
insur-ance.10 Banks also participate in the CDS market
by entering into client facilitation trades with their customers. When a customer wishes to buy CDS protection, the bank may enter into a CDS Transaction as Seller in order to facilitate the cus-tomer’s strategy.
CDS Transactions are natural investments for leveraged entities, such as hedge funds. Unlike a bond issued by a Reference Entity, a CDS Trans-action is intrinsically leveraged because it does not require initial funding. Hedge funds make up a sig-nificant portion of the CDS Market, utilizing CDS Transactions to maximize returns and to manage portfolio risk. Insurance companies participate in the CDS market through non-insurance company
subsidiaries (“transformers”11) and through what
are called “Replication” transactions. Replication transactions are derivatives transactions entered into for the purpose of reproducing the investment effects of otherwise permissible investments.12
A CDS Transaction entered into for any of these purposes could fall within the Circular Letter’s def-inition of insurance if the CDS Buyer happens to own the asset that is the subject of the transaction.
Regulation of CDS
Federal Regulation of CDS
The Commodity Futures Modernization Act of 2000 (the “CFMA”) creates a “safe harbor” for CDS Transactions that preempts state and
lo-cal gaming and bucket shop laws (other than any generally applicable anti-fraud provisions thereof) and exempts most CDS Transactions from regula-tion by the Commodity Futures Trading Commis-sion (“CFTC”). CDS Transactions are expressly exempted from regulation by the CFTC so long as the contracts are not executed or traded on a trading facility and are between “eligible contract participants”13 (including, most notably, financial
institutions, mutual funds, commodity pools, and entities with total assets in excess of $10 million). One could therefore conclude that when, in 2000, Congress considered the regulation of CDS Trans-actions, it determined that regulation was not re-quired where each of the parties was either a regu-lated entity or met the specified financial tests.
The CFMA effectively excludes CDS Transactions from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”)14
and from the general provisions of the Exchange
Act of 1934, as amended (the “Exchange Act”)15
because it clarifies that a swap based on a security is not a security. The CFMA introduced the term “security-based swap agreement,” to mean those swaps that derive at least one of their key terms from the price, yield, maturity or volatility of a secu-rity, group of securities or index of securities.16 CDS
Transactions fall within the definition of “security-based swap agreements” when the Reference Obli-gation or Deliverable ObliObli-gation is a security, i.e., a bond. The only provisions of the Securities Act and the Exchange Act that apply to security-based swap agreements are the anti-fraud and anti-market manipulation provisions thereof.17
nyS Insurance Department
Treatment of CDS
Regulation of FGI Insurance
Policies on CDS
The NYS Insurance Department regulates most of the nation’s financial guarantee insurance com-panies (“FGIs”).18 FGIs authorized to do business
in New York must comply with various special-ized and highly technical requirements intended to safeguard their financial solvency for the ben-efit of their policyholders. Until recently, the NYS
Insurance Department allowed (with certain re-quirements) FGIs to guarantee the CDS payment obligations of their affiliated “transformer”19
en-tities. In 1997, the NYS Insurance Department confirmed that an FGI may provide a financial guaranty policy with respect to the CDS payment obligations of an affiliated transformer resulting from the bankruptcy of or payment default by the issuer of the bond or other security referenced in
the CDS.20 The NYS Insurance Department
deter-mined that the guaranty of the transformer’s ob-ligations as CDS Seller was “substantially similar to a direct guarantee of the underlying obligation protected by the CDS, and thus permissible
un-der Insurance Law § 6904(b)(1)(J).”21 The 1997
Opinion Letter did not address the status of early termination payments under CDS Transactions resulting from events of default or termination events with respect to the transformer or the FGI as guarantor. That clarification came in 1999, when the NYS Insurance Department published another opinion clarifying that guarantees of ear-ly termination payments “do not represent guar-antees of acceleration payments prohibited under
[Insurance Law] Section 6905 … .”22
The 1997 and 1999 opinions of the NYS In-surance Department formed the basis of the 2004 amendment to Article 69 of the New York State Insurance Law, which modified the definition of “asset-backed securities” (a permissible guarantee category under Section 6904(b)(1)(F)) to include “a pool of credit default swaps or credit default swaps referencing a pool of obligations,” subject to certain requirements.23 Therefore, if the CDS
itself does not constitute an insurance contract or the doing of an insurance business, then an FGI is permitted to issue an insurance policy that guar-antees payments by a transformer or other party pursuant to such CDS.
