Comparing Credit Default Swaps to Insurance Contracts

REPRINT ARTICLE The Journal on the Law of Investment & Risk Management Products Futures & Derivatives LawREPORT to CDS … .” York New Law of Insurance application its indefinitely “delay would department ance did constitute insurance contracts, the insur swaps default credit certain stating although that, time this announcement, another made department the 2008, 20, November On contracts. insurance as swaps credit default certain regulating be would it that announced York Insurance of New Department State the 2008, 22, September On stein Sandler, PC. Lowen- Counsel, are Singer M. Adam and Magidson Matthew Firm; the of Member a Venokuris Sherri By SherriVenokur,Matthew Magidson,andAdamM.Singer Get ItRight? Insurance Department Did theNew York State Contracts: Swaps toInsurance Comparing Credit Default fault swaps as insurance. It will describe describe will de- It insurance. as credit swaps fault certain categorized properly has Insurance of Department State York New the whether discuss will article This lation ofcreditdefaultswapsasinsurance. fications of the insurance department’s regu- rami- consequent and scope anticipated the with struggled market swap default credit vast the in participants market various the and associations trade committees, ciation asso- bar announcements, two the between 1 During the two-month period - CONTINUED ONPAGE 3 fault swapsandinsurance. de- credit between differences the forth set then and insurance, not are swaps default credit that view market the discuss ance, Insur of Department YorkState New the by rulings various under and 2000 Modernization of Act Futures Commodity the under agreements” swap “security-based as both swaps, default credit of treatment how it is documented, cover the regulatory and participants market financial by used is it how product, swap default credit the thomson.com www.west. visit please publication this Reuters/West. For more information about Law Report. Copyright © 2008 Thomson Reprinted from the Futures & Derivatives Article December 2008

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n Volume 28 n Issue11 - Futures & Derivatives Law Report

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Editorial Board Rhett Campbell Donald L. Horwitz Glen A. Rae Thompson & Knight LLP One Chicago Banc of America Securities LLC Stephen W. Seemer Houston, TX Chicago, IL New York, NY Publisher, Thomson/Legalworks ANDREA M. CORCORAN Philip McBride Johnson Kenneth M. Raisler Carrie A. Petersen Promontory Financial Group Skadden Arps Slate Meagher & Flom Sullivan & Cromwell Publication Editor, Thomson/West Washington, D.C. Washington, D.C. New York, NY Richard A. Miller W. Iain Cullen Dennis Klejna Richard A. Rosen Editor-in-Chief, Prudential Financial st Simmons & Simmons MF Global Paul, Weiss, Rifkind, Wharton & Garrison LLP 751 Broad Street, 21 Floor, Newark, NJ 07102 London, England New York, NY New York, NY Phone: (973) 802-5901 Fax: (973) 802-2393 E-mail: [email protected] Warren N. Davis Robert M. McLaughlin Kenneth M. Rosenzweig Sutherland Asbill & Brennan Katten Muchin Rosenman Katten Muchin Rosenman Michael S. Sackheim Washington, D.C. New York, NY Chicago, IL Managing Editor, Sidley Austin LLP 787 Seventh Ave., New York, NY 10019 Susan C. Ervin Charles R. Mills Thomas A. Russo Phone: (212) 839-5503 Dechert LLP Kirkpatrick & Lockhart Lehman Brothers Fax: (212) 839-5599 Washington, D.C. Washington, D.C. New York, NY E-mail: [email protected] Ronald H. Filler David S. Mitchell Howard Schneider PAUL ARCHITZEL Lehman Brothers Fried, Frank, Harris, Shriver & Jacobson LLP MF Global Alston & Bird New York, NY New York, NY New York, NY Washington, D.C. Edward H. Fleischman Richard E. Nathan Stephen F. Selig Geoffrey Aronow Linklaters Los Angeles Brown Raysman Millstein Felder & Steiner LLP Heller Ehrman LLP New York, NY New York, NY Washington, D.C. Paul J. Pantano Denis M. Forster McDermott Will and Emery Paul Uhlenhop Conrad G. Bahlke New York, NY Washington, D.C. Lawrence, Kamin, Saunders & Uhlenhop OTC Derivatives Editor Chicago, IL Weil, Gotshal & Manges Thomas Lee Hazen Frank Partnoy New York, NY University of North Carolina at Chapel Hill University of San Diego Emily M. Zeigler School of Law Willkie Farr & Gallagher New York, NY

