cdo and cds litigation trends
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CDO and CDS Litigation Trends. Kiran H. Mehta, Partner, Charlotte Office Anthony R. G. Nolan, Partner, New York Office. Today’s Presenters. Kiran H. Mehta, Partner Charlotte, NC Office [email protected] 704.331.7437. Anthony R.G. Nolan, Partner New York Office - PowerPoint PPT PresentationTRANSCRIPT
CDO and CDS Litigation Trends
Kiran H. Mehta, Partner, Charlotte OfficeAnthony R. G. Nolan, Partner, New York Office
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Today’s Presenters
Anthony R.G. Nolan, PartnerNew York Office [email protected]
Kiran H. Mehta, PartnerCharlotte, NC Office [email protected]
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About K&L Gates K&L Gates comprises approximately 1,900 lawyers in 32 offices located in North
America, Europe and Asia. We represent capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector entities.
K&L Gates maintains one of the most prominent financial services practices in the United States – with more than 150 U.S.-based lawyers representing diversified financial services institutions and their affiliated service providers.
The U.S. National Law Journal has identified K&L Gates as a “go-to” law firm for Financial America.
In 2007 and 2008, Chambers USA, an independent and research-based guide to the legal profession, ranked K&L Gates as having one of the leading financial services practices in the country.
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Agenda CDO and CDS overview Recent cases and themes in litigation Rating agency suits and the viability of traditional defenses Strategies in administration and liquidation suits
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Source: Celent Estimate 2006Bernstein Research 2008
2007 2008
Global CDO Market
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Source: Celent Estimate 2004ISDA Market Statistics 2007, 2008
Global Credit Derivatives Market
2007
US $35.4trn
US$62.2trn(+81% y-y)
2008
US$54 trn
30 ~ ~ ~~
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CDO portfolios became increasingly concentrated in MBS and CMBS from 2003.
2005-2006 vintages moved towards CDO portfolios consisting largely of home equity ABS and Alt-A / Subprime RMBS.
CDS began referencing HEL ABS / MBS in 2005; CDOs in 2006. 250 CDOs experienced events of default by late 2008. 160 of
those (64%) were ABS CDOs that had events of default when downgrades of underlying ABS and MBS caused portfolios to be valued at less than par; this breached OC tests and triggered EOD.
CDO defaults correlated to credit events on CDS referencing CDOs. CMBS downgrades correlated to credit events on some ABS CDS. CDO defaults triggered termination events on embedded derivatives.
Some CDO and CDS Market Dynamics
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Credit Default Swaps
Credit Default Swaps are documented on ISDA forms: ISDA master agreement and schedule; Confirmation incorporating 2003 Credit Derivatives Definitions.
Credit default swaps are “security-based swap agreements” that synthetically transfer credit risk of a reference entity. Not subject to securities law registration requirements. Subject to securities law anti-fraud rules.
Buyer pays seller a fixed premium for the term of the agreement. Seller makes no payments unless a specified credit event occurs to the reference entity. Settlement is based on value of deliverable securities or other obligations.
Reference entity may include corporate issuer, sovereign or ABS issuer. CDO tranches often referenced.
Reference Entity
Protection Seller Protection BuyerFixed Fee (in bps per period)
Contingent Payment upon “Credit Event”
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Trustee Paying Agent,Collateral Agent
(Securityholder protectionand other fiduciary &administrative duties)
Portfolio Manager
(Manages reference portfolio inaccordance with investment
restrictions)
Protection Buyer
(Short position in reference assets or
entities)
Investors
(Buy ratedABS and
equity interest)
IssuerSpecial-Purpose Entity
(Invests proceeds in eligible investmentsto collateralize its obligationsunder the credit default swap)
Proceeds of ABS
Receive principal andinterest on rated ABSand equity payments onunrated ABS
Debt and equity ABS
Credit default swap
Contingent payment following Credit event on reference assets
CreditSupport
Payments fromHedge Provider
Fees and other payments toHedge Provider
CreditEnhancement for
Interest and Principalof Debt ABS
(Senior/subordinated structure;
overcollateralization; excessspreads; guarantees; bondinsurance; credit default
swaps; etc.)
HedgeCounterparty
(Includes equity and creditderivatives to hedge various
risks, including credit, interestand market risk, and to
manage portfolio)
Risk-based premium
Collateral Debt Securities
& Eligible Investments
Assets(Physical assets)
CDS Counter-parties
(CDS that sell protection in
reference assets or entities)
Credit default swap
AAA,maybe alsosuper-senior
swap
AAABBB
Collateralized Debt Obligations
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Credit Protection Purchaser
(OriginatingBank)
Rated Note Tranches
Equity Tranche
SwapPremium
CreditProtectio
n Interest &
Principal
Funding
Credit defaultSwap
counterparty
Bankruptcy-remote SPV
SwapPremium
CreditProtection;
Termination Payment
Protections
Super-Senior Swap
counterparty
Monoline orBank
Reference pool
Super-Senior Swap in CDO Structure
Collateralized Debt Obligations
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“Tranche Warfare” -- suits among competing claims of investors re administration of CDO Many cases for interpleader / declaratory relief
highly fact specific; Highlight inconsistencies in CDO documentation.
