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.


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:

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


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

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

In association with
Related Video
Up-coming Events Search
Font Size:
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
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). 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 & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd 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 or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.