Ambac Financial Services faces an uphill battle in convincing a court that the Bay Area Toll Authority (BATA) shorted it by $50 million on swap termination payments, securities lawyers and swap advisers said this week.

The company sued BATA in federal court earlier this month, alleging that the toll bridge operator didn't get firm, actionable market quotes for the swaps it terminated after Ambac's credit rating fell to junk. Ambac said loss calculations show that BATA owed $156.6 million, not the $104.6 million BATA paid to terminate the swaps.

"We believe that Ambac's legal arguments are questionable," said Peter Shapiro, managing director of Swap Financial Group in South Orange, N.J.

Shapiro and others interviewed for this story cautioned that they haven't seen the details of the swap contracts between Ambac and BATA, but they said most municipal bond issuers stick close to the standard terms in the International Swaps and Derivatives Association's (ISDA) Master Agreement.

"If they just have a standard contract, then I'm not sure what Ambac's smoking," said one leading swap lawyer, who asked not to be identified because the attorney's firm hadn't approved the comments.

A spokeswoman for Ambac declined to comment for this story.

BATA also declined to comment on the pending lawsuit, which was filed in the U.S. District Court for the Southern District of New York on Aug. 10.

Oakland-based BATA is a government agency that operates seven state-owned toll bridges in the San Francisco Bay Area. In July, it terminated $1.1 billion of swaps with Ambac Financial, a unit of bond insurer Ambac Financial Group, because the insurer's credit ratings had fallen to junk status. BATA made swap termination payments of $105 million based on a market quotation process.

According to court documents, BATA and Ambac entered into six swap agreements in 2002, 2004, and 2005. Under the agreements, BATA hedged its variable-rate debt exposure by paying fixed rates to Ambac in return for a flow of variable-rate payments.

BATA terminated the swaps July 22 after Ambac's credit ratings fell to junk status from triple-A in just over a year. Standard & Poor's downgraded Ambac Financial's counterparty rating to 'CC' with a negative outlook from 'BB' on July 28. Moody's Investors Service cut the company's senior unsecured debt rating to 'Ca' from 'Caa1' the next day.

BATA paid $104.6 million to get out of the deal.

BATA "did not seek in good faith to obtain genuine quotations for transactions that were economically equivalent to the terminated transactions," Ambac said in its complaint.
"Rather, it sought indications of the amount of termination values for the terminated transactions, thereby frustrating the purpose of the market quotation method of obtaining genuine market quotations, subject to the discipline of such quotations being actionable," it said.

The general process for determining market quotations is spelled out in a 1992 ISDA Master Agreement. Under the standard agreement, BATA would have the right to terminate the swap if its counterparty defaulted. Issuers and swap dealers also typically define additional termination events, such as Ambac's credit rating downgrades, that allow parties to exit the swap.

As the burdened party, BATA would calculate a termination payment by seeking four or more quotes from recognized market makers. The bids are the prices the reference dealers would charge or pay to enter into economically equivalent swaps. The burdened party must secure bids from at least three market makers, and it must set the termination payment at the average bid after discarding the highest and lowest quotes. If no market exists for the swap and bids cannot be secured, the burdened party must calculate "loss" to determine the termination payment.
According to Ambac's suit, BATA sought bids but it does not make clear how many or what type.
"The ISDA documentation does not say they need to be actionable bids," Shapiro said. "They just say they need to be quotations."

Sam Gruer, managing director of Millburn, N.J.-based Cityview Capital Solutions, a municipal advisory firm with a specialty in derivatives, said firm bids are the best way for a municipality to prove it has fairly valued a termination payment.

"A market quotation process with actionable numbers that are acted upon is certainly cleaner and less risky legally for a municipality than one in which no actionable numbers are received," he said.

The swap lawyer quoted above said Ambac may have a case if it can show that BATA didn't solicit "firm" or "actionable" bids, but Ambac would be breaking new ground legally in convincing a court that firm bids are required in the standard swap contracts.

None of these sources took a position on whether or not BATA actually sought firm bids. The toll agency has not yet responded to the suit in court, and Ambac has not yet presented evidence of its allegations.

It is possible that Ambac is trying to push a novel legal argument that the bids are not valid if the issuer doesn't act on one of them.

According to this view, the dispute is not over whether BATA solicited what market participants call "firm" bids, but whether any bid can be considered valid if BATA didn't actually enter into new swaps.

"That certainly isn't in the ISDA Master Agreement and isn't consistent with the general market approach to what an actionable or 'firm' bid is," the swaps lawyer said. "The concept of 'firm' bids is used in many different contexts in derivatives — other than for determining termination payments — and that is not consistent with the context in those other situations."

Market participants said disagreements about the pricing of a termination payment are common. But the parties usually negotiate until they reach a mutually agreeable number.

"The suits by Ambac are highly unusual," Shapiro said, noting that thousands of Lehman Brothers swaps have terminated without litigation in the past year.

The BATA lawsuit is Ambac's second suit against a California municipality over swap terminations this year.

In that case, Ambac Assurance Corp. in June sued the Adalento Public Utility Authority in Southern California, saying the utility failed to take steps to prevent a swap it insured from being terminated, leaving Ambac liable for a $6 million payment.

The Ambac suit says that BATA's alleged failure to solicit actionable bids means the termination payments must be calculated by the "loss" method.

The insurer's suit said the termination payment should be the difference between the present value of Ambac's variable-rate payments and BATA's fixed-rate payments, according to Ambac.
But swap lawyers and advisers universally panned Ambac's attempt at calculating loss. Some laughed when asked about it.

"It's supposed to approximate the current value of the contract that you would have otherwise gotten via the market quotation process," the swap lawyer quoted above said. "There's not a single reference in the ISDA Master Agreement that provides for you to calculate up all of the cash flows and present value them."

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