On June 10, 2008, US District Judge Jed S. Rakoff of the US District Court for the Southern District of New York issued a notable ruling enforcing a credit default swap ("CDS") that Merrill Lynch & Co. ("Merrill Lynch") had purchased to hedge certain of its collateralized-debt obligations ("CDOs"). The ruling is significant for financial institutions relying on CDSs, which often are used for hedging or risk management purposes but have evolved within recent years to become investments by themselves.
In a one-page order, Judge Rakoff granted Merrill Lynch summary judgment against bond insurer XL Capital Assurance Inc. ("XLCA") and ruled that XLCA must honor its more than $3 billion CDS obligation, holding that "XLCA's purported terminations of those credit default swaps are without effect." XLCA had attempted to terminate the CDSs on the grounds that Merrill Lynch had breached certain provisions thereof granting XLCA control rights in the CDOs by subsequently entering into CDSs referencing more senior tranches of the CDOs with MBIA Inc. ("MBIA"), another bond insurer. In this regard, XLCA alleged that Merrill Lynch had violated the control provisions by shifting control rights in the CDOs to MBIA in connection with the MBIA CDSs. Judge Rakoff rejected XLCA's contention that entering into the subsequent CDSs prevented Merrill Lynch from fulfilling its contractual obligations to XLCA. The Court stated that it will issue a full opinion in due course.
The ruling comes in an area in which litigation activity is expected to increase. CDOs are used to repackage bonds and other assets into new securities. Since the beginning of the year, mortgage-bond CDOs have been the largest single contributor to write-downs and losses at banks and securities firms around the world. To hedge against losses, banks and securities firms have purchased substantial amounts of CDSs in recent years. In exchange for fixed payments, CDSs pay if the underlying securities do not pay or are written down. If the enforceability of the CDSs is put in doubt, financial institution losses could rise significantly.
In sum, the summary order reaches the unsurprising, yet significant conclusion that, despite the complexity of these instruments, courts will apply traditional principles of contractual interpretation in resolving disputes involving CDSs. (Note that the Court has not issued a full opinion yet, which will likely contain additional details and analysis.)
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.