Futures & Derivatives Law

REPORT The Journal on the Law of Investment & Risk Management Products Futures & Derivatives Law December 2008 n Volume 28 n Issue 11 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, Lowenstein Sandler, PC. On September 22, 2008, the New York State Department of Insurance announced that it would be regulating certain credit default swaps as insurance contracts. On November 20, 2008, the department made another announcement, this time stating that, although certain credit default swaps did constitute insurance contracts, the insurance department would delay indefinitely its application of New York Insurance Law to CDS. 1 During the two-month period between the two announcements, bar association committees, trade associations and the various market participants in the vast credit default swap market struggled with the anticipated scope and consequent ramifications of the insurance department s regulation of credit default swaps as insurance. This article will discuss whether the New York State Department of Insurance has properly categorized certain credit default swaps as insurance. It will describe the credit default swap product, how it is used by financial market participants and how it is documented, cover the regulatory treatment of credit default swaps, both as security-based swap agreements under the Commodity Futures Modernization Act of 2000 and under various rulings by the New York State Department of Insurance, discuss the market view that credit default swaps are not insurance, and then set forth the differences between credit default swaps and insurance. CONTINUED ON PAGE 3 Article REPRINT Reprinted from the Futures & Derivatives Law Report. Copyright 2008 Thomson Reuters/West. For more information about this publication please visit www.west. thomson.com 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. For authorization to photocopy, please contact the Copyright Clearance Center at 222 Rosewood Drive, Danvers, MA 01923, USA (978) 750-8400; fax (978) 646-8600 or West s Copyright Services at 610 Opperman Drive, Eagan, MN 55123, fax (651)687-7551. Please outline the specific material involved, the number of copies you wish to distribute and the purpose or format of the use. For subscription information, please contact the publisher at: west.legalworkspublications@thomson.com Editorial Board Stephen W. Seemer Publisher, Thomson/Legalworks Carrie A. Petersen Publication Editor, Thomson/West Richard A. Miller Editor-in-Chief, Prudential Financial 751 Broad Street, 21 st Floor, Newark, NJ 07102 Phone: (973) 802-5901 Fax: (973) 802-2393 E-mail: richard.a.miller@prudential.com Michael S. Sackheim Managing Editor, Sidley Austin LLP 787 Seventh Ave., 10019 Phone: (212) 839-5503 Fax: (212) 839-5599 E-mail: msackheim@sidley.com PAUL ARCHITZEL Alston & Bird Geoffrey Aronow Heller Ehrman LLP Conrad G. Bahlke OTC Derivatives Editor Weil, Gotshal & Manges Rhett Campbell Thompson & Knight LLP Houston, TX ANDREA M. CORCORAN Promontory Financial Group W. Iain Cullen Simmons & Simmons London, England Warren N. Davis Sutherland Asbill & Brennan Susan C. Ervin Dechert LLP Ronald H. Filler Lehman Brothers Edward H. Fleischman Linklaters Denis M. Forster Thomas Lee Hazen University of North Carolina at Chapel Hill Donald L. Horwitz One Chicago Chicago, IL Philip McBride Johnson Skadden Arps Slate Meagher & Flom Dennis Klejna MF Global Robert M. McLaughlin Katten Muchin Rosenman Charles R. Mills Kirkpatrick & Lockhart David S. Mitchell Fried, Frank, Harris, Shriver & Jacobson LLP Richard E. Nathan Los Angeles Paul J. Pantano McDermott Will and Emery Frank Partnoy University of San Diego School of Law Glen A. Rae Banc of America Securities LLC Kenneth M. Raisler Sullivan & Cromwell Richard A. Rosen Paul, Weiss, Rifkind, Wharton & Garrison LLP Kenneth M. Rosenzweig Katten Muchin Rosenman Chicago, IL Thomas A. Russo Lehman Brothers Howard Schneider MF Global Stephen F. Selig Brown Raysman Millstein Felder & Steiner LLP Paul Uhlenhop Lawrence, Kamin, Saunders & Uhlenhop Chicago, IL Emily M. Zeigler Willkie Farr & Gallagher Futures & Derivatives Law Report West Legalworks 195 Broadway, 9th Floor 10007 2008, Thomson Reuters/West One Year Subscription n 11 Issues n $438.00 (ISSN#: 1083-8562) Please address all editorial, subscription, and other correspondence to the publishers at west.legalworksregistration@thomson.com For authorization to photocopy, please contact the Copyright Clearance Center at 222 Rosewood Drive, Danvers, MA 01923, USA (978) 750-8400; fax (978) 646-8600 or West s Copyright Services at 610 Opperman Drive, Eagan, MN 55123, fax (651) 687-7551. Please outline the specific material involved, the number of copies you wish to distribute and the purpose or format of the use. West Legalworks offers a broad range of marketing vehicles. For advertising and sponsorship related inquiries or for additional information, please contact Mike Kramer, Director of Sales. Tel: 212-337-8466. Email: mike.kramer@thomson.com. This publication was created to provide you with accurate and authoritative information concerning the subject matter covered. However, this publication was not necessarily prepared by persons licensed to practice law in a particular jurisdication. 