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Credit Default Swaps In The Crosshairs Law360, New York (March 24, 2009) -- The current global economic crisis and the meltdown in the financial markets have prompted heightened scrutiny of various derivative products, with increasing focus on credit default swaps ("CDS"). This is largely due to the monumental size and opaqueness of the CDS market and the significant role that CDS are believed to have played in the financial crisis to date. At their peak in mid-2008, the total notional amount of CDS outstanding was roughly $60 trillion, a number which dwarfs the approximately $11 trillion U.S. home mortgage market.[1] Because CDS are private contracts, there is little transparency in the market. This lack of transparency is deepened by the fact that a substantial percentage of CDS transactions are entered into by hedge funds, which themselves are largely unregulated private entities, not subject to disclosure obligations.[2] Moreover, the significant contribution of CDS to the financial firestorm faced by companies like American International Group Inc. (“AIG”) has placed CDS dead center in the crosshairs of litigants, prosecutors and legislators.

Background: A CDS Mini-Primer A CDS is a bilateral contract that transfers the credit risk of an underlying “reference obligation” from a party seeking protection (the buyer) to a party providing protection (the seller). Typical reference obligations include corporate bonds, mortgage-backed securities (“MBS”) and collateralized debt obligations (“CDO”). The International Swaps & Derivatives Association (“ISDA”) provides a master agreement for standardization and ease of contracting. Alternatively, the buyer and seller may structure a one-off, custom transaction. ________________________________________________________________________________________________________________ All Content Copyright 2008, Portfolio Media, Inc.

In executing the contract, the buyer agrees to pay periodic premiums to the seller; in exchange, the seller assumes the risk associated with a particular credit event, e.g. a corporate default or debt restructuring. CDS sometimes require the seller to post collateral, the amount of which depends on the value of the underlying reference obligation. The following example illustrates the mechanics of a basic CDS transaction without a collateral posting requirement. Assume an investor owns $5 million of a corporation’s bonds and wishes to insure against default. The investor can purchase a CDS, in which it would agree to tender a stream of payments; in exchange, the counterparty would be obligated to pay up to $5 million to the investor if there was a default on the corporation’s debt. If, on the other hand, no default or other credit event occurred, the seller would have collected a handsome premium. Of course, this straightforward use of CDS as a hedge is not the type of transaction that has caused this risk-management instrument to be placed under the regulatory microscope. The more interesting uses of CDS — which are the target of regulators and civil suits — are those where, for example: 1) the CDS buyer does not own the underlying reference obligation and is merely speculating, hoping to profit from future movements in the obligation’s credit quality; 2) the buyer purchases a CDS to remove the credit risk of the underlying obligation from its balance sheet, but the seller (often a hedge fund) is thinly capitalized and unable to cover if a credit event occurs; or 3) a seller writes CDS with respect to its own underlying assets to generate income, but miscalculates the probability of a credit event or the underlying assets deteriorating in value, triggering payment obligations that it is unable to cover. Not surprisingly, CDS have been the subject of significant litigation.

In the Crosshairs of the Courts: Litigation Involving CDS Much of the CDS-related litigation has fallen into two distinct categories: counterparty disputes and federal securities class actions.[3] One common thread that appears to tie these distinct categories of litigation together is the allegation that a party misrepresented the risk of CDS or the underlying reference obligation. Counterparty Disputes ________________________________________________________________________________________________________________ All Content Copyright 2008, Portfolio Media, Inc.

