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I have the pleasure of introducing you -- many of you, anyway -- to three outstanding young lawyers.

On January 1, at 12:01 a.m., each of them crossed over into the mystic bonds of law partnership.   At Susman Godfrey L.L.P.

We couldn't be happier to have them join us.

Here they are:

Suyash Agrawal (New York)

Mr. Agrawal 's achievements include magna cum laude honors from Bucknell University; membership on the University of Chicago Law Review; and a clerkship with Hon. Jacques Wiener of the Fifth Circuit.  He recently moved from Houston to work in our Manhattan office.

Justin Nelson (Seattle)

Mr. Nelson earned his undergraduate degree from Yale University and his J.D. from Columbia; worked as Articles Editor at the Columbia Law Review; and clerked for Hon. J. Harvie Wilkinson, II, of the Fourth Circuit and for Hon. Sandra Day O'Connor of the Supreme Court.

Shawn Rabin (Dallas)

Mr. Rabin graduated from Georgetown University and the University of Texas Law School; served as an Associate Editor on the Texas Law Review; and clerked for Hon. Juan Tuerruella of the First Circuit.

Congratulations to Suyash, Justin, and Shawn.

Accomplishments?  Seriously?

 Antitrust Division Grows Testy over Criticism.

Your Editor recently read a troubling item in Corporate Crime Reporter.  The title -- "Connor Says Antitrust Division Becoming Increasingly Irrelevant In Fight Against Cartels" -- refers to an interview with an Economics professor, John Connor, of Purdue University.  Dr. Connor last month finished a 93-page report for the pro-enforcement American Antitrust Institute.  Among his findings:

• Since 1990, the Antitrust Division has collected only 20 percent of the fines and settlements that government agencies and private plaintiffs have garnered from antitrust law violators.
• The number of criminal cartel cases that the Division brought dropped 49 percent from 1995-99 to 2004-06.
• The Division devotes just 29 percent of its staff and budget to detecting and prosecuting cartels.

The Division's dismal performance has provoked me to comment -- via Blawgletter? -- too.  Posts have included:

• Antitrust Division:  Going Straight for the Capillary.
• Antitrust Division Disbands, Declares Competition Safe.
• Joy!  A New Price-Fixing Investigation.
• Edentulous Antitrust Law?
• Antitrust Crime Watch.
• Annals of Antitrust Enforcement:  Where Have All the Price-Fixers Gone?

The Corporate Crime Reporter item also quoted Antitrust Division representative Scott Hammond, who responded thus to suggestions that the private antitrust bar does more than the Division for effective enforcement:

I have been with the Division for 20 years.  I am familiar with every single international cartel investigation that we have opened.  I can tell you that there is not a single example, not one, where we have learned about an international cartel that was detected by the private bar before we began an investigation.  There is not a single case where the private bar has detected the cartel activity before we did where we subsequently brought a criminal prosecution.

Hmmm.  The statement means either that the Division always beats the private bar to the punch or that it never brings a case if the private bar uncovers cartel activity first.  Mr. Hammond also said:

Furthermore there is not a single case brought by the plaintiff bar where as the result of their discovery they have advanced one of our international cartel prosecutions or investigations.

Those pesky private lawyers!

Some months ago, I heard Mr. Hammond address the Dallas Bar Association's antitrust section and asked him what policy the Division has for following up on investigations that it hears about from antitrust enforcers in Europe.  He said that the Division works quite a lot with the European Commission, but he offered no explanation for why the EC brings so many more cases than the Division does.  He nonetheless touted the marine hose prosecution, which principally benefits multinational oil companies.

Mr. Hammond also praised the Division's work in foiling bid-rigging plots and kickback schemes, particularly in connection with government contracts and the federal e-rate program.  That doesn't strike Your Editor as the core mission of the Antitrust Division, and yet it absorbs 71 percent of the Division's resources.  No wonder, as Professor Connor said, "fewer than 20 percent of the world's cartels are being investigated and prosecuted."

Rip Van Winkle.

We Went on Hiatus.  For Six Months.  Sorry.

Your Editor hasn't published Barnett's Notes for awhile.  Six months, to tell the truth.  Do you want to know why?

Of course you do.

I wish I had a good excuse.  Yes, I did have a long trial of a multi-district class action case.  Also summer lassitude, a firm retreat, a bunch of depositions, scads of hearings, lots of briefs, many client consultations, several potential client face-to-faces, quite abundant case evaluations, a great gob of firm meetings, multiple bar activities, a bunch of important family commitments, and your usual complement of holiday activities. 

But I expect most of you did, too.

I regret our failure to furnish you, Dear Reader, the Constant Flow of Information and, well, Commentary, you deserve.

Your Editor pledges to do better in 2009, consistency-wise.  A foolish consistency may be the hobgoblin of little minds, but nobody much minds a Constant Information Flow.