In addition, the amendment added to Insur-ance Law § 6901(j-1) the following definition for CDS:
“ ‘Credit default swap’ means an agreement referencing the credit derivative definitions published by the International Swap and Derivatives association, Inc. or otherwise ac-ceptable to the superintendent, pursuant to which a party agrees to compensate another party in the event of a payment default by, insolvency of, or other adverse credit event in respect of, an issuer of a specified secu-rity or other obligation; provided that such
agreement does not constitute an insur-ance contract and the making of such credit default swap does not constitute the doing of an insurance business.”24
The NYS Insurance Department’s recent diver-sion from its previous position certainly narrows the scope of available protection under policies issuable by FGIs. The Circular Letter states that it expects FGIs will limit the risks it covers under its policies to “namely, only failure to pay obligations when due or payable when the failure is the result of a finan-cial default or insolvency.”25 Moreover, the NYS
In-surance Department’s categorization of certain CDS Transactions as insurance contracts may also mean that FGIs will not be authorized to issue policies covering those CDS Transactions that fall within the NYS Insurance Department’s expanded defini-tion of insurance. The language of the Circular Let-ter also calls into question the continuing viability of the NYS Insurance Department’s prior opinions on the relationship between derivatives transactions and contracts of insurance.
NYS Insurance Department
Treatment of CDS
In New York, an insurance contract is defined as “any agreement or other transaction whereby one party, the ‘insurer’, is obligated to confer a benefit of pecuniary value upon another party, the ‘insured’ or ‘beneficiary’, dependent upon the happening of a fortuitous event in which the in-sured or beneficiary has, or is expected to have at the time of such happening, a material interest which will be adversely affected by the happening of such event.”26
Clearly, CDS Transactions and insurance con-tracts share some of the same characteristics. A
Credit Event triggered under a CDS Transaction could constitute “the happening of a fortuitous event,” and the payment due from the Seller to the Buyer upon settlement of the CDS Transac-tion would be an obligaTransac-tion “to confer a benefit of pecuniary value” upon the Buyer. The similari-ties break down, however, when we examine the “material interest” component of the definition, because there is no requirement in a CDS Trans-action for the Buyer to have any interest whatso-ever that could be adversely affected by the Credit Event. CDS Transactions do not require the Buyer to own or have any interest in the Reference En-tity or an Obligation of the Reference EnEn-tity.
Another factor distinguishing a CDS Transaction from an insurance contract is the absence of any re-quirement that the occurrence of the Credit Event cause the CDS Buyer to suffer a loss. By contrast, the term “insurance” contemplates that the insured or beneficiary has or expects to have a material in-terest in the subject of the insurance, e.g., the house or car, as well as proof of loss incurred by virtue of the occurrence of a “fortuitous event.” For this reason, the NYS Insurance Department concluded in a 1998 opinion that certain catastrophe options were not subject to regulation as insurance because they did not obligate the option seller to indemnify the purchaser for actual losses incurred by the pur-chaser.27 Similarly, that same year, the NYS
Insur-ance Department determined that an index swap transaction did not constitute insurance “unless the terms of the instrument provide that … payment to the Fixed Rate Payment Payer is dependent upon that party suffering a loss.”28
Two years later, in 2000, the Office of General Counsel of the NYS Insurance Department is-sued an informal opinion stating that weather derivatives are not insurance contracts because these derivatives contracts “do not provide that … payment to the purchaser is dependant upon that party suffering a loss.” The opinion states that “[n] either the amount of the payment nor the trigger itself in the weather derivative bears a relationship to the purchaser’s loss. Absent such obligations, the instrument is not an insurance contract.”29
