Wording In Bond Insurance Contracts Could Drive Lawsuits

Last Update: 3/20/2008 4:39:46 PM

By Lavonne Kuykendall and Chad Bray
Of DOW JONES NEWSWIRES

Bond insurers have reassured investors for months that ironclad protections they
built into insurance policies for derivatives gave them unique controls over the
complex securities they guaranteed. Now those contract clauses may help in an
unexpected way: by giving bond insurers a way out of some of the most exposed
deals.

Bond insurer Security Capital Assurance (SCA) says that Merrill Lynch & Co. (MER)
signed seven credit default swap contracts with Security Capital subsidiary XL
Capital Assurance Inc. that gave the bond insurer ultimate control of underlying
collateralized debt obligations totaling $3.1 billion in face value. Merrill then
violated the agreement, SCA says, by making side deals giving the same control to
rival insurer MBIA Inc. (MBI).

The issue plays into what bond insurers have long called one of the strengths of
the financial guarantees they write on investment bank securities: the powers
they can exercise when something goes wrong.

When payments fall short, the contracts give the controlling bond insurer
authority to make changes to maximize performance. But the wording of the
contract could be key in determining which insurer takes control.

Merrill filed a lawsuit Wednesday to force Security Capital to honor the
contracts. It says the credit default swap contracts are “a very common
contractual arrangement” and that Security Capital is trying to cancel because of
“sellers remorse” in a badly deteriorating market. Merrill on Thursday declined
to provide further comment on the dispute beyond its complaint.

Lawyers who specialize in insurance issues say that until recently these
contracts have rarely gone bad, and that bond insurers are studying the issue as
guarantees they wrote in the last few years rack up increasing losses.

One CDO deal called Sagittarius triggered a similar dispute late last year
between insurer MBIA, Wachovia Corp. (WB) and UBS AG (UBS).

Security Capital said in an August investor presentation, around the time it
signed the last of its Merrill Lynch deals, that it required “sufficient
protection designed to cover us in severe situations.”

One way it protected itself was by doing deals only at so-called “super senior”
levels, which put it first in line for payments if losses on the underlying
securities rose too high, Security Capital said at the time.

But in at least one of the Merrill deals, Merrill gave the same super-senior
rights to rival MBIA, which “has represented that it is the ’sole controlling
party’ in all of the CDOs in which it participates,” according to a Security
Capital letter quoted in Merrill’s lawsuit.

In a statement Thursday, Security Capital said Merrill “repudiated its
contractual obligations” by giving other parties “the same CDO control rights
that it had previously promised to XLCA.”

Industry insiders suggest that MBIA is also involved in some of the other Merrill
deals Security Capital wants to cancel. An MBIA spokeswoman declined a request
for comment.

At least two of the seven CDOs named in Merrill’s lawsuit have registered
so-called events of default, which could trigger control issues for the insurers
involved.

Silver Marlin CDO I, with a face value of $1.3 billion, and Biltmore CDO 2007-1,
with a face value of $1 billion, received event of default notices in February,
according to a March 17 Standard and Poor’s report.

Such events can cause payments on the securities to be diverted “to the most
senior class of noteholders on a sequential basis, which means that more junior
classes, even if rated AAA, may not receive principal or interest payments until
the balance of the senior-most class has been paid in full,” according to the S&Preport.

It is unclear who would receive payments first if more than one insurer has a
controlling role.

The issue is not addressed in New York insurance law, but covers a critical issue
for insurers, said Deputy New York Insurance Superintendent Michael Moriarty.

“Clearly, a lack of control could be detrimental to the insurer,” Moriarty said
via email. “The Department is currently doing an extensive review of the laws and
regulations covering bond insurers.”

At stake is more than 5% of Security Capital’s outstanding CDO exposure, which
includes some of its most toxic deals, all of them written in the first three
quarters of 2007, which is turning out to be the high point for underperforming
loans.

Sherri Venokur, a lawyer at Lowenstein Sandler PC in New York, said it’s hard to
determine how much of a defense SCA has without seeing the precise language of
the contract itself. “In these contracts, in all contracts, the question always
is which party takes the risk of an unanticipated risk,” said Venokur, who
advises clients on CDS contracts during negotiations.

She said there’s less negotiation now on CDS contracts than there was years ago
before there were standard contract documents for these transactions. Venokur
said she expects more cases over CDOs down the line, saying “these cases are
going to be brought one after another.”

Security Capital representatives didn’t return phone calls Thursday requesting
further comment.

Some firms do a better job than others in spelling out control rights very
clearly, though much of the language in these deals is fairly standardized, said
Brian James, a partner at New York recruiting and consulting firm Link Global
Solutions. James was former co-head of fixed income at Cohen & Co., a structured
credit manager and investment bank.

“I think there’s always wrestling back and forth in terms of control, even if
it’s clearly defined,” he said. He said the “unanticipated credit situation” is
what’s driving these disputes. “This wasn’t forecast in their credit due
diligence,” James said. “Everybody is trying to squeeze out all they can to
protect themselves as much as they can.”

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