CDS buyer/seller litigation typically arises when a seller has been unable to meet its obligations, most often a call for increased collateral. The case of UBS v. Paramax Capital is illustrative.[4] In UBS, Paramax Capital, a modest-sized hedge fund with approximately $200 million under management, sold a CDS to UBS, agreeing to provide UBS with protection on $1.31 billion of subprime mortgage-backed CDO. At the outset, Paramax was only required to post $4.5 million in collateral. Soon after entering into the transaction, UBS began taking a series of precipitous asset markdowns, which led to additional collateral calls, bringing the total collateral requirement to $66 million. When Paramax failed to meet the calls, UBS sued for breach of contract. Paramax counterclaimed, alleging fraud in the inducement and other claims. Paramax’s defense mirrored allegations often made by plaintiffs in securities fraud actions. Paramax asserted that: - UBS had failed to disclose its own internal conflict over its accounting for the underlying CDO portfolio. - UBS had orally assured Paramax that it would use a subjective valuation methodology to keep the pricing at a level that would not trigger additional collateral calls. In essence, UBS represented that writedowns were not a significant concern and risk was “de minimis.” - UBS’ main purpose in entering into the CDS with Paramax was to justify removing liabilities related to the CDO from its books when valuing those liabilities at market rates would have required UBS to record a $300 million loss. Paramax also alleged that UBS sought to enter into the CDS with Paramax to take advantage of the accounting benefits, even though it knew that Paramax was not in a financial position to provide UBS with a true financial hedge. The case settled before the court was called on to address these issues. Most CDS counterparty litigation, however, is limited to relatively straightforward contract claims. For example, in VCG Special Opportunities Master Fund Ltd. v. Citibank NA,[5] a hedge fund seller sought a declaratory judgment and rescission of its CDS, alleging claims for breach of the duty of good faith and fair dealing, among others. Judge Jones awarded judgment on the pleadings to the defendant buyer by applying the language of the CDS contract and the underlying indenture, along with other traditional contracts principles. ________________________________________________________________________________________________________________ All Content Copyright 2008, Portfolio Media, Inc.

Securities Violations As in the UBS counterparty dispute, a recurring theme in securities fraud litigation involving CDS is the concealment of the true risk associated with these financial products. These allegations are central to Plumbers’ Union Local No. 12 Pension Fund v. Swiss Reinsurance Co.,[6] which involves the issuance of CDS guaranteeing subprime mortgage-related securities. In Swiss Re, a putative class of Swiss Reinsurance (“Swiss Re”) stock purchasers allege that Swiss Re and certain of its officers and directors violated §10(b) of the Exchange Act when they failed to disclose that Swiss Re had written two CDS in which the company guaranteed the credit risk of subprime mortgage-related CDO. According to plaintiffs, Swiss Re had exposed itself to billions of dollars of potential liabilities in the event the subprime mortgage-backed assets underlying the CDS declined in value. Plaintiffs claim that defendants should have recognized that the housing and mortgage-related securities markets were deteriorating. Instead, plaintiffs allege, Swiss Re’s public disclosures continued to paint a rosy picture, misrepresenting Swiss Re’s risk exposure until the company was forced to take a massive writedown, purportedly causing a precipitous drop in its stock price. Swiss Re has recently moved to dismiss. Among other points, Swiss Re argues that plaintiffs cannot plead, based on the general downturn in the market during 2006-07, that Swiss Re must have known that the assets underlying its CDS portfolio had deteriorated: “Plaintiffs cannot use such broad market information to infer knowledge that a security was impaired.”[7] Swiss Re’s motion is currently sub judice. An insurer’s alleged failure to disclose its exposure to CDS risk is also at the heart of the AIG securities litigation. In Epstein Real Estate Advisory v. Am. Int’l Group Inc.,[8] a putative class of AIG debt purchasers claim they purchased AIG notes at artificially inflated prices because AIG’s offering materials failed to disclose its CDS risk exposure. In particular, plaintiffs allege, AIG sold CDS with collateral-posting requirements on a number of CDO that had exposure to the subprime mortgage market. Plaintiffs assert that AIG’s actual exposure was finally thrust into the Klieg lights in the fall of 2008, when the massive insurer needed $150 billion in government aid to stay afloat. Most recently, AIG has been sued by none other than its former Chairman and CEO Maurice “Hank” Greenberg.[9] Greenberg alleges that after he left the company in 2005, ________________________________________________________________________________________________________________ All Content Copyright 2008, Portfolio Media, Inc.

AIG and certain of its officers and directors misrepresented its exposure to CDS in its public disclosures. As averred by Greenberg, such misrepresentations came to light when AIG was forced to apply an appropriate valuation model to its CDS portfolio and, as a result, reported staggering losses.[10] The central theme in much of the CDS-related litigation is the failure to disclose the true exposure to these derivatives. Since so many CDS guaranty mortgage-based securities, these claims appear to assume that parties could have foretold the dramatic meltdown in the housing and related credit markets and the intensity of the impact it would have on their CDS portfolios. For these types of allegations to have any traction will require a willingness on the part of judges to make assumptions about what parties must have known at the time they entered into their CDS, without the benefit of hindsight. While the courts wrestle with what parties must have known in the past, legislators attempting to deal with CDS-related issues are looking forward.