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. 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 Circular Letter No. 19 (2008) (the Circular Letter ), issued by the New York State Department of Insurance (the NYS Insurance Department ) on September 22, 2008, outlines best practices for financial guaranty insurers and includes specific recommendations regarding the provision by financial guaranty insurers of policies covering their affiliates payment obligations under credit default swap ( CDS ) transactions ( CDS Transactions ). In the Circular Letter, the NYS Insurance Department stated that a CDS Transaction is an insurance contract when it is purchased by a party who, at the time at which the agreement is entered into, holds, or reasonably expects to hold, a material interest in the referenced obligation. 2 Two months later, on November 20, 2008, the NYS Insurance Department issued a First Supplement to Circular Letter 19 (2008) (the First Supplement ), stating that the NYS Insurance Department would delay indefinitely its application of New York Insurance Law to CDS. 3 According to the First Supplement, the NYS Insurance Department s decision to refrain from regulating CDS at this time is based on the initiatives announced on November 14, 2008, by the President s Working Group on Financial Markets to strengthen oversight and transparency and to create a centralized market infrastructure for the over-the-counter derivatives market, including credit default swaps. 4 NYS Insurance Department Superintendent Eric Dinallo, however, has not retreated from his view, as stated in the Circular Letter, that a CDS Transaction is an insurance contract when the buyer has or expects to have a material interest in the subject of the transaction. This statement represents both an expansion of the common understanding of what constitutes insurance and a reversal of how prior NYS Insurance Department opinions have been interpreted by the marketplace. Admittedly, CDS Transactions and insurance contracts are very similar, and most newspaper and magazine articles attempt to explain CDS Transactions by using examples and terms from the insurance context: the buyer makes premium payments to the seller and receives a payment from the seller if a covered event occurs. Historically, however, the two products have been distinguished by the fact that insurance requires the buyer to have an insurable interest in the subject of the insurance, e.g., the house or car, as well as proof of loss incurred by virtue of the occurrence of the covered event. 5 CDS Transactions do not require the buyer to have an interest in the Reference Entity or an Obligation of the Reference Entity 6 and, thus, do not condition the seller s payment to the buyer upon the buyer s proof of loss by virtue of the occurrence of a Credit Event. For this and other reasons undoubtedly including an understandable reluctance on the part of the NYS Insurance Department to assume responsibility for regulating a global financial product the NYS Insurance Department s Office of General Counsel ( OCG ) issued an opinion, dated June 16, 2000, stating that a CDS Transaction is not insurance if the seller s payment to the buyer is not dependent upon the buyer having suffered a loss. 7 Given the current market turmoil and the blame that the CDS product has taken for the near collapse of the global financial markets, it is not surprising that the NYS Insurance Department stepped in to fill what was perceived as a regulatory vacuum with respect to CDS Transactions. At this time, there seems to be unanimous agreement among the Federal Reserve, the Securities and Exchange Commission and the Commodities Futures Trading Commission, as well as the NYS Insurance Department, that regulation of CDS Transactions should be at the federal level. Credit Default Swap Basics A credit default swap is a bilateral contract between a buyer of protection ( Buyer ) and a seller of protection ( Seller ) with respect to an obligation (usually a bond or loan) of a particular entity, called the Reference Entity. The Buyer pays a periodic fee to the Seller, and, if a certain specified Credit Event occurs, then the Seller is required to make a payment to the Buyer by means 2008 thomson reuters/west 3

Futures & Derivatives Law Report of either physical settlement or cash settlement. In a physical settlement transaction, the Buyer delivers to the Seller an obligation of the Reference Entity that has certain specified characteristics (a Deliverable Obligation ) in exchange for the face amount of the Deliverable Obligation. 