CORPORATE AFTERSHOCK 2 PHẦN 7 pdf

Certainly after Enron, counter parties to unfunded credit derivatives and investors in funded credit derivatives would do well to review carefully the representations by credit providers

Enron lenders were to deliver to the SPE “senior obligations of Enron that rank[ed] at least equal to claims against Enron for senior unsecured in-debtedness for borrowed money” having a principal balance equal to the notional amount of the CDS The SPE was to deliver to the Enron lenders the SPE’s investments with a principal amount equal to the amount of Enron debt delivered to the SPE, plus the base amount of the subordi-nated notes.25

When Enron failed, the Enron CLNs performed precisely as they were intended, relieving the Enron lenders of all loss with respect to the ref-erence Enron obligations up to the notional amount of the CDS But be-cause of the generally unanticipated and highly suspicious nature of Enron’s bankruptcy, considerable criticism has been leveled at the Enron lenders for shifting their credit exposure to the capital markets Citigroup has responded that “[c]redit-linked notes are well-recognized f inancial instruments, widely issued and traded each year The instruments were sold to the largest, and most sophisticated, institutional investors in several Rule 144A offerings Citi promised investors that the CLNs would perform similarly to straight Enron bonds—and they have.”26

But the issues in the litigation over the Enron CLNs do not concern the legitimacy of the Enron CLN structure or the sophistication of the purchasers Rather, the thrust of the litigation is that the Enron lenders were willing to lend great sums of money to Enron either without con-ducting appropriate due diligence or with knowledge that Enron’s

credit-worthiness was not being accurately reported because they had no intention

of ever being exposed to Enron’s credit risk In other words, the key alle-gations in the litigation involve an assertion that the Enron lenders “lent Enron more the $2.5 billion and invested at least $25 million in Enron’s fraudulent partnerships in order to secure future investment banking busi-ness”27and that they were willing to do this because they intended “fraud-ulently [to] shift 100 percent of their risk of loss” to unknowing note holders.28

Obviously, the allegations in the Hudson Soft litigation are just

that—al-legations Nevertheless, they raise a serious issue concerning the use of credit derivatives A credit provider intending to reduce or eliminate its credit risk through the use of credit derivatives may well have significantly more information about the reference entity or portfolio than the poten-tial counter party or note purchasers The concern is that this information will not be shared either through the swap negotiation process or in the note sale disclosure documents Certainly after Enron, counter parties to unfunded credit derivatives and investors in funded credit derivatives would do well to review carefully the representations by credit providers and all disclosures concerning the credit condition of the reference entity

CR EDI T DE R I VAT I V E S OR I NSU R A NC E

Credit derivatives and insurance have a number of similarities, and, in-deed, credit derivatives are often characterized as functioning, in many circumstances, as the financial equivalent of indemnity contracts and fi-nancial guarantees But functional equivalence is one thing and legal

equivalence is another If credit derivatives were deemed to be insurance,

the consequences under state insurance law would be highly adverse for this vibrant and valuable market

For example, a derivative that is found to be an insurance policy can

be sold only by a licensed insurance broker Thus, a protection seller found to have been selling an insurance contract would be acting unlaw-fully In California, this would be a misdemeanor.29In Connecticut, fines, imprisonment, or both can be imposed for acting “as an insurance pro-ducer” without a license.30Under Delaware law, a Delaware corporation can lose its “charter” to do business31if it acts “as an insurer” without a

“certif icate of authority”32 to conduct an insurance business.33 In New York, insurance law violations are a misdemeanor,34with fines increasing for subsequent violations.35And in Illinois, no one can “sell, solicit, or ne-gotiate insurance” unless licensed.36

Because the term insurance contract is separately def ined by each of

the 50 states and the District of Columbia,37it becomes important for the participants in the credit derivatives market to understand and abide by clear guidelines to ensure that credit derivatives—financial market trans-actions—are not treated as insurance, which are state-regulated service contracts

Act ivit ies Assoc iated with Insurance

The leading insurance treatise defines insurance as:

A contract by which one party (the insurer), for a consideration that is usu-ally paid in money, either in a lump sum or at different times during the continuance of the risk, promises to make a certain payment, usually of money, upon the destruction or injury of ‘something’ in which the other party (the insured) has an interest [cite omitted] In other words, the pur-pose of insurance is to transfer risk from the insured to the insurer Insur-ance companies act as f inancial intermediaries by providing a f inancial risk transfer service that is funded by the payment of insurance premiums that they receive from policyholders 38

