State Initiatives To Regulate Credit Default Swaps Deferred Pending Federal Action

Tuesday, September 1, 2009 - 01:00

In recent months, credit default swaps ("CDS") have attracted growing public scrutiny. As defaults by sellers of these instruments have risen, there have been efforts at both the state and federal levels to regulate CDS. While the regulatory goal is to increase disclosure and transparency and to ensure capital adequacy and sufficient risk management of the parties to CDS contracts, mechanisms through which the state and federal governments currently propose to regulate CDS differ. The Obama administration and Congress propose the formation of exchanges and clearing houses for CDS, whereas state legislators propose to regulate a certain segment of CDS as insurance. As discussed in more detail below, state initiatives to regulate CDS as insurance are currently on hold while state legislators await the outcome of the pending federal derivatives initiatives. The states' public policy interests in CDS regulation, current deferral to federal action and possible actions in response to the speed of adoption, and ultimate regulatory outcome, of federal initiatives are discussed below.

Credit Default Swap Basics

A CDS is a type of over-the-counter negotiated contractual arrangement (collectively, "OTC Derivatives") between two counterparties designed to transfer credit risk. The protection "Buyer" makes a fixed payment (either up-front or periodically) to the protection "Seller," and the Seller agrees to pay a "Settlement Amount" to the Buyer if a specified event or events (each, a "Credit Event") occur with respect to a specified asset (the "Reference Obligation") issued or guaranteed by a specified company (the "Reference Entity") that is unrelated to the Buyer or the Seller. Common examples of Credit Events include bankruptcy and payment default, but the parties to a CDS transaction can contractually agree to name any Credit Events they wish.

Some CDS are purchased by a Buyer with an interest in the underlying Reference Obligation as a hedge against the Buyer's risk of loss on such Reference Obligation; for example, if the underlying Reference Obligation suffers a payment default, or the Reference Entity goes into bankruptcy, the Buyer would receive a Settlement Amount. Such a CDS is referred to as a "Covered Swap" and is similar to a traditional insurance policy, which is usually only purchased on an "insurable interest" (i.e., an asset in which the Buyer holds an interest).

Additionally, a Buyer may purchase a CDS on a Reference Entity in which the Buyer does not hold any interest, in order to speculate (rather than hedge against the risk of loss) on the future creditworthiness of the Reference Entity (e.g., buying a CDS on a security issued by an entity in financial distress). Such a speculative CDS is referred to as a "Naked Swap."

Currently, CDS are generally unregulated by the federal government. CDS have been excluded from the definition of "securities" under the federal securities laws and are not regulated by the Securities and Exchange Commission. The Commodity Futures Modernization Act of 2000 also exempts CDS from regulation by preempting state and local gaming laws (except for general antifraud provisions) and exempting certain derivatives, including CDS, from regulation by the U.S. Commodity Futures Trading Commission (the "CFTC").

State Initiatives To Regulate CDS As Insurance

While there have been efforts to regulate Covered Swaps as insurance by New York, Missouri and, to some extent, Virginia, at this time all such efforts appear to have been halted pending federal action. If federal regulation of CDS is considered to be sufficient by the state insurance regulators, states may conclude that although Covered Swaps are deemed to be insurance, they are properly regulated by the federal, and not the state, government.

New York.

The New York insurance statutes and regulations currently do not specifically state whether swaps are included within or excepted from the definition of insurance. The New York State Insurance Department (the "NYSID") has addressed this issue, however, in several written opinions (the "2000/2002 Opinions"), stating that a CDS transaction is not an insurance contract where: (i) the reference obligation is a portfolio of corporate bonds; (ii) the Seller will make payment to the Buyer upon the happening of a negative credit event including bankruptcy, failure to pay, obligation acceleration or restructuring; and (iii) such payment is not dependent upon the Buyer's having suffered a loss.1The 2000/2002 Opinions stopped short of addressing whether the NYSID considered Covered Swaps to be insurance.

On September 22, 2008, New York Governor David A. Paterson announced that in January of 2009 the state would begin regulating Covered Swaps as insurance.2On November 20, 2008, however, the NYSID announced that it would "delay indefinitely its application of New York Insurance Law" to CDS pending action at the federal level.3New York recognized that dividing the CDS market by regulating only Covered Swaps at the state level, while Naked Swaps are regulated by the federal government, was not the ideal solution.4

The Governor's Program Bill #50,5introduced in the New York State Legislature in June of this year, would amend Article 69 of the insurance law governing financial guaranty insurers, including the deletion of almost all references to CDS. Noting New York's recognition of "the rapidly changing landscape and uncertainty with respect to CDS,"6Program Bill #50 authorizes the New York Superintendent of Insurance to assess the efficacy and sufficiency of federal regulation of CDS and determine whether Covered Swaps should be regulated as insurance at the state level and whether Sellers of Covered Swaps should be subject to insurance company licensing requirements. Program Bill #50 is expected to become law in 2010.