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Introduction tions by using examples and terms from the insurance context: the buyer makes premium payments Circular Letter No. 19 (2008) (the “Circular Let- to the seller and receives a payment from the seller ter”), issued by the New York State Department of if a covered event occurs. Historically, however, Insurance (the “NYS Insurance Department”) on the two products have been distinguished by the September 22, 2008, outlines “best practices” for fact that insurance requires the buyer to have an financial guaranty insurers and includes specific “insurable interest” in the subject of the insurance, recommendations regarding the provision by fi- e.g., the house or car, as well as proof of loss in- nancial guaranty insurers of policies covering their curred by virtue of the occurrence of the covered affiliates’ payment obligations under credit default event.5 CDS Transactions do not require the buyer swap (“CDS”) transactions (“CDS Transactions”). to have an interest in the Reference Entity or an In the Circular Letter, the NYS Insurance Depart- Obligation of the Reference Entity6 and, thus, do ment stated that a CDS Transaction “is an insur- not condition the seller’s payment to the buyer ance contract when it is purchased by a party who, upon the buyer’s proof of loss by virtue of the oc- at the time at which the agreement is entered into, currence of a Credit Event. For this and other rea- holds, or reasonably expects to hold, a ‘material sons — undoubtedly including an understandable interest’ in the referenced obligation.”2 reluctance on the part of the NYS Insurance De- Two months later, on November 20, 2008, the partment to assume responsibility for regulating a NYS Insurance Department issued a First Sup- global financial product — the NYS Insurance De- plement to Circular Letter 19 (2008) (the “First partment’s Office of General Counsel (“OCG”) is- Supplement”), stating that the NYS Insurance sued an opinion, dated June 16, 2000, stating that Department would “delay indefinitely its appli- a CDS Transaction is not insurance if the seller’s cation of New York Insurance Law to CDS … payment to the buyer “is not dependent upon the .”3 According to the First Supplement, the NYS buyer having suffered a loss … .”7 Insurance Department’s decision to refrain from Given the current market turmoil and the blame regulating CDS at this time is based on the initia- that the CDS product has taken for the near col- tives announced on November 14, 2008, by the lapse of the global financial markets, it is not President’s Working Group on Financial Markets surprising that the NYS Insurance Department “to strengthen oversight and transparency and to stepped in to fill what was perceived as a regula- create a centralized market infrastructure for the tory vacuum with respect to CDS Transactions. over-the-counter derivatives market, including At this time, there seems to be unanimous agree- credit default swaps … .”4 ment among the Federal Reserve, the Securities NYS Insurance Department Superintendent and Exchange Commission and the Commodities Eric Dinallo, however, has not retreated from his Futures Trading Commission, as well as the NYS view, as stated in the Circular Letter, that a CDS Insurance Department, that regulation of CDS Transaction is an insurance contract when the Transactions should be at the federal level. buyer has or expects to have a material interest in the subject of the transaction. This statement Credit Default Swap Basics represents both an expansion of the common un- A credit default swap is a bilateral contract derstanding of what constitutes insurance and a between a buyer of protection (“Buyer”) and a reversal of how prior NYS Insurance Department seller of protection (“Seller”) with respect to an opinions have been interpreted by the market- obligation (usually a bond or loan) of a particular place. entity, called the Reference Entity. The Buyer pays Admittedly, CDS Transactions and insurance a periodic fee to the Seller, and, if a certain speci- contracts are very similar, and most newspaper and fied “Credit Event” occurs, then the Seller is re- magazine articles attempt to explain CDS Transac- quired to make a payment to the Buyer by means

of either physical settlement or cash settlement. ing perceived pricing inefficiencies in the capital In a physical settlement transaction, the Buyer de- structure of an issuer or between issuers; and (D) livers to the Seller an obligation of the Reference managing regulatory capital requirements (and Entity that has certain specified characteristics (a potentially taking advantage of different capital “Deliverable Obligation”) in exchange for the requirements for banks versus insurance compa- face amount of the Deliverable Obligation.8 In a nies). In addition, a CDS Buyer may be seeking to cash settlement transaction, the payment from the terminate or offset another trade on the same or Seller to the Buyer is the difference between the similar Reference Entity or Reference Obligation face amount of the Reference Obligation and its that it entered into as Seller, if the cost to termi- current market value. nate the first trade would exceed the present value CDS Transactions are documented using stan- of the future premium payments on the second dardized contracts and incorporating definitions trade (the same is also true for a CDS Buyer enter- published by the International Swaps and De- ing into a second trade as CDS Seller). rivatives Association, Inc. (“ISDA”). Most CDS Of all the additional uses of CDS Transactions Transactions are evidenced by an ISDA-based con- noted above, only the diversification of credit ex- firmation, which incorporates the ISDA Master posure is a