Credit Default Swaps: Lessons From Two Recent Decisions. New York Law Journal. January 5, 2009.
By Keith Miller and Kevin Broughel
Reprinted with permission from the January 5, 2009 edition of the New York Law Journal. © 2009 Incisive US Properties, LLC. All rights reserved. Further duplication without permission is prohibited.
A credit default swap (CDS) is a derivative contract between two parties designed to hedge against the risk of default of a debt instrument or loan.1 In a typical CDS, one party (the credit protection seller) receives a premium for agreeing to pay a sum of money to another party (the credit protection buyer) if a "credit event" or default occurs in a referenced obligation. Almost completely unregulated, CDSs do not typically require that the buyer of protection own the underlying debt instruments; nor do they typically require that the credit protection seller have adequate reserves to cover any payments when the protection is called.2 Thus, the parties to CDS contracts take significant risk relating to the creditworthiness of their counterparty. Protection claims can be sizeable and if they are not timely settled can have drastic consequences to a counterparty and to the counterparty's creditors, potentially causing a chain reaction.
With the credit crisis now in full swing, CDSs have moved to the forefront of the financial litigation landscape, with current estimates placing the total value of the CDS market at roughly $60 trillion.3 The rapid market downturn has resulted in recent defaults on numerous debt instruments, with subsequent auctions held to determine settlement amounts, including several important auctions in October and November 2008 for CDSs referencing obligations of Lehman Brothers, Fannie Mae, Freddie Mac, Washington Mutual and Landsbanki.4
As a result of the settlement process, credit protection buyers are now calling upon credit protection sellers to settle their contractual payment obligations. However, credit protection sellers who had written large amounts of swaps on this type of debt may not be able, or willing, to make credit protection payments on what could be enormous claims.5 This has spawned a number of lawsuits as banks and hedge funds are now seeking to recoup losses on CDSs tied to failed financial institutions.6 Two recently decided cases provide helpful guidance on how courts approach disputes involving CDS agreements, and what parties to these agreements might expect when litigating such claims.
In VCG Special Opportunities Master Fund Limited v. Citibank, N.A.,7 hedge fund plaintiff VCG and defendant Citibank entered into a CDS contract where VCG sold Citibank credit protection against the risk of default on Class B Notes issued by a collateralized debt obligation8 called Millstone III CDO Ltd. III-A. In return for periodic fixed payments, VCG agreed to pay Citibank a "Floating Payment" if certain "Floating Amount Events" (credit events) occurred during the term of the CDS contract. VCG also agreed to deposit collateral at the time of execution of the CDS contract to secure Citibank in the event that VCG was unable to make payment if called upon.
After executing the CDS contract, Citibank demanded at various times additional collateral from VCG based upon the downward movement in the daily "mark-to-market value"9 of the Class B Notes. Although VCG questioned Citibank's evaluation of the credit risk of the Class B Notes, and whether the CDS contract allowed for Citibank to demand additional collateral, VCG paid the sums requested.
Eventually, Citibank sent VCG an event of default notice stating that an "implied writedown" had occurred with respect to the Class B Notes, and demanded a corresponding credit protection payment amount of $10 million. VCG disputed Citibank's assertion that an event of default had taken place, on the basis that the CDS contract did not give Citibank the right to demand credit protection payments based upon an "implied writedown" of the Class B Notes.
After Citibank terminated the CDS contract based on VCG's refusal to pay, VCG sued Citibank for breach of contract, rescission, unjust enrichment, and breach of the implied covenant of good faith and fair dealing. VCG also sought a declaratory judgment determining whether Citibank improperly demanded additional collateral and improperly declared an event of default. Citibank, in turn, moved for judgment on the pleadings pursuant to Rule 12(c) of the Federal Rules of Civil Procedure.
