Much has been written lately regarding the role of derivatives, and specifically, credit default swaps (CDS) in the current market turmoil. Despite the legitimate credit risk transfer and hedging technology embodied in CDS, these products have been pilloried as a significant contributor to current market conditions, and many have called for a swift increase in the regulation of CDS.
The Sunday evening broadcast news program "60 Minutes" has dedicated two segments to CDS in recent weeks. Those calling for regulatory changes have included, among others, various U.S. Congressmen, the Chairman of the U.S. Securities and Exchange Commission (SEC), the Acting Chairman of the Commodities Futures Trading Commission (CFTC), the Governor of New York and the Superintendent of the State of New York Insurance Department (Insurance Department). Even former Federal Reserve Chairman Alan Greenspan, previously a staunch public supporter of the virtues of CDS, stated recently to the House Committee on Oversight and Government Reform that there are significant problems with CDS.
Although the International Swaps and Derivatives Association (ISDA) continues to work with the major CDS dealers and the Federal Reserve to implement infrastructure improvements for CDS trading, increased regulation by federal or state authorities appears highly likely. Questions remain as to the scope of the regulation and who will be empowered to develop, implement and enforce it.
Current Regulation Of CDS
Under a CDS, a buyer of credit protection generally pays a recurring fee to a seller of credit protection in exchange for payment by the seller to the buyer if certain negative events occur with respect to an entity referenced in the CDS. This effectively transfers the risk of default by the reference entity from buyer to seller. There is no obligation on the part of the buyer of credit protection to own or have an interest in the reference entity.
CDS are currently not regulated as insurance, securities or futures in the United States. CDS are, however, subject to the anti-fraud and anti-manipulation provisions of the Securities Act of 1933 (1933 Act) and the Securities Exchange Act of 1934 (1934 Act). CDS are generally privately negotiated and traded financial contracts. ISDA, which represents participants in the derivatives industry, has worked with its members, including the major CDS dealers, and the Federal Reserve over recent years to improve upon various shortcomings in the existing trading infrastructure and has standardized components of CDS trading documentation.
A fundamental premise of the CDS market is that CDS are not insurance contracts. The conclusion that CDS are not insurance contracts is based upon the fact that the buyer of credit protection under a CDS need not suffer any loss nor provide any evidence of any loss with respect to the relevant reference entity or obligation to receive payment from seller. This position historically has been supported by the Insurance Department, notably in a June 2000 opinion issued by the Insurance Department's Office of General Counsel (General Counsel). As discussed below, however, the Insurance Department is currently revisiting whether CDS should be regulated as insurance contracts.
The Commodity Futures Modernization Act of 2000 (CFMA), signed into law by President Clinton on December 21, 2000, generally excludes CDS from regulation as "futures" under the Commodity Exchange Act. Furthermore, the CFMA provides that CDS are "swap agreements" that do not constitute "securities" for purposes of the 1933 Act or the 1934 Act. The CFMA does provide that CDS are subject to the anti-fraud and anti-manipulation provisions of the 1933 Act and 1934 Act as "security-based swap agreements" but prohibits the SEC from taking preventative measures against fraud or manipulation with respect to security-based swaps.
Potential New Regulation
The most specific recent regulatory proposal with respect to CDS has been that of the Insurance Department. In its Circular Letter No. 19 (2008) (Circular), dated September 22, 2008, the Insurance Department made clear that they will be revisiting the June 2000 opinion issued by the General Counsel on the basis that the opinion did not consider the situation where the buyer of credit protection under a CDS "holds, or reasonably expects to hold, a 'material interest' in the referenced obligation." The Circular goes on to state that such "omission will be rectified and addressed in a forthcoming opinion to be prepared" by the General Counsel.
The new Insurance Department regulatory regime is intended to be effective on January 1, 2009, and it appears that the Insurance Department will require sellers of credit protection under such CDS to be licensed as insurance providers. As announced, the proposal is not intended to affect so-called naked CDS, under which the buyer does not hold and does not expect to hold a material interest (as noted above, a buyer of protection is under no such obligation under a CDS). One of the many questions presented by the Circular is how it will be determined whether the buyer under a CDS "reasonably expects" to hold a material interest in the reference obligation at the time the CDS is entered into.1Uncertainty in this determination may cause the parties to seek advice from the Insurance Department prior to trading or treat the CDS as an insurance contract for fear of having the Insurance Department or courts later reach a contrary conclusion. However this distinction between naked CDS and non-naked CDS might ultimately be determined, the notion that any CDS should be treated as an insurance product is a seismic shift in the historical regulatory treatment of CDS and would likely have a profound impact on the CDS market.