substitute for financial guaranty insur- Agreement entered into between the parties and ance.10 Banks also participate in the CDS market the 2003 ISDA Credit Derivatives Definitions. by entering into client facilitation trades with their customers. When a customer wishes to buy How Market Participants Use Credit CDS protection, the bank may enter into a CDS Default Swaps Transaction as Seller in order to facilitate the customer’s strategy. Parties may enter into CDS Transactions to gain CDS Transactions are natural investments for or reduce exposure to credit risk. Credit exposure leveraged entities, such as hedge funds. Unlike a can be gained by the Seller of CDS protection with- bond issued by a Reference Entity, a CDS Trans- out the initial cash outlay required when purchasing action is intrinsically leveraged because it does not a bond or making a loan. In addition, a CDS Buyer require initial funding. Hedge funds make up a sig- can reduce exposure to a credit risk without actu- nificant portion of the CDS Market, utilizing CDS ally selling the relevant loan or bond. This unique Transactions to maximize returns and to manage feature of CDS allows banks to purchase CDS pro- portfolio risk. Insurance companies participate in tection in order to reduce their exposure to certain the CDS market through non-insurance company borrowers or industries without jeopardizing their subsidiaries (“transformers”11) and through what customer relationships. For example, if a bank cus- are called “Replication” transactions. Replication tomer requests a $100,000,000 loan, and the bank transactions are derivatives transactions entered is only willing to assume $50,000,000 in credit ex- into for the purpose of reproducing the investment posure to its customer, then, instead of referring the effects of otherwise permissible investments.12 customer to a competitor or syndicating the loan, A CDS Transaction entered into for any of these the bank could loan the entire $100,000,000 to its purposes could fall within the Circular Letter’s def- customer and buy CDS protection on the loan as inition of insurance if the CDS Buyer happens to the Reference Obligation in the Notional Amount own the asset that is the subject of the transaction. of $50,000,000. As the CDS market developed, its uses expand- Regulation of CDS ed to include: (A) obtaining increased access to credit markets (bonds and loans are limited to the Federal Regulation of CDS actual amount issued or borrowed by the underlying credit, but CDS has no parallel limitation); (B) The Commodity Futures Modernization Act the creation of new kinds of credit exposure not of 2000 (the “CFMA”) creates a “safe harbor” otherwise available in the market9; (C) arbitrag- for CDS Transactions that preempts state and lo-

cal gaming and bucket shop laws (other than any Insurance Department allowed (with certain re- generally applicable anti-fraud provisions thereof) quirements) FGIs to guarantee the CDS payment and exempts most CDS Transactions from regula- obligations of their affiliated “transformer”19 en- tion by the Commodity Futures Trading Commis- tities. In 1997, the NYS Insurance Department sion (“CFTC”). CDS Transactions are expressly exempted from regulation by the CFTC so long confirmed that an FGI may provide a financial as the contracts are not executed or traded on a guaranty policy with respect to the CDS payment trading facility and are between “eligible contract obligations of an affiliated transformer resulting participants”13 (including, most notably, financial from the bankruptcy of or payment default by the institutions, mutual funds, commodity pools, and issuer of the bond or other security referenced in entities with total assets in excess of $10 million). the CDS.20 The NYS Insurance Department deter- One could therefore conclude that when, in 2000, mined that the guaranty of the transformer’s ob- Congress considered the regulation of CDS Trans- actions, it determined that regulation was not re- ligations as CDS Seller was “substantially similar quired where each of the parties was either a regu- to a direct guarantee of the underlying obligation lated entity or met the specified financial tests. protected by the CDS, and thus permissible un- The CFMA effectively excludes CDS Transactions der Insurance Law § 6904(b)(1)(J).”21 The 1997 from the registration requirements of the Securities Opinion Letter did not address the status of early 14 Act of 1933, as amended (the “Securities Act”) termination payments under CDS Transactions and from the general provisions of the Exchange resulting from events of default or termination Act of 1934, as amended (the “Exchange Act”)15 events with respect to the transformer or the FGI because it clarifies that a swap based on a security is not a security. The CFMA introduced the term as guarantor. That clarification came in 1999, “security-based swap agreement,” to mean those when the NYS Insurance Department published swaps that derive at least one of their key terms another opinion clarifying