CDO and CDS Litigation Trends

Kiran H. Mehta, Partner, Charlotte Office

Anthony R. G. Nolan, Partner, New York Office

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Today’s Presenters

Anthony R.G. Nolan, PartnerNew York Office anthony.nolan@klgates.com212.536.4843

Kiran H. Mehta, PartnerCharlotte, NC Office kiran.mehta@klgates.com

704.331.7437

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About K&L Gates

K&L Gates comprises approximately 1,900 lawyers in 32 offices located in North America, Europe and Asia. We represent capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector entities.

K&L Gates maintains one of the most prominent financial services practices in the United States – with more than 150 U.S.-based lawyers representing diversified financial services institutions and their affiliated service providers.

The U.S. National Law Journal has identified K&L Gates as a “go-to” law firm for Financial America.

In 2007 and 2008, Chambers USA, an independent and research-based guide to the legal profession, ranked K&L Gates as having one of the leading financial services practices in the country.

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Agenda

CDO and CDS overview Recent cases and themes in litigation Rating agency suits and the viability of traditional defenses Strategies in administration and liquidation suits

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Source: Celent Estimate 2006Bernstein Research 2008

2007 2008

Global CDO Market

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Source: Celent Estimate 2004ISDA Market Statistics 2007, 2008

Global Credit Derivatives Market

2007

US $35.4trn

US$62.2trn(+81% y-y)

2008

US$54 trn

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~ ~ ~~

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CDO portfolios became increasingly concentrated in MBS and CMBS from 2003.

2005-2006 vintages moved towards CDO portfolios consisting largely of home equity ABS and Alt-A / Subprime RMBS.

CDS began referencing HEL ABS / MBS in 2005; CDOs in 2006. 250 CDOs experienced events of default by late 2008. 160 of

those (64%) were ABS CDOs that had events of default when downgrades of underlying ABS and MBS caused portfolios to be valued at less than par; this breached OC tests and triggered EOD.

CDO defaults correlated to credit events on CDS referencing CDOs. CMBS downgrades correlated to credit events on some ABS CDS. CDO defaults triggered termination events on embedded derivatives.

Some CDO and CDS Market Dynamics

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Credit Default Swaps

Credit Default Swaps are documented on ISDA forms: ISDA master agreement and schedule; Confirmation incorporating 2003 Credit Derivatives Definitions.

Credit default swaps are “security-based swap agreements” that synthetically transfer credit risk of a reference entity. Not subject to securities law registration requirements. Subject to securities law anti-fraud rules.

Buyer pays seller a fixed premium for the term of the agreement. Seller makes no payments unless a specified credit event occurs to the reference entity. Settlement is based on value of deliverable securities or other obligations.

Reference entity may include corporate issuer, sovereign or ABS issuer. CDO tranches often referenced.

Reference Entity

Protection Seller Protection Buyer

Fixed Fee (in bps per period)

Contingent Payment upon “Credit Event”

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Trustee Paying Agent,Collateral Agent

(Securityholder protectionand other fiduciary &administrative duties)

Portfolio Manager

(Manages reference portfolio inaccordance with investment

restrictions)

Protection Buyer

(Short position in reference assets or

entities)

Investors

(Buy ratedABS and

equity interest)

IssuerSpecial-Purpose Entity

(Invests proceeds in eligible investmentsto collateralize its obligationsunder the credit default swap)

Proceeds of ABS

Receive principal andinterest on rated ABSand equity payments onunrated ABS

Debt and equity ABS

Credit default swap

Contingent payment following Credit event on reference assets

CreditSupport

Payments fromHedge Provider

Fees and other payments toHedge Provider

CreditEnhancement for

Interest and Principalof Debt ABS

(Senior/subordinated structure;

overcollateralization; excessspreads; guarantees; bondinsurance; credit default

swaps; etc.)

HedgeCounterparty

(Includes equity and creditderivatives to hedge various

risks, including credit, interestand market risk, and to

manage portfolio)

Risk-based premium

Collateral Debt Securities

& Eligible Investments

Assets(Physical assets)

CDS Counter-parties

(CDS that sell protection in

reference assets or entities)

Credit default swap

AAA,maybe alsosuper-senior

swap

AAA

BB

B

Collateralized Debt Obligations

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Credit Protection Purchaser

(OriginatingBank)

Rated Note Tranches

Equity Tranche

SwapPremium

CreditProtectio

n Interest &

Principal

Funding

Credit defaultSwap

counterparty

Bankruptcy-remote SPV

SwapPremium

CreditProtection;

Termination Payment

Protections

Super-Senior Swap

counterparty

Monoline orBank

Reference pool

Super-Senior Swap in CDO Structure

Collateralized Debt Obligations

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“Tranche Warfare” -- suits among competing claims of investors re administration of CDO Many cases for interpleader / declaratory relief

highly fact specific; Highlight inconsistencies in CDO documentation.

