United States: Second Circuit Strictly Construes Credit Default Swap Contract

On February 5, 2007, the United States Court of Appeals for the Second Circuit issued an important credit default swap (CDS) opinion indicating that such transactions should be strictly construed according to the terms of the contract at issue, without resort to the parties’ overall hedging strategy. The court’s decision in Aon v. Société Générale1 reinforces traders’ reliance on the terms of the CDS form documentation promulgated by the International Swaps and Derivatives Association (ISDA).

CDSs are derivative instruments by which financial institutions and other businesses manage their exposure to credit risk. In a CDS, a buyer of risk protection negotiates with a risk protection seller for the seller to assume certain specified default risks. The risks specified in the CDS are taken by the seller in exchange for periodic payments by the CDS buyer. If a designated "credit event" occurs, the CDS buyer is able to put a specified deliverable obligation(s) to the CDS seller in exchange for a sum stated in the contract, generally the nominal value of the contract.

In 1999, Société Générale sold a CDS with a nominal value of $10 million to Aon. The CDS’s "Reference Obligation" was a $500 million bond issued by the Republic of the Philippines (the Reference Entity). The price was $328,000 per year. A credit event in the CDS, titled "Sovereign Event," stated that the exchange would be triggered if the Republic failed to honor "any obligation issued by the government of the [Republic] or the central bank of the [Republic]."

A week before this transaction, Aon had sold a CDS to Bear Stearns. The Reference Obligation of this CDS was a $10 million surety bond issued by a Philippine governmental agency (the Reference Entity) that guaranteed payment on a condominium construction project. The price of this CDS was $425,000 per year. The "Failure to Pay" Credit Event in this CDS was a "failure by [the agency] to make, when due, any payments under the Obligations for whatever reason or cause."

When the agency refused to honor the surety bond and Bear Stearns sought to collect $10 million from Aon, Aon attempted to put the risk to Société Générale under the later-executed CDS. Société Générale rejected the demand, contending that no Sovereign Event had occurred because the agency and its surety bond did not constitute the Reference Entity (the Republic) and the Reference Obligation (the $500 million bond) specified in the Société Générale-Aon CDS. Moreover, there was no evidence that the agency’s surety bond default injured the creditworthiness of the Republic – i.e., the market price of Philippine debt was unchanged by the default.

Separate lawsuits under the two swaps were brought in the U.S. District Court for the Southern District of New York. In the Bear Stearns v. Aon case, the District Court ruled that, according to the terms of that CDS, Aon was obligated to pay Bear Stearns the $10 million. In the Aon v. Société Générale suit, the District Court agreed with Aon that the refusal of the Philippine agency to pay on the surety bond constituted a Sovereign Event, and that despite Aon’s failure to tender the surety bond as the deliverable obligation, Société Générale was obligated to pay Aon the $10 million nominal value of the CDS. Essentially, notwithstanding the differences between the terms of the two CDSs, the District Court viewed the Société Générale-Aon CDS to be Société Générale’s indemnification of Aon under the Aon-Bear Stearns CDS. Société Générale appealed both determinations to the Second Circuit, arguing that the surety bond was not an "obligation issued by the government," that no Sovereign Event occurred because the agency’s rejection of its surety bond was not a sovereign action, and that the surety bond did not meet the CDS’s delivery terms. ISDA filed an amicus brief supporting this last proposition.

The Second Circuit reversed the judgment of the District Court and entered judgment for Société Générale. The Second Circuit acknowledged that the two CDSs constituted a series of transactions related to the condominium financing. Critically, however, the appellate court also recognized that CDSs are not indemnification agreements; rather, they effectuate firms’ hedging strategies by allowing the parties to purchase protection for (or retain) specified credit risks. That is, because the "terms of each credit swap agreement independently define the risk being transferred[,] the risk transferred to Aon and the risk transferred by it were not necessarily identical." (Emphases in original). Thus, "it does not follow from the occurrence of a Credit Event as defined in one contract that there was a Credit Event as defined in the other." Though defined risks in multiple CDSs may be correlated, they do not necessarily overlap perfectly.

Applying its analytical template of independent definitions, the Second Circuit determined that no Credit Event had occurred under the Société Générale-Aon CDS. In doing so, the court noted the differences in the Reference Entities and Reference Obligations terms specified in the two CDSs. Also, the court found significant the fact that the riskier instrument for which Bear Stearns bought protection from Aon under the first CDS cost approximately $100,000 more per year than the protection Aon in turn purchased from Société Générale.

The Société Générale v. Aon decision is likely to have salutary effects on the CDS marketplace and financial derivative transactions generally, and it holds several lessons for institutions in these markets.

First, each CDS or derivative trade will be judged independently, without resort to the parties’ overall trading or hedging strategy to determine contractual intent. The decision reinforces parties’ reliance on the written terms of a derivative instrument, which will facilitate trading of credit default risks, and enable institutions efficiently to adjust risks held in their portfolios. The role of CDSs and other derivatives in international finance will only increase with the certainty added by this decision. Objective intent as evidenced by each individual CDS supersedes the subjective intent of the parties’ hedging strategies.

Second, a party who does not fully understand a CDS can be disappointed by an outcome that was predictable given the terms of the CDS. In this case, for a gain of roughly $100,000, Aon retained certain risks – that the construction loan would not be repaid, that the surety bond would be called, that the agency would refuse to pay, that the Republic would back the agency’s decision, and that the refusal to pay would not affect the Republic’s creditworthiness. According to the Second Circuit, Aon "reduce[d] its own risk exposure through the [Société Générale] CDS", but it did not eliminate that exposure.

Third, CDS notices are important. Under the terms of the CDS, Aon was obligated, within the dates covered by the CDS, to give Société Générale an irrevocable notice that a credit event had occurred before the term of the CDS expired. However, the only notice Aon gave Société Générale within the prescribed period was a notice that if Aon was liable to Bear Stearns, Société Générale would be liable to Aon. Though it was not necessary to its decision, the Second Circuit noted that this contingent notice was insufficient under the CDS’s terms, and thus that it could not trigger Société Générale’s obligation to pay. Parties who have purchased default risk protection and who claim that a CDS has been triggered should strictly adhere to the terms of the CDS and, if appropriate, give unequivocal notice of a purported credit event.

Fourth, although the Second Circuit did not reach the issue, Aon and Société Générale also disputed the settlement procedures of the CDS. Except in limited circumstances, the CDS called for Physical Settlement, whereby in exchange for Société Générale's $10 million payment, Aon was obligated to deliver a portfolio of Deliverable Obligations with a face value of $10 million that "rank[ed] equal in priority of payment" to the $500 million bond. Aon contended that it did not have to tender such a portfolio, or, alternatively, that it could deliver the surety bond. Here, once the surety bond had been rejected by the agency, it was worthless, and on this basis the District Court had ruled the tender of the surety bond was not necessary. Given the Second Circuit’s construction of this CDS and the tenor of the opinion, had it reached the issue the appellate court likely would not have excused Aon’s failure to tender the bond. For many types of Reference Obligations, ISDA is shifting to a cash settlement regime with built-in offsets, which should avoid, or at least reduce, tender related disputes. However, entities who have purchased CDSs that provide for physical settlement should be prepared to tender the required obligation(s) should a credit event occur.

Note: Pillsbury Winthrop Shaw Pittman LLP represented Société Générale in this case, and regularly represents financial institutions in litigation involving derivative instruments.

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.