Dear Reader, we face many challenges this year.  But we shall overcome them together.   Happy New Year.

Hot Lunch.

The President of the State Bar of Texas, Harper Estes, a few months ago wrote the best "My Opinion" column (in the Texas Bar Journal) that Your Editor has ever had the privilege to read.  I challenge you to start reading it and then try to stop.  Betcha can't do it.

What makes it compelling?  For starters, it opens with a humanizing title -- "Call Me Pollyanna".  Which has at least one parallel in literature.  Remember that long whale story?  The one with Captain Ahab -- he of the peg leg and textbook manifestations of obsessive-compulsive disorder? 

Right.  Herman Melville's Moby-Dick (1851).  The novel opens with the main character in first-person narrator mode.  He says, immortally, "Call me Ishmael."

Call me Pollyanna grabs you in a similar way.  It draws you in.  You quickly see that the writer has a self-deprecating sense of humor.  You also infer that he has read a lot, relating themes and quotes not only from Pollyanna (the 1960 movie) but also from the likes of Abraham Lincoln, Winston Churchill, Sigmund Freud, and even Rabbi Tarfon.

President Estes also addresses a Serious Subject -- that of making a difference to our profession and our communities.  He gently exhorts the 83,000 members of the Texas Bar to work together "to educate the public about the rule of law and its importance, not only to our democracy, but to the everyday lives of all Texans."

I urge you to begin reading President Estes's column.  It might make you a little more Pollyanna-ish too.

A Primer on Credit Default Swaps

Warren Buffett called derivatives "financial weapons of mass destruction."

Your Editor got a call not long ago from a former official of an institution that oversees pension and retirement fund investments.  The impetus?  The ex-official's conviction that the $58 trillion market for credit default swaps bears material, if not primary, responsibility for the late wipeout on Wall Street and the deepening worldwide recession.

Does it?  And what can lawyers do if it does?

The nature of CDSs.  A court recently described a "typical CDS transaction" thus:

[O]ne party (the ?protection buyer?) pays periodic fixed amounts to the other party (the ?protection seller?) with respect to a specified amount of a ?reference obligation? issued by a ?reference entity,? here, the Millstone III CDO.  In return, the protection seller is required to provide the protection buyer certain consideration if specified events occur with respect to the reference obligation or entity-usually, a negative event concerning the creditworthiness of the reference obligation or entity.  The buyer of CDS protection need not actually own the reference obligation or have any relationship to the reference entity.

Citigroup Global Markets Inc. v. VCG Special Opportunities Master Fund, 2008 WL 4891229, at *1 (S.D.N.Y. Nov. 12, 2008) (references to complaint omitted).

The last sentence tells us that anybody can buy "protection".  Protection the purchaser doesn't need.  Protection that enables the buyer to profit from a "negative event" despite his lack of an economic interest in the reference security. 

I'll say more below about the implications, but for now, as the folks at Investopedia gently note, "it is obvious that speculation has grown to be the most common function for a CDS contract." 

How it began.   The CDS industry got a congressional shove with the bracingly deregulatory Commodity Futures Modernization Act of 2000.  The statute, which Congress rushed through in the final 45 days of the Clinton administration, aimed, it said, "to promote innovation for futures and derivatives and to reduce systemic risk by enhancing legal certainty in the markets for certain futures and derivatives transactions".  H.R. 5660 ? 2(6) (emphasis added).

But it did so, with respect to CDSs, by insulating them from regulation by the Securities and Exchange Commission.  The Act achieved that result by amending the Securities Act of 1933 and the Securities Exchange Act of 1934 to bar the SEC from using its principal regulatory tools -- requiring registration of securities and reporting of securities transactions.(1) 

As outgoing SEC Chairman Christopher Cox said in September 2008:

The $58 trillion notional market in credit default swaps ? double the amount outstanding in 2006 ? is regulated by no one. Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market.

Legalizing gambling -- and bucket shops.  My immediate thought, when I first smelled the strong whiff of a CDS casino, ran to laws against gaming.  Others felt the same way.  As Professor Thomas Lee Hazen observed in 2005:

The illegality of, and law's disdain for, gambling has moral overtones which makes it difficult to draw the line between bona fide market transactions and a wager.  Even outside of derivative investments, the law has had difficulty drawing the line between permissible contracts and illegal gambling arrangements.  The basic premise is that wagers are illegal and therefore unenforceable as a matter of contract law.  Some courts have gone so far as to invalidate a loan on the grounds that the loan was designed to pay for illegal gambling debts.

Thomas Lee Hazen, Disparate Regulatory Schemes for Parallel Activities:  Securities Regulation, Derivatives Regulation, Gambling, and Insurance, 24 Ann. Rev. Banking & Fin. L. 375, 403-04 (2005) (footnotes omitted).

