Recent innovations in credit derivatives, such as collateralized debt obligations referenced to asset-backed securities, are getting too close for comfort to insurance contracts, according to lawyers. If regulators deem the contracts to be insurance products they could fine investors and structures and possibly even revoke banking licenses, according to Patrick Clancy, counsel at Shearman & Sterling in London. Lawyers predicted that regulators will only start dishing out major penalties if there is a continuing breach of the rules. Officials at the Financial Services Authority declined comment.
Bankers are starting to look at this problem in credit derivatives in general, because contracts are becoming more tailored to individual assets, according to Chris Georgiou, partner in the securities and structured finance practice at Ashurst Morris Crisp in London. "We are working on this. The next couple of months will be critical in forming an opinion on where the law stands," he added.
Two tests which can distinguish derivatives from insurance contracts are whether there is an insurable interest and whether the investor has to prove a loss. Some of the contracts sellers of protection are demanding could mean these deals cross the line between derivatives and insurance contracts. "There is little case law in this area, and the distinctions are very gray," said Clancy.
The requirement that buyers hold the reference obligations in CDOs is one of the demands which most worries lawyers. The chances of the contract being classified as insurance increases when investors insist the protection buyer must suffer a loss in order to get paid. One way around this is to say the buyer of protection must hold the assets at the outset, but can sell them during the transaction. However, "If you are trying to create a disconnect between holding the underlying and getting paid, [the disconnect] must be genuine," said Clancy, adding, "If it is just papering over the crack--a regulator could dispute it."
To show there is a real chance of the assets being sold the CDO manager should write a regular formal review about selling the assets. It will likely be seen as legitimate if, at the end of the transaction, the manager has not sold the assets because it was a good stock pick, according to lawyers.
"The FSA guidance paper on insurance does not help with this issue," according to Clancy.
