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A fundamental premise of the CDS market is that CDS are not insurance contracts. The conclusionthat CDS are not insurance contracts is based upon the fact that the buyer of credit protection undera CDS need not suffer any loss nor provide any evidence of any loss with respect to the relevantreference entity or obligation to receive payment from seller. This position historically has beensupported by the Insurance Department, notably in a June 2000 opinion issued by the InsuranceDepartment’s Office of General Counsel (General Counsel). As discussed below, however, theInsurance Department is currently revisiting whether CDS should be regulated as insurance contracts.The Commodity Futures Modernization Act of 2000 (CFMA), signed into law by President Clintonon December 21, 2000, generally excludes CDS from regulation as “futures” under the Commodity Exchange Act. Furthermore, the CFMA provides that CDS are “swap agreements” that do notconstitute “securities” for purposes of the 1933 Act or the 1934 Act. The CFMA does provide thatCDS are subject to the anti-fraud and anti-manipulation provisions of the 1933 Act and 1934 Act as“security-based swap agreements” but prohibits the SEC from taking preventative measures againstfraud or manipulation with respect to security-based swaps.
Potential New Regulation
The most specific recent regulatory proposal with respect to CDS has been that of the InsuranceDepartment. In its Circular Letter No. 19 (2008) (Circular), dated September 22, 2008, theInsurance Department made clear that they will be revisiting the June 2000 opinion issued by theGeneral Counsel on the basis that the opinion did not consider the situation where the buyer of creditprotection under a CDS “
holds, or reasonably expects to hold, a ‘material interest’ in the referenced obligation.
” The Circular goes on to state that such “omission will be rectified and addressed in aforthcoming opinion to be prepared” by the General Counsel.The new Insurance Department regulatory regime is intended to be effective on January 1, 2009 andit appears that the Insurance Department will require sellers of credit protection under such CDS tobe licensed as insurance providers. As announced, the proposal is not intended to affect so-called“naked CDS,” under which the buyer does not hold and does not expect to hold a material interest (asnoted above, a buyer of protection is under no such obligation under a CDS). One of the many questions presented by the Circular is how it will be determined whether the buyer under a CDS“reasonably expects” to hold a material interest in the reference obligation at the time the CDS isentered into.
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Uncertainty in this determination may cause the parties to seek advice from the
www.kramerlevin.comFinancial Institutions Derivatives Alert
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As examples of how broadly the language “holds or reasonably expects to hold” and investor intent may be interpreted, see, e.g., theInsurance Department opinion dated December 19, 2005 (2005 Opinion) and
Life Product Clearing LLC v. Ange
l (S.D.N.Y. 2008)(Life Product Clearing). The 2005 Opinion and Life Product Clearing each involved life insurance transactions and considered theintent of an insurance policyholder that assigned its policy to an investor shortly after initial purchase. In the 2005 Opinion, theInsurance Department concluded that the transaction in question involved the procurement of insurance solely as speculativeinvestment, even though the initial policyholder had the contractual option to retain the policy for its duration. In
Life Product Clearing LLC v. Angel
, the United States District Court for the Southern District of New York declined to dismiss the action onpleadings so that it could be determined whether a life insurance policy was procured “with a view to its immediate assignment” and whether the policy in question was capable, under New York insurance law, of being transferred to a third party not having aninsurable interest. The court noted, generally, that cases that turn on the issue of intent are not appropriate for summary dispositionand cited the 2005 Opinion to note the public policy against “gaming” through insurance policy purchases.
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