Specifically with respect to CDS Transactions, the NYS Insurance Department concluded in an opinion dated June 16, 2000, that a CDS is not
an insurance contract because the Seller’s pay-ment is not conditioned upon a loss incurred by the Buyer.30 Based on the line of reasoning in the
precedent opinions, the consistent position of the NYS Insurance Department has been abundantly clear: Unless the seller’s payment obligation is based on actual loss incurred by the buyer, a de-rivatives contract is not insurance. 31
Nonetheless, the Circular Letter states that the categorization of certain CDS Transactions as in-surance is not a reversal, but simply a clarifica-tion, of its 2000 OGC Opinion Letter:
although oGC’s June 16, 2000 opinion suggests that a CDS is not an insurance contract if the payment by the protection buyer is not conditioned upon an actual pe-cuniary loss, that opinion did not grapple with whether, under Insurance Law §1101, a CDS is an insurance contract when it is purchased by a party who, at the time at which the agreement is entered into, holds, or reasonably expects to hold, a “material interest” in the referenced obligation.32
Superintendent Eric Dinallo in testimony before Congress reiterated his view that the 2000 OGC
Opinion Letter is incomplete and was never in-tended to exempt “covered” CDS from insurance regulation.33 Dinallo testified:
Clearly, the question was framed to ask only about naked credit default swaps with no proof of loss. Under the facts we were given, the swap was not “a contract of insurance”, because the buyer had no material interest and the filing of claim does not require a loss. But the entities in-volved were careful not to ask about cov-ered credit default swaps. nonetheless, the market took the Department’s opinion on a subset of credit default swaps as a ruling on all swaps and, to be fair, the Depart-ment did nothing to the contrary.34
The NYS Insurance Department has made a clear distinction between “naked” CDS — where the Buyer has no material interest in the underly-ing entity or obligation — and “covered” CDS — where the Buyer either has or expects to have such a material interest. According to the NYS Insurance Department, “naked” CDS is not in-surance but “covered” CDS is inin-surance.
Market View That CDS Is Not Insurance
As discussed above, the NYS Insurance De-partment’s opinions prior to the Circular Letter consistently held that swaps are not insurance un-less the swap contract conditions payment upon a party’s actual loss. Because there is no require-ment in a CDS Transaction that the Buyer actu-ally hold the Reference Obligation, the fact that a particular Buyer actually did hold the Reference Obligation did not put the parties on notice that their contract might be viewed by the NYS Insur-ance Department as constituting insurInsur-ance. In-deed, there was no reason for the Seller to know whether the Buyer held the Reference Obligation and no requirement for the Seller to inquire.By contrast, as noted above, an insured cannot obtain insurance unless he has an “insurable inter-est”35 in the subject of the insurance. In addition,
an insured cannot collect under a policy without showing proof of loss, and any settlement with respect to the amount owed is determined by the parties themselves.
A significant portion of the CDS market is un-related to the protection of an asset owned by the Buyer. Even under a CDS Transaction where the Buyer holds the Reference Obligation, the Buy-er can sell the RefBuy-erence Obligation at any time without having to terminate the CDS Transac-tion and, if a Credit Event occurs with respect to that Reference Obligations, collect a settlement payment from the Seller. As noted in footnote 8 above, the amount of the settlement payment generally is determined through a market-wide auction process, and the payment itself may not even come from the particular Seller.