that guarantees of ear- from the price, yield, maturity or volatility of a secu- ly termination payments “do not represent guar- 16 rity, group of securities or index of securities. CDS antees of acceleration payments prohibited under Transactions fall within the definition of “security- [Insurance Law] Section 6905 … .”22 based swap agreements” when the Reference Obli- The 1997 and 1999 opinions of the NYS In- gation or Deliverable Obligation is a security, i.e., a bond. The only provisions of the Securities Act surance Department formed the basis of the 2004 and the Exchange Act that apply to security-based amendment to Article 69 of the New York State swap agreements are the anti-fraud and anti-market Insurance Law, which modified the definition of manipulation provisions thereof.17 “asset-backed securities” (a permissible guarantee NYS Insurance Department category under Section 6904(b)(1)(F)) to include “a pool of credit default swaps or credit default Treatment of CDS swaps referencing a pool of obligations,” subject 23 Regulation of FGI Insurance to certain requirements. Therefore, if the CDS Policies on CDS itself does not constitute an insurance contract or the doing of an insurance business, then an FGI is The NYS Insurance Department regulates most permitted to issue an insurance policy that guar- of the nation’s financial guarantee insurance com- antees payments by a transformer or other party panies (“FGIs”).18 FGIs authorized to do business pursuant to such CDS. in New York must comply with various special- ized and highly technical requirements intended In addition, the amendment added to Insur- to safeguard their financial solvency for the ben- ance Law § 6901(j-1) the following definition for efit of their policyholders. Until recently, the NYS CDS:

“ ‘Credit default swap’ means an agreement Credit Event triggered under a CDS Transaction referencing the credit derivative definitions could constitute “the happening of a fortuitous published by the International Swap and event,” and the payment due from the Seller to Derivatives Association, Inc. or otherwise ac- the Buyer upon settlement of the CDS Transac- ceptable to the superintendent, pursuant to tion would be an obligation “to confer a benefit which a party agrees to compensate another of pecuniary value” upon the Buyer. The similari- party in the event of a payment default by, ties break down, however, when we examine the insolvency of, or other adverse credit event “material interest” component of the definition, in respect of, an issuer of a specified secu- because there is no requirement in a CDS Trans- rity or other obligation; provided that such action for the Buyer to have any interest whatso- agreement does not constitute an insur- ever that could be adversely affected by the Credit ance contract and the making of such Event. CDS Transactions do not require the Buyer credit default swap does not constitute to own or have any interest in the Reference En- 24 the doing of an insurance business.” tity or an Obligation of the Reference Entity. Another factor distinguishing a CDS Transaction The NYS Insurance Department’s recent diver- from an insurance contract is the absence of any re- sion from its previous position certainly narrows the quirement that the occurrence of the Credit Event scope of available protection under policies issuable cause the CDS Buyer to suffer a loss. By contrast, by FGIs. The Circular Letter states that it expects the term “insurance” contemplates that the insured FGIs will limit the risks it covers under its policies to or beneficiary has or expects to have a material in- “namely, only failure to pay obligations when due terest in the subject of the insurance, e.g., the house or payable when the failure is the result of a finan- or car, as well as proof of loss incurred by virtue cial default or insolvency.”25 Moreover, the NYS In- of the occurrence of a “fortuitous event.” For this surance Department’s categorization of certain CDS reason, the NYS Insurance Department concluded Transactions as insurance contracts may also mean in a 1998 opinion that certain catastrophe options that FGIs will not be authorized to issue policies were not subject to regulation as insurance because covering those CDS Transactions that fall within they did not obligate the option seller to indemnify the NYS Insurance Department’s expanded defini- the purchaser for actual losses incurred by the pur- tion of insurance. The language of the Circular Let- chaser.27 Similarly, that same year, the NYS Insur- ter also calls into question the continuing viability ance Department determined that an index swap of the NYS Insurance Department’s prior opinions transaction did not constitute insurance “unless the on the relationship between derivatives transactions terms of the instrument provide that … payment to and contracts of insurance. the Fixed Rate Payment Payer is dependent upon NYS Insurance Department that party suffering a loss.”28 Treatment of CDS Two years later, in 2000, the Office