Significant themes include: Controlling class determinations. Liquidation of collateral after default . Conflicts between waterfall and subordination provisions after event of default . Hedge counterparties v. investors. E.g.:

LBSFI v. Ballyrock 2007-1 CDO Ltd. (SDNY Bkr. 2008) Rabobank v. Wells Fargo N.A. (SDNY 2008)

Suits against underwriter / manager / rating agency relating to structuring of transactions Suits brought by investors. E.g.:

M&T Bank Corp. v. Gemstone CDO VII Ltd. (NY Sup. Ct. 2008) HSH Nordbank AG v. UBS AG (NY Sup. Ct. 2008) Oddo Asset Management v. Barclays Bank (NY Sup. Ct. 2008) Abu Dhabi Commercial Bank v. Morgan Stanley & Co. (SDNY 2008)

Third party suits alleging misrepresentation, fraud etc. E.g.: MBIA Ins. Corporation v. Merrill Lynch Pierce Fenner & Smith (NY Sup Ct. 2009) Barclays Bank v. Bear Stearns Asset Management (NY Sup. Ct. 2008)

Investor suitability. E.g.: Kenosha Unified School District v. Stifel Nicolaus & Co. (ED Wis. 2008)

Derivative shareholder or indirect class action or representative litigation

Recent Litigation Themes involving CDOs

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Recent Litigation Themes involving CDS

Counterparty disputes Disputes over whether a credit event occurred. E.g.:

Aon Financial Products Inc. v. Société Générale (2d Cir. 2007) VCG Special Opportunities Master Fund v. Citibank (SDNY 2008)

Challenges to settlement requirements. E.g.: Deutsche Bank AG v. AMBAC Credit Products (SDNY 2006)

Disputes over whether a termination event occurred. Merrill Lynch Inc. v. XL Capital Assurance Inc. (SDNY 2008)

Challenges to margin calls and valuation procedures. E.g.: VCG Special Opportunities Master Fund v. Citibank (SDNY 2008) CDO Plus v. Wachovia (NY Sup. Ct. 2007) UBS AG v. Paramax (NY Sup. Ct. 2007) High Risk Op. HUB Fund Ltd. v. Crédit Lyonnais (NY Sup. Ct. 2005)

Securities law derivative actions. Enforcement actions by SEC and NYAG.

Recent statements indicate 50+ active derivatives investigations. CDS Insider trading complaint by SEC (SEC v. Rorech and Negrin). Possible indication that the securities law surrounding CDS and swaps generally may yet

develop through enforcement actions.

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CDO / CDS Litigation Trends: The More Things Change . . .

• “Exotic” instruments; familiar legal theories• Securities fraud – Rule 10b5• Common law fraud and misrepresentation• Negligence / negligent misrepresentation• Breach of Contract

• The players, however, can be different from the “classic” securities case, as can the forums in which the litigation occurs• Rating Agencies

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Trustee Paying Agent,Collateral Agent

(Securityholder protectionand other fiduciary &administrative duties)

Portfolio Manager

(Manages reference portfolio inaccordance with investment

restrictions)

Protection Buyer

(Short position in reference assets or

entities)

Investors

(Buy ratedABS and

equity interest)

IssuerSpecial-Purpose Entity

(Invests proceeds in eligible investmentsto collateralize its obligationsunder the credit default swap)

Proceeds of ABS

Receive principal andinterest on rated ABSand equity payments onunrated ABS

Debt and equity ABS

Credit default swap

Contingent payment following Credit event on reference assets

CreditSupport

Payments fromHedge Provider

Fees and other payments toHedge Provider

CreditEnhancement for

Interest and Principalof Debt ABS

(Senior/subordinated structure;

overcollateralization; excessspreads; guarantees; bondinsurance; credit default

swaps; etc.)

HedgeCounterparty

(Includes equity and creditderivatives to hedge various

risks, including credit, interestand market risk, and to

manage portfolio)

Risk-based premium

Collateral Debt Securities

& Eligible Investments

Assets(Physical assets)

CDS Counter-parties

(CDS that sell protection in

reference assets or entities)

Credit default swap

AAA,maybe alsosuper-senior

swap

AAA

BB

B

Collateralized Debt Obligations

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CDO / CDS Litigation Trends

• CDO “Tranche warfare” and CDS counterparty suits – basically Breach of Contract• Complex contracts, but . . . • Absent ambiguity, should be able to get an “answer” as a

matter of law• Aon Financial v. Société Générale (SDNY and 2d Cir.) – Summary

Judgment• VCG Special Opportunities Master Fund v. Citibank (SDNY) –

Judgment on the Pleadings

• Speed

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CDO / CDS Litigation Trends

• Securities fraud claims• Impact of the PSLRA’s enhanced pleading

requirements and the Supreme Court’s Tellabs decision (Tellabs Inc. v. Makor Issues & Rights Ltd., 551 U.S. 308 (2007)

• Inference of scienter under the PSLRA must be “cogent and at least as compelling as any opposing reference of nonfraudulent intent.”

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CDO / CDS Litigation Trends• Claims against Rating Agencies

• Historically, few liability concerns• Today, a different story – because of the central role

played by the Ratings Agencies in the subprime meltdown• In re Nat’l Century Financial Enters., Inc., 580 F.Supp.2d

630 (S.D. Ohio 2008) • Dismissal of Rule 10b5 and fraud claims• Survival of negligent misrepresentation and Ohio “Blue

Sky” claims

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• Rating Agency Litigation• SEC Investigation (July 2008)• Damaging emails

CDO / CDS Litigation Trends

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Questions?

CDO / CDS Litigation Trends