Significant themes include: Controlling class determinations. Liquidation of collateral after default . Conflicts between waterfall and subordination provisions after event of default . Hedge counterparties v. investors. E.g.:
LBSFI v. Ballyrock 2007-1 CDO Ltd. (SDNY Bkr. 2008) Rabobank v. Wells Fargo N.A. (SDNY 2008)
Suits against underwriter / manager / rating agency relating to structuring of transactions Suits brought by investors. E.g.:
M&T Bank Corp. v. Gemstone CDO VII Ltd. (NY Sup. Ct. 2008) HSH Nordbank AG v. UBS AG (NY Sup. Ct. 2008) Oddo Asset Management v. Barclays Bank (NY Sup. Ct. 2008) Abu Dhabi Commercial Bank v. Morgan Stanley & Co. (SDNY 2008)
Third party suits alleging misrepresentation, fraud etc. E.g.: MBIA Ins. Corporation v. Merrill Lynch Pierce Fenner & Smith (NY Sup Ct. 2009) Barclays Bank v. Bear Stearns Asset Management (NY Sup. Ct. 2008)
Investor suitability. E.g.: Kenosha Unified School District v. Stifel Nicolaus & Co. (ED Wis. 2008)
Derivative shareholder or indirect class action or representative litigation
Recent Litigation Themes involving CDOs
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Recent Litigation Themes involving CDS
Counterparty disputes Disputes over whether a credit event occurred. E.g.:
Aon Financial Products Inc. v. Société Générale (2d Cir. 2007) VCG Special Opportunities Master Fund v. Citibank (SDNY 2008)
Challenges to settlement requirements. E.g.: Deutsche Bank AG v. AMBAC Credit Products (SDNY 2006)
Disputes over whether a termination event occurred. Merrill Lynch Inc. v. XL Capital Assurance Inc. (SDNY 2008)
Challenges to margin calls and valuation procedures. E.g.: VCG Special Opportunities Master Fund v. Citibank (SDNY 2008) CDO Plus v. Wachovia (NY Sup. Ct. 2007) UBS AG v. Paramax (NY Sup. Ct. 2007) High Risk Op. HUB Fund Ltd. v. Crédit Lyonnais (NY Sup. Ct. 2005)
Securities law derivative actions. Enforcement actions by SEC and NYAG.
Recent statements indicate 50+ active derivatives investigations. CDS Insider trading complaint by SEC (SEC v. Rorech and Negrin). Possible indication that the securities law surrounding CDS and swaps generally may yet
develop through enforcement actions.
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CDO / CDS Litigation Trends: The More Things Change . . .
• “Exotic” instruments; familiar legal theories• Securities fraud – Rule 10b5• Common law fraud and misrepresentation• Negligence / negligent misrepresentation• Breach of Contract
• The players, however, can be different from the “classic” securities case, as can the forums in which the litigation occurs• Rating Agencies
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Trustee Paying Agent,Collateral Agent
(Securityholder protectionand other fiduciary &administrative duties)
Portfolio Manager
(Manages reference portfolio inaccordance with investment
restrictions)
Protection Buyer
(Short position in reference assets or
entities)
Investors
(Buy ratedABS and
equity interest)
IssuerSpecial-Purpose Entity
(Invests proceeds in eligible investmentsto collateralize its obligationsunder the credit default swap)
Proceeds of ABS
Receive principal andinterest on rated ABSand equity payments onunrated ABS
Debt and equity ABS
Credit default swap
Contingent payment following Credit event on reference assets
CreditSupport
Payments fromHedge Provider
Fees and other payments toHedge Provider
CreditEnhancement for
Interest and Principalof Debt ABS
(Senior/subordinated structure;
overcollateralization; excessspreads; guarantees; bondinsurance; credit default
swaps; etc.)
HedgeCounterparty
(Includes equity and creditderivatives to hedge various
risks, including credit, interestand market risk, and to
manage portfolio)
Risk-based premium
Collateral Debt Securities
& Eligible Investments
Assets(Physical assets)
CDS Counter-parties
(CDS that sell protection in
reference assets or entities)
Credit default swap
AAA,maybe alsosuper-senior
swap
AAABBB
Collateralized Debt Obligations
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CDO / CDS Litigation Trends
• CDO “Tranche warfare” and CDS counterparty suits – basically Breach of Contract• Complex contracts, but . . . • Absent ambiguity, should be able to get an “answer” as a
matter of law• Aon Financial v. Société Générale (SDNY and 2d Cir.) – Summary
Judgment• VCG Special Opportunities Master Fund v. Citibank (SDNY) –
Judgment on the Pleadings
• Speed
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CDO / CDS Litigation Trends
• Securities fraud claims• Impact of the PSLRA’s enhanced pleading
requirements and the Supreme Court’s Tellabs decision (Tellabs Inc. v. Makor Issues & Rights Ltd., 551 U.S. 308 (2007)
• Inference of scienter under the PSLRA must be “cogent and at least as compelling as any opposing reference of nonfraudulent intent.”
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CDO / CDS Litigation Trends• Claims against Rating Agencies
• Historically, few liability concerns• Today, a different story – because of the central role
played by the Ratings Agencies in the subprime meltdown• In re Nat’l Century Financial Enters., Inc., 580 F.Supp.2d
630 (S.D. Ohio 2008) • Dismissal of Rule 10b5 and fraud claims• Survival of negligent misrepresentation and Ohio “Blue
Sky” claims
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• Rating Agency Litigation• SEC Investigation (July 2008)• Damaging emails
CDO / CDS Litigation Trends
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Questions?
CDO / CDS Litigation Trends