Increased CDS Use May Mean More Suits

Increased use of credit default swaps may increase the potential for lawsuits following corporate defaults. The legal specter has returned since a ruling last month upheld strict delivery deadlines for defaulted bonds under older CDS protection contracts that are still in play.

The problem centers on theInternational Swaps and Derivatives Association1999 credit derivative definitions, which allow only a one-week grace period after the delivery deadline for protection buyers to exchange bonds for credit protection. Recent bankruptcies such asDelphihave highlighted the imbalance of CDS contracts relative to bonds available for delivery. The fear is if the credit cycle changes as expected, a spate of bankruptcies could test deals structured under these documents, as dealers scramble to hand over bonds inside the time constraints.

The issue was at the crux of the July ruling in monolineAmbac的支持,之后Deutsche Bankattempted to sue the insurer for non-payment of protection. The judge in that case based her ruling on the wording of the documents, rather than on a verbal agreement Deutsche Bank said existed between the parties. Such agreements are not uncommon and lawyers said the decision does not prevent protection buyers in similar positions from bringing lawsuits against sellers over the next few years.

Lawyers warn a big bankruptcy could seize the market and make physical delivery harder than ever. While the ruling sets a strong precedent, it is not set in stone. Deutsche Bank may yet appeal and new cases could try the same argument on different judges in different courts or make different arguments depending on the case, lawyers said.