Regulation of Credit Default Swaps
September 26, 2008
Here we go again! Calamitous events are often catalysts for regulatory change. The market crash of 1929 spawned a spate of such changes, including the separation of investment banks and commercial banks under the Glass-Steagall Act of 1933 (relaxed in 1999 under the Gramm-Leach-Bliley Act) and the enactment of a trio of acts: the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Companies Act of 1940. The Enron and WorldCom accounting scandals produced the Sarbanes-Oxley Act in 2002. The recent rescue of American International Group has sparked regulatory action in the State of New York in the hitherto unregulated "covered" credit default swap (CDS) market and could result in new regulation of the "naked" CDS market.
Credit Default Swaps
A CDS is a private contract that transfers credit or default risk related to an underlying or reference entity or obligation from one counterparty (protection buyer) to another (protection seller) in exchange for a payment or stream of payments. There are many variations on this theme that can make the transaction quite complex. In the plain vanilla version, the underlying or reference obligation may be a bond issued by a municipality or corporate borrower and held by the protection buyer (a "covered CDS"). The reference obligation may be an asset-backed security (ABS) issued by a conduit that owns a pool of assets (car loans, credit cards) or pools of tranches of asset-backed securities (collateralized debt obligation or CDOs). The entity or obligation may not be a single entity or obligation, but rather a basket of names, whether created for the specific transaction, (i.e., "bespoke") or based on a publicly traded index. The event requiring the protection seller to make a settlement is usually the bankruptcy of the reference entity or a default in the payment of principal or interest on the reference entity’s obligations in excess of a threshold amount. However, the CDS may go farther and require payment or the posting of collateral — for example, in the event of a ratings decline of the issuer of the reference obligation or of the protection seller. In certain instances, special purpose vehicles (dubbed transformers) may sell a CDS to a counterparty with the transformer’s obligations being guaranteed by a credit-worthy affiliate of the seller, such as a financial guarantee insurer.
Financial guarantee insurers (monolines) have historically provided only credit protection or enhancement of the plain vanilla kind by wrapping bonds issued by municipalities or corporate issuers. For the past several years, however, monolines have participated heavily in selling protection in respect of ABSs based on pools of sub-prime mortgages or CDOs based on tranches of such ABSs. In May 2008, New York insurance regulators raised the prospect of regulating the "covered" CDS market under the State’s jurisdiction over insurance products. Apparently, recent events have galvanized the State’s regulators to act.
Regulation of CDSs may be based on their characterization as either "insurance" or "securities." It may also arise from initiatives to move trading to a clearing-house structure with a central counterparty. The latter is beyond the scope of this note.
Regulation may have significant implications for the operation of the securitization market. It may also affect who may sell protection, the terms of the protection, and its cost.
Action by New York Insurance Department
Adopting the "insurance" approach, the Office of the Governor of the State of New York issued a press release on September 22, 2008, announcing that beginning January 1, 2009, and on a prospective basis, the State of New York will regulate a part of the CDS market (that in "covered" CDSs) that has to date been unregulated. Following this announcement, the State of New York Insurance Department issued Circular Letter No. 19 (2008) setting out the broad strokes of the proposed regulation.
On the day of the announcement, the Governor of the State of New York also called on the federal government to regulate the rest of the CDS market. Picking up this theme, and adopting the "securities" approach, the Chairman of the Securities and Exchange Commission (SEC) stated in his testimony before the Senate Banking Committee on the same day that Congress should "immediately" grant authority to regulate the CDS market.
While largely cast as relating to financial guarantee insurance corporations providing financial guarantee insurance under Article 69 of the New York Insurance Law, the scope of the proposed regulation by the State of New York would appear to extend beyond such entities.
Under current New York law, financial guarantee insurers may sell protection for CDSs falling within the statutory definition of:
"[A]n agreement referencing the credit derivative definitions published by the International Swap and Derivatives Association, Inc., 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."