8 In a cash settlement transaction, the payment from the Seller to the Buyer is the difference between the face amount of the Reference Obligation and its current market value. CDS Transactions are documented using standardized contracts and incorporating definitions published by the International Swaps and Derivatives Association, Inc. ( ISDA ). Most CDS Transactions are evidenced by an ISDA-based confirmation, which incorporates the ISDA Master Agreement entered into between the parties and the 2003 ISDA Credit Derivatives Definitions. How Market Participants Use Credit Default Swaps Parties may enter into CDS Transactions to gain or reduce exposure to credit risk. Credit exposure can be gained by the Seller of CDS protection without the initial cash outlay required when purchasing a bond or making a loan. In addition, a CDS Buyer can reduce exposure to a credit risk without actually selling the relevant loan or bond. This unique feature of CDS allows banks to purchase CDS protection in order to reduce their exposure to certain borrowers or industries without jeopardizing their customer relationships. For example, if a bank customer requests a $100,000,000 loan, and the bank is only willing to assume $50,000,000 in credit exposure to its customer, then, instead of referring the customer to a competitor or syndicating the loan, the bank could loan the entire $100,000,000 to its customer and buy CDS protection on the loan as the Reference Obligation in the Notional Amount of $50,000,000. As the CDS market developed, its uses expanded to include: (A) obtaining increased access to credit markets (bonds and loans are limited to the actual amount issued or borrowed by the underlying credit, but CDS has no parallel limitation); (B) the creation of new kinds of credit exposure not otherwise available in the market 9 ; (C) arbitraging perceived pricing inefficiencies in the capital structure of an issuer or between issuers; and (D) managing regulatory capital requirements (and potentially taking advantage of different capital requirements for banks versus insurance companies). In addition, a CDS Buyer may be seeking to terminate or offset another trade on the same or similar Reference Entity or Reference Obligation that it entered into as Seller, if the cost to terminate the first trade would exceed the present value of the future premium payments on the second trade (the same is also true for a CDS Buyer entering into a second trade as CDS Seller). Of all the additional uses of CDS Transactions noted above, only the diversification of credit exposure is a substitute for financial guaranty insurance. 10 Banks also participate in the CDS market by entering into client facilitation trades with their customers. When a customer wishes to buy CDS protection, the bank may enter into a CDS Transaction as Seller in order to facilitate the customer s strategy. CDS Transactions are natural investments for leveraged entities, such as hedge funds. Unlike a bond issued by a Reference Entity, a CDS Transaction is intrinsically leveraged because it does not require initial funding. Hedge funds make up a significant portion of the CDS Market, utilizing CDS Transactions to maximize returns and to manage portfolio risk. Insurance companies participate in the CDS market through non-insurance company subsidiaries ( transformers 11 ) and through what are called Replication transactions. Replication transactions are derivatives transactions entered into for the purpose of reproducing the investment effects of otherwise permissible investments. 12 A CDS Transaction entered into for any of these purposes could fall within the Circular Letter s definition of insurance if the CDS Buyer happens to own the asset that is the subject of the transaction. Regulation of CDS Federal Regulation of CDS The Commodity Futures Modernization Act of 2000 (the CFMA ) creates a safe harbor for CDS Transactions that preempts state and lo- 4 2008 Thomson Reuters/west

July/August 2008 n Volume 28 n Issue 7 cal gaming and bucket shop laws (other than any generally applicable anti-fraud provisions thereof) and exempts most CDS Transactions from regulation by the Commodity Futures Trading Commission ( CFTC ). CDS Transactions are expressly exempted from regulation by the CFTC so long as the contracts are not executed or traded on a trading facility and are between eligible contract participants 13 (including, most notably, financial institutions, mutual funds, commodity pools, and entities with total assets in excess of $10 million). One could therefore conclude that when, in 2000, Congress considered the regulation of CDS Transactions, it determined that regulation was not required where each of the parties was either a regulated entity or met the specified financial tests. The CFMA effectively excludes CDS Transactions from the registration requirements of the Securities Act of 1933, as amended (the Securities Act ) 14 and from the general provisions of the Exchange Act of 1934, as amended (the Exchange Act ) 15 because it clarifies that a swap based on a security is not a security. The CFMA introduced the term security-based swap agreement, to mean those swaps that derive at least one of their key terms from the price, yield, maturity or volatility of a security, group of securities or index of securities. 16 CDS Transactions fall within the definition of securitybased swap agreements when the Reference Obligation or Deliverable Obligation is a security, i.e., a bond. The only provisions of the Securities Act and the Exchange Act that apply to security-based swap agreements are the anti-fraud and anti-market manipulation provisions thereof. 