The issue the court, in the Southern District of New York, had to grapple with was whether Citibank properly exercised its rights under the implied writedown provision in the CDS contract. Pursuant to the CDS contract, an event of default was triggered by (1) a failure to pay principal, (2) an interest shortfall, or (3) a writedown. The court observed there was no real dispute that an "implied writedown" constituted a writedown under the CDS contract. However, the CDS' terms stated that if the reference obligation's "Underlying Instruments" (i.e., the Indenture) provided for writedowns of the Class B Notes, the implied writedown would be zero. If the Indenture did not provide for writedowns of the Class B Notes, Citibank, as Calculation Agent, could determine an implied writedown amount. VCG argued that the Indenture provided for writedowns of collateral that were "passed on" to the Class B Notes. In response, Citibank argued that there was no "serious dispute" that the Indenture did not provide for express writedowns of the Class B Notes, and therefore Citibank properly determined the implied writedown amount.
After closely examining the language of the Indenture, the court, in the Southern District of New York, held that the "written down amount" referred to in the Indenture did not involve the Class B Notes. According to the court, "VCG confuse[d] the CDO's assets (the securities it owns) with its liabilities (the securities it issues)." Moreover, the court dismissed VCG's argument that writedowns of the collateral assets owned by the Millstone III CDO were the equivalent of writedowns on the Class B Notes, because "deterioration in the CDO's collateral assets and any payment shortfalls [would] not result in any writedown of the principal amount of the [Class B Notes], which is the type of writedown contemplated under the CDS Contract."
As for VCG's claim that Citibank improperly demanded additional collateral, the court held that the CDS contract clearly permitted Citibank to do so. Even if, as VCG argued, there was some sort of inconsistency within the CDS' terms, VCG waived its claim by posting the collateral and continuing to collect Citibank's periodic fixed payments. Additionally, the terms of the CDS contract contained an alternative dispute resolution provision "to challenge Citibank's Exposure determinations or demands for additional collateral." The court rejected VCG's claim that invoking the provision would have been "meaningless" because the parties were still in ongoing discussions about posting additional collateral when the event of default had occurred. Citing New York's public policy in favor of alternative dispute resolution, the court held VCG should have first invoked the alternative dispute resolution mechanism of the CDS contract before challenging through litigation Citibank's request for additional collateral.
On VCG's rescission claim, the court did not find credible VCG's claim of unilateral mistake because it allegedly believed "it was agreeing to sell credit protection on a credit default swap and not to take the risk of daily mark-to-market movement in the value of the reference obligation." First, the court held that the language of the CDS contract made clear that Citibank could request additional collateral depending on Citibank's calculation of its exposure. Second, the court observed that VCG was a sophisticated hedge fund and hence its rescission claim would not stand. In light of the court's conclusion that VCG could not state a claim for rescission, the court held that VCG's unjust enrichment and conversion claims failed as being duplicative of its breach of contract claim.
Finally, while the court acknowledged a breach of the implied duty of good faith and fair dealing claim could exist independently from a breach of contract claim, it dismissed the action. With regard to the additional collateral issue, the court held that VCG waived its claim by posting the requested collateral and continuing to accept Citibank's payments. Concerning Citibank's role as Calculation Agent, the court found that VCG failed to assert specific facts of Citibank's alleged arbitrary or irrational exercise of its discretion under the CDS contract. Thus, the court granted Citibank's motion for judgment on the pleadings.
In contrast to VCG, in Merrill Lynch International v. XL Capital Assurance Inc.,10 it was the plaintiff credit protection buyer Merrill Lynch International (MLI) that sought judicial relief. MLI entered into seven separate CDS contracts with defendant XL Capital Assurance Inc. (XLCA) on certain CDOs. MLI owned both the A-1 and A-2 super senior tranches of the CDOs but only purchased credit protection on the A-2 tranche. In a somewhat unusual arrangement, XLCA, as credit protection seller, obtained exclusive "controlling class" voting rights with respect to the A-1 tranche although it was only insuring the A-2 tranche.
In a separate transaction, MLI subsequently entered into six distinct CDS contracts with a third-party credit protection seller, with MBIA acting as financial guarantor. The subject of the MBIA CDS contracts were the A-1 notes of six of the seven CDOs of the XLCA swaps. The MBIA contracts contained a provision requiring MLI to exercise certain voting rights with respect to the A-1 notes according to MBIA's written instructions. When XLCA became aware of this fact, it sent MLI six termination notices corresponding to the six CDOs that were the subject of the MBIA CDS contracts.