of General Counsel of the NYS Insurance Department is- In New York, an insurance contract is defined sued an informal opinion stating that weather as “any agreement or other transaction whereby derivatives are not insurance contracts because one party, the ‘insurer’, is obligated to confer a these derivatives contracts “do not provide that … benefit of pecuniary value upon another party, payment to the purchaser is dependant upon that the ‘insured’ or ‘beneficiary’, dependent upon the party suffering a loss.” The opinion states that “[n] happening of a fortuitous event in which the in- either the amount of the payment nor the trigger sured or beneficiary has, or is expected to have itself in the weather derivative bears a relationship at the time of such happening, a material interest to the purchaser’s loss. Absent such obligations, which will be adversely affected by the happening the instrument is not an insurance contract.”29 of such event.”26 Specifically with respect to CDS Transactions, Clearly, CDS Transactions and insurance con- the NYS Insurance Department concluded in an tracts share some of the same characteristics. A opinion dated June 16, 2000, that a CDS is not

an insurance contract because the Seller’s pay- Opinion Letter is incomplete and was never in- ment is not conditioned upon a loss incurred by tended to exempt “covered” CDS from insurance the Buyer.30 Based on the line of reasoning in the regulation.33 Dinallo testified: precedent opinions, the consistent position of the NYS Insurance Department has been abundantly Clearly, the question was framed to ask clear: Unless the seller’s payment obligation is only about naked credit default swaps based on actual loss incurred by the buyer, a de- with no proof of loss. Under the facts we rivatives contract is not insurance. 31 were given, the swap was not “a contract Nonetheless, the Circular Letter states that the of insurance”, because the buyer had no categorization of certain CDS Transactions as in- material interest and the filing of claim surance is not a reversal, but simply a clarifica- does not require a loss. But the entities in- tion, of its 2000 OGC Opinion Letter: volved were careful not to ask about covered credit default swaps. Nonetheless, the Although OGC’s June 16, 2000 opinion market took the Department’s opinion on suggests that a CDS is not an insurance a subset of credit default swaps as a ruling contract if the payment by the protection on all swaps and, to be fair, the Depart- buyer is not conditioned upon an actual pe- ment did nothing to the contrary.34 cuniary loss, that opinion did not grapple with whether, under Insurance Law §1101, The NYS Insurance Department has made a clear a CDS is an insurance contract when it is distinction between “naked” CDS — where the purchased by a party who, at the time at Buyer has no material interest in the underly- which the agreement is entered into, holds, ing entity or obligation — and “covered” CDS or reasonably expects to hold, a “material — where the Buyer either has or expects to have interest” in the referenced obligation.32 such a material interest. According to the NYS Superintendent Eric Dinallo in testimony before Insurance Department, “naked” CDS is not in- Congress reiterated his view that the 2000 OGC surance but “covered” CDS is insurance.

Market View That CDS Is Not Insurance Christopher Cox. The PWG’s goals are: (i) to im- prove market transparency and integrity for CDS, As discussed above, the NYS Insurance De- (ii) to enhance risk management of OTC deriva- partment’s opinions prior to the Circular Letter tives, (iii) to strengthen OTC derivatives market consistently held that swaps are not insurance un- infrastructure, and (iv) to continue cooperation less the swap contract conditions payment upon among regulators.36 a party’s actual loss. Because there is no require- In order to help streamline the regulatory pro- ment in a CDS Transaction that the Buyer actu- cess, promote consistent oversight, and enhance ally hold the Reference Obligation, the fact that a cooperation, the Board of Governors of the Fed- particular Buyer actually did hold the Reference eral Reserve System, the Securities and Exchange Obligation did not put the parties on notice that Commission and the CFTC` entered into a Memo- their contract might be viewed by the NYS Insur- randum of Understanding on November 14, 2008 ance Department as constituting insurance. In- (the “Memorandum”). Under the Memorandum, deed, there was no reason for the Seller to know the parties established a framework for coopera- whether the Buyer held the Reference Obligation tion, information sharing and consultation related and no requirement for the Seller to inquire. to the creation of central counterparties for CDS By contrast, as noted above, an insured cannot Transactions.37 Central counterparties would inter- obtain insurance unless he has an “insurable inter- pose themselves between CDS market participants est”35 in the subject of the insurance. In addition, and provide