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U.S. Court Ruling Appears To Shake CDS Agreements

18 May 2006

The legal stability of credit-default swap contracts has come under threat from a ruling against Société Générale in the U.S. District Court for the Southern District of New York.

The legal stability of credit-default swap contracts has come under threat from a ruling against Société Générale in the U.S. District Court for the Southern District of New York. Legal officials say the ruling, which found in favor of swap counterparty Aon Financial Products andAon Corporation, undermines standard CDS documentation and could have far reaching consequences because few legal precedents have been set for disputes between credit derivative participants.

Full details of the dispute could not be immediately ascertained, beyond that it centered on the settlement of a USD10.1 million CDS in which SG sold Aon protection on the risk of default by the Republic of Philippines. The court ruled SG was liable to pay protection to Aon without receiving the bonds, because Aon was in turn liable under a separate CDS contract entered into at the same time, in which it sold protection on an entity within the Phillipines to another counterparty.

The International Swaps and Derivatives Association has filed an amicus curiae brief in support of an SG appeal to the U.S. Court of Appeals for the Second Circuit, in which it seeks a reversal of the decision. "The court failed to see through the differences in these two contracts and just collapsed everything together," said Lary Stromfeld, partner at Cadwalader, Wickersham & Taft in New York and counsel to ISDA. "The court had a fundamental misunderstanding of how CDS contracts work and this could introduce legal uncertainty into market," he noted.Louise Marshall, spokeswoman, added the brief is necessary to uphold the integrity of the USD17 trillion CDS market.

Ken Hagan, spokesman at SG in New York, and Thaddeus Woosley, spokesman at Aon in Chicago, did not return phone messages by press time.

18 May 2006