Appeals Court Examines Sovereign Event in Credit Default Swap Context
Recently, a panel of the US Court of Appeals for the Second Circuit had occasion to examine what a sovereign event is in the context of a credit default swap agreement. Aon Financial Products, Inc. v. Société Générale, CA-2, Docket No. 06-1080-cv.
A credit default swap is the most common form of credit derivative, i.e., a contract which transfers credit risk from a protection buyer to a credit protection seller. Credit default swaps do not, and are not meant to, indemnify the buyer of protection against loss. Rather, they allow parties to hedge risk by buying and selling risks at different prices and with varying degrees of correlation.
The case arose out of one of a series of transactions related to the financing of a condominium complex in the Philippines. Bear Stearns agreed to loan a company $9.3 million to build the complex and the company, in turn, agreed to repay Bear Stearns $10 million. As a condition precedent to that loan, Bear Stearns required the company to procure a surety bond from Government Service Insurance System (GSIS), an agency of the Philippine Government.
In order to protect itself against the risk of GSIS defaulting on the surety bond, Bear Stearns entered into a credit default swap with Aon under which Aon promised to pay Bear Stearns $10 million upon the occurrence of a credit event. In order to reduce its own risk exposure, Aon entered into a separate credit default swap agreement with SG under which SG promised to pay Aon $10 million upon the occurrence of a credit event, defined in part as a sovereign event.
About one year later, the company defaulted on its Bear Stearns loan and GSIS stated that it did not intend to pay on the bond because it had not been appropriately authorized on GSIS's behalf. Aon filed against SG, seeking payment of $10 million under the Aon/SG credit default swap agreement.
The appeals court concluded that GSIS's default was not a sovereign event as that term is used in the Aon/SG credit default swap agreement. With the Aon/SG credit default swap, Aon hedged the risk that it bought from Bear Stearns by selling to SG the risk of a credit event as defined by the Aon/SG contract. But the risk transferred to Aon and the risk transferred by it were not necessarily identical, said the court, since the terms of each credit swap agreement independently define the risk being transferred.
The default resulted from GSIS's decision that it was not legally bound to honor its putative obligation to pay. This was not a sovereign event, reasoned the appeals court, since such refers to large-scale events like the restructuring of the sovereign's debt, which may be expected to cause a general condition throughout the country.