Court battle between Merrill Lynch and bond insurer over credit derivatives suggests counterparties may try to use voting rights as a way to bail out of their exposureBy Marine Cole
March 31, 2008
SourceThe legal dispute between Merrill Lynch and monoline insurer XL Capital Assurance over credit default swaps on collateralized debt obligations could be a harbinger of more lawsuits to come as counterparties to such contracts try to minimize losses stemming from the credit crunch.
Merrill is suing the financial guaranty subsidiary of Security Capital Assurance over the termination of seven CDS contracts the bank had purchased to protect against losses on structured finance CDOs. XLCA claims Merrill itself terminated the contracts by offering voting rights to the collateral to a third party. The seven CDOs have an aggregate notional amount of $3.1 billion.
“I am fairly certain that we will see more monolines trying to get out of their credit default swaps,” said David Grais, a partner at Grais & Ellsworth.
Other lawyers agree. “We’re in economic circumstances where parties are under stress and are going to be looking carefully at their contracts,” said Josh Cohn, a partner at Allen & Overy. “It’s just natural given the economic circumstances. These are complex transactions with complex documents.” Part of the complexity has to do with who gets to decide when collateral is liquidated, as evident in the dispute between Merrill Lynch and XLCA.
The latter’s parent recently posted a $1.2 billion fourth-quarter loss. Merrill is expected to write down anywhere from $4.5 billion to $6 billion from exposure to mortgage-related securities and counterparties such as troubled bond insurers during the first quarter, adding to the more than $20 billion of CDOs it has already written down since the beginning of the subprime crisis.
Many monolines wrote protection for CDOs collateralized by subprime mortgage loans that have been weakening. If these CDOs start approaching default or simply get downgraded, insurers will have to raise more capital to cover payments to buyers of the protection.
Such contracts carry voting provisions that typically say that the buyer of protection through a swap, in this case Merrill Lynch, passes its voting rights for the security to the monoline selling protection. Voting rights must be exercised when deciding whether to liquidate a CDO, for instance.
The issue is a key consideration in the event of a CDO default, as the seller of protection would have to pay any potential shortfalls in principal and interest for the life of the security. If a CDO is liquidated and the collateral covers only part of the losses, the monoline would have to cover the difference. This is why monolines require voting rights in exchange for protection.
According to the complaint Merrill Lynch filed in mid-March in the U.S. District Court for the Southern District of New York, SCA alleges that Merrill Lynch repudiated the CDS contracts by committing to provide another monoline, MBIA, with the same CDO voting rights it had promised XLCA. In many cases, voting rights for the collateral in a CDO are parceled out to different sellers of protection according to the tranche they cover. But XLCA claims no such agreement was made in this case. “We have a responsibility to take the appropriate action and terminate these contracts,” it said in a press release responding to the complaint.
“XL seems to be saying the fact that you own another class [in the CDOs] and bought protection [with another monoline] violates the intention of the voting provisions under your class,” said Joel Telpner, partner with law firm Mayer Brown.
Merrill counters that it did not share XLCA’s rights with MBIA. Instead, it charges that the termination constitutes a breach of XLCA’s contractual obligations. “Apparently, in light of the current dramatic downturn and deterioration in the credit markets, defendants are having ‘sellers’ remorse’ and are seeking to avoid their potential obligations of up to approximately $3.1 billion under the credit default swaps at issue,” Merrill Lynch said in the complaint.
Losses on SCA’s structured finance CDOs backed by subprime residential mortgage-backed securities will ultimately be between $3 billion and $4 billion, “very close to their capital levels,” according to Thomas Abruzzo, analyst with Fitch Ratings, which last week downgraded the company to BB from A.
Although disputes involving CDOs have been common since the subprime crisis started, there aren’t any precedents for lawsuits involving monolines, according to the lawyers interviewed by Financial Week.
Mr. Telpner believes there will be additional lawsuits involving monolines that will go beyond the question of who holds the voting rights to collateral. Many swaps include an exception to the transfer of voting rights if a decision to liquidate the collateral would have a material effect on its financial condition.
“Generally speaking, most CDS have some types of carve-outs along those lines,” Mr. Telpner said. “That will be a more likely scenario.” FW