In what is described as a "clarification," the Circular states
"With today’s Circular Letter, the Department clarifies that to the extent that the making of the CDS itself may constitute "the doing of an insurance business" within the meaning of Insurance Law § 1101, then the protection seller should consider seeking an opinion from the Department’s Office of General Counsel to assess whether the protection seller should be licensed as an insurer pursuant to Insurance Law § 1102. 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. That omission will be rectified and addressed in a forthcoming opinion to be prepared by OGC."
In addition to opening the door to the characterization of a "covered" CDS as an insurance contract, the seller of which would need to be licensed as an insurer, the Circular proposes a number of "best practices" for financial guarantee insurers, which — if implemented — would restrict the insurance of CDOs of ABS, redefine concentration risk, restrict the commercial terms of CDSs that financial guarantee insurers may insure, impose oversight of underwriting and risk management standards, increase capital and surplus requirements, and increase reporting. The application of the licensing requirement and best practices to "non-insurance" entities who sell covered CDSs would be a sea change in the CDS market.
The Circular Letter makes it clear that the proposed regulation would not apply to "naked" CDSs, that is, those in which the protection buyer does not hold or have a material interest in the reference obligation.
It remains to be seen whether Congress will heed the Governor’s request, and the urging of the SEC Chairman, to regulate "naked" CDSs. The issue may well get caught up in the proposal in the March 2008 Department of Treasury Blueprint for a Modernized Financial Regulatory Structure to consolidate the Securities and Exchange Commission and the Commodity Futures Trading Commission.
To those familiar with the Canadian regime for regulation of securities by ten provinces and three territories, the prospect of regulation of "covered" CDSs by 50 states seems ironic. The Treasury Blueprint appears to have been alert to this type of issue when it called for the creation of a federal regulatory structure and optional federal charter for insurance. Given the structural level at which the Blueprint was written, it did not expressly address the regulation of CDSs as securities.
The question of the definition of the term "insurance" in England is under active consideration. Unlike the State of New York’s legislation, and most Canadian jurisdictions’ acts, the Insurance Companies Act, 1982 does not provide a statutory definition of what constitutes an insurance contract. That is left to the common law. The statute does, however, set out classes of insurance. In January 2006, The Law Commission and The Scottish Law Commission issued a joint scoping paper that asked for input as to whether their review of insurance law should include in its scope the question of whether there should be a statutory definition of insurance. In August 2006, following a public consultation process that included representations from the International Swaps and Derivatives Association, Inc. (ISDA) and the Financial Services Authority (FSA), the Law Commissions published "Insurance Contract Law – Analysis of Responses and Decisions on Scope" in which they concluded that they would include the question of a statutory definition of insurance within the scope of their review. Interestingly, the FSA supported a principles-based statutory definition. The ISDA did not, citing a 1997 opinion from Robin Potts, Q.C., that "credit derivatives should not be characterized as contracts of insurance because they are structured to pay out on the occurrence of the default or other relevant event irrespective of whether the protection buyer suffers a loss." While the work of both law commissions continues, any UK regulatory action with respect to CDSs would likely follow an independent time line.
How might the "insurance" and "securities" approaches to regulation of CDSs play out in Canada?
Constitutionally, the regulation of insurance is a shared jurisdiction between the federal government and the provinces. As a matter of property and civil rights, the provinces have the exclusive jurisdiction to regulate market conduct with respect to the sale of insurance, including the types of insurance that may be sold, who may sell insurance and the terms of insurance contracts. The federal government regulates the incorporation, licensing, capital governance and solvency of federal insurance companies and the licensing and solvency of foreign insurance companies. There is no enumerated head of federal jurisdiction under the constitution in respect of insurance.
In the province of Ontario, the term "insurance" is broadly defined to mean the undertaking by one person to indemnify another person against loss or liability for loss in respect of certain risk or peril to which the object of the insurance may be exposed, or to pay a sum of money or other thing of value upon the happening of a certain event, and includes life insurance. This definition diverges from the New York definition of insurance contract, which means any agreement or other transaction whereby one party, the "insurer," is obligated to confer 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 that will be adversely affected by the happening of such event.
The broad wording of the Ontario definition has been read down in case law.