In November of 2008, the acting director of the Missouri Department of Insurance, Financial Institutions and Professional Registration (the "Missouri Department") issued a bulletin stating that "[e]ngaging in the business of issuing a covered credit default swap is an insurance business that requires a certificate of authority from the director [of the Missouri Department] when such business is done in the state of Missouri."7The acting director further stated in the bulletin, however, that enforcement of the insurance regulatory scheme on the issuance of Covered Swaps would be premature at the time of the issuance of the bulletin, given the expectation of the timely enactment of comprehensive regulation of CDS by the federal government. The acting director concluded that while she will begin regulatory enforcement with regard to Covered Swaps on January 1, 2009, she will exercise discretion in such enforcement "in order to allow an opportunity for the enactment of comprehensive federal regulation" of CDS.


In January of this year, H.B. 2320 was introduced in the Virginia General Assembly to create a mechanism to regulate financial guaranty insurance and permit financial guaranty insurers to insure obligations under a pool of CDS.8H.B. 2320 attempts to define when CDS is insurance in the context of financial guaranty insurance. Virginia's 2009 Regular Legislative Session adjourned sine die on February 28, 2009, and H.B. 2320 was not signed into law.

National Conference Of Insurance Legislators ("NCOIL")9

Last November, NCOIL's Financial Services and Investment Products Committee (the "Committee") decided to "explore the role of credit default swaps and other financial instruments, develop a position, and communicate to legislative colleagues regarding their public policy implications."10Members of the NCOIL Task Force on Credit Default Swaps Regulation subsequently approved plans to treat CDS as insurance and to develop model legislation to regulate the CDS market at the state level.

The "Credit Default Insurance Model Legislation" (the "Model Legislation"), which was exposed for comment in May of 2009,11provides that only a licensed "credit default insurance corporation" would be permitted to issue "credit default insurance," and that such insurance would be regulated by the applicable state departments of insurance. Issuance of credit default insurance would be limited to purchasers with a material interest in the underlying asset, and Naked Swaps would be prohibited.

Interested parties, including the International Swaps & Derivatives Association ("ISDA"), the Securities Industry & Financial Markets Association ("SIFMA"), the American Academy of Actuaries (the "AAA") and the American Council of Life Insurers (the "ACLI"), have voiced their opinions on the Model Legislation, including that: (i) the proposed ban on Naked Swaps would adversely affect legitimate risk management activities of various market participants and effectively eliminate the entire domestic CDS market;12(ii) characterization of CDS as insurance under the Model Legislation may not be proper;13and (iii) NCOIL should be mindful of various pending federal initiatives that may be better suited for the regulation of CDS than regulation at the state level.14

During NCOIL's summer 2009 meeting, Committee members debated the merits of adopting the Model Legislation given the federal government's active efforts to develop a comprehensive mechanism to regulate CDS. The Committee moved to postpone the adoption of the Model Legislation until NCOIL's annual meeting in November to allow for further consideration of the Model Legislation. On July 22, 2009, NCOIL submitted a letter to Congress to inform federal lawmakers of NCOIL's development of the Model Legislation premised on classification that CDS, in which the Buyer has a material interest, are insurance and should be regulated as such at the state level.

National Association of Insurance Commissioners15

The National Association of Insurance Commissioners (the "NAIC") formed a Credit Default Swap Working Group (the "Working Group") on October 16, 2008 to address the regulatory treatment of CDS. The Working Group found that the regulation of the CDS market was "necessary" and concluded that "in the absence of Congressional action to legislate an effective comprehensive approach of regulating this market, insurance regulators intend to do what is necessary to provide this protection in a manner consistent with solvency regulation."16In light of the steps taken by industry, federal agencies and Congress toward a holistic solution to achieve a transparent and regulated market, however, the Working Group recommended continued monitoring of these developments until a new regulatory structure is in place. The Working Group has been inactive since the beginning of 2009; however, it is likely that like New York, the NAIC will adopt model legislation that would authorize state insurance commissioners to assess the sufficiency of federal regulation in determining whether Covered Swaps should be subject to state regulation.

Obstacles To Regulation Of CDS At The State Level

Drafting and Interpretation.