17 NYS Insurance Department Treatment of CDS Regulation of FGI Insurance Policies on CDS The NYS Insurance Department regulates most of the nation s financial guarantee insurance companies ( FGIs ). 18 FGIs authorized to do business in New York must comply with various specialized and highly technical requirements intended to safeguard their financial solvency for the benefit of their policyholders. Until recently, the NYS Insurance Department allowed (with certain requirements) FGIs to guarantee the CDS payment obligations of their affiliated transformer 19 entities. In 1997, the NYS Insurance Department confirmed that an FGI may provide a financial guaranty policy with respect to the CDS payment obligations of an affiliated transformer resulting from the bankruptcy of or payment default by the issuer of the bond or other security referenced in the CDS. 20 The NYS Insurance Department determined that the guaranty of the transformer s obligations as CDS Seller was substantially similar to a direct guarantee of the underlying obligation protected by the CDS, and thus permissible under Insurance Law 6904(b)(1)(J). 21 The 1997 Opinion Letter did not address the status of early termination payments under CDS Transactions resulting from events of default or termination events with respect to the transformer or the FGI as guarantor. That clarification came in 1999, when the NYS Insurance Department published another opinion clarifying that guarantees of early termination payments do not represent guarantees of acceleration payments prohibited under [Insurance Law] Section 6905. 22 The 1997 and 1999 opinions of the NYS Insurance Department formed the basis of the 2004 amendment to Article 69 of the New York State Insurance Law, which modified the definition of asset-backed securities (a permissible guarantee category under Section 6904(b)(1)(F)) to include a pool of credit default swaps or credit default swaps referencing a pool of obligations, subject to certain requirements. 23 Therefore, if the CDS itself does not constitute an insurance contract or the doing of an insurance business, then an FGI is permitted to issue an insurance policy that guarantees payments by a transformer or other party pursuant to such CDS. In addition, the amendment added to Insurance Law 6901(j-1) the following definition for CDS: 2008 thomson reuters/west 5

Futures & Derivatives Law Report Credit default swap means an agreement referencing the credit derivative definitions published by the International Swap and Derivatives Association, Inc. or otherwise acceptable to the superintendent, pursuant to which a party agrees to compensate another party in the event of a payment default by, insolvency of, or other adverse credit event in respect of, an issuer of a specified security or other obligation; provided that such agreement does not constitute an insurance contract and the making of such credit default swap does not constitute the doing of an insurance business. 24 The NYS Insurance Department s recent diversion from its previous position certainly narrows the scope of available protection under policies issuable by FGIs. The Circular Letter states that it expects FGIs will limit the risks it covers under its policies to namely, only failure to pay obligations when due or payable when the failure is the result of a financial default or insolvency. 25 Moreover, the NYS Insurance Department s categorization of certain CDS Transactions as insurance contracts may also mean that FGIs will not be authorized to issue policies covering those CDS Transactions that fall within the NYS Insurance Department s expanded definition of insurance. The language of the Circular Letter also calls into question the continuing viability of the NYS Insurance Department s prior opinions on the relationship between derivatives transactions and contracts of insurance. NYS Insurance Department Treatment of CDS In New York, an insurance contract is defined as any agreement or other transaction whereby one party, the insurer, is obligated to confer a benefit of pecuniary value upon another party, the insured or beneficiary, dependent upon the happening of a fortuitous event in which the insured or beneficiary has, or is expected to have at the time of such happening, a material interest which will be adversely affected by the happening of such event. 26 Clearly, CDS Transactions and insurance contracts share some of the same characteristics. A Credit Event triggered under a CDS Transaction could constitute the happening of a fortuitous event, and the payment due from the Seller to the Buyer upon settlement of the CDS Transaction would be an obligation to confer a benefit of pecuniary value upon the Buyer. The similarities break down, however, when we examine the material interest component of the definition, because there is no requirement in a CDS Transaction for the Buyer to have any interest whatsoever that could be adversely affected by the Credit Event. CDS Transactions do not require the Buyer to own or have any interest in the Reference Entity or an Obligation of the Reference Entity. Another factor distinguishing a CDS Transaction from an insurance contract is the absence of any requirement that the occurrence of the Credit Event cause the CDS Buyer to suffer a loss. By contrast, the term insurance contemplates that the insured or beneficiary has or expects to have a material interest in the subject of the insurance, e.g., the house or car, as well as proof of loss incurred by virtue of the occurrence of a fortuitous event. For this reason, the NYS Insurance Department concluded in a 1998 opinion that certain catastrophe options were not subject to regulation as insurance because they did not obligate the option seller to indemnify the purchaser for actual losses incurred by the purchaser. 