I learned to my chagrin that the same notion had already occurred to sponsors of the CFMA.  They, at the very end of the statute, H.R. 5660 ? 408(b)-(c), tacked on two get out of jail free cards.(2 )  These subsections, together with the Act's prohibition against SEC  regulation of CDSs, mean that the CMFA immunizes CDS transactions from virtually any "prophylactic" measures.  Federal laws governing contracts for purchase or sale of commodities don't apply -- and, astonishingly, neither do laws that prohibit, or even restrict, gambling and bucket shops  (brokerages that take orders for trades but only pretend to execute them)!

What does that leave?  The express provisions of the CMFA mandate a broad hands-off approach to federal concerns about CDSs.  But, on the positive side, a good bit of non-prophylactic law remains.

Federal securities laws.  As the Second Circuit has noted, "Sections 302 and 303 of the CMFA define 'swap agreements' and then expressly exclude them from the definition of 'securities,' but amend section 10(b) to reach swap agreements."  Ciaolo v. Citibank, N.A., New York, 295 F.3d 312, 327 (2d Cir. 2002).  The court observed that, in light of the amendment to section 10(b) of the Securities Exchange Act, if plaintiff Ciaolo had "entered into his synthetic stock transactions after the enactment of the CFMA, they clearly would now be covered under Rule 10b-5."  Id. (holding that Ciaolo waived argument for retroactive application of CFMA by failing to raise it in district court but reversing dismissal of securities fraud claims relating to other "securities" transactions).

As the principal cheerleader for CDS contracts, the International Swaps and Derivatives Association, Inc., observed in a "Memorandum for ISDA Members" on January 5, 2001, even after the CMFA "[s]wap agreements that are based on securities prices, yields or volatilities are, however, subject to specific antifraud, antimanipulation and anti-insider trading provisions of the 1933 Act and 1934 Act."(3 )

Racketeer Influenced and Corrupt Organizations Act.  RICO authorizes recovery of treble damages plus attorneys' fees for certain kinds of fraudulent conduct.  And just last year the U.S. Supreme Court clarified that RICO doesn't require direct reliance by the victim in cases involving mail or wire fraud as the predicate acts.  See Bridge v Phoenix Bond & Indemnity Co., 128 S. Ct. 2131 (2008).

But in 1995 Congress amended RICO to bar claims, with few exceptions,  that rely on "conduct that would have been actionable as fraud in the purchase or sale of securities".  18 U.S.C. ? 1964(c).  I doubt that narrowing of RICO reaches fraud involving CDSs, which the CFMA defines as "security-based swap agreement" separately from "security".   

Contract law.   Developing case law applies contract doctrines as if the CMFA didn't exist.  For example:

• Commercial impracticability.  In Hoosier Energy Rural Electric Co-op, Inc. v. John Hancock Life Ins. Co., 2008 WL 5068649 (S.D. Ind. Nov. 25, 2008), the court granted Hoosier Energy a temporary injunction against enforcement of CDS contracts.  The court applied New York law in determining that the doctrine of "temporary commercial impracticability" excused Hoosier Energy from its obligation to replace the CDS of a swooning seller of credit default protection with a more solid one.  The court later required Hoosier Energy to post a $121 million bond as a condition to continuing the preliminary injunction against enforcement.  Hoosier Energy Rural Electric Co-op, Inc. v. John Hancock Life Ins. Co., 2008 WL 5216027 (S.D. Ind. Dec. 11, 2008).  News article here.
• Unilateral mistake.  The court rejected a claim for rescission under the New York doctrine of unilateral mistake because the plaintiff, "a sophisticated hedge fund, simply failed to review carefully the terms of the parties' agreement."  VCG Special Opportunities Master Fund Ltd. v. Citibank, N.A., 2008 WL 4809078, at *7 (S.D.N.Y. Nov. 5, 2008).
• Late delivery.  Deutsche Bank waited too long to fulfill a condition to payment on a CDS contract -- delivery of the bonds as to which it bought protection.  Deutsche Bank AG v. AMBAC Credit Products, Inc., 2008 WL 1867497 (S.D.N.Y. July 6, 2006).
• Wrong "reference entity".  The court concluded that "Republic of Phillipines" as the "Reference Entity" under a CDS contract didn't encompass the General Service Insurance System, an agency of the Phillipines government.  Aon Fin. Products, Inc. v. Societe Generale, 476 F.3d 90 (2d Cir. 2007) (applying New York law).

Presumably other doctrines of contract law, including unconscionability, apply as well.

What to do?  Turmoil and fear have produced nods in the direction of gaining some order in, and control over, the CDS market.  Private efforts to develop a central counterparty clearing arrangement appear chief among them.  And the Group of 30 proposes a five-step program for regulating the over-the-counter CDS industry(4 ).