In evaluating which “financial risk transfer services” are insurance, five characteristics are typically identified:

1 The insured must have an “insurable risk” (such as the risk of a

f inancial loss on the occurrence of a disaster, theft, or credit event) with respect to a “fortuitous event” that is capable of f i-nancial estimate.39

2 The insured must “transfer” its “risk of loss” to an insurance

com-pany (referred to as risk shifting or underwriting), under a contract

that provides the insured with an “indemnity” against the loss (with the indemnity limited to the insured’s actual loss)

3 The insured must pay a “premium” to the insurance company for assuming the insured’s “insurable risk.”

4 The insurance company typically assumes the risk as part of a larger program for managing loss by holding a large pool of con-tracts covering similar risks This pool is often large enough for actual losses to fall within expected statistical benchmarks

(re-ferred to as risk distribution or risk spreading).40

5 Before it can collect on an insurance contract, the insured must demonstrate that its injury was from an “insurable risk” as the re-sult of an “insured event.” In other words, the insured must demon-strate that it has actually suffered a loss that was covered in the contract

In general, therefore, an insurance contract covers the risk that an insured will suffer an insured loss, and payment is due under the insur-ance contract only if there is “proof of an insured loss,” and then only in

an amount equal to the lesser of the insured’s actual loss or the maximum loss covered by the contract

Credit De r ivat ives Are Not Insurance

New York State is a key insurance regulator with jurisdiction over most of the largest insurance companies in the United States As a consequence,

New York’s view of when a contract does and does not constitute insurance

is highly inf luential In New York, an insurance contract is defined as an agreement under which the insurance company is obligated “to confer a benef it of pecuniary value” on the insured or benef iciary on the “hap-pening of a fortuitous event in which the insured has a material in-terest which will be adversely affected” by the happening of such event.41

In determining whether a risk shifting contract falls within this definition

or outside it, New York’s basic approach is entirely consistent with the pre-ceding discussion

The New York Insurance Department (N Y ID) takes the position that derivative contracts are not insurance contracts as long as the payments

due under the derivatives are not dependent on the establishment of an actual loss For example, in considering catastrophe options (Cat options) providing for payment in the event of a specified natural disaster (such

as a hurricane or major storm), the NY ID stated that the Cat options were not insurance contracts because the purchaser did not need to be injured

by the event or prove it had suffered a loss In reaching this conclusion,

the N Y ID distinguished between derivatives products, which transfer risk without regard to a loss, and insurance, which transfers only the risk of a

purchaser’s actual loss.42

Similarly, the N Y ID concluded that weather derivatives are not in-surance contracts under New York law because neither the amount of the payment due nor the event triggering the payment necessarily relates to the purchaser’s loss.43 And most recently, the N Y ID concluded that be-cause CDSs provide that the seller must pay the buyer on the occurrence

of a “negative credit event” without regard for whether the buyer has “suf-fered a loss,” they are not insurance contracts.44It appears clear, there-fore, at least under New York law, that if the provisions of a credit derivative contract do not tie payment to the actual loss experience of the protection buyer, the derivative product will not be deemed an in-surance contract

Doc ument at ion Conside rat ions

There are, nevertheless, certain conceptual overlaps between credit de-rivative contracts and insurance contracts As a consequence, care should

be taken in documenting such derivative contracts to avoid any implica-tion that a party will receive a payment under the contract only for actual loss To ensure that credit derivatives are treated as derivatives and not as insurance, the following drafting guidelines may be helpful:

䡲 Form of contract: Unfunded credit derivatives should be documented

with an ISDA Master Agreement with the specif ic terms of the agreement specified in the schedule, confirmations, and any credit support documents The offering material for funded credit de-rivatives (notes) should specify the terms of the notes in language

as similar to that of the ISDA definitions as possible

䡲 Disclaimer: The documentation for both funded and unfunded

credit derivatives should include a disclaimer that the transaction

is not intended to be insurance, the contract is not suitable as a substitute for insurance, and the contract is not guaranteed by any

“Property and Casualty Guaranty Fund or Association” under ap-plicable state law

䡲 Marketing materials: Marketing materials for a credit derivative

transaction should avoid any references to similarities between the

contract and insurance and should not use words such as

indem-nity, guarantee, and protect.

