Litigating The Terms Of Credit Default Swaps

Credit Default Swaps ("CDS's") are getting new attention as governments, institutions and personal investors endeavor to navigate the first great financial storm of this century.  While business and legal commentators predict that CDS's and other financial derivatives will create a new wave of litigation, the dearth of reported decisions addressing CDS's means that there will be little judicial guidance in the short term.  One of the earliest cases to litigate the terms of a CDS was Aon Financial vs. Societe General, 476 F.3d 90 (2d Cir. 2007).  This case demonstrates the importance of the language of the instrument in determining the outcome of the case, and proves that litigating CDS's is a fact-specific exercise that makes it difficult to draw broad legal conclusions to guide future litigation on these financial derivatives.

The transactions at issue in Aon Financial stemmed from the financing of a condominium development in the Philippines.  Ecobel Land ("Ecobel") borrowed about $10 million from Bear Stearns International Limited ("BSIL") to build the condominiums.  As part of the loan arrangement, BSIL was named as obligee on a $10 million surety bond from Governmental Service Insurance System (GSIS), a Philippine government agency, covering Ecobel's loan.  To hedge its exposure on the surety bond, BSIS bought a credit default swap from Aon (the "First CDS").  To reduce its own risk, Aon turned around and bought its own credit default swap from Societe Generale ("SG") (the "Second CDS").  About one year later, Ecobel defaulted and GSIS refused to pay on the surety bond.  Litigation ensued, with Aon simultaneously defending an action against it on the First CDS (the "Ursa Minor" litigation) and, in a separate suit, seeking recovery under the Second CDS.  The Ursa Minor court entered judgment against Aon on the First CDS, finding that GSIS's failure to pay on the surety bond was a "credit event" as defined by that agreement.  Then, in Aon's action on the Second CDS, the district court entered judgment for Aon, finding that the default by GSIS constituted a "credit event" under the plain and unambiguous language of that agreement.  Aon Fin. Prod. V. Societe Generale, 2005 WL 427535 (S.D.N.Y. February 22, 2005).  Aon's victory was short-lived, however, when the Second Circuit reversed.

On appeal, Aon argued, among other things, that under collateral estoppel principles the Ursa Minor court's finding of a "failure to pay" precluded the court from deciding that there was no "failure to pay" under the Second CDS.  Rejecting Aon's argument, the Second Circuit stated that the "risk transferred to Aon and the risk transferred by it were not necessary identical.  The terms of each credit swap agreement independently define the risk being transferred."  Id. at 96 (emphasis supplied in original).  The court examined the language of the agreements, finding that while the First CDS defined a "credit event" to include a failure to pay by GSIS on the surety bond, the Second CDS explicitly did not.  Id. at 101.  The court ultimately found that a "credit event" did not occur and, as a result, that Aon could not recover.             

What is striking about this case is that Aon lost twice.  First, it sought to avoid its obligations under the BSIL/Aon instrument.  After losing that initial case, Aon proceeded to lose the second case where it had sought to enforce the Aon/SG agreement. How can this result be explained? The risks that Aon accepted, on the one hand, and that it transferred, on the other, were different by the fact of the contract language used.  This case illustrates how fact-specific disputes over CDS obligations will be.  Before initiating suit on a CDS, the buyer of the protection must carefully review the actual language of the instrument to ensure that the "credit event" has actually occurred. This case warns parties to be cautious about the language of any credit default swap and to tread carefully in the exercise of their rights.

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