Canada: Uncertainties Inherent In Synthetic CDOs / Credit Default Swaps

Last Updated: August 24 2009
Article by Daniel Parlow

As instances of default under collateralized debt obligations (CDOs) rise, uncertainty over the resolution of eventual disputes takes on increasing significance for parties to derivatives investments. Nowhere is this better demonstrated than in the enforcement of rights under credit default swaps. By 2008, outstanding credit default swap contracts had a combined market value of more than US$2 trillion1.


Synthetic vs Cash CDOs

CDOs are a form of asset-backed security under which a special-purpose vehicle (SPV) is established to hold cash-producing assets carrying various levels of risk and reward. The SPV issues bonds or other securities to investors in tranches which reflect the productivity of the assets from which their value is ultimately derived. Often the SPV is an offshore corporation established to avoid or minimize tax otherwise payable to the revenue authorities of the U.S., Canada and other industrialized countries.

Securities issued through CDOs are derivative in nature, funded through either a portfolio of cash assets such as bonds or mortgage-backed securities ("cash CDOs"), or a portfolio of credit default swaps ("synthetic CDOs"). Parties to synthetic CDOs enter into contractual arrangements which expose the SPV to credit risk in exchange for periodic payments. The arrangement is roughly equivalent to an insurance contract in which the SPV insures its counterparty against defaults on its own mortgage portfolio or against specified losses which it may incur from other financial obligors in the course of its business (the "reference portfolio").


Uncertainties Arising from Leverage

By their nature, synthetic CDOs carry with them a number of inherent uncertainties rendering them more susceptible than cash CDOs to litigation.

To maximize leverage, CDOs are structured so as to minimize cash reserves. Collateral is posted equating to an agreed portion of the aggregate potential exposure of the credit protection purchaser.

Agreements between swap counterparties specify circumstances (called "material adverse events") under which collateral must be augmented. Whether such events have taken place will depend on the terms negotiated and then current financial circumstances.

In exercising its remedies the secured party must balance its interests against its contractual obligations. If it purports to terminate or demands excessive collateral, its good faith may be called into question. Good faith is a term often implied by the courts and specified under standard contractual terms such as those of the International Swaps and Derivatives Association (ISDA)2.

Similarly, there may be a question whether a material adverse event has occurred, and/or have triggered termination rights under the ISDA's 1992 and 2002 Master Agreements or other comparable documents, if the party or its credit support provider merges or amalgamates with another party under circumstances where the creditworthiness of the merged vs pre-merger body is arguable. Valuations may be necessary to determine the relative values.

Valuations of assets within the reference portfolio may also be necessary and these may give rise to difficulties. In High Risk Opportunities HUB Fund Ltd. v. Credit Lyonnais3 a derivatives case involving non-deliverable forwards linked to currency fluctuations, the financial institution was found to have improperly valued the subject contracts upon the occurrence of an event of default. The counterparty successfully argued that Credit Lyonnais' market quotations were not obtained in good faith and that it interfered with market-makers' independence in the valuation process. Credit Lyonnais, by urging an improper interpretation, not only reduced High Risk's termination balance but limited its own margin call obligations, subjecting itself not only to a large difference but to claims that High Risk's insolvency had been caused by the valuation.

The consequences of making the wrong decision are made more severe by short time fuses for increasing collateral, potentially leading to interlocutory injunction hearings. Several U.S. financial institutions have been sued on notices to substantially increase collateral, for example and CDO Plus Master Fund Ltd. v. Wachovia Bank, N.A.4. In Canada, parties seeking injunctive relief may be required to post an undertaking in damages and security in support thereof, which may have similar effect to the collateral required under the agreement.

The effect of leverage is evident in UBS v. Paramax Capital Int'l5, in which a hedge fund agreed to provide protection on over US$1.3 billion in CDOs and was only required to post some $4.5 million in collateral. Unfortunately, the CDOs were backed by subprime mortgage investments, and as the portfolio assets were written down, UBS made collateral calls increasing the total required collateral by approximately 1,400%. This gave rise to arguments in litigation that UBS had entered into the transactions without disclosing the true nature of the assets, misrepresenting its write-down policy and failing to disclose accounting benefits which it would derive from entering into the credit default swap.


Choice of Law and Jurisdiction of Dispute Resolution

Parties structuring synthetic CDOs should pay particular attention to jurisdictional and choice of law provisions which may come into conflict in the plethora of applicable contracts. This is exemplified in the multijurisdictional litigation of UBS AG and UBS Securities LLC et al v. HSH Nordbank AG6 (English Court of Appeal) with the parties reversed in the New York Supreme Court7.

The synthetic CDO in UBS was structured roughly as follows:

The complexity of the arrangement included different choice of law and jurisdictional clauses:

  • Agreement under which Assignee would issue notes to dealers (including UBS) as part of a pre-existing programme, and Information Memorandum relating to same: governed by English law; England non-exclusive jurisdiction for disputes
  • UBS-Assignee letter agreement re intended structure and sale of Senior SPV Notes to Assignee: governed by New York law; no jurisdiction clause
  • Pricing Supplement and Dealer's Confirmation re issuance of the Assignee notes: governed by English law; England exclusive jurisdiction for disputes
  • Offering Circular and Trust Indenture re linkage between SPV notes and Reference Pool assets, and triggers for credit protection payments and corresponding reductions in balance due under SPV notes: governed by New York law; New York non-exclusive jurisdiction for disputes
  • Credit Swap governing credit premium payments and credit protection payments in event of credit events. The Credit Swap incorporated by reference ISDA Master Agreement: governed by English law; England non-exclusive jurisdiction for disputes
  • Reference Pool Side Agreement governing UBS' management of the reference portfolio and monitoring its credit quality: governed by New York law; New York non-exclusive jurisdiction for disputes

On February 25, 2008, proceedings were commenced in New York by the Assignee's successor. Allegations included breach of contract in the sale of SPV notes to the Assignee; fraudulent or negligent representations inducing the Assignee to have purchased the SPV notes; breach of fiduciary duty and breach of a duty of good faith relating to UBS' management of the Reference Portfolio; unjust enrichment and conversion.

