Davis Polk & Wardwell Newsflash

New York and SEC Move to Regulate Credit Default Swaps

September 24, 2008

On September 22, 2008, New York Governor David Paterson announced that New York State will regulate part of the credit default swap market, and the New York State Department of Insurance (the “NYS Department of Insurance”) issued guidelines concerning this market.  On September 23, 2008, SEC Chairman Christopher Cox asked Congress to grant the SEC jurisdiction over the credit default swap market.  There has been a large volume of preliminary commentary, much of which appears to be inaccurate, regarding these developments.  This newsflash is intended to report what we understand to be the current state of affairs.

A credit default swap is an over-the-counter contract where the buyer makes periodic payments to the seller in exchange for the right to a payoff if there is a specified credit event in respect of a third party’s debt.  It therefore can be used to protect the buyer against defaults on the debt of the third party, although buyers often enter into credit default swaps even where they do not own the underlying third party debt.  Currently, credit default swaps are not regulated as either insurance or securities (though they may be subject to anti-fraud and related provisions of the securities laws).  The notional value of outstanding credit default swaps has been estimated to be in excess of $60 trillion.

New York Regulatory Action on Credit Default Swaps

Governor Paterson’s press release, and the NYS Department of Insurance’s new guidelines, essentially state that some credit default swaps are, or will be treated as, insurance and therefore New York will subject them (and their sellers) to state insurance regulation.  While the Governor’s press release suggested that this change would occur in 2009, the NYS Department of Insurance’s guidelines have a more immediate potential impact.

According to Governor Paterson’s press release, beginning in January 2009, when a buyer of a credit default swap owns the underlying reference security, the seller will be considered to be selling an insurance contract, and therefore required to be licensed to conduct insurance business in the State of New York.  Credit default swaps issued to a buyer that does not own the underlying reference security will not be deemed to be insurance contracts and therefore will not be regulated by the NYS Department of Insurance.

In addition to the press release, the NYS Department of Insurance has released Circular Letter No. 19 (the “Circular”).  In prior opinions, the NYS Department of Insurance had stated that credit default swaps are not insurance contracts because the buyer is entitled to a payout, without any proof of loss, upon a default with respect to the third party’s debt.  The Circular states that the prior opinions did not address situations where the buyer actually “holds, or is reasonably expected to hold, a material interest in the referenced obligation.”  In that situation, the Circular suggests that the prior opinions are not relevant, and that the NYS Department of Insurance’s Office of the General Counsel will be issuing an opinion that will take a position with respect to whether such a credit default swap is an insurance contract.  Based on Governor Paterson’s statement, it is clear that the opinion intends to conclude that such credit default swaps are insurance contracts.   In the meantime, the Circular notes that, to the extent that the selling of the credit default swap itself may constitute “the doing of an insurance business,” the seller of a credit default swap should consider seeking an opinion from the Office of General Counsel to assess whether it should be licensed as an insurer pursuant to New York State Insurance Law.

While there is nothing dispositive in the Circular, it would be prudent for sellers of credit default swaps to consider obtaining representations from their buyer stating that such buyer does not hold and does not expect to hold, a material interest in the referenced obligation.  By obtaining this representation and reasonably believing it to be accurate, a seller could continue to rely upon the prior opinions, which the Circular confirms are still valid.  When a seller cannot obtain such a representation and is either domiciled in New York or doing business in New York or with New York counterparties, the Circular raises at least a question as to whether selling the credit default swap constitutes engaging in the business of insurance in New York without a license.

Most credit default swaps are written for buyers that do not hold, or reasonably expect to hold, a “material interest in the referenced obligation.”  For credit default swaps where the buyer does hold, or expects to hold, such a material interest, the Circular may chill the market for swaps in New York or involving New York parties.

Federal Efforts to Regulate the Credit Default Swap Market

In Tuesday morning’s Senate Banking Committee hearings, SEC Chairman Christopher Cox encouraged Congress to provide the SEC with explicit authority to regulate the credit default swap market (credit default swaps are currently excluded from the definition of “securities” in most of the securities laws).  He said, “I urge you to provide in statute the authority to regulate [credit default swaps] to enhance investor protection and ensure the operation of fair and orderly markets.”  In addition, several Senators questioned Secretary Paulson, Chairman Cox and Chairman Bernanke regarding the state of affairs in the credit default swap market and what regulatory changes might be needed going forward.

Because the credit default swap market is extremely large, crosses state borders, and is also implicated in some aspects of the current financial crisis, Congress and the federal regulators are likely to consider seriously whether to regulate credit default swaps nationally; actions such as those taken by New York will only encourage this in order to avoid having states implement varied and possibly inconsistent regimes.

We will continue to monitor developments and update you with additional newsflashes and memoranda accordingly.


See a copy of Circular 19

See a copy of Governor Paterson’s press release

If you have any questions regarding this newsflash, please call your Davis Polk contact.

Davis Polk & Wardwell