Notwithstanding the proposal of the Insurance Department, SEC Chairman Cox, in a recent New York Times op-ed piece and in testimony before the Senate Banking Committee, has argued that the SEC is well positioned to regulate CDS. Specific regulatory plans were not announced by Chairman Cox, but his statements have focused in large part on naked CDS. In his testimony, Chairman Cox stated that unregulated CDS "can be used as synthetic substitutes for regulated securities...which can have profound and even manipulative effects on regulated markets." New York Governor Paterson has urged federal regulators to address naked CDS as a complement to the proposal announced by the Insurance Department.
The CFTC, in testimony by Acting Chairman Walter Lukken to the House Committee on Agriculture, which shares legislative jurisdiction over the futures markets, has proposed certain key principles upon which the regulation of CDS should be premised. The financial press has noted that a regulatory turf war between the SEC and the CFTC may be simmering. SEC Chairman Cox has stated that "[t]oday's balkanized regulatory system undermines the objectives of getting results and ensuring accountability" and has endorsed a merger of the SEC and the CFTC. Acting Chairman Lukken has noted the importance of regulators, in the U.S. as well as internationally, working together to develop appropriate regulation.
While it remains unclear whether the SEC, the CFTC, the Insurance Department or some combination thereof will be charged with implementing and enforcing a new CDS regulatory regime, regulation of CDS as securities, futures or insurance would represent a significant departure from the status quo. It is also unclear what impact the Obama administration or its appointees, if any, to the SEC and the CFTC may have on initiatives to regulate CDS.
Meanwhile, efforts of the private sector to improve upon CDS trading infrastructure continue. The Federal Reserve had reportedly requested final written plans for the creation of a centralized counterparty by October 31 from market participants and competing trade clearing houses, including IntercontinentalExchange and the CME Group, that have been involved in discussions. Whether CDS will be required to be traded on an organized exchange, as recently suggested by Senator Harkin, Chairman of the Senate Committee on Agriculture, Nutrition and Forestry, or through a centralized counterparty is to be seen. ISDA, in addition to promoting continuing public education with respect to CDS and noting the resilience of existing trading and settlement infrastructure evidenced during this current market turmoil, has urged coordination between regulators with respect to new regulation.
The ultimate objective for new regulation and trading infrastructure improvements will be to reduce the potential for systemic risk should another major CDS dealer fail, and to improve transparency in the market to facilitate exposure reporting and pricing. What effect such regulation will have on the CDS market remains difficult to gauge. 1 As examples of how broadly the language "holds or reasonably expects to hold" and investor intent may be interpreted, see, e.g., the Insurance Department opinion dated December 19, 2005 (2005 Opinion) and Life Product Clearing LLC v. Angel (S.D.N.Y. 2008) (Life Product Clearing). The 2005 Opinion and Life Product Clearing each involved life insurance transactions and considered the intent of an insurance policyholder that assigned its policy to an investor shortly after initial purchase. In the 2005 Opinion, the Insurance Department concluded that the transaction in question involved the procurement of insurance solely as speculative investment, even though the initial policyholder had the contractual option to retain the policy for its duration. In Life Product Clearing LLC v. Angel, the United States District Court for the Southern District of New York declined to dismiss the action on pleadings so that it could be determined whether a life insurance policy was procured "with a view to its immediate assignment" and whether the policy in question was capable, under New York insurance law, of being transferred to a third party not having an insurable interest.The court noted, generally, that cases that turn on the issue of intent are not appropriate for summary disposition and cited the 2005 Opinion to note the public policy against "gaming" through insurance policy purchases.
Howard T. Spilko, a Partner with Kramer Levin, has a diverse transactional-based practice with significant experience in domestic and cross-border mergers and acquisitions, joint ventures and alliances, finance, including derivatives transactions and general corporate matters. Fabien Carruzzo, an Associate, practices in the areas of mergers and acquisitions, private equity/venture capital, structured finance and derivatives transactions. Associate Kevin Zadourian's practice focuses on derivatives and structured finance matters as well as general corporate matters. Kramer Levin's Financial Institutions practice group provides counseling, transactional and litigation services to a wide variety of financial institutions and market participants.