ONGOI NG EF FORT S TO I M PROV E DOCUM EN TAT ION

The documentation of unfunded credit derivatives is generally done on ISDA-published forms.45Indeed, ISDA has taken the lead in standardizing the terms of credit derivatives In 1998, it published a model “Confirma-tion of OTC Credit Swap Transac“Confirma-tion.” In 1999, it published the “1999 ISDA Credit Derivatives Def initions,” which were followed in 2001 by three supplements that expanded and clarified the 1999 definitions.46As

a result of Enron, Argentina, and numerous other credit defaults, ISDA worked throughout 2002 to draft and release a comprehensive set of re-vised credit definitions

ISDA’s 2003 Credit Derivatives Def initions, published on February

11, 2003, incorporate the three ISDA supplements issued in 2001 to the

1999 credit def initions, update many of the def initions, and generally bring documentation standards current with evolving market practices

As a result, we believe that the documentation practice for credit deriva-tives have been substantially improved

CONC LUSION

As a result of the credit defaults during the early part of this century, the value of the credit derivatives market has become more apparent than ever While representing a natural extension of the markets for products that “unbundled” risks, such as those for interest rate and foreign ex-change derivatives, the credit derivatives market has provided a unique mechanism for assuming and shedding direct exposure to a reference en-tity’s creditworthiness As such, credit derivatives represent a unique and important development for the worldwide financial markets

Despite concerns about the misuse of credit derivatives (as

high-lighted by the Hudson Soft litigation) and the desirability of further

fine-tuning of ISDA documentation, the credit derivatives market has proven itself to be sound, effective, and vigorous through a very difficult credit period Further, it is important to recognize that this market has devel-oped and adapted without governmental regulation or supervision

It is also interesting to note the development of the credit deriva-tives markets alongside the highly regulated insurance market Primar-ily because of tax considerations, there remain enormous incentives for

insurance companies to provide credit loss protection through insurance contracts Nevertheless, we are seeing increasing intersections between

the derivatives and insurance markets as the nature of the risks assumed

by these markets converge Thus, for example, more and more so-called

transformer transactions are occurring whereby a f inancial instrument

(e.g., a CDS) is transformed into an insurance contract or vice versa.47

Insurance companies, prohibited under applicable state law from en-tering into credit derivatives, can often assume the same economic po-sition as if they had “sold” protection to a derivatives counter party by issuing an insurance policy against a credit event specif ied in the de-rivative held by the insured The insurance company thus assumes the economic results of holding the credit derivative while still complying with regulatory restrictions

The expansion and strengthening of the credit derivatives market will unquestionably contribute to a more efficient allocation of credit risk in the economy This market will allow banks efficiently to reduce undesir-able concentrations of credit exposure by diversifying this risk beyond their customer base This market should also lead to improved pricing informa-tion relating to both loans and credit exposures generally In addiinforma-tion, this market will facilitate further specialization whereby financial institutions can fund participants in limited areas of commercial activity without hav-ing to bear the risk of excessive exposure to such limited sectors Finally,

by separating both risk from funding obligations and original risk from restructured risk, credit derivatives offer an extraordinarily important mechanism for financial market participants to play precisely the role at precisely the risk/reward level they deem prudent and appropriate

NOTE S

1 It has been reported that the International Swaps and Derivatives

Associa-tion (ISDA) f irst used the term credit derivatives in 1992 “EvoluAssocia-tion of Credit

Derivatives,” available at http://www.credit-deriv.com/evolution.htm (vis-ited November 4, 2002).

2 Remarks by Alan Greenspan, chairman, Board of Governors of the U.S Fed-eral Reserve System, at the Institute of International Finance, New York (via videoconference) (April 22, 2002), available at http://www.federalreserve gov/boarddocs/speeches/2002/20020422/default.htm (visited October

16, 2002) (hereinafter “Greenspan Remarks”).

3 ISDA, News Release, “ISDA 2002 Mid-Year Market Survey Debuts Equity De-rivatives Volumes at $2.3 Trillion; Identif ies Signif icant Increase for Credit Derivatives,” (September 25, 2002), available at http://www.isda.org/press /index.html (visited October 22, 2002).

4 See note 3.

5 BBA, Credit Derivatives Survey, 2001/2002, Executive Summary, available at http://www.bba.org.uk/pdf/58304.pdf (visited September 20, 2002).

6 Off ice of the Comptroller of the Currency, “OCC Bank Derivatives Report, Second Quarter 2002,” available at http://www.occ.treas.gov/ftp/deriv /dq202.pdf (visited October 14, 2002), 1.