The recent market turbulence, including the collapse of Lehman Brothers and Washington Mutual and the bailout of Bear Stearns, Fannie Mae, Freddie Mac and AIG, has resulted in plans for increased federal regulation of the over-the-counter derivatives markets in general and CDS Transactions in particular. In March 2008, Presi-dent Bush created the PresiPresi-dent’s Working Group on Financial Markets (the “PWG”) headed by Treasury Secretary Henry Paulson and includ-ing Federal Reserve Chairman Ben Bernake and Securities and Exchange Commission Chairman
Christopher Cox. The PWG’s goals are: (i) to im-prove market transparency and integrity for CDS, (ii) to enhance risk management of OTC deriva-tives, (iii) to strengthen OTC derivatives market infrastructure, and (iv) to continue cooperation
among regulators.36
In order to help streamline the regulatory pro-cess, promote consistent oversight, and enhance cooperation, the Board of Governors of the Fed-eral Reserve System, the Securities and Exchange Commission and the CFTC` entered into a Memo-randum of Understanding on November 14, 2008 (the “Memorandum”). Under the Memorandum, the parties established a framework for coopera-tion, information sharing and consultation related to the creation of central counterparties for CDS Transactions.37 Central counterparties would
inter-pose themselves between CDS market participants and provide clearing and settlement services.38
Differences Between CDS
and Insurance
In addition to the differences already discussed, CDS Transactions and insurance contracts differ in the way they are underwritten and taxed. The underwriter of an insurance policy evaluates the asset being insured, while the CDS Seller looks at the creditworthiness of the Buyer as well as the market price of the CDS Transaction. An insur-ance premium is typically an annual amount that is payable as agreed between the parties and is subject to adjustment on a periodic basis (typi-cally, annually) at the discretion of the insurer. If the insured fails to make a required premium payment, the policy is cancelled by the insurer. In a CDS context, the parties agree to the duration of the Transaction, which is generally a period of several years and which is specified in the CDS Transaction confirmation. The CDS premium usually is paid quarterly and the premium rate re-mains constant throughout the term of the CDS Transaction. If the Buyer fails to make a required payment, the Seller has the right under the ISDA Master Agreement to terminate all outstanding Transactions (which may include other types of derivatives transactions as well as other CDS Transactions), obtain a close-out amount, and pursue the Buyer for that amount. In addition,
because a CDS Transaction is for a set term, the Buyer has no legal right to terminate the trade; a CDS Buyer that no longer wants the trade either has to come to an agreement with the Seller re-garding a termination price or, with the Seller’s consent, assign the trade to a third party. In either case, the termination payment may be payable by either Buyer or Seller depending upon the then current market value of the trade).
Upon the occurrence of an event constituting a risk covered by the policy, the insured must show proof of his loss in order to receive payment. The insurer also can resist payment to the beneficiary based upon a number of well-established defenses including, most notably, fraud. A defense to pay-ment based on fraud could be predicated, for ex-ample, on the duty of the insured to make the re-quired disclosures on the insurance application.
There are no parallel defenses to payment with respect to CDS Transactions because no such duty exists between the parties to a CDS Transaction. If a Credit Event occurs and the CDS Buyer follows the procedures for settlement, the Seller must make payment on the CDS Transaction. Except in very limited situations, a CDS Seller cannot argue that its Buyer failed to disclose material information or lied when negotiating the terms of the trade. In fact, each party to a CDS Transaction expressly acknowledges that it is not relying on any infor-mation provided by the other party and that it is capable of evaluating the risks of the transaction.
CDS Transactions and insurance contracts may also be subject to different tax regimes. In an in-surance contract, the inin-surance settlement may not be taxed at all as the settlement is based on the actual loss suffered and that loss may be equal to the tax basis of the damaged property. The amount of a CDS settlement payment is based on the difference between the current value of the Deliverable Obligation or Reference Obligation and its Par Value, and the actual loss, if any, to the Buyer is not relevant. The Buyer’s premium payment is treated differently as well: a company purchasing insurance on an asset generally would be able to deduct the premium payment as a cost of doing business. A CDS Buyer may not be en-titled to a similar tax deduction. There is also the question whether “covered” CDS will be subject
to U.S. excise tax. Insurance premiums paid to foreign persons with respect to a U.S. risk are sub-ject to excise tax. Market participants have distin-guished CDS from insurance contracts subject to excise tax because CDS does not require the Buyer to suffer an actual loss and does not contemplate risk shifting or distribution,39 but commentators
have stated that certain CDS may be subject to U.S. excise tax if the contract requires the Buyer to hold the underlying obligation.40
Conclusion
Even though, based on the First Supplement, it is unlikely that “covered” CDS will be regulated as insurance by the NYS Insurance Department, the First Supplement reiterates the determination by the NYS Insurance Department in the Circu-lar Letter, that “covered” CDS Transactions are properly classified as insurance contracts. The classification of “covered” CDS Transactions as insurance may have serious ramifications wheth-er these transactions are ultimately regulated by the NYS Insurance Department or by a federal regulator. As discussed above, the Internal Rev-enue Service taxes insurance payments differently from CDS payments, and the Financial Account-ing Standards Board may weigh in on this as well. Further, while two U.S. “eligible contract partici-pants” cannot invalidate their CDS Transaction, a non-U.S. CDS Seller might be able to avoid making a settlement payment to its Buyer based on defenses that otherwise would not be available to a CDS Seller but that are available to an in-surer. At this point one can only guess at what consequences will flow from the NYS Insurance Department’s determination.
noTES
1. n.Y. Ins. Dept. First supplement to Circular Letter no. 19 (2008), november 20, 2008; see
Eric Dinallo, Testimony Before the house of
Representatives Committee on Agriculture, hearing to Review the Role of Credit Derivatives in the u.s. economy, november 20, 2008. 2. n.Y. Ins. Dept. Circular Letter no. 19 (2008), 7,
september 22, 2008.
