Financial Derivative Litigation: A Key Case on Credit Default Swaps

Published on Financial Services Law360 and Securities Law360 by Portfolio Media on November 14, 2008.

Financial derivatives, especially Credit Default Swaps ("CDS's") have received a lot of attention in the press lately.  Up until now derivatives were obscure financial instruments known by only to a few. Today derivatives are the focus of the global economic crisis and have brought down major investment houses and a giant insurance company.  The very existence of many financial institutions is threatened due to these instruments that Warren Buffet famously referred to as "Weapons of Mass Financial Destruction". Currently, some business and legal commentators are predicting that CDS's and other financial derivatives will create an enormous amount of litigation.  There are, however, surprisingly few such cases that have actually been brought.  This article examines one derivative case to see what legal principals emerge that might guide future litigation on the derivatives.

In the landmark case, Merrill Lynch Int'l v. XL Capital Assurance Inc., 564 F.Supp.2d 298 (S.D.N.Y. 2008), Merrill Lynch International ("Merrill Lynch") sued for a declaratory judgment that it had not breached its Credit Default Swap agreement with XL Capital Assurance's ("XLCA") by purchasing additional protection on a specific bond issue.  XL Capital counterclaimed alleging that Merrill Lynch had committed an anticipatory breach of the agreement.

On summary judgment, Judge Rakoff held that XLCA's purported cancellation of seven credit default swaps was invalid.  Judge Rakoff focused on two key issues in his opinion: 1) whether Merrill Lynch's decision to enter into six additional credit default swaps, which XLCA argued implicated voting rights they had garnered under their prior deal with Merrill Lynch, amounted to anticipatory breach and 2) whether the doctrine of adequate assurance applied where XLCA had sought assurances from Merrill Lynch that it did not intend to breach its contract with XLCA.

Regarding the first issue, Judge Rakoff focused on the voting rights that XLCA had received as part of its deal with Merrill Lynch.  Interestingly, XLCA had contracted with Merrill Lynch to insure the A-2 notes, but XLCA had also negotiated and received controlling class rights to the A-1 tranche.  Merrill Lynch Int'l, 564 F.Supp.2d at 300.  Sometime after, Merrill Lynch entered into another credit default swap with different parties where the subject of the swaps was the A-1 tranche.  Id. at 301.  XLCA saw this implication of its rights in the A-1 tranche as an anticipatory breach of contract by Merrill. 

Judge Rakoff disagreed.  He found that, despite the dual assignment of rights to the A-1 tranche, Merrill Lynch never prevented itself from complying with its obligations to XLCA.  Id. at 304-305.  If conflict arose in relation to XLCA's voting rights, Merrill could either heed XLCA's instructions or give up its coverage with XLCA.  There was no breach because Merrill Lynch "retained the ability to abide by XLCA's voting instructions".  Id. at 305.  Further, Merrill Lynch controlled whether it would trigger the event that would allow XLCA to terminate coverage.  Id.  As such, Judge Rakoff found no anticipatory breach by Merrill Lynch.

Regarding assurance, Judge Rakoff first rejected the use of the argument in the context of credit default swaps, noting that it was applicable to New York's Uniform Commercial Code.  Id. 306.  Even if the doctrine had applied, Judge Rakoff found that Merrill Lynch's responses to XLCA's requests for assurance were sufficient.  In these responses, Merrill Lynch assured XLCA that it had not failed to exercise Voting Rights as directed by XLCA nor had it exercised any rights without XLCA's consent.  Id. at 302.  Judge Rakoff found such to be sufficient assurance. 

Since the decision, Merrill Lynch and XLCA agreed to settle their dispute.  What is interesting is that Judge Rakoff noted that the liability of XLCA could have been near $3 billion, but the settlement fell to the amount of $623 million.  This illustrates how this decision affects both sides.  On the one hand, XLCA's anticipatory breach argument was rejected, and others in a situation similar to Merrill Lynch may benefit from such precedent.  On the other, Judge Rakoff reinforced the defenses available where a contract is not honored.  In this way, this opinion may be a warning to parties to be cautious in the language of any credit default swaps and tread carefully in the exercise and control of their rights.