Capítulo 4. Modelado matemático del invernadero
4.4 Validación del modelo del sistema
Let us now examine the arguments of Potts and other critics of insurance recharacterization in detail. The easiest issue to tackle concerns the relationship between the legal form of a transaction and its so-called substance. Given that CDSs are functionally very much like insurance, the question is whether their legal recharacterization can be avoided by shunning the language of insurance, or by inserting “no intention to insure” clauses. The brief answer is negative, but the matter merits a closer look, as it reveals some fundamental points about insurance law and CDSs.
3.1.4.1 The Primacy of Substance over Form
Insurance regulation is not voluntary, and it cannot be avoided simply because the parties wish to do so. This is why form—contracting language and terms—is not the final word in insurance law, as Hellner has aptly summarized:
Although there are good reasons for submitting anything that is frankly called insurance to insurance regulation, since the public might otherwise be misled, the test is clearly unsuitable when applied to business which is not called insurance for then an easy way to avoid the burden of regulation would be to use another name.71
It is therefore generally established that, in insurance law, substance matters more than form. Summarizing the position of US states, Hellner writes: “Directly or indirectly this [formal] test is rejected almost universally. It is not the term used, but the characteristic features of the activity that are held decisive.”72 In
England, the FSA guidelines state explicitly: “more weight attaches to the substance of the contract, than to the form of the contract.”73
Of course, the question that arises is what is meant by substance. In English law, the notion of substance refers fundamentally to the obligation(s) of the
70 Id. para. 7.11. 71 Hellner 1963: 500. 72 Hellner 1963: 500. 73 FSA 2012: para. 6.5.4(1).
insurance provider.74 In CDS transactions, the obligation of the protection seller is
to compensate for the loss of reference asset value following a credit event: a CDS effects precisely the assumption, by the protection seller, of credit risk in return for periodic consideration.
Substance, therefore, does not mean merely the “economic effect” of the contract. For example, a farmer may enter into a commodity futures transaction for hedging purposes, but the agreement does not thereby become an insurance contract.75 Contrary to Potts and his instructing solicitors,76 the substance of the
transaction does not refer to the intentions, motivations or investment strategies of the parties; the FSA specifically states that it “is unlikely to treat the provider’s or the customer’s intention or purpose in entering into a contract as relevant to its classification.”77
The case law in the United States and England reveals that insurance law has been applied to many transactions in which the parties may have been unaware of effecting insurance, but the rights and obligations were essentially those of insurance.78 Of special interest for present purposes is the English case of Fuji
Finance v. Aetna Life Insurance.79 The case concerned the legal nature of a financial
transaction, which consisted of a single premium capital investment bond that was used as a form of life insurance.80 At first instance, the court ruled that the
contract was not insurance, because there was no sufficiently close connection between the benefit and the adverse event.81 However, the Court of Appeals
74 FSA 2012: para. 6.5.4(2) (citing In re Sentinel Securities [1996] 1 WLR 316). 75 Henderson 2009a: 4.
76 SeeAllen & Overy 1997: 8 (referring to prior discussions in which, according to Potts,
the construction of a contract depends on “the rights, obligations and intentions of the parties” at the time of contracting); Potts 1997: 6 (para. 4) (arguing that construction must depend on “the object of both parties” because “otherwise some non-disclosed desire” by one party might turn the transaction into an insurance contract).
77 FSA 2012: para. 6.5.4(2).
78 In the United States, consider for example the numerous burial contract cases: see
Hellner 1963: 509–510. In England, an amusing example is Department of Trade and Industry v.
St. Christopher Motorists’ Association Ltd. [1974] 1 All ER 395, where a motorists’ association promised to provide chauffeur services to its members if they lost their driving licence as a result of being convicted of having too much alcohol in the blood; this was considered insurance.
79Fuji Finance Inc. v. Aetna Life Insurance Co. Ltd. [1996] 4 All ER 608.
80 SeeEnglish and Scottish Law Commissions 2008: para. 7.25 n.21 (summarizing the case
and its history).
81Fuji Finance Inc. v. Aetna Life Insurance Co. Ltd [1994] 4 All ER 1025. According to English
and Scottish Law Commissions 2008: para. 7.25 n.21, “there was uncertainty about when the money would become payable and it did not chiefly depend on the length of the insured life.”
CDS IN LIGHT OF INSURANCE LAW PRINCIPLES
reversed the ruling and held that the transaction constituted insurance, following a broad definition of life insurance.82
Care should be exercised when drawing analogies from Fuji, because the facts of the case were peculiar and it involved life insurance. It is clear, however, that the earlier Fuji decision cannot be relied upon to argue that a contract cannot be insurance simply because it has an investment element.83 In fact, it has been
suggested that the logic of the Court of Appeals was that “the contract was both an investment product and a life insurance”.84 Now, it might be suggested that
CDSs should be construed as a similar combination of insurance and investment products; but this would be inaccurate, because CDSs are like insurance in a simpler way: in Fuji, the transaction that was basically an investment product that was structured in a particular way so as to function as life insurance; in CDSs, in contrast, the transaction is structurally just like an insurance contract, but it may be used for speculative purposes by persons not having insurable interest in the covered assets.