That will take time.  And it won't remedy the losses that individuals, the financial system, and the broader economy have already sustained.

Your Editor doesn't have any across-the-board, easy-to-apply approach to achieving effective relief for the multitude of people who have suffered.  But in the item just below, we explore a possible strategy for a key group of players in the CDS market -- the counterparties, those protection sellers who may now face ruinous liability.

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Pushing Systemic Risk.

As we have seen, a buyer of CDS protection may run afoul of federal securities laws (for example) by exploiting non-public (inside) information about the issuer of a reference security, by making manipulative trades or spreading rumors that trigger a default, and in myriad other ways.

Your Editor imagines that the authors of the CFMA thought that their implantation of securities law remedies into the statute's otherwise deregulatory scheme for CDSs might catch an occasional bad actor.  They likely didn't imagine what has come to pass -- the tipping of systemic risk into catastrophic territory.

Economist Arnold Kling wrote last October:

The problem with credit default swaps is not (just) that they are traded over-the-counter. The more serious problem is that they entail huge systemic risk. Getting rid of counterparty risk does not solve the problem. The issue is not that any one party is unable to meet its obligations. The issue is that in the aggregate, credit default swaps allow the market to sell more default risk protection than it's possible to produce. This false sense of security leads people to pile on risk, and then when the crisis comes, their protection fails.

[Let us pause here to recall the irony that the CFMA claimed as one of its purposes the reduction of "systemic risk by enhancing legal certainty in the markets for certain futures and derivatives transactions".  H.R. 5660 ? 2(6).]

The failure of Lehman Brothers -- and the near-burial of AIG -- illustrate how the meteoric growth of the CDS market created an unacceptable degree of systemic risk.  CDSs that used Lehman or AIG bonds as the reference securities triggered an obligation to pay losses to the protection buyers.  The sellers then had to scramble to meet demands for payment.  The ensuing payments and liquidation of marketable assets -- almost always other issuers' bonds and securities -- depressed the market value of not only the protection sellers themselves but also of the other issuers whose securities glutted the market.

The process cascaded through the market.  Financial institutions -- including such titans as Citigroup, Bank of America, Wachovia, Goldman Sachs, and Morgan Stanley -- teetered on the brink.  Only the blank-check Wall Street bailout allowed them to survive.

And where did the bailout money go?  Thanks to the opaqueness of the CDS market and of the Treasury Department's secretive and stumbling implementation of the bailout, even the Congressional Oversight Panel observed on January 9, 2009, that it "still does not know what the banks are doing with taxpayer money."

On October 26, 2008, 60 Minutes aired a segment it called "The Bet That Blew Up Wall Street:  Steve Kroft on Credit Default Swaps and Their Central Role in the Unfolding Economic Crisis".  The report includes this:

But the rocket fuel was the trillions of dollars in side bets on those mortgage securities, called "credit default swaps." They were essentially private insurance contracts that paid off if the investment went bad, but you didn't have to actually own the investment to collect on the insurance.

"If I thought certain mortgage securities were gonna fail, I could go out and buy insurance on them without actually owning them?" Kroft asks Eric Dinallo, the insurance superintendent for the state of New York.

"Yeah," Dinallo says. "The irony is, though, you're not really buying insurance at that point. You're just placing the bet."

Dinallo says credit default swaps were totally unregulated and that the big banks and investment houses that sold them didn't have to set aside any money to cover their potential losses and pay off their bets.

"As the market began to seize up and as the market for the underlying obligations began to perform poorly, everybody wanted to get paid, had a right to get paid on those credit default swaps. And there was no 'there' there. There was no money behind the commitments. And people came up short. And so that's to a large extent what happened to Bear Stearns, Lehman Brothers, and the holding company of AIG," he explains.

I believe that a fruitful line of inquiry for CDS protection sellers would consist in exposing the role that protection buyers played in driving down the ratings of reference securities, triggering a wave of "negative events" and therefore liability for protection sellers under CDS contracts.

In the market environment we've seen since September 2008, the profitability (to speculative protection buyers) of sowing chaos and promoting fear likely proved irresistible.  And why wouldn't they succumb?  Nobody seems to have much noticed that the CFMA made manipulation for such purposes illegal.  No one, to my knowledge, has ever sued for manipulation under the CFMA.  The combination of ignorance about liability for manipulation, the opaqueness of the CDS market (and therefore the low likelihood of detection), plus the probability of great wealth created a perfect storm for greed.

I'm just sayin'.

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 Presumption of Innocence.

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Links and Info.

Barnett's Notes on Commercial Litigation does not provide or constitute legal advice.  Receiving Notes does not establish an attorney/client relationship with Mr. Barnett or with Susman Godfrey L.L.P.    

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