clearing and settlement services.38 an insured cannot collect under a policy without showing proof of loss, and any settlement with Differences Between CDS respect to the amount owed is determined by the and Insurance parties themselves. In addition to the differences already discussed, A significant portion of the CDS market is un- CDS Transactions and insurance contracts differ related to the protection of an asset owned by the in the way they are underwritten and taxed. The Buyer. Even under a CDS Transaction where the underwriter of an insurance policy evaluates the Buyer holds the Reference Obligation, the Buy- asset being insured, while the CDS Seller looks at er can sell the Reference Obligation at any time the creditworthiness of the Buyer as well as the without having to terminate the CDS Transac- market price of the CDS Transaction. An insur- tion and, if a Credit Event occurs with respect to ance premium is typically an annual amount that that Reference Obligations, collect a settlement is payable as agreed between the parties and is payment from the Seller. As noted in footnote subject to adjustment on a periodic basis (typi- 8 above, the amount of the settlement payment cally, annually) at the discretion of the insurer. generally is determined through a market-wide If the insured fails to make a required premium auction process, and the payment itself may not payment, the policy is cancelled by the insurer. In even come from the particular Seller. a CDS context, the parties agree to the duration The recent market turbulence, including the of the Transaction, which is generally a period of collapse of Lehman Brothers and Washington several years and which is specified in the CDS Mutual and the bailout of Bear Stearns, Fannie Transaction confirmation. The CDS premium Mae, Freddie Mac and AIG, has resulted in plans usually is paid quarterly and the premium rate re- for increased federal regulation of the over-the- mains constant throughout the term of the CDS counter derivatives markets in general and CDS Transaction. If the Buyer fails to make a required Transactions in particular. In March 2008, Presi- payment, the Seller has the right under the ISDA dent Bush created the President’s Working Group Master Agreement to terminate all outstanding on Financial Markets (the “PWG”) headed by Transactions (which may include other types of Treasury Secretary Henry Paulson and includ- derivatives transactions as well as other CDS ing Federal Reserve Chairman Ben Bernake and Transactions), obtain a close-out amount, and Securities and Exchange Commission Chairman pursue the Buyer for that amount. In addition,

because a CDS Transaction is for a set term, the to U.S. excise tax. Insurance premiums paid to Buyer has no legal right to terminate the trade; a foreign persons with respect to a U.S. risk are sub- CDS Buyer that no longer wants the trade either ject to excise tax. Market participants have distin- has to come to an agreement with the Seller re- guished CDS from insurance contracts subject to garding a termination price or, with the Seller’s excise tax because CDS does not require the Buyer consent, assign the trade to a third party. In either to suffer an actual loss and does not contemplate case, the termination payment may be payable by risk shifting or distribution,39 but commentators either Buyer or Seller depending upon the then have stated that certain CDS may be subject to current market value of the trade). U.S. excise tax if the contract requires the Buyer Upon the occurrence of an event constituting a to hold the underlying obligation.40 risk covered by the policy, the insured must show proof of his loss in order to receive payment. The Conclusion insurer also can resist payment to the beneficiary Even though, based on the First Supplement, it based upon a number of well-established defenses is unlikely that “covered” CDS will be regulated including, most notably, fraud. A defense to pay- as insurance by the NYS Insurance Department, ment based on fraud could be predicated, for ex- the First Supplement reiterates the determination ample, on the duty of the insured to make the re- by the NYS Insurance Department in the Circu- quired disclosures on the insurance application. There are no parallel defenses to payment with lar Letter, that “covered” CDS Transactions are respect to CDS Transactions because no such duty properly classified as insurance contracts. The exists between the parties to a CDS Transaction. If classification of “covered” CDS Transactions as a Credit Event occurs and the CDS Buyer follows insurance may have serious ramifications wheth- the procedures for settlement, the Seller must make er these transactions are ultimately regulated by payment on the CDS Transaction. Except in very the NYS Insurance Department or by a federal limited situations, a CDS Seller cannot argue that regulator. As discussed above, the Internal Rev- its Buyer failed to disclose material information enue Service taxes insurance payments differently or lied