3.1.4.2 Transformers: Insurance and CDSs
In order to perceive more clearly that the rights and obligations in CDS transactions are essentially those of insurance, it is useful to consider so-called transformer arrangements, whereby CDSs are sometimes explicitly transformed into insurance contracts in order to exploit differences between regulatory regimes in banking and insurance (e.g. regulatory capital, tax and accounting differences).85 In a typical arrangement, a transformer company would first write
the original CDS, and an authorized insurer would then insure the transformer company by way of traditional insurance or financial guaranty insurance (see Figure 6).86
This arrangement is especially revealing when the insurance leg incorporates the CDS terms “back to back”.87 Some lawyers have discouraged the
incorporation of ISDA’s CDS documentation into the insurance contract, because it risks a court holding that the insurance policy written through the transformer
82Fuji Finance Inc. v. Aetna Life Insurance Co. Ltd [1996] 4 All ER 608, at 618 (finding that the
essence of life insurance is that “the right to benefits is related to life or death”).
83 See Allen & Overy 1997: 8 (arguing this). The interpretation of the Fuji cases is more
nuanced in Potts 1997: 6 (para. 4).
84 Benjamin 2007: 139.
85 See FSA2002:paras 3.25–3.29, 3.67, 3.107, 3.116; Ibid.Annex A, and Annex B, p. 3–4
(discussing the structure, logic and implications of transformers); Ross and Davies 2001: 4–5 (describing transformers).
86 FSA2002:Annex B, p. 3. 87 FSA2002:Annex B, p. 3
was a sham.88 However, writing independent terms and different provisions
creates unwanted risks, and the FSA in 2002 estimated that the standard approach had been to incorporate ISDA documentation.89
The existence of transformers—and the incorporation of CDS terms— highlights the difficulty of claiming that CDSs differ from insurance in terms of the rights and obligations. Such a claim would imply that two contracts, that have exactly the same terms, are governed by entirely different legal rules and regulatory regimes, even though insurance law is supposed to be determined by substance rather than form.
There is also another paradox: the prudent lawyers argued that the insurance leg of the transformer arrangement might be construed as a sham, i.e. an illicit derivatives transaction (which an insurance company would be prohibited from entering) masked as an insurance contract. Yet it could be argued that it is the CDS leg that is a sham, i.e. an illicit insurance contract masked as a derivative. These two prospects cannot both be true at the same time, and it is submitted that the latter view is better.
Figure 6 A CDS–insurance transformer arrangement.
3.1.4.3 Where Is the Swap in a Credit Default Swap?
The confusing distinction between insurance and derivatives leads us back to the fundamental problem that, over time and in different contexts, different terminology has developed to describe activities that are at least partially overlapping. The hard question is what legal effect should be given to this linguistic confusion. On one hand, it was already mentioned that the FSA is a more likely treat a contract as insurance if it uses terms and obligations typical of insurance, but different terminology does not suffice to prove it is not insurance. On the other hand, it has been argued that the deliberate avoidance of insurance-
88 Ross and Davies 2001: 4–5; FSA2002:Annex B, p. 4, and para. 3.108. 89 FSA2002:Annex B, p. 4, and para. 3.77.
CDS IN LIGHT OF INSURANCE LAW PRINCIPLES
type language might be interpreted in the opposite manner if there is evidence that it is motivated by the evasion of insurance regulation.
It is important to understand that the likeness between insurance and CDSs is not merely one of economic effect, as seems to have been assumed by Potts. He was certainly right that mere economic consequences are inconclusive; a farmer may enter into a commodity futures transaction for hedging purposes, but the agreement does not thereby become an insurance contract.90 Instead, as Potts
correctly stated, legal construction depends on the rights and obligations specified in the contract. And a CDS effects precisely the assumption, by the protection seller, of credit risk in return for periodic consideration.
The issue may be further clarified by asking: Where is the swap in a credit default swap? There may be disagreement on what derivatives are, but not so with swaps: it is widely agreed in finance that, in the words of Partnoy, “a swap is a private agreement between two parties to exchange cash flows at certain times according to a prearranged formula.”91 Feder writes similarly that a “swap is an
exchange of cash flows. A cash flow is a series of future cash payments.”92
In contrast to swaps, a CDS is not an exchange of cash flows—and it definitely is not an exchange of credit defaults (as the name literally suggests). It bears no functional resemblance to genuine swap agreements. This has been acknowledged by some commentators, including Banks and others: “Because the transaction is unilateral […], it does not take the form of a standard OTC swap contract, which is always bilateral.”93 Ayadi and Behr concur: “Unlike other types
of derivatives such as interest rate swaps, the risks assumed by the protection buyer and the protection seller in a CDS transaction are not symmetrical.”94
So there clearly is no swap in a CDS. In this respect, Potts was more accurate in writing about “credit default options”—as the products were called at the time—rather than credit default swaps. Others have made the same point: “it may be more accurate to think of credit default swaps as options”95 or “binary default
90 Henderson 2009a: 4.
91 Partnoy 1997: 219 (emphasis added).
92 Feder 2002: 701 (emphasis added). See likewise Henderson 1993: 349: “In broad terms,
a swap is an exchange of cash flows between two parties, each of which cash flows is, in the eyes of the respective parties, equal to the other at the start of the agreement. Specifically, the standard swap is an agreement between two parties in which each party agrees to pay the other an amount of interest calculated on a principal amount over several specified periods of time. If the principal amount is the same for both parties, the rate bases of calculation will be different and it is called an interest rate swap. If the principal amounts are expressed in different currencies, it is called a currency swap and, in addition to cross-payment of interest in the different currencies, there is usually an exchange of the principal amounts at the beginning and end of the swap.”
93 Banks, Glantz and Siegel 2007: 33. 94 Ayadi and Behr 2009: 182.
options”.96 Naturally, this does not resolve the legal question, because all
insurance contracts are, in modern financial theory, put options of a peculiar type.97 Yet it would be ludicrous to claim that insurance law has suddenly become
inapplicable because finance theorists have defined insurance contracts as options.