Various classes of insurance are defined both federally and by the provinces. These definitions are not as expansively drafted as those seen in the State of New York.
Whether a CDS would constitute "insurance" in Ontario would turn on the characterization of the specific terms and conditions of the CDS relative to the statutory definition as interpreted by case law.
Securities regulation is currently a matter of provincial jurisdiction in Canada. As a result, each of the ten provinces and three territories has its own legislative scheme for regulating the securities trading that takes place within its own provincial or territorial jurisdiction, and it has its own regulatory authority for administering and enforcing such legislation. For the purpose of identifying the securities legislation that applies to a particular transaction, one generally looks to the securities legislation of the provinces or territories in which the parties to the transaction are located.
Generally speaking, the securities legislation of all provinces and territories regulates trading in securities by requiring those who trade securities to become registered as a dealer, and by requiring those who distribute securities to file a prospectus with, and obtain a receipt therefor from, the applicable securities regulatory authorities unless:
- the applicable securities legislation provides for an express statutory exemption from one or both of these requirements; or
- it is possible to obtain an exemption order exempting a trade, a security or a person or company from either or both of these requirements
For purposes of these dealer registration and prospectus requirements, the term "trade" is broadly defined to include any sale or disposition of a security for valuable consideration, as well as any act, advertisement, solicitation, conduct or negotiation directly or indirectly in furtherance thereof. The term "distribution" is defined with reference to the term "trade" to include a trade in the securities of an issuer that have not been previously issued.
Whether the parties to a CDS must comply with the dealer registration and prospectus requirements of Canadian securities legislation is dependent upon the extent to which the CDS can be characterized as a security. The term "security" is broadly defined in Canadian securities legislation and can vary from province to province. In some provinces, the definition expressly contemplates over-the-counter derivative (OTC Derivative) transactions and in others it does not. In either case, the definition is capable of being applied to a wide variety of instruments, particularly if it is applied literally. Canadian market participants have therefore had to contend with a considerable amount of regulatory uncertainty when developing, offering and trading new financial products and services. The Canadian securities regulatory authorities have long been cognizant of this uncertainty, and several provincial securities regulatory authorities have made a concerted effort to address the uncertainty associated with the conduct of OTC Derivative transactions such as CDSs.
Between 1994 and 2000, the Ontario Securities Commission (OSC) sought to establish a rule that would provide a clearly defined regulatory framework for the conduct of OTC Derivatives transactions in Ontario. Proposed OSC Rule 91-504 (the Proposed Rule) was intended to regulate the trading of OTC Derivatives in Ontario by applying the dealer registration and prospectus requirements of the Securities Act (Ontario) to all transactions involving an OTC Derivative, whether the OTC Derivative could be characterized as a security or not, and then exempting certain transactions from these requirements, including OTC Derivative transactions entered into between specified institutional investors and high net worth individuals, referred to in the Proposed Rule as "Qualified Parties." Although in November 2000 the Proposed Rule was referred back to the OSC by Ontario’s Minister of Finance for further consideration, and has not become effective in Ontario, a similar rule was adopted by the British Columbia Securities Commission in November 1999, and a more narrowly defined rule was adopted by the Alberta Securities Commission at approximately the same time. Most recently, in June 2008, the Québec National Assembly passed the Derivatives Act (Québec). Although it has not yet become effective, it will establish a comprehensive scheme for the regulation of derivatives transactions in Québec — if and when it is proclaimed in force.
None of these Canadian provincial rules or legislation is as specifically directed to the regulation of CDSs as is the proposed New York regulation.
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The Circular Letter leaves the details of implementation to regulations or legislations that are to follow. It remains to be seen what effect the New York regulatory steps will have on the CDS market in that State and in the rest of the world.
If the provinces of Canada do take action to specifically regulate CDSs as either insurance or securities, one might expect that federally regulated banks and other financial institutions would question the jurisdictional authority and constitutionality of such action, as was the experience in Canadian Western Bank v. Alberta, decided by the Supreme Court of Canada in May 2007.