when negotiating the terms of the trade. In from CDS payments, and the Financial Account- fact, each party to a CDS Transaction expressly ing Standards Board may weigh in on this as well. acknowledges that it is not relying on any infor- Further, while two U.S. “eligible contract partici- mation provided by the other party and that it is pants” cannot invalidate their CDS Transaction, capable of evaluating the risks of the transaction. a non-U.S. CDS Seller might be able to avoid CDS Transactions and insurance contracts may making a settlement payment to its Buyer based also be subject to different tax regimes. In an in- on defenses that otherwise would not be available surance contract, the insurance settlement may to a CDS Seller but that are available to an in- not be taxed at all as the settlement is based on surer. At this point one can only guess at what the actual loss suffered and that loss may be equal consequences will flow from the NYS Insurance to the tax basis of the damaged property. The Department’s determination. amount of a CDS settlement payment is based on the difference between the current value of the NOTES Deliverable Obligation or Reference Obligation 1. n.Y. Ins. Dept. First Supplement to Circular and its Par Value, and the actual loss, if any, to Letter No. 19 (2008), November 20, 2008; see the Buyer is not relevant. The Buyer’s premium Eric Dinallo, Testimony Before the House of payment is treated differently as well: a company Representatives Committee on Agriculture, Hearing to Review the Role of Credit Derivatives purchasing insurance on an asset generally would in the U.S. Economy, November 20, 2008. be able to deduct the premium payment as a cost 2. N.Y. Ins. Dept. Circular Letter No. 19 (2008), 7, of doing business. A CDS Buyer may not be en- September 22, 2008. titled to a similar tax deduction. There is also the 3. n.Y. Ins. Dept. First Supplement to Circular question whether “covered” CDS will be subject Letter No. 19 (2008), November 20, 2008; see

Eric Dinallo, Testimony Before the House of domestic; 4. a regulated commodity pool with Representatives Committee on Agriculture, total assets in excess of $5,000,000, foreign Hearing to Review the Role of Credit Derivatives or domestic; 5. a corporation, partnership, in the U.S. Economy, November 20, 2008. proprietorship, organization, trust, or other 4. Id. entity: a) that has total assets exceeding 5. In the case of life insurance, the beneficiary is $10,000,000; b) the obligations of which under entitled to the entire contract amount upon the the agreement, contract, or transaction are death of the insured, i.e., loss to the insured is guaranteed or otherwise supported by certain presumed. entities (but not by individuals); c) that has a 6. These terms (“Reference Entity” and net worth exceeding $1,000,000 and that enters “Obligation”) are defined in the 2003S I DA into the agreement, contract, or transaction Credit Derivatives Definitions, as are the terms in connection with the conduct of its business “Credit Event,” “Reference Obligation” and or to manage the risk associated with an asset “Deliverable Obligation” used elsewhere in this or liability owned or incurred in the conduct article. of its business; 6. a certain type of an ERISA 7. N.Y. Ins. Dept. Op. Off. Gen. Couns., 2000 NY plan, foreign or domestic; 7. a certain type of Insurance GC Opinions LEXIS 144, *2, June 16, a governmental entity, foreign or domestic; 2000. 8. a broker-dealer (other than an individual) 8. Because the notional amount of outstanding registered under the Exchange Act; 9. a futures CDS Transactions far exceeds the amount of commission merchant subject to regulation outstanding Deliverable Obligations, physical under the CEA; 10. a floor broker or floor settlement by all CDS Buyers is not feasible. trader subject to regulation under the CEA; Market participants, under the auspices of the and 11. an individual who has total assets in International Swaps and Derivatives Association, an amount in excess of a) $10,000,000; or b) Inc., have developed a protocol methodology $5,000,000 and who enters into the agreement, whereby the adhering parties amend their contract, or transaction in order to manage the agreements to provide for cash settlement risk associated with an asset owned or liability and an auction process to determine the cash incurred, or reasonably likely to be owned or settlement final price. incurred, by the individual. 9. For example, an investor who wants to take 14. securities Act §2A. (b)(2), 15 U.S.C. 77b et five-year (or longer) exposure to a particular seq. added by §302 of Commodities Futures issuer would be able to do that through a CDS Modernization Act of 2000, H.R. 4577, 106th Transaction even if the issuer has outstanding Cong. (2000). only a three-year credit facility and commercial 15. exchange Act §3A.