3. n.Y. Ins. Dept. First supplement to Circular Letter no. 19 (2008), november 20, 2008; see
Eric Dinallo, Testimony Before the house of
Representatives Committee on Agriculture, hearing to Review the Role of Credit Derivatives in the u.s. economy, november 20, 2008. 4. Id.
5. In the case of life insurance, the beneficiary is entitled to the entire contract amount upon the death of the insured, i.e., loss to the insured is presumed.
6. These terms (“Reference entity” and “obligation”) are defined in the 2003 IsDA Credit Derivatives Definitions, as are the terms “Credit event,” “Reference obligation” and “Deliverable obligation” used elsewhere in this article.
7. n.Y. Ins. Dept. op. off. Gen. Couns., 2000 nY Insurance GC opinions LeXIs 144, *2, June 16, 2000.
8. Because the notional amount of outstanding CDs Transactions far exceeds the amount of outstanding Deliverable obligations, physical settlement by all CDs Buyers is not feasible. market participants, under the auspices of the International swaps and Derivatives Association, Inc., have developed a protocol methodology whereby the adhering parties amend their agreements to provide for cash settlement and an auction process to determine the cash settlement final price.
9. For example, an investor who wants to take five-year (or longer) exposure to a particular issuer would be able to do that through a CDs Transaction even if the issuer has outstanding only a three-year credit facility and commercial paper. Conversely, if the issuer has only long-term bonds outstanding, an investor could use CDs to take shorter term exposure. A CDs Transaction can be effected at a time when a cash bond of the Reference entity of a particular maturity is not available.
10. As discussed below, the definition of CDs in section 6901(j-1) of the new York Insurance Law includes the proviso that “such agreement does not constitute an insurance contract and the making of such credit default swap does not constitute the doing of an insurance business.” n.Y. Ins. Law §6901(j-1) (mcKinney 2004). 11. See n. 19, infra.
12. n.Y. Ins. Law §1401(a)(18) (mcKinney 1984). 13. Commodities exchange Act, 7 u.s.C. §1(a)(12)
(1936), defines an “eligible contract participant” as: 1. a financial institution; 2. a regulated insurance company, foreign or domestic; 3. a regulated investment company, foreign or
domestic; 4. a regulated commodity pool with total assets in excess of $5,000,000, foreign or domestic; 5. a corporation, partnership, proprietorship, organization, trust, or other entity: a) that has total assets exceeding $10,000,000; b) the obligations of which under the agreement, contract, or transaction are guaranteed or otherwise supported by certain entities (but not by individuals); c) that has a net worth exceeding $1,000,000 and that enters into the agreement, contract, or transaction in connection with the conduct of its business or to manage the risk associated with an asset or liability owned or incurred in the conduct of its business; 6. a certain type of an eRIsA plan, foreign or domestic; 7. a certain type of a governmental entity, foreign or domestic; 8. a broker-dealer (other than an individual) registered under the exchange Act; 9. a futures commission merchant subject to regulation under the CeA; 10. a floor broker or floor trader subject to regulation under the CeA; and 11. an individual who has total assets in an amount in excess of a) $10,000,000; or b) $5,000,000 and who enters into the agreement, contract, or transaction in order to manage the risk associated with an asset owned or liability incurred, or reasonably likely to be owned or incurred, by the individual.
14. securities Act §2A. (b)(2), 15 u.s.C. 77b et seq. added by §302 of Commodities Futures modernization Act of 2000, h.R. 4577, 106th Cong. (2000).
15. exchange Act §3A.(b)(1), 15 u.s.C. 78c et seq. added by §303 of Commodities Futures modernization Act of 2000.