In the Crosshairs of the Lawmakers: Proposed Legislation Aimed at CDS Presently, CDS are governed by the Commodity Futures Modernization Act (“CFMA”) of 2000. The CFMA provides that CDS are not “securities” and therefore are not subject to the registration or reporting requirements of the federal securities laws.[11] This purported lack of regulation has been singled out as one of the principal causes of the CDS wildfire that is tearing through the financial sector.[12] Not surprisingly, a number of legislators have come forward to answer the call with “wet blanket” proposals. One such proposal was introduced by Minnesota’s Rep. Collin Petersen, Chairman of the U.S. House of Representatives Committee on Agriculture. A brief analysis of his proposed bill, The Derivatives Markets Transparency and Accountability Act of 2009, provides some insight into where CDS legislation may be headed. The first draft of the bill would have prohibited entering into “naked” CDS, i.e. a transaction in which the buyer does not own the underlying reference obligation. This provision would have stamped out the vast majority of CDS transactions and was dropped before the bill made it out of committee. However, the latest draft still contains several provisions designed to stiffly regulate the CDS market.

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Perhaps most importantly, the bill would generally require that CDS transactions be cleared through a registered clearinghouse or that the contracting parties demonstrate the “financial integrity” of the transaction and themselves. The latest draft of the bill would also enable the Commodities Future Trading Commission (“CFTC”) to “summarily suspend trading” in any CDS if “the public interest and the protection of investors so require.” Other legislators and regulators have also recommended creating a central clearinghouse for CDS, called for increased regulation by the SEC and/or CFTC, and proposed regulating CDS as insurance products.[13] The new head of the CFTC under President Obama, Gary Gensler, has vowed to make CDS regulation a priority.[14] Most recently, ICE US Trust, LLC (“ICE”) has obtained approval from the Board of Governors of the Federal Reserve System (the “Fed”) and the SEC to become a central counterparty or clearinghouse for CDS.[15] ICE, now a member of the Federal Reserve System, began clearing CDS transactions among its initial participants on March 9, 2009.[16] As a clearinghouse, ICE will take one side of every CDS transaction it accepts for clearing, becoming the buyer to every seller and the seller to every buyer.[17] The intention is to reduce the risk associated with trading and settlement of CDS transactions by shifting the risk from private counterparties to the clearinghouse. When a participant defaults on its CDS obligation, ICE will be able to draw on guaranty fund contributions made by that participant and, if necessary, other participants, to meet the obligation. At the moment, ICE’s clearing capabilities will be limited to CDS on certain CDX North American credit indices. Regardless of which proposals catch hold, greater regulation of CDS — in some form — appears inevitable.

Conclusion: Pulling the Trigger It is important for courts and legislators not to lose sight of the fact that, when used properly, CDS are important risk-management tools. Provided the seller is financially robust and the underlying risk is understood, CDS can serve a critical role by enabling parties to hedge or transfer credit risk. Even the speculative use of CDS to bet on future movements in credit quality can be beneficial, since these transactions provide much-needed liquidity. Nevertheless, CDS are likely to remain the focus of litigation and legislative scrutiny for the foreseeable future. On the legislative side, only time will tell whether the proposed ________________________________________________________________________________________________________________ All Content Copyright 2008, Portfolio Media, Inc.

