December 2008 n Volume 28 n Issue 11 REPORT Comparing Credit Default Swaps to Insurance Contracts: Did the New York State Insurance Department Get It Right? BY SHERRI VENOKUR, MattHEW MAGIDSON, AND ADAM M. SINGER 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 the credit default swap product, how it is State Department of Insurance announced used by financial market participants and that it would be regulating certain credit how it is documented, cover the regulatory default swaps as insurance contracts. On treatment of credit default swaps, both as November 20, 2008, the department made “security-based swap agreements” under another announcement, this time stating the Commodity Futures Modernization that, although certain credit default swaps Act of 2000 and under various rulings by The Journal on the Law of Investment & Risk Management Products The Journal did constitute insurance contracts, the insur- the New York State Department of Insur- ance department would “delay indefinitely ance, discuss the market view that credit its application of New York Insurance Law default swaps are not insurance, and then to CDS … .”1 During the two-month period set forth the differences between credit de- between the two announcements, bar asso- fault swaps and insurance. ciation committees, trade associations and the various market participants in the vast credit default swap market struggled with the anticipated scope and consequent rami- CONTINUED ON PAGE 3 fications of the insurance department’s regu- lation of credit default swaps as insurance. Article REPRINT This article will discuss whether the New Reprinted from the Futures & Derivatives York State Department of Insurance has Law Report. Copyright © 2008 Thomson Reuters/West. For more information about properly categorized certain credit de- this publication please visit www.west. fault swaps as insurance. It will describe thomson.com Futures & Derivatives Law Futures REPRINT ARTICLE Futures & Derivatives Law Report © 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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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. 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(ISSN#: 1083-8562) Copyright is not claimed as to any part of the original work prepared by a United States Government officer or employee as part of the person’s official duties. 2 © 2008 THOMSON REUTERS/WEST July/August 2008 n Volume 28 n Issue 7 Introduction tions by using examples and terms from the insur- ance 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.