7 See note 2.

8 Reference obligations are also referred to in discussions of credit

deriva-tives as reference assets or reference credits.

9 In fact, the 1999 ISDA Credit Derivatives Def initions simply def ine a Credit

Derivative Transaction as “any transaction that is identified in the related

Con-f irmation as a Credit Derivative Transaction or any transaction that incor-porates these Def initions.” 1999 Credit Def initions, at § 1.1.

10 Banking or insurance regulations may require a bank or insurance market participant to own a reference obligation, but that is not a requirement for entering into a CDS.

11 1999 Credit Def initions 16 –18.

12 For example, if after a credit event, a reference obligation is valued at $3 million and the notional amount specif ied in the contract is $10 million, the protection seller must pay the protection buyer $7 million Alternatively,

the protection seller may be required to pay a predetermined sum (a binary

settlement) regardless of the then-value of the reference obligation.

13 Board of Governors of the Federal Reserve System, “Supervisory Guidance

for Credit Derivatives,” SR Letter 96-17 (August 12, 1996), Appendix.

14 “Depending on the performance of a specif ied reference credit, and the type of derivative embedded in the note, the note may not be redeemable at par value For example, the purchaser of a credit-linked note with an em-bedded default swap may receive only 60 percent of the original par value if

a reference credit defaults” ( J.P Morgan, 1998).

15 See note 14.

16 OCC, OCC Bulletin 96 - 43, “Credit Derivatives Description: Guidelines for National Banks,” available at http://www.occ.treas.gov/f h/bulletin/96 - 43.txt (visited November 26, 2002).

17 Goodman (2002), pp 60 –61 SCDOs are referred to as synthetic because the

credit exposure is created by the derivative contract and not with an actual obligation of, or relationship with, the reference portfolio.

18 Gibson, Lang, “Synthetic Credit Portfolio Transactions: The Evolution of Synthetics,” available at www.gtnews.com/articles6/3918.pdf (visited Octo-ber 1, 2002).

19 See note 18.

20 Hudson Soft Co Ltd et al v Credit Suisse First Boston Corp et al., Civil Action

02-CV-5768 (TPG) (October 8, 2002) (Amended Complaint).

21 We used the phrase structured f inance transactions as it is used by Kavanagh in

Chapter 8 as any transaction that makes use of an SPE or special purpose ve-hicle (SPV).

22 Newby v Enron Corp (In re Enron Corp., Securities Litigation), Civil Action

No H- 01-3624, 206 F.R.D 427.

23 Hudson Soft Class Action Amended Complaint, supra note 25, at 44 –58.

24 On November 4, 1999, Yosemite Securities Trust I 8.25 percent Series 1999-A Linked Enron Obligations in the aggregate amount of $750 million were issued On August 25, 2000, Enron Credit Linked Notes Trust issues Enron CLNs in the aggregate amount of $500 million On May 24, 2001, three separate Enron CLNs were issued: (1) Enron Euro Credit Linked Notes Trust 6.5 percent Notes in the aggregate amount of EUR200 million, (2) Enron Sterling Credit Linked Notes Trust 7.25 percent Notes in the ag-gregate amount of £125 million, and (3) Enron Credit Linked Notes Trust

II 7.3875 percent Notes in the aggregate amount of $500 million On Octo-ber 18, 2001, Credit Suisse First Boston International JPY First-to-Default Credit Linked 0.85 percent Notes were issued in the aggregate amount of

¥1.7 trillion.

25 S&P Corporate Ratings, “New Issue: Enron Credit Linked Notes Trust, $500 million Enron Credit Linked “Notes (October 9, 2000), available at http://www.standardandpoors.com (visited November 26, 2002) Senate Per-manent Subcommittee on Investigation, Appendix D, Citigroup Case His-tory See also, Opening Statement of Rick Caplan before the Senate Permanent Subcommittee on Investigations, July 23, 2002 (Caplan Opening Statement) available at http://www.senate.gov/∼gov_affairs/072302caplan pdf (visited October 22, 2002).

26 Statement of Rick Caplan supra note 30.

27 Hudson Soft Class Action Amended Complaint, supra note 25, at 153 –156.

28 See note 27 at 157–162.

29 Cal Ins Code § 1633 (2001).

30 Conn Gen Stat § 38a-704 (2001) The penalty for acting as an insurance producer without a license is a f ine of not more than $500 or imprisonment

of not more than three months or both Ibid An insurance producer is def ined

at Conn Gen Stat § 38a-702(1) (2001).

