Lloyd's Maritime and Commercial Law Quarterly
The legal nature of credit default swaps
Marcus Smith *
I. INTRODUCTION
Private lawyers are well aware of the importance of classification in commercial law. The success, or successful defence, of a case can often turn on how a contract is classified. A contract of guarantee will be void if it does not comply with the Statute of Frauds 1677, s 4, whereas a contract of indemnity is not subject to the Statute of Frauds at all. Contingency insurance is subject to the requirements of the Life Assurance Act 1774, whereas indemnity insurance is not. The obligation of utmost good faith applies with full force to contracts of insurance, but only operates in an attenuated way in the context of contracts of guarantee and indemnity, and not at all in the case of other contracts.1
* QC, Fountain Court Chambers.
The following abbreviations are used:
Benjamin: J Benjamin, Financial Law, 1st edn (2007);
Castagnino: JP Castagnino, Derivatives: The Key Principles, 3rd edn (2009);
Chitty: H Beale et al (eds), Chitty on Contracts, 30th edn (2008);
FSA: Financial Services Authority;
FSA Handbook: Financial Services Authority’s Handbook;
FSMA: Financial Services and Markets Act 2000;
MacGillivray: N Legh-Jones, J Birds and D Owen (eds), MacGillivray on Insurance Law, 11th edn (2008);
RAO: Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI 2001/544);
Smith & Monkcom: S Monkcom, Smith & Monkcom: The Law of Gambling, 3rd edn (2009);
Turner Review: Financial Services Authority, The Turner Review: A regulatory response to the global banking crisis (March 2009).
1. The duty of utmost good faith applies to contracts of insurance, but not to other commercial contracts: P MacDonald Eggars, S Picken and P Foss, Good Faith and Insurance Contracts, 2nd edn (2004), [1.07], [1.18], [1.25], [1.26] and [2.09–2.20]; Seaton v. Burnand [1899] 1 QB 782. The point arose with great force in the film finance litigation, where the claimants appeared to be contending that the protection offered by Lexington was not insurance at all, but some form of financial guarantee. The FSA’s May 2002 discussion paper on Cross-sector Risk Transfers observed: “The most public of these disputes has been about a refusal to pay by Lexington Insurance Company, a subsidiary of AIG. Lexington insured Hollywood Funding No 5, using a policy similar to the HIH policy. This led to a disagreement between AIG and Standard & Poor’s (who rated the transaction), and AIG and CSFB (the arranger and lead manager). Some commentators have suggested that the dispute arose because Standard & Poor’s and CSFB expected the insurers to treat the contracts as financial guarantees and not standard contracts of insurance”.
THE LEGAL NATURE OF CREDIT DEFAULT SWAPS
387