27 Similarly, that same year, the NYS Insurance Department determined that an index swap transaction did not constitute insurance unless the terms of the instrument provide that payment to the Fixed Rate Payment Payer is dependent upon that party suffering a loss. 28 Two years later, in 2000, the Office of General Counsel of the NYS Insurance Department issued an informal opinion stating that weather derivatives are not insurance contracts because these derivatives contracts do not provide that payment to the purchaser is dependant upon that party suffering a loss. The opinion states that [n] either the amount of the payment nor the trigger itself in the weather derivative bears a relationship to the purchaser s loss. Absent such obligations, the instrument is not an insurance contract. 29 Specifically with respect to CDS Transactions, the NYS Insurance Department concluded in an opinion dated June 16, 2000, that a CDS is not 6 2008 Thomson Reuters/west

July/August 2008 n Volume 28 n Issue 7 an insurance contract because the Seller s payment is not conditioned upon a loss incurred by the Buyer. 30 Based on the line of reasoning in the precedent opinions, the consistent position of the NYS Insurance Department has been abundantly clear: Unless the seller s payment obligation is based on actual loss incurred by the buyer, a derivatives contract is not insurance. 31 Nonetheless, the Circular Letter states that the categorization of certain CDS Transactions as insurance is not a reversal, but simply a clarification, of its 2000 OGC Opinion Letter: Although OGC s June 16, 2000 opinion suggests that a CDS is not an insurance contract if the payment by the protection buyer is not conditioned upon an actual pecuniary loss, that opinion did not grapple with whether, under Insurance Law 1101, a CDS is an insurance contract when it is purchased by a party who, at the time at which the agreement is entered into, holds, or reasonably expects to hold, a material interest in the referenced obligation. 32 Superintendent Eric Dinallo in testimony before Congress reiterated his view that the 2000 OGC Opinion Letter is incomplete and was never intended to exempt covered CDS from insurance regulation. 33 Dinallo testified: Clearly, the question was framed to ask only about naked credit default swaps with no proof of loss. Under the facts we were given, the swap was not a contract of insurance, because the buyer had no material interest and the filing of claim does not require a loss. But the entities involved were careful not to ask about covered credit default swaps. Nonetheless, the market took the Department s opinion on a subset of credit default swaps as a ruling on all swaps and, to be fair, the Department did nothing to the contrary. 34 The NYS Insurance Department has made a clear distinction between naked CDS where the Buyer has no material interest in the underlying entity or obligation and covered CDS where the Buyer either has or expects to have such a material interest. According to the NYS Insurance Department, naked CDS is not insurance but covered CDS is insurance. 2008 thomson reuters/west 7

Futures & Derivatives Law Report 8 2008 Thomson Reuters/west

July/August 2008 n Volume 28 n Issue 7 Market View That CDS Is Not Insurance As discussed above, the NYS Insurance Department s opinions prior to the Circular Letter consistently held that swaps are not insurance unless the swap contract conditions payment upon a party s actual loss. Because there is no requirement in a CDS Transaction that the Buyer actually hold the Reference Obligation, the fact that a particular Buyer actually did hold the Reference Obligation did not put the parties on notice that their contract might be viewed by the NYS Insurance Department as constituting insurance. Indeed, there was no reason for the Seller to know whether the Buyer held the Reference Obligation and no requirement for the Seller to inquire. By contrast, as noted above, an insured cannot obtain insurance unless he has an insurable interest 35 in the subject of the insurance. In addition, an insured cannot collect under a policy without showing proof of loss, and any settlement with respect to the amount owed is determined by the parties themselves. A significant portion of the CDS market is unrelated to the protection of an asset owned by the Buyer. Even under a CDS Transaction where the Buyer holds the Reference Obligation, the Buyer can sell the Reference Obligation at any time without having to terminate the CDS Transaction and, if a Credit Event occurs