Petersen bill or another will pass and how effectively any new legislation will address CDS issues. Given the vital role CDS play in managing credit risk, the real challenge for any new legislation will be to address the potential harm without destroying the vital role CDS play in the global financial markets. Put simply, what the markets need is not the expansive blast of a shotgun, but the precision of a well-aimed rifle shot. --By Paul A. Straus and Paul B. Maslo, King & Spalding LLP Paul Straus is a partner with King & Spalding in the firm's New York office. Paul Maslo is an associate with the firm in the New York offfice. The opinions expressed are those of the authors and do not necessarily reflect the views of Portfolio Media, publisher of Law360. [1] Federal Reserve System, Order Approving Application For Membership of ICE US Trust LLC (Mar. 4, 2009), (the “Fed Order”) at 2, www.federalreserve.gov/newsevents/ press/orders/orders20090304a1.pdf; The U.S. Mortgage Market Needs $1 Trillion, Analysts Say, Bloomberg, Mar. 7, 2008, www.bloomberg.com/apps/news?pid= 20601087 &sid=a WM0APufFq Gg&refer =Easy HUD.com /blog. The amount of CDS outstanding has been reduced but was still over $30 trillion as of March 4, 2009. Fed Order at 2. [2] E.g., David Evans, Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults, Bloomberg, May 20, 2008, www.bloomberg.com/apps/news?pid=20601109&sid =aCFGw7GYxY14&refer=home; Implications of the Growth of Hedge Funds, Staff Report to the U.S. SEC (Sep. 2003), www.sec.gov/news/studies/hedgefunds0903.pdf. [3] CDS have also been the target of regulators and prosecutors. Both the SEC and New York Attorney General, for example, have launched investigations into possible market manipulation involving CDS. Joseph Giannone, New York Probing Credit Default Swap Market: Source, Reuters, Sep. 26, 2008, www.reuters.com/article/ousiv/ idUSTRE48P7XH20080926?rpc=77. These investigations appear to be in the relatively early stages. [4] UBS v. Paramax Capital Int’l, Civ. No. 07604233 (Sup. Ct. N.Y. Co.) (complaint filed Dec. 26, 2007; answer and counterclaims filed Jan. 04, 2008; stipulation of discontinuance filed Oct. 23, 2008). [5] No. 08-CV-01563 (BSJ), 2008 WL 4809078 (S.D.N.Y. Nov. 5, 2008), reconsideration denied, 2009 WL 311362 (Jan. 29, 2009). ________________________________________________________________________________________________________________ All Content Copyright 2008, Portfolio Media, Inc.

[6] Civ. No. 1:08-cv-01958-JGK (S.D.N.Y.) (amended complaint filed Sept. 10, 2008; motion to dismiss filed Nov. 10, 2008). [7] Swiss Re, Memorandum of Law in Support of Motion to Dismiss at 16. [8] 09 Civ. No. 00428 (S.D.N.Y.) (complaint filed Jan. 15, 2009). [9] Maurice Greenberg v. American Int’l Group Inc., 09 Civ., 09 Civ. No. 1885 (S.D.N.Y.) (complaint filed Feb. 27, 2009). [10] Greenberg, Complaint ¶ 132. [11] They may, however, be subject to the anti-fraud and anti-manipulation provisions of the securities laws. The CFMA amended section 10(b) of the Securities Exchange Act of 1934 and section 17(a) of the Securities Act of 1933, for example, so that those provisions apply to “any security-based swap agreement.” [12] Kevin McCoy, SEC Chief Urges Oversight of Credit Default Swaps, USA Today, Sep. 26, 2008, www.usatoday.com/money/industries/banking/2008-09-23-cox-creditdefault-swaps_N.htm. [13] E.g., Lisa Lambert, Update 2-Dinallo: NY Ready To Regulate Credit Default Swaps, Reuters, Oct. 14, 2008, www.reuters.com/article/marketsNews/idUSN1452190620081014 (proposes to regulate CDS as insurance). [14] Ben James, Gensler Lists Swaps, OTC Derivatives As Priorities, Law360, Feb. 26, 2009, securities.law360.com/print_article/89002. [15] Fed Order at 1-2, 9; Order Granting Temporary Exemptions Under The Securities Exchange Act Of 1934 In Connection With Request On Behalf Of ICE US Trust LLC Related To Central Clearing Of Credit Default Swaps And Request For Comments, Release No. 34-59527, (Mar. 6, 2009) (the “SEC Release”), www.knowledgemosaic.com/ gateway/Rules/EO.34-59527.030609.pdf. [16] The initial participants are Bank of America, Barclays Capital, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, J.P. Morgan, Merrill Lynch, Morgan Stanley and UBS. ICE Trust To Begin Processing And Clearing Credit Default Swaps March 9, 2009, ir.theice.com/releasedetail.cfm?ReleaseID=369373. [17] SEC Release at 7.

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