Uberrimae Fidei: Legal Solution to CDO and CDS Ethics Problems

Includes: AIG, GS
by: Tom Armistead

As the situation around CDOs, CDS and synthetic CDOs develops, and with the SEC's suit against Goldman Sachs (NYSE:GS) in the headlines, I have been thinking of an old legal doctrine: uberrimae fidei. Briefly, it's a Latin term, translated as “of the utmost good faith.” A contract is said to be uberrimae fidei when it requires a high standard of honesty - unprompted disclosure of all material facts: absent good faith at this level, it is voidable.

The thesis presented in this article is that financial innovation has outpaced the development of legal principles to control fraud, abuse and manipulation. The solution: CDS are contracts of insurance, and like insurance, contracts uberimae fidei. Further, the concept can be extended into the entire area of securitization: MBS, CMBS, ABS, CDOs of ABS etc. should all be accorded the status of contracts uberrimae fidei.

The legal requirements for contracts of this type also need to be extended to include the complete absence of conflicts of interest. A man cannot serve two masters.

A distinguishing feature of the prospectuses that I have read on CDOs is the artful inclusion of disclosures of conflict of interest. Deep in these documents, which run to hundreds of pages, the alert leader will find that all parties responsible for creating and managing the CDO are subject to conflicts of interest. The legal theory is, if the conflicts are disclosed, they are excused, and the creators and managers are thereby made free to act in their own unfettered self-interest. Even a modicum of good faith is impossible under these conditions.

Insurance contracts have long been considered uberrimae fidei. The insurance underwriter knows less about the subject of the insurance than the applicant, who has an information advantage. Further, the considerations exchanged are unequal: often the premium is very small compared to the loss payments that will be made if the contingency insured against happens. For that reason, an applicant for insurance is required to disclose all information he has that is material to the exposure assumed – even if he is not asked. Otherwise, the contract is voidable.

Now CDS, like insurance, involve the transfer of risk, asymmetry of information, and asymmetry of consideration versus potential payment. Therefore, CDS should be contracts uberrimae fidei.

Regular readers know that I have long held that CDS are insurance, and should be regulated as such, with the requirement of insurable interest on the part of the buyer and adequate capital on the part of the seller. Larry Summers and his co-conspirators, as they shepherded CFMA past Congress, were careful to obtain, by devious means, a finding from the NY Insurance Department that CDS were not insurance. The point was, that although it waddled like a duck and quacked like a duck, it was not to be considered a duck.

As we examine the fallout from the perpetration of fraud by means of CDS, it becomes evident that CDS contracts should also be interpreted by the courts in light of the principles of contract law applicable to insurance.

Getting back to conflicts of interest. Here is a typical disclosure:

28. Potential Conflicts of Interest Involving the Manager. Various potential and actual conflicts of interest may arise from the overall investment activities of the Manager and its affiliates. The following briefly summarizes some of these conflicts but is not intended to be an exhaustive list of all such conflicts. The Manager and its affiliates may invest for the account of others in credit default swaps or directly in debt obligations that would be appropriate as Eligible Collateral Debt Securities and Reference Obligations in respect of the CDS Assets and have no duty in making such investments to act in a way that is favorable to the Issuer or the holders of the Secured Notes or the holders of the Income Notes. Such investments may be different from, or conflict with, those made on behalf of the Issuer. For example, the Manager may enter into short positions with respect to certain Reference Obligations on behalf of other accounts managed by it while maintaining long positions with respect to such Reference Obligations on behalf of the Issuer.

The Manager, its affiliates and client accounts for which the Manager or its affiliates act as investment adviser may at times own Notes of one or more Classes (such Notes and the Income Notes purchased by the Manager and/or an affiliate on the Closing Date, the "Manager Notes"). At any given time, the Manager, its affiliates and accounts managed by any of them will not be entitled to vote Manager Notes with respect to (i) any removal of the Manager and any replacement of any such removed Manager with an affiliate thereof, (ii) any assignment of the rights or obligations of the Manager under the Management Agreement or (iii) any change in the compensation to the Manager (other than with respect to an unaffiliated successor Manager). However, at any given time the Manager, its affiliates and such accounts will be entitled to vote Manager Notes with respect to all other matters, including in connection with approving or objecting to a replacement Manager that is not an affiliate.

The ownership of Notes of any Class by the Manager, its affiliates and client accounts, for which the Manager or its affiliates act as investment adviser will give the Manager an incentive to take actions that vary from the interests of the holders of the other Classes of Notes. None of the Manager, its affiliates or such accounts is contractually restricted under the Indenture or the Management Agreement or otherwise from selling or otherwise disposing of all or part of the Income Notes held by it. Although the Manager or one of its affiliates may at times be a holder of the Notes, the interests and incentives of the Manager will not necessarily be completely aligned with those of the other holders of the Notes (or of the holders of any particular Class of the Secured Notes or of the Income Notes).