In the termination notices, XLCA concluded that MLI had "repudiated its contractual obligations," thereby triggering an event of default entitling XLCA to exercise its termination rights under the CDS agreements. MLI brought a declaratory relief action, seeking a declaration that it had not anticipatorily breached its contracts with XLCA, and that XLCA remained bound under the swaps. XLCA in response asserted counterclaims against MLI including, among other claims, declaratory relief and breach of contract. MLI then moved for summary judgment.
The court, in the Southern District of New York, found in favor of MLI, holding that XLCA's belief that MLI was unable to perform under its CDS contracts with XLCA "[did] not square with the plain language either of the XLCA swaps or of the MBIA swaps." Regarding the XLCA contracts, the court held that the contracts did not grant controlling class voting rights unconditionally to XLCA. Rather, the express terms allowed MLI to refuse to vote in accordance with XLCA's wishes, although that refusal would mean that MLI would lose the credit protection it bargained for and force MLI to provide XLCA with certain "make-whole payments." As for the MBIA CDS contracts, the court stated that "the plain text of those contracts expressly qualified MLI's obligations to obey MBIA's instructions where doing so would conflict with MLI's obligations due to other agreements." In short, the court held that when reading the plain language of all of the agreements together "MLI fully retained the ability to abide by XLCA's voting instructions. While doing so might trigger a termination event in MLI's other agreements (the MBIA swaps), the choice to trigger the termination event remain[ed] MLI's."
Regarding the seventh unrelated swap, XLCA claimed it was entitled to termination because "MLI's conduct with respect to the other six CDS contracts allegedly gave XLCA reason to doubt MLI's intent to perform," and because XLCA had sought, but did not receive, adequate assurances of performance from MLI within a reasonable time. In response, the court made three separate points. First, it was erroneous for XLCA to view MLI's conduct pertaining to the other six CDS contracts as a basis for nonperformance, since the court found that XLCA had no grounds in the first case to issue the termination notices for the other six CDS contracts.
Second, the court noted it was far from clear whether the doctrine of adequate assurance even applied in a credit default swap context, since its application outside of the Uniform Commercial Code (UCC) was limited to contracts "closely analogous to one for the sale of goods." Accordingly, the court declined to extend the doctrine to the case before it. Finally, the court determined that even if the doctrine was applicable, the written assurances that MLI gave to XLCA were sufficient and within a reasonable time.
The foregoing cases highlight a number of important lessons for parties that may find themselves embroiled in CDS disputes. First, while recently it has been a "buyer's market" for CDS litigations, with courts finding in favor of the credit protection buyer, one must be careful to avoid the sweeping conclusion that the credit protection buyer will enjoy an advantage in litigation over the credit protection seller. No matter which side of the equation a CDS party finds itself on, the decisions demonstrate that courts are somewhat reluctant to consider extrinsic evidence when faced with language that may arguably be viewed as clear and unambiguous. Accordingly, arguments that the court must permit further discovery or consider extrinsic evidence beyond the four corners of the relevant agreements have thus far failed.11 These include assertions that a party was not conducting itself in a commercially reasonable manner or acting in accordance with industry standards.12 Therefore, CDS parties in certain cases should expect to resolve litigation based on the documentary evidence without resorting to lengthy fact discovery or expert testimony.
Second, if a party has any doubt as to whether its counterparty is properly exercising its rights under a CDS agreement, that party should swiftly act to take appropriate measures, contractual or otherwise, to protect its rights, even if that party fears being in technical breach of its obligations. Failure to do so may operate as a waiver, barring a party from enforcing contractual provisions for its benefit, even if the counterparty has breached. However, care must be taken to closely adhere to any contractual directives designed to resolve disputes prior to initiating action. As VCG illustrates, failure to invoke such alternative dispute resolution provisions could prohibit a claim in future litigation.