with respect to that Reference Obligations, collect a settlement payment from the Seller. As noted in footnote 8 above, the amount of the settlement payment generally is determined through a market-wide auction process, and the payment itself may not even come from the particular Seller. The recent market turbulence, including the collapse of Lehman Brothers and Washington Mutual and the bailout of Bear Stearns, Fannie Mae, Freddie Mac and AIG, has resulted in plans for increased federal regulation of the over-thecounter derivatives markets in general and CDS Transactions in particular. In March 2008, President Bush created the President s Working Group on Financial Markets (the PWG ) headed by Treasury Secretary Henry Paulson and including Federal Reserve Chairman Ben Bernake and Securities and Exchange Commission Chairman Christopher Cox. The PWG s goals are: (i) to improve market transparency and integrity for CDS, (ii) to enhance risk management of OTC derivatives, (iii) to strengthen OTC derivatives market infrastructure, and (iv) to continue cooperation among regulators. 36 In order to help streamline the regulatory process, promote consistent oversight, and enhance cooperation, the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission and the CFTC` entered into a Memorandum of Understanding on November 14, 2008 (the Memorandum ). Under the Memorandum, the parties established a framework for cooperation, information sharing and consultation related to the creation of central counterparties for CDS Transactions. 37 Central counterparties would interpose themselves between CDS market participants and provide clearing and settlement services. 38 Differences Between CDS and Insurance In addition to the differences already discussed, CDS Transactions and insurance contracts differ in the way they are underwritten and taxed. The underwriter of an insurance policy evaluates the asset being insured, while the CDS Seller looks at the creditworthiness of the Buyer as well as the market price of the CDS Transaction. An insurance premium is typically an annual amount that is payable as agreed between the parties and is subject to adjustment on a periodic basis (typically, annually) at the discretion of the insurer. If the insured fails to make a required premium payment, the policy is cancelled by the insurer. In a CDS context, the parties agree to the duration of the Transaction, which is generally a period of several years and which is specified in the CDS Transaction confirmation. The CDS premium usually is paid quarterly and the premium rate remains constant throughout the term of the CDS Transaction. If the Buyer fails to make a required payment, the Seller has the right under the ISDA Master Agreement to terminate all outstanding Transactions (which may include other types of derivatives transactions as well as other CDS Transactions), obtain a close-out amount, and pursue the Buyer for that amount. In addition, 2008 thomson reuters/west 9

Futures & Derivatives Law Report because a CDS Transaction is for a set term, the Buyer has no legal right to terminate the trade; a CDS Buyer that no longer wants the trade either has to come to an agreement with the Seller regarding a termination price or, with the Seller s consent, assign the trade to a third party. In either case, the termination payment may be payable by either Buyer or Seller depending upon the then current market value of the trade). Upon the occurrence of an event constituting a risk covered by the policy, the insured must show proof of his loss in order to receive payment. The insurer also can resist payment to the beneficiary based upon a number of well-established defenses including, most notably, fraud. A defense to payment based on fraud could be predicated, for example, on the duty of the insured to make the required disclosures on the insurance application. There are no parallel defenses to payment with respect to CDS Transactions because no such duty exists between the parties to a CDS Transaction. If a Credit Event occurs and the CDS Buyer follows the procedures for settlement, the Seller must make payment on the CDS Transaction. Except in very limited situations, a CDS Seller cannot argue that its Buyer failed to disclose material information or lied when negotiating the terms of the trade. In fact, each party to a CDS Transaction expressly acknowledges that it is not relying on any information provided by the other party and that it is capable of evaluating the risks of the transaction. CDS Transactions and insurance contracts may also be subject to different tax regimes. In an insurance contract, the insurance settlement may not be taxed at all as the settlement is based on the actual loss suffered and that loss may be equal to the tax basis of the damaged property. The amount of a CDS settlement payment is based on the difference between the current value of the Deliverable Obligation or Reference Obligation and its Par Value, and the actual loss, if any, to the Buyer is not relevant. The Buyer s premium payment is treated differently as well: a company purchasing insurance on an asset generally would be able to deduct the premium payment as a cost of doing business. A CDS Buyer may not be entitled to a similar tax deduction. There is also the question whether covered CDS will be subject to U.S. excise tax. Insurance premiums paid to foreign persons with respect to a U.S. risk are subject to excise tax. Market participants have distinguished CDS from insurance contracts subject to excise tax because CDS does not require the Buyer to suffer an actual loss and does not contemplate risk shifting or distribution, 39 but commentators have stated that certain CDS may be subject to U.S. excise tax if the contract requires the Buyer to hold the underlying obligation. 