16. Graham-Leach-Bliley Act, §206B, added by § 301(a) of Commodities Futures modernization Act of 2000.
17. specifically, see securities Act of 1933, 15 u.s.C §77(a) et seq., § 17(a) (anti-fraud provisions), paragraphs (2) through (5) (anti-manipulation and anti-fraud provisions) and securities exchange Act of 1934, 15 u.s.C. §78(a) et seq., §§ 9(a), 10(b) (adding security-based swap agreement to anti-manipulation provisions), 15(c)(1) (adding security-based swap agreement to anti-fraud provisions), 20(d) (adding security-based swap agreement to insider trading provisions) and 21A(a)(1) (including security-based swap agreements in the civil penalty provisions).
18. See Circular Letter, supra note 1, “Best practices for financial guaranty insurers,” at page 1,
noting that FGIs that are not legally domiciled in new York are licensed to issue financial guaranty insurance under Article 69 of the new York Insurance Law.
19. FGIs, known as “monolines,” are only permitted to issue financial guaranty insurance policies and are not permitted to enter into other types of transactions. Therefore, in order to assume the economic risk of a CDs seller, an FGI typically would create a special purpose bankruptcy-remote entity, referred to as a “transformer,” that would act as the CDs seller, and the FGI then would issue a financial guaranty insurance policy to guarantee the performance of the transformer to the CDs Buyer.
20. See n.Y. Ins. Dept. op. off. Gen. Couns., september 24, 1997 (the “ 1997 oGC opinion Letter”).
21. The nYs Insurance Department required that the FGI meet certain requirements, including that the FGI use its customary underwriting criteria, that the CDs tenor not exceed five years, and that the referenced security be rated at least investment grade.
22. n.Y. Ins. Dept. op. off. Gen. Couns., April 8, 1999 (the “1999 oGC opinion Letter”).
23. n.Y. Ins. Law §6901 (mcKinney 2005).
24. n.Y. Ins. Law §6901 (j-1) (mcKinney 2005) (emphasis added).
25. See Circular Letter, supra note 1.
26. n.Y. Ins. Law §1101(a)(1) (mcKinney 2003). 27. Catastrophe options opinion, dated June 25,
1998, p. 2.
28. Index swap Transaction opinion, dated June 26, 1998, p. 1. That letter stated: “In order for an Index swap (or other derivative) to constitute an insurance contract, it must obligate the index payer (as insurer) to indemnify the Fixed Rate Payment Payer (as insured) for the actual loss incurred by the Fixed Rate Payment Payer. Indemnification of loss is an essential indicia of an insurance contract which courts have relied upon in the analysis of
whether a particular agreement is an insurance contract under new York law. Absent such a contractual provision the instrument is not an insurance contract.” Id. at 2.
29. n.Y. Ins. Dept. op. off. Gen. Couns., February 15, 2000 (the “2000 oGC opinion Letter”). 30. See n.Y. Ins. Dept. op. off. Gen. Couns., supra
note 6.
31. See, e.g., 1997 oGC opinion Letter; 1999 oGC opinion Letter; and 2000 oGC opinion Letter. 32. See Circular Letter, supra note 1, at 5; see n.Y.
Ins. Dept. op. off. Gen. Couns., supra note 6. 33. eric Dinallo, Testimony before the senate
Committee on Agriculture, nutrition and Forestry, october 14, 2008.
34. Id.
35. “no contract or policy of insurance…shall be enforceable except for the benefit of some person having an insurable interest in the property insured.” n.Y. Ins. Law §3401 (mcKinney 1985). “Insurable interest shall include any lawful and substantial economic interest in the safety or preservation of property from loss, destruction or pecuniary damage.” Id.
36. “PwG Policy objectives”, www.treasury.gov/ press/releases/reports/policyobjectives.pdf, november 14, 2008.
37. memorandum of understanding between the Board of Governors of the Federal Reserve system, the u.s. Commodity Futures Trading Commission and the u.s. securities and exchange Commission Regarding Central Counterparties for Credit Default swaps, november 14, 2008. 38. Id. at 1-2.
39. See I.R.s. Bulletin 2004-32 (August 9, 2004) (requesting comments on u.s. tax treatment of CDs and discussing how some commentators have distinguished CDs from insurance). 40. See new York state Bar Association, Tax Section
Comments on Credit Default Swap Rules,