Third, there is substantial doubt, at least in New York, as to whether the doctrine of adequate assurance applies when a party believes its counterparty may no longer perform or be unable to perform under the CDS agreement. Although the aggrieved party may seek adequate assurances from the repudiating party, a failure to respond may be meaningless in light of XL Capital, which strongly suggests the doctrine would not apply to cases in the credit default swap arena.
Fourth, courts will likely be unsympathetic to any claims or defenses where a CDS party alleges it did not understand what it was bargaining for. Allegations of an imbalance between the sophistication of the parties will be closely scrutinized and likely rejected. While there is no doubt that CDS transactions involve complex, intertwining agreements, they are also by and large the product of comprehensive negotiations between sophisticated financial institutions, and courts will be loath to rescind or reform an agreement in this context.
Finally, any party to a CDS transaction must remember to continually examine every document carefully, including those "underlying" agreements of the reference obligation and reference entity at issue, to fully understand how and when contractual obligations are triggered. Neglecting to do so may result in exposing oneself to unnecessary litigation and financial risk, whether by breaching the agreement or failing to understand the credit risk one is being exposed to.
Keith Miller is co-chair of the subprime mortgage and credit crisis group and a partner in the securities litigation and enforcement group at Paul, Hastings, Janofsky & Walker. Kevin Broughel is an associate in the firm's litigation department. They are resident in the firm's New York office.
1. See generally Allison Taylor and Alicia Sansone, THE HANDBOOK OF LOAN SYNDICATIONS AND TRADING 742-43 (2007).
2. Although largely unregulated, both federal and state agencies are currently investigating the CDS market, and the SEC is working on a disclosure regime designed to "improve transparency" for CDSs. See Vikas Bajaj, "Joint U.S.-New York Inquiry Into Credit-Default Swaps," N.Y. TIMES, Oct. 20, 2008, available at
3. See Steve Kroft, "A Look at Wall Street's Shadow Market," 60 MINUTES (Oct. 5, 2008); Alan Rappeport, "Systemic Risk Haunts Credit-Default Swaps," CFO MAGAZINE, Sept. 18, 2008, available at
5. See Gabrielle Stein, "CDS Disputes Rise Amid Slew of Structured Finance Litigation," ASSET SECURITIZATION REPORT, Nov. 3, 2008.
6. See, e.g., Gsef Al Nawras (Cayman) Ltd. v. Lehman Brothers OTC Derivatives Inc., Case No. 08-CV-8487 (SDNY filed Oct. 3, 2008); Fir Tree Value Master Fund, L.P. et al. v. Lehman Brothers Special Financing Inc., (N.Y. Sup. Ct. filed Oct. 3, 2008).
7. No. 08-CV-01563 (BSJ), 2008 WL 4809078 (SDNY Nov. 5, 2008).
8. A collateralized debt obligation (CDO) is "a structured repackaging vehicle that issues multiple classes of liabilities created from a pool of assets (the collateral pool)." Many recent CDOs were secured by subprime residential mortgage-backed securities. See generally Allison Taylor and Alicia Sansone, THE HANDBOOK OF LOAN SYNDICATIONS AND TRADING 711 (2007).
9. "Mark-to-market" value means pricing an asset based on its market price. The SEC has recently undertaken a study of "mark-to-market" accounting, which includes considering the impact such accounting had on the bank failures of 2008. See "SEC Commences Work on Congressionally Mandated Study on Accounting Standards" (Oct. 7, 2008), available at
10. 564 F.Supp.2d 298 (SDNY 2008).
11. VCG Special Opportunities Master Fund Ltd. v. Citibank, N.A., 2008 WL 4809078, at *7 (rejecting argument that complaint presented questions that could only be resolved by discovery and expert testimony at trial); Merrill Lynch Int'l v. XL Capital Assurance Inc., 564 F.Supp.2d at 306, n.10 (refusing to consider extrinsic evidence such as e-mail exchanges and financial performance).
12. 2008 WL 4809078, at *8 (dismissing argument that defendant did not calculate "Floating Payment Amount" in commercially reasonable manner); 564 F.Supp.2d at 306, n.11 (expressing no opinion as to whether plaintiff's conduct with respect to swaps was standard in industry).