40 Conclusion Even though, based on the First Supplement, it is unlikely that covered CDS will be regulated as insurance by the NYS Insurance Department, the First Supplement reiterates the determination by the NYS Insurance Department in the Circular Letter, that covered CDS Transactions are properly classified as insurance contracts. The classification of covered CDS Transactions as insurance may have serious ramifications whether these transactions are ultimately regulated by the NYS Insurance Department or by a federal regulator. As discussed above, the Internal Revenue Service taxes insurance payments differently from CDS payments, and the Financial Accounting Standards Board may weigh in on this as well. Further, while two U.S. eligible contract participants cannot invalidate their CDS Transaction, a non-u.s. CDS Seller might be able to avoid making a settlement payment to its Buyer based on defenses that otherwise would not be available to a CDS Seller but that are available to an insurer. At this point one can only guess at what consequences will flow from the NYS Insurance Department s determination. NOTES 1. N.Y. Ins. Dept. First Supplement to Circular Letter No. 19 (2008), November 20, 2008; see Eric Dinallo, Testimony Before the House of Representatives Committee on Agriculture, Hearing to Review the Role of Credit Derivatives in the U.S. Economy, November 20, 2008. 2. N.Y. Ins. Dept. Circular Letter No. 19 (2008), 7, September 22, 2008. 3. N.Y. Ins. Dept. First Supplement to Circular Letter No. 19 (2008), November 20, 2008; see 10 2008 Thomson Reuters/west

July/August 2008 n Volume 28 n Issue 7 Eric Dinallo, Testimony Before the House of Representatives Committee on Agriculture, Hearing to Review the Role of Credit Derivatives in the U.S. Economy, November 20, 2008. 4. Id. 5. In the case of life insurance, the beneficiary is entitled to the entire contract amount upon the death of the insured, i.e., loss to the insured is presumed. 6. These terms ( Reference Entity and Obligation ) are defined in the 2003 ISDA Credit Derivatives Definitions, as are the terms Credit Event, Reference Obligation and Deliverable Obligation used elsewhere in this article. 7. N.Y. Ins. Dept. Op. Off. Gen. Couns., 2000 NY Insurance GC Opinions LEXIS 144, *2, June 16, 2000. 8. Because the notional amount of outstanding CDS Transactions far exceeds the amount of outstanding Deliverable Obligations, physical settlement by all CDS Buyers is not feasible. Market participants, under the auspices of the International Swaps and Derivatives Association, Inc., have developed a protocol methodology whereby the adhering parties amend their agreements to provide for cash settlement and an auction process to determine the cash settlement final price. 9. For example, an investor who wants to take five-year (or longer) exposure to a particular issuer would be able to do that through a CDS Transaction even if the issuer has outstanding only a three-year credit facility and commercial paper. Conversely, if the issuer has only longterm bonds outstanding, an investor could use CDS to take shorter term exposure. A CDS Transaction can be effected at a time when a cash bond of the Reference Entity of a particular maturity is not available. 10. As discussed below, the definition of CDS in Section 6901(j-1) of the New York Insurance Law includes the proviso that such agreement does not constitute an insurance contract and the making of such credit default swap does not constitute the doing of an insurance business. N.Y. Ins. Law 6901(j-1) (McKinney 2004). 11. See n. 19, infra. 12. N.Y. Ins. Law 1401(a)(18) (McKinney 1984). 13. Commodities Exchange Act, 7 U.S.C. 1(a)(12) (1936), defines an eligible contract participant as: 1. a financial institution; 2. a regulated insurance company, foreign or domestic; 3. a regulated investment company, foreign or domestic; 4. a regulated commodity pool with total assets in excess of $5,000,000, foreign or domestic; 5. a corporation, partnership, proprietorship, organization, trust, or other entity: a) that has total assets exceeding $10,000,000; b) the obligations of which under the agreement, contract, or transaction are guaranteed or otherwise supported by certain entities (but not by individuals); c) that has a net worth exceeding $1,000,000 and that enters into the agreement, contract, or transaction in connection with the conduct of its business or to manage the risk associated with an asset or liability owned or incurred in the conduct of its business; 6. a certain type of an ERISA plan, foreign or domestic; 7. a certain type of a governmental entity, foreign or domestic; 8. a broker-dealer (other than an individual) registered under the Exchange Act; 9. a futures commission merchant subject to regulation under the CEA; 10. a floor broker or floor trader subject to regulation under the CEA; and 11. an individual who has total assets in an amount in excess of a) $10,000,000; or b) $5,000,000 and who enters into the agreement, contract, or transaction in order to manage the risk associated with an asset owned or liability incurred, or reasonably likely to be owned or incurred, by the individual. 