What is being called a complete misunderstanding by a district court judge of a credit derivatives contract is causing some to question the clarity of credit default swap documentation. The Southern District Court of New York in February ruled that the French bank Societe Generale, as a protection seller in a CDS transaction, should pay the buyer and plaintiff Aon Financial Products, a division of Aon Corp., $10.1 million despite its failure to deliver bonds to SG. According to industry professionals, the decision was based on an entirely separate derivatives contract and viewed SG as more of a guarantor than a CDS party. SG filed an appeal to the decision in March, and oral argument is expected to begin in late August or September.
"It was, well, strange," said Lary Stromfeld, a partner in the capital markets department at Cadwalader, Wickersham & Taft LLP and lawyer on behalf of the International Swaps and Derivatives Association, which earlier this month filed an amicus brief on behalf of SG in the case. Although Stromfeld described the decision as an "aberration," he, along with others, said it is in the CDS market's interest that it not be upheld, should it be used as precedent in future cases. "I think the court just didn't understand what they were doing," Stromfeld said. " It is not like the court came up with a clever approach that nobody was thinking of, it just didn't understand this."
In 1999, Aon had purchased $10 million in credit default protection from SG on $500 million of debt issued by the Republic of the Philippines. Aon did so in order to hedge a separate transaction in which it sold $10 million in credit protection to Bear Stearns on a surety bond issued by the Philippine Government Service Insurance System. According to court filings, Aon argued that because the SG transaction was made in connection with the Bear transaction in order to hedge against potential losses, the SG swap therefore guaranteed payment if losses were incurred in the Bear transaction - despite there having been two completely different CDS contracts. "The basic error," according to SG's appeal, was "the finding that the two swaps hedged against the same risk on the same terms."
According to ISDA, the court erred in two respects. First, SG was found liable to pay Aon based on the derivatives transaction Aon had with Bear - even though the only material similarities between the transactions was that they were each credit default swaps in the amount of $10 million. Second, after finding SG liable to pay Aon in the CDS, it "completely ignored" the contract's settlement provisions. Despite the CDS containing a physical settlement provision, SG was ordered to pay Aon the full principal amount of the underlying security, even though it was never delivered by Aon, Stromfeld said.
The decision, even if it was an anomaly, does not set a good example for future treatments of the transactions in the courtoom, said Janet Tavakoli, president of Tavakoli Structured Finance. Since the inception of the CDS market, disputes have risen on as many as 40% of defaulted reference entities, according to Tavakoli. Because most of the disputes are settled in arbitration, they cannot set a precedent for future decisions, but they are time consuming and expensive for companies that go through them, she said.
"The wide implication here is that people are getting dragged into court on these terms, and they are getting dragged into arbitration," she said, adding that clearer documentation would go a long way toward avoiding the suits. ISDA documentation is used in some 90% of outstanding CDS contracts, according to Tavakoli. "Even the brightest people are having difficulty interpreting these documents," she said. Al Orendorff, a spokesman for Aon, and Jim Galvin, spokesman for SG, declined to comment on the case.
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