31 18 Del C § 505(c) (2001).

32 18 Del C § 505(a) (2001).

33 18 Del C § 505(b) (2001).

34 New York Ins Law § 109(a) (2002).

35 New York Ins Law § 1102(a) (2002).

36 215 ILCS 5/500 -15(a) (2002).

37 McCarron-Ferguson Act, 15 U.S.C § 1011-1015.

38 67 Fed Reg 64067 (October 17, 2002).

39 The insured must be able to demonstrate that it has both an economic and

a legal connection to the asset or subject matter of the risk Financial

Ser-vices Authority, Discussion Paper: Cross-Sector Risk Transfers (May 2002) at

Annex B1.

40 Because most business relationships involve risks and the assumption of risk, the key here is that an insurance company spreads or distributes the risks

among a pool of contracts covering similar risks See Amerco v Comm’r, 96 T.C.

18 (1991), aff ’d 979 F.2d 192 (9th Cir 1992) See also, Comm’r v Treganowan,

183 F.2d 288 (2nd Cir 1950).

41 N Y Ins Law § 1101(a)(1) (LEXIS through Ch 221, 8/29/2001) Key to this def inition is the notion that the insured will be adversely affected by the specif ied fortuitous event In other words, insurances require the establish-ment of actual loss.

42 N Y ID, “Catastrophe Options,” Office of General Counsel Informal Opinion ( June

25, 1998).

43. N Y ID, “ Weather Financial Instruments (derivatives, hedges, etc.) “Off ice

of General Counsel Informal Opinion” (February 15, 2000), available at

http://www.ins.state.ny.us/rg000205.htm>.

44 N Y ID, Letter dated June 16, 2000, addressing a credit default option facil-ity, available at http://www.ins.state.ny.us.

45 ISDA has developed standard agreements that have been widely adopted by parties to unfunded derivative contracts The ISDA Web site is www.isda.org.

Although CLNs, CDOs, and SCDOs are credit derivatives, we do not discuss

their documentation in this chapter CLNs, CDOs, and SCDOs are typically documented as privately placed notes.

46 Restructuring Supplement to the 1999 ISDA Credit Derivative Def initions (May 11, 2001); Supplement to the 1999 ISDA Credit Derivatives Def ini-tions Relating to Convertible, Exchangeable or Accreting Obligaini-tions (No-vember 9, 2001); Commentary on Supplement Relating to Convertible, Exchangeable or Accreting Obligations (November 9, 2001); Supplement Relating to Successor and Credit Events to the 1999 ISDA Credit Deriva-tives Def initions, (November 28, 2001).

47 Cross -Sector Risk Transfers (U.K May 2002), supra note 44 Annex A: Trans-formers, available at www.fsa.gov.uk/pubs/discussion/index-2002.html Press Release, “Risk Transfer: Benef its and Drawbacks Need Careful Balancing,” May 3, 2002, available at http://www.fsa.gov.uk/pubs/press/2002/049.html cite visited September 16, 2002.

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13

THE M A R K ET FOR C OMPLEX

CR EDI T R ISK

P AUL P ALMER

The failure of Enron and the widely publicized losses at WorldCom,

Global Crossing, Tyco, and other f irms have heightened market participants’ attention to credit risk in general and to transactions that can be used to manage credit risk in particular Recent events rein-force some fundamental structural inefficiencies that were already pres-ent in the market for structured credit assets These inefficiencies cpres-enter around the fact that banks and insurance companies that provide credit enhancement services rely extensively on rating agencies, which exercise signif icant power over these entities To attract the capital required to make meaningful investments in the credit sector, banks and insurance companies need high debt and stock market ratings

In the current environment, both the rating agencies and stock mar-ket analysts loathe the credit sector; and investors in credit assets are routinely penalized Rating agencies, in particular, are anxious to be perceived as sages of credit, providing timely advice as opposed to the lagging indicators they are often accused of being The ratings volatil-ity we are currently experiencing is directly related to this push by rat-ing agencies to be leadrat-ing indicators of corporate creditworthiness Consequently, credit spreads on noninvestment-grade (NIG) and story credits, especially, have widened tremendously because of the resultant lack of investor demand

Thus, the paradox: Bank and insurance company investors that best understand complex credit risk are unable to fully capitalize on their spe-cialized credit skills As public, regulated entities, they are compelled to minimize credit risk to comply with regulatory and market requirements