The Manager and its affiliates will not be restricted in their performance of any other services or types of investments, which they may make, and will not be required to offer such services or investments to the Issuer or provide notice of such activities to the Issuer. Although the officers and employees of the Manager will devote as much time to the Issuer as the Manager deems appropriate, such officers and employees may have conflicts in allocating their time and services among the Issuer and other accounts advised by the Manager and/or its affiliates.

The Manager and its affiliates currently manage investment entities that invest in investment-grade securities, mezzanine securities and/or other securities and assets. The Manager and its affiliates may establish in the future additional investment entities to invest in such securities. The Manager also acts as Manager with respect to, and is an investor in, certain other collateralized debt obligation vehicles some of which invest in securities similar to those in which the Issuer will invest synthetically. The Manager and its affiliates may also have ongoing relationships with companies whose securities constitute the Reference Obligations of the CDS Assets and may own debt or equity securities issued by issuers of the Reference Obligations of CDS Assets. The Manager may take into consideration such relationships in its management of the Collateral. For instance, there may be certain investments that the Manager generally will not undertake on behalf of the Issuer in view of such relationships. Furthermore, as a result of such relationships the Manager may have material non-public information, which would place significant restriction on the Manager's ability to buy or sell the related securities or otherwise using such information for the benefit of its clients or itself, which may prevent the Manager from taking actions which it might consider in the best interests of the Issuer and the Noteholders.

The Manager may not effect agency cross transactions where the Manager causes a transaction to be effected between the Issuer and another account advised by the Manager or its affiliates unless such transactions are (i) exempt from the prohibited transaction rules of ERISA and the Code and will be consummated on the terms prevailing in the market and (ii) in compliance with the Advisers Act. Client cross transactions enable the Manager to purchase or sell a block of securities for the Issuer at a set price and possibly avoid an unfavorable price movement that may be created through entrance into the market with such purchase or sell order. Under the Management Agreement, the Issuer will authorize the Mana er to execute such client cross transactions; provided, however, that such authorization is terminable at the Issuer's option without penalty, effective upon receipt by the Manager of written notice from the Issuer. By purchasing Notes, each investor shall be deemed to have consented to the transactions and procedures described above relating to principal trades and client cross transactions.

The Manager and its affiliates may serve as a general partner or manager of, or as an investment adviser for entities organized to issue collateralized debt obligations secured by asset-backed securities, high-yield debt securities and loans (or synthetic securities referencing the foregoing) which may compete with the Issuer for investment opportunities. The Manager may at certain times be simultaneously seeking to purchase investments for the Issuer and any other related entity for which it serves as manager or investment advisor, or for its own account or for affiliates (including investment funds managed by the Manager or its affiliates) (the "Related Entities"). In its capacity as investment adviser and manager, the Manager may engage in other business and furnish investment management and advisory services to Related Entities whose investment policies differ from those followed by the Manager on behalf of the Issuer as required by the Indenture. The Manager may make recommendations or effect transactions which differ from those effected with respect to the Collateral. In addition, the Manager may, from time to time, cause or direct Related Entities to enter into, buy or sell, or may recommend to Related Entities the entering into, buying and selling of, securities (including synthetic securities) of the same or of a different kind or class of the same obligor (or reference obligor), as securities or CDS Assets which are part of the Collateral which the Manager directs to be purchased or disposed on behalf of the Issuer. Situations may occur where the Issuer could be disadvantaged because of the investment activities conducted by the Manager for the Related Entities, including through reduced availability of investment opportunities and resources for the Issuer.

Please accept my apologies for the length and the fine print – that's how it is in the prospectus. Someday a judge is going to look at one of these, think about it for a few minutes, and rip it up.

The Utmost Good Faith – I am aware this will be very difficult for the denizens of Wall Street to grasp. It would require them to totally reverse their mental processes. Some of them no doubt would lose, or perhaps, regain, their sanity in the process.

However, if health is to be restored to the financial system, existing legal principles will need to be extended to interpret CDS, MBS and CDOs as contracts requiring the utmost good faith, and the total absence of conflicts of interest.

Fiduciary Duty – The courts could of course address the conflicts of interest by finding an inescapable fiduciary duty on the part of the manger of CDOs, and perhaps on the part of the originators.

Goldman's Abacus Transaction – Viewed in this light, Fabrice Tourre's failure to disclose Paulson's role in selecting the collateral is sufficient to void the contract. We know without further research and investigation that many of the synthetic CDOs that went bad so quickly would not stand legal scrutiny under the standards proposed.

Manager Misconduct – A recent article in Business Week points out how Lou Lucido of TCW, as manager of a CDO insured by AIG (NYSE:AIG), was able to trade contrary to the interests of the holders of the CDO, thereby exacerbating AIG's losses. We know without further research or investigation that this is not an isolated incident.

Investment Implications – This could take a while to play out. But I would tend to invest in the perceived victims, ordinary insurance companies or banks that bought the tainted product. I would avoid investing in those whose bad faith created the financial meltdown.

Disclosure: No positions