14. Securities Act 2A. (b)(2), 15 U.S.C. 77b et seq. added by 302 of Commodities Futures Modernization Act of 2000, H.R. 4577, 106th Cong. (2000). 15. Exchange Act 3A.(b)(1), 15 U.S.C. 78c et seq. added by 303 of Commodities Futures Modernization Act of 2000. 16. Graham-Leach-Bliley Act, 206B, added by 301(a) of Commodities Futures Modernization Act of 2000. 17. Specifically, see Securities Act of 1933, 15 U.S.C 77(a) et seq., 17(a) (anti-fraud provisions), paragraphs (2) through (5) (anti-manipulation and anti-fraud provisions) and Securities Exchange Act of 1934, 15 U.S.C. 78(a) et seq., 9(a), 10(b) (adding security-based swap agreement to anti-manipulation provisions), 15(c)(1) (adding security-based swap agreement to anti-fraud provisions), 20(d) (adding securitybased swap agreement to insider trading provisions) and 21A(a)(1) (including securitybased swap agreements in the civil penalty provisions). 18. See Circular Letter, supra note 1, Best practices for financial guaranty insurers, at page 1, 2008 thomson reuters/west 11

Futures & Derivatives Law Report noting that FGIs that are not legally domiciled in New York are licensed to issue financial guaranty insurance under Article 69 of the New York Insurance Law. 19. FGIs, known as monolines, are only permitted to issue financial guaranty insurance policies and are not permitted to enter into other types of transactions. Therefore, in order to assume the economic risk of a CDS Seller, an FGI typically would create a special purpose bankruptcyremote entity, referred to as a transformer, that would act as the CDS Seller, and the FGI then would issue a financial guaranty insurance policy to guarantee the performance of the transformer to the CDS Buyer. 20. See N.Y. Ins. Dept. Op. Off. Gen. Couns., September 24, 1997 (the 1997 OGC Opinion Letter ). 21. The NYS Insurance Department required that the FGI meet certain requirements, including that the FGI use its customary underwriting criteria, that the CDS tenor not exceed five years, and that the referenced security be rated at least investment grade. 22. N.Y. Ins. Dept. Op. Off. Gen. Couns., April 8, 1999 (the 1999 OGC Opinion Letter ). 23. N.Y. Ins. Law 6901 (McKinney 2005). 24. N.Y. Ins. Law 6901 (j-1) (McKinney 2005) (emphasis added). 25. See Circular Letter, supra note 1. 26. N.Y. Ins. Law 1101(a)(1) (McKinney 2003). 27. Catastrophe Options Opinion, dated June 25, 1998, p. 2. 28. Index Swap Transaction Opinion, dated June 26, 1998, p. 1. That letter stated: In order for an Index Swap (or other derivative) to constitute an insurance contract, it must obligate the index payer (as insurer) to indemnify the Fixed Rate Payment Payer (as insured) for the actual loss incurred by the Fixed Rate Payment Payer. Indemnification of loss is an essential indicia of an insurance contract which courts have relied upon in the analysis of whether a particular agreement is an insurance contract under New York law. Absent such a contractual provision the instrument is not an insurance contract. Id. at 2. 29. N.Y. Ins. Dept. Op. Off. Gen. Couns., February 15, 2000 (the 2000 OGC Opinion Letter ). 30. See N.Y. Ins. Dept. Op. Off. Gen. Couns., supra note 6. 31. See, e.g., 1997 OGC Opinion Letter; 1999 OGC Opinion Letter; and 2000 OGC Opinion Letter. 32. See Circular Letter, supra note 1, at 5; see N.Y. Ins. Dept. Op. Off. Gen. Couns., supra note 6. 33. Eric Dinallo, Testimony before the Senate Committee on Agriculture, Nutrition and Forestry, October 14, 2008. 34. Id. 35. No contract or policy of insurance shall be enforceable except for the benefit of some person having an insurable interest in the property insured. N.Y. Ins. Law 3401 (McKinney 1985). Insurable interest shall include any lawful and substantial economic interest in the safety or preservation of property from loss, destruction or pecuniary damage. Id. 36. PWG Policy Objectives, www.treasury.gov/ press/releases/reports/policyobjectives.pdf, November 14, 2008. 37. Memorandum of Understanding between the Board of Governors of the Federal Reserve System, the U.S. Commodity Futures Trading Commission and the U.S. Securities and Exchange Commission Regarding Central Counterparties for Credit Default Swaps, November 14, 2008. 38. Id. at 1-2. 39. See I.R.S. Bulletin 2004-32 (August 9, 2004) (requesting comments on U.S. tax treatment of CDS and discussing how some commentators have distinguished CDS from insurance). 40. See New York State Bar Association, Tax Section Comments on Credit Default Swap Rules, September 9, 2005. 12 2008 Thomson Reuters/west