On the same day, UBS filed suit in London seeking a declaration that the essence of the dispute falls within the jurisdiction of the English courts by virtue of the Dealer's Confirmation. The presiding judge disagreed and the matter was unsuccessfully appealed to the Court of Appeal for England which, noting contradictory jurisdictional provisions, had to analyze the various agreements and the substance of the dispute before it8:

But the essential task is to construe the jurisdiction agreement in the light of the transaction as a whole. As I suggested in Satyam Computer Services Ltd v Upaid Systems Ltd [2008] EWCA Civ 487, [2008] 2 All ER (Comm) 465, at [93], whether a dispute falls within one or more related agreements depends on the intention of the parties as revealed by the agreements.

Plainly the parties did not actually contemplate at the time of the conclusion of the contracts that there would be litigation in two countries involving allegations of misrepresentation in the inception and performance of the agreements. But in my judgment sensible business people would not have intended that a dispute of this kind would have been within the scope of two inconsistent jurisdiction agreements. The agreements were all connected and part of one package, and it seems to me plain that the result for which UBS contends would be a wholly uncommercial result and one that sensible business people cannot have intended.

Given the plethora of agreements and potential issues arising in respect of synthetic CDOs, parties entering into them should pay particular attention to avoid jurisdictional and choice-of-law clashes which may contribute to the already costly and time-consuming nature of litigation in these matters.


Conflicts of Interest

As demonstrated in UBS, synthetic CDO arrangements may involve an inherent conflict of interest in which a party's duties are difficult to discharge. In UBS, the financial institution that monitored the reference portfolio potentially stood to gain from allowing lower quality assets to enter the pool, since material adverse events would trigger credit protection payments to the detriment of the Assignee. Although the parties specifically contemplated this potential conflict in entering into the "Reference Pool Side Agreement", it is nevertheless difficult for a conflicted party to discharge its obligations of good faith under such contracts.

For example, in High Risk v. Credit Lyonnais, supra, the financial institution was found to have interfered with market-makers' independence in valuing the subject contracts, having a fundamental impact on resolution of the claim and, it was argued, on the very solvency of the counterparty.


Other Securities Law Claims

Synthetic CDOs are also particularly vulnerable to arguments advanced to impugn securities transactions generally. Here are but a few examples:

  • Claims against investment advisors based on suitability and know-your-client rules. In 2007, Aastra Technologies Limited commenced legal proceedings against its investment advisor, HSBC Securities (Canada) Inc. and one of its employees, in the Ontario Superior Court of Justice seeking damages relating to investment advice provided with respect to Aastra's purchase of $13.7 million of investments in non-bank asset-backed commercial paper (ABCP) that were frozen following the U.S. subprime mortgage industry collapse. The claim alleged that the employee had described ABCP as primarily baskets of residential mortgages with limited car loans and credit card debt, bundled to produce a "high-quality, short-term investment product".9 A large number of similar claims have arisen in the United States since the subprime meltdown.
  • In addition to derivatives investments being relatively risky, they can be subject to specific statutory, regulatory or contractual prohibitions knowledge of which may be imputed to the investment advisor. In Daniel Boone School Dist. v. Lehman Bros. Inc.10 for example, not only did the advisor face liability in the face of a prohibitory state statute but the issuer faced liability as a co-conspirator.
  • Claims of misrepresentation in marketing materials and pre-contractual negotiations. Well-drafted offering memoranda, trust indentures and other CDO agreements will include disclaimers effective in most circumstances. See for instance, Banco Espirito Santo de Investimento, S.A. v. Citibank, N.A.11

In conclusion, while synthetic CDOs and credit default swaps carry with them leverage and hedging opportunities, parties considering such transactions should give due attention to legal uncertainties which may arise from their complexity.


Footnotes

1 Per Moody's Investors Service, May 2008

2 The ISDA represents participants in the privately negotiated derivatives industry. Since its inception, the ISDA has pioneered efforts to identify and reduce the sources of risk in the derivatives and risk management business: http://isda.org/

3 N.Y. Sup. Ct. July 07, 2005

4 07-11078, S.D.N.Y. Dec. 7, 2007

5 Civ. No. 07604233, Sup. Ct. N.Y. Co., commenced Dec. 26, 2007

6 [2009] EWCA Civ 585 (Eng. CA)

7 HSH Nordbank AG v. UBS AG and UBS Securities LLC, N.Y. Sup. Ct. no. 08/600562

8 Supra, note 6, per Lord Collins of Mapesbury at paras. 83-84

9 http://www.aastra.com/cps/rde/xbcr/04/PR_3rd_Qtr_2007_AAH.pdf

10 187 F. Supp. 2d 400 (W. D. Pa. 2002),

11 2003, S.D.N.Y. 2d Cir.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions