Basics of Credit Derivatives

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Legal enforceability of credit default swaps

Probably the only case dealing with credit derivatives is the ruling in URSA MINOR LIMITED, and BANKERS TRUSTEE COMPANY LIMITED v. AON FINANCIAL PRODUCTS, INC, before the US Court of Appeals for the Second Circuit. The ruling in the case was given on 11th April 2001. The court ordered that the case will not be cited as a precedent but may be brought to the attention in any case.

The case involved a credit default swap where the defandant had sold protection in a swap in a surety bond issued by a Philippine government body. The bond issuer denied liability on the bond, asserting its invalidity, and the plaintiffs sought to recover from the defendants under the credit default swap.

The defendant refused to pay. The Court held in favour of the plaintiff, on the ground that there was a clear waiver in the swap papers that the defandant will not raise defenses concerning the invalidity, illegality, or unenforceability of the GSIS surety bond. The Court cited from Compagnie Financiere de CIC et de L'Union Europeenne v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 188 F.3d 31, 34-35 (2d Cir. 1999); and Grumman Allied Indus., Inc. v. Rohr Indus., Inc., 748 F.2d 729, 735 (2d Cir. 1984) holding that where the parties to an agreement have expressly allocated risks, the judiciary shall not intrude into their contractual relationship. . . . [despite] efforts at semantical legerdemain . . . .".

The case as well as the citation relating to judiciary's disinclination to interfere against specific allocation of risks by parties is a significant ruling for credit derivatives.