In a September 22, 2008 Circular Letter, the New York Insurance Department announced that it would regulate certain kinds of credit default swaps as insurance. Credit default swaps are contracts under which a "protection seller" promises to pay a "protection buyer" following a credit event involving a reference entity or obligation. Such credit events can include a default by the reference entity or a credit downgrade of the reference entity. The protection buyer makes regular premium-like payments to the protection seller in return for the protection seller's promise to pay if the event occurs. The market for credit default swaps has been estimated at approximately $62 trillion.
In its Circular Letter, the Insurance Department eschewed any intention to regulate so-called "naked" swaps, which the Department defined as swaps where the protection buyer has no interest in the reference entity or obligation. The Department, however, intends to regulate, beginning January 1, 2009, swaps in which the protection buyer "holds, or reasonably expects to hold, a 'material interest' in the referenced obligation." Prior to this announcement, under previous opinions of the Department, swap agreements were not considered insurance contracts. This new announcement overrules those prior opinions. Although the Department has not yet released the regulations, the Department's comments thus far have raised a number of questions.
First, what constitutes a "material interest" in a reference obligation?
The Department's use of the term "material interest" appears to be a reference to Section 1101 of the New York Insurance law, which defines an insurance contract as:
"any agreement or other transaction whereby one party. . . is obligated to confer benefit of pecuniary value upon another party . . . dependent upon the happening of a fortuitous event in which the insured or beneficiary has, or is expected to have at the time of such happening, a material interest which will be adversely affected by the happening of such event."
The lack of regulation of naked swaps can be traced to Section 1101's "material interest" requirement as well as Section 6901 of New York's Financial Guaranty Law that provides that financial guaranty insurance includes not only insurance policies but also, when issued by a New York licensed insurer, indemnity contracts in which a loss is payable due to the failure of an obligor to pay a debt due. Thus, under New York law, financial guaranty insurance can either be an "insurance policy" (as defined by Section 1101) or an indemnity contract (if issued by a New York licensed insurer) in which loss is payable on the failure to pay a financial obligation. Under New York law, financial guaranty insurance may only be issued by a licensed financial guaranty insurer. Therefore, a naked swap issued by an entity without an insurance license would not fit the definition of financial guaranty insurance becuase the protection buyer lacks the "material interest" required by section 1101 to make the guaranty a contract of insurance, and the protection seller is not a licensed financial guaranty insurer that would make an indemnity contract or guaranty financial guaranty insurance under section 6901.
Section 1101, however, does not define "material interest." No further explanation of how a protection buyer might "hold" or "reasonably expect to hold" such an interest is provided. Little other guidance exists as New York courts have not grappled with the question in the context of capital markets transactions. Obviously, if a protection buyer owns 100% of the reference obligation it has a material interest in it. But what if the protection buyer holds only a minority stake in the reference obligation or in a small number of reference obligations out of a larger portfolio of reference obligations? What if the protection buyer itself holds no interest in the reference entity, but the buyer is a subsidiary of a holding company that does? Will the holding company's interest be attributed to the subsidiary? Consequently, specific regulatory guidance from the Department will be needed on how it will determine the materiality of an interest in a reference obligation.
These issues will be further complicated if protection buyers must determine whether they have a reasonable expectation of holding a material interest in a reference entity. What, as an initial matter, constitutes a reasonable expectation? This question will be especially difficult to answer for subsidiaries of large holding companies. Will protection buyers be deemed to have notice of the investment expectations of affiliated companies?
All of these issues also raise a more fundamental question: how will a protection seller learn about the holdings and expectations of a protection buyer? After all, any regulatory penalties will almost certainly fall on protection sellers for selling credit default swaps without the necessary license from the Department. Will the burden be on the protection seller to find out what its counterparty's interest in the reference entity is, or will the protection buyer have a duty to disclose such interests?
In the end, answering all of these questions before entering into a swap will likely be impractical in the fast-moving world of capital markets transactions. Protection sellers may determine that it is more practical to simply obtain the required license to sell insurance from the Department. Whatever form the regulations take, however, it is a certainty that they will provoke still more questions. Saul Ewing LLP is following these developments closely and will be issuing additional analysis in the near future as further guidelines, regulations or developments occur.
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