(b)(1), 15 U.S.C. 78c et paper. Conversely, if the issuer has only long- seq. added by §303 of Commodities Futures term bonds outstanding, an investor could Modernization Act of 2000. use CDS to take shorter term exposure. A CDS 16. Graham-Leach-Bliley Act, §206B, added by § Transaction can be effected at a time when a 301(a) of Commodities Futures Modernization cash bond of the Reference Entity of a particular Act of 2000. maturity is not available. 17. specifically, see Securities Act of 1933, 15 U.S.C 10. As discussed below, the definition of CDS in §77(a) et seq., § 17(a) (anti-fraud provisions), Section 6901(j-1) of the New York Insurance paragraphs (2) through (5) (anti-manipulation Law includes the proviso that “such agreement and anti-fraud provisions) and Securities does not constitute an insurance contract and Exchange Act of 1934, 15 U.S.C. §78(a) et seq., the making of such credit default swap does not §§ 9(a), 10(b) (adding security-based swap constitute the doing of an insurance business.” agreement to anti-manipulation provisions), N.Y. Ins. Law §6901(j-1) (McKinney 2004). 15(c)(1) (adding security-based swap agreement 11. See n. 19, infra. to anti-fraud provisions), 20(d) (adding security- 12. n.Y. Ins. Law §1401(a)(18) (McKinney 1984). based swap agreement to insider trading 13. Commodities Exchange Act, 7 U.S.C. §1(a)(12) provisions) and 21A(a)(1) (including security- (1936), defines an “eligible contract participant” based swap agreements in the civil penalty as: 1. a financial institution; 2. a regulated provisions). insurance company, foreign or domestic; 3. 18. See Circular Letter, supra note 1, “Best practices a regulated investment company, foreign or for financial guaranty insurers,” at page 1,

noting that FGIs that are not legally domiciled whether a particular agreement is an insurance in New York are licensed to issue financial contract under New York law. Absent such a guaranty insurance under Article 69 of the New contractual provision the instrument is not an York Insurance Law. insurance contract.” Id. at 2. 19. FGIs, known as “monolines,” are only permitted 29. n.Y. Ins. Dept. Op. Off. Gen. Couns., February to issue financial guaranty insurance policies 15, 2000 (the “2000 OGC Opinion Letter”). and are not permitted to enter into other types 30. See N.Y. Ins. Dept. Op. Off. Gen. Couns., supra of transactions. Therefore, in order to assume note 6. the economic risk of a CDS Seller, an FGI typically 31. See, e.g., 1997 OGC Opinion Letter; 1999 OGC would create a special purpose bankruptcy- Opinion Letter; and 2000 OGC Opinion Letter. remote entity, referred to as a “transformer,” 32. See Circular Letter, supra note 1, at 5; see N.Y. that would act as the CDS Seller, and the FGI Ins. Dept. Op. Off. Gen. Couns., supra note 6. then would issue a financial guaranty insurance 33. eric Dinallo, Testimony before the Senate policy to guarantee the performance of the Committee on Agriculture, Nutrition and transformer to the CDS Buyer. Forestry, October 14, 2008. 20. See N.Y. Ins. Dept. Op. Off. Gen. Couns., 34. Id. September 24, 1997 (the “ 1997 OGC Opinion 35. “No contract or policy of insurance…shall be Letter”). enforceable except for the benefit of some 21. The NYS Insurance Department required that person having an insurable interest in the the FGI meet certain requirements, including property insured.” N.Y. Ins. Law §3401 (McKinney that the FGI use its customary underwriting 1985). “Insurable interest shall include any criteria, that the CDS tenor not exceed five lawful and substantial economic interest in the years, and that the referenced security be rated safety or preservation of property from loss, at least investment grade. destruction or pecuniary damage.” Id. 22. n.Y. Ins. Dept. Op. Off. Gen. Couns., April 8, 36. “PWG Policy Objectives”, www.treasury.gov/ 1999 (the “1999 OGC Opinion Letter”). 23. n.Y. Ins. Law §6901 (McKinney 2005). press/releases/reports/policyobjectives.pdf, 24. n.Y. Ins. Law §6901 (j-1) (McKinney 2005) November 14, 2008. (emphasis added). 37. memorandum of Understanding between the 25. See Circular Letter, supra note 1. Board of Governors of the Federal Reserve 26. n.Y. Ins. Law §1101(a)(1) (McKinney 2003). System, the U.S. Commodity Futures Trading 27. Catastrophe Options Opinion, dated June 25, Commission and the U.S. Securities and Exchange 1998, p. 2. Commission Regarding Central Counterparties 28. Index Swap Transaction Opinion, dated June 26, for Credit Default Swaps, November 14, 2008. 1998, p. 1. That letter stated: “In order for an 38. Id. at 1-2. Index Swap (or other derivative) to constitute an 39. See I.R.S. Bulletin 2004-32 (August 9, 2004) insurance contract, it must obligate the index payer (requesting comments on U.S. tax treatment of (as insurer) to indemnify the Fixed Rate Payment CDS and discussing how some commentators Payer (as insured) for the actual loss incurred by have distinguished CDS from insurance). the Fixed Rate Payment Payer. Indemnification of 40. See New York State Bar Association, Tax Section loss is an essential indicia of an insurance contract Comments on Credit Default Swap Rules, which courts have relied upon in the analysis of September 9, 2005.