States' decision to halt regulating Covered Swaps pending federal action appears to be based on their recognition that it is not practical to ban Naked Swaps completely and that dividing the regulation of CDS between state and federal regulators is not the most desirable solution. The following substantive issues have been noted in connection with state regulation of CDS:

• Whether CDS are properly considered to be, and regulated as, insurance.

While insurance spreads and diffuses risk across the full spectrum of policyholders and provides protection from a common fund, CDS shift risk from one commercial party to another in "distinctive, individualized 'swaps.'"17Also, unlike insurance that requires, as its essential element, an insurable interest be held by a buyer, CDS are commonly purchased by parties that have no exposure to the underlying Reference Obligation.18In addition to the lack of existence of an insurable interest in a CDS contract, CDS differ from insurance in that they are frequently bought and sold, unlike an insurance contract, which is held by the policyholder upon purchase.19Also, unlike payments under an insurance contract, which are made only upon incurring loss, payments under a CDS contract are not dependent upon the happening of a loss.20

• Definition of "material interest."

While NCOIL's Model Legislation limits issuance of credit default insurance to purchasers with a "material interest" in the underlying asset, the Model Legislation does not define the term "material interest" nor provide any means of determining whether a prospective CDS Buyer has a material interest in the underlying Reference Obligation.

• Transfer of underlying Reference Obligation.

NCOIL's Model Legislation does not provide for a mechanism to monitor the continued ownership of a material interest by a CDS Buyer. In an environment where the underlying assets of CDS are frequently traded, it is not clear whether the credit default insurance could or would be transferred to the new owner of the underlying asset or be prohibited from being so transferred.21

Conflict and Overlap with Federal Initiatives.

There are several proposals and bills introduced and currently pending in Congress to regulate CDS.22Most of the federal initiatives propose that all credit derivatives (and in some cases all OTC Derivatives) should be traded on an exchange and cleared through regulated central counterparties (i.e., a clearinghouse) (collectively, "CCPs"). While parties to credit derivatives are exposed to each other's creditworthiness, a CCP, by interposing itself between the counterparties, would become the Buyer to every Seller and the Seller to every Buyer. We note that current federal initiatives do not address whether a certain segment of CDS is insurance or whether state regulation of such segment would be preempted by federal regulation.Thus, it is possible that even with federal regulation of the CDS market, states that are not satisfied with the protections afforded by federal law may attempt to regulate Covered Swaps as insurance.To avoid dual regulation of CDS, certain market participants are lobbying federal lawmakers to include specific federal preemption of state law in the federal derivatives legislation. The controlling premise is that Congress will move this year or next year to pass a comprehensive financial system reform package that will include the regulation of CDS.

Concluding Remarks

It appears that states will defer action on CDS pending the adoption of a federal regulatory initiative. Some federal regulation of CDS will likely be part of the upcoming financial services regulatory reforms; however, such reforms could take months or longer to develop. Upon enactment of federal legislation to regulate CDS, depending upon whether, and to what extent, state action is preempted, the states will have the opportunity to closely review the efficacy and sufficiency of such regulation and determine whether state laws should be amended to exclude Covered Swaps from insurance regulation or take other actions to protect and regulate the CDS market. 1 Opinion of the Office of General Counsel (the "OGC") of the NYSID (unnumbered) (June 16, 2000); see OGC Opinion (unnumbered) (May 2, 2002) (In a transaction where a Buyer entered into multiple credit default swaps with various counterparties and the Seller was obligated to pay the amount under the swap regardless of whether the Buyer suffered an actual loss or not, the OGC opined that since the Seller is obligated to pay the Buyer only upon the happening of a negative credit event and the payment is not dependent upon the Buyer's having suffered a loss, the credit default swap was not an insurance contract).

2 See Circular Letter 2008-19 (September 22, 2008).

3 Circular Letter 2008-19 Supplement 1.The NYSID has not since provided any additional substantial guidance on CDS as insurance.

4 Hearing on The Role of Financial Derivatives in the Current Financial Crisis Before the Comm. on Agriculture, Nutrition, and Forestry, 110th Cong. (2008) (testimony of Eric Dinallo, Superintendent of New York State Insurance Department).

5 Program Bill #50, Assem. 8855, 232nd Sess. (N.Y. 2009); S.B. 6001, 232nd Sess. (N.Y. 2009); A.B. 8855, 232nd Sess. (N.Y. 2009).By proposing to remove almost all references to CDS in Article 69, Program Bill #50 eliminates the authority of a financial guaranty insurer to insure a pool of CDS.

6 Memorandum from the N.Y. State Legislature on Assem. 8855 (2009) available at the New York Governor's website at:

7 Mo. Bulletin 08-12 (November 19, 2008).

8 The text of Virginia House Bill 2320 is available at 091+ful+HB2320.

9 NCOIL is an organization of state legislators whose main area of public policy interest is insurance legislation and regulation.Most legislators active in NCOIL either chair or are members of the committees responsible for insurance legislation in their respective state houses across the country.NCOIL's website at:

10 NCOIL's website at:

11 The full text of the Model Legislation is available at NCOIL's website at: Docs/CDSModelAct.pdf.

12 Joint letter from Cory N. Strupp, Managing Director, SIFMA, and Katherine Darras, General Counsel, Americas, ISDA, to the Honorable Joseph Morelle, Chairman, Task Force on Credit Default Swaps Regulation (June 26, 2009) available at NCOIL's website at:; Written Remarks Relating to Oral Presentation to National Conference of Insurance Legislators on behalf of ISDA and SIFMA by Ellen P. Pesch, Sidley Austin, LLP on June 5, 2009 available at NCOIL's website at: June5SIFMAISDAOralComments.pdf.

13 Joint letter from Cory N. Strupp, Managing Director, SIFMA, and Katherine Darras, General Counsel, Americas, ISDA, to the Honorable Joseph Morelle, Chairman, Task Force on Credit Default Swaps Regulation (May 22, 2009); testimony by the AAA at the NCOIL Summer 2009 Meeting.

14 ISDA/SIFMA June 26, 2009 letter, supra; Written Remarks Relating to Oral Presentation on June 5, 2009, supra; Letter from Carl B. Wilkerson, Vice President & Chief Counsel, Securities & Litigation, ACLI, to the Honorable Joseph Morelle, Chair, Task Force on Credit Default Swaps Regulation (May 22, 2009) available at NCOIL's website at:

15 The National Association of Insurance Commissioners is the organization of insurance regulators from the 50 states, the District of Columbia and the five U.S. territories and provides a forum for the development of uniform policy when uniformity is appropriate.NAIC's website at: index_about.htm.

16 Final recommendation from Thomas Sullivan, Chair-CDS (EX) Working Group, to Executive (EX) Committee (December 2, 2008) available at NAIC's website at:

17 See Regulation of the Credit Default Swap Market, Hearing before NCOIL Steering and Financial Services & Investment Products Committees (January 24, 2009) (Submitted testimony on behalf of the National Association of Mutual Insurance Companies) (citations omitted).

18 See id.

19 See ISDA/SIFMA May 22, 2009 letter, supra.

20 See id.

21 See Letter from Michael and Constance Erlanger, Managing Principals,, Inc., to The NCOIL Task Force on Credit Default Swaps Regulation (June 17, 2009).

22 See S. 272, 111th Cong. (2009) (proposing to grant the CFTC regulatory authority over OTC Derivatives, including CDS); H.R. 977, 111th Cong. (2009) (proposing to grant the CFTC primary regulatory authority over OTC Derivatives and to require the clearing of almost all OTC Derivatives; removing a ban on naked credit derivatives contained in an earlier draft); S. 961, 111th Cong. (2009) (proposing to remove essentially all current exemptions provided to OTC Derivatives under federal securities and commodities laws, so that all OTC Derivatives and exchange-traded derivatives would be subject to broader federal regulation); "Financial Regulatory Reform, A New Foundation:Rebuilding Financial Supervision and Regulation" issued by the Obama Administration (proposing to amend the Commodity Exchange Act and the securities laws to require clearing and trading of all standardized OTC Derivatives through CCPs and on exchanges; customized OTC Derivatives would be permitted, but the parties thereto would be subject to more conservative margin and capital requirements); Over-the-Counter Derivatives Markets Act of 2009 (developed out of the Obama Administration's financial reform plan); Description of Principles for OTC Derivatives Legislation by Congressmen Collin Peterson and Barney Frank (similar to the Obama Administration's Reform Plan, proposing the central clearing and exchange trading of OTC Derivatives in standardized transactions, significantly higher capital and margin requirements for market participants entering into non-standardized transactions, and heightened oversight of speculative transactions).

Leah Campbell is a Partner in the Corporate and Financial Services Department of the New York office of Willkie Farr & Gallagher LLP; she specializes in insurance regulation, insurance coverage and reinsurance. Robin Choi is an Associate in the Corporate and Financial Services Department.

Please email the authors at or with questions about this article.