A Review Of Recent Derivatives Litigation
FORDHAM JOURNAL
OF CORPORATE & FINANCIAL LAW
Fordham Journal of Corporate & Financial Law
A Review
John D. Finnerty
Kishlaya Pathaky
Copyright c 2011 by the authors. Fordham Journal of Corporate & Financial Law is produced by The Berkeley Electronic Press (bepress). http://ir.lawnet.fordham.edu/jcfl
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2011
BOOK 1
y
A Review Of Recent Derivatives Litigation
The global over-the-counter derivatives market exceeded $33 trillion of gross market value as
of year-end 2008, according to the Bank for International Settlements.1 Recent headlines suggest
that derivatives – specifically, credit default swaps – pose an enormous potential systemic risk and
that they are one of the root causes of the current economic crisis.2
A REVIEW OF RECENT DERIVATIVES
LITIGATION
John D. Finnerty*
Kishlaya Pathak†
I. INTRODUCTION
The global over-the-counter derivatives market exceeded $33
trillion of gross market value as of year-end 2008, according to the Bank
for International Settlements.1 Recent headlines suggest that derivatives
– specifically, credit default swaps – pose an enormous potential
systemic risk and that they are one of the root causes of the current
economic crisis.2 Warren Buffett, who leads a conglomerate—
Berkshire Hathaway—which held $63 billion of derivatives as of April
* Professor of Finance, Fordham University and Managing Principal, Finnerty
Economic Consulting, LLC ( and ).
B.A., Williams College; B.A., M.A., Cambridge University (Marshall Scholar); Ph.D.,
Naval Postgraduate School. I gratefully acknowledge Eric Borun and Sherry Chen for
outstanding research assistance.
† Fixed Income Strategist, Barclays Capital ().
B.A. Honors Economics, University of Delhi; M.A. Economics, University of Delhi;
MBA, Stephen M. Ross School of Business, University of Michigan. I gratefully
acknowledge Eric Borun and Sherry Chen for outstanding research assistance. This
article was written while I was at Finnerty Economic Consulting and reflects my views
and not those of Barclays Capital..
1. See Mark Brown, OTC Derivatives Volume Fell, WALL ST. J., May 19, 2009, at
C5. Gross market value is the cost of replacing existing OTC derivatives contracts.
Market size is often stated in terms of notional value, but gross market value is a better
measure of the level of risk in the derivatives market. The size of the market is as of
December 31, 2008. Gross market value rose 66.5% in the second half of 2008 even
though aggregate notional amount fell 13.4% (to $592 trillion from $684 trillion).
2. For example, the obligations associated with credit default swaps and other
derivative positions that were not fully hedged have been held responsible for American
International Group’s financial distress. See Liam Pleven & Randall Smith, Action on
AIG Unit May Cost Taxpayers, WALL ST. J., Apr. 13, 2009, at C1.
2010, has warned, “Derivatives are financial weapons of mass
destruction.”3 This remark suggests that these instruments should carry the
warning,
“Improper use can be hazardous to your financial health.” Mounting
concerns over derivatives have recently led the U.S. Treasury to propose
a comprehensive regulatory framework to bring greater transparency to
the derivatives market, restrict derivatives trading, and impose closer
supervision on derivatives market participants to reduce systemic risk.4
Importantly, the proposals call for amending the Commodity Exchange
Act and the securities laws to “prevent market manipulation, fraud, and
other market abuses.”5
Derivatives, when used properly, improve economic efficiency and
allow companies to manage unwanted risk exposures. Allegations of
derivatives abuse in recent litigation provide a stern reminder that
substantial damage can occur when they are misapplied.6 A review of
court records highlights how important it is for market participants to
understand these instruments before using them. Court records reveal
that the complexity of derivatives often leads to misunderstandings and
is sometimes exploited by unscrupulous financial promoters to take
unfair advantage of unsophisticated or unsuspecting investors. The
apparent investor acceptance of Bernard Madoff’s purported
‘splitstrike’ strategy—in which the execution of stock call and put options
supposedly enabled the fund to achieve superior risk-adjusted returns—
3. Annual Letter to Shareholders from Warren Buffett, Chairman, Berkshire
Hathaway, Inc., Feb. 21, 2003, at 15, available at
http://www.berkshirehathaway.com/letters/2002pdf.pdf. But see Damien Paletta,
Democrats Deny Buffett on a Key Provision, WALL ST. J., Apr. 27, 2010 (stating
Buffett’s “Berkshire [Hathaway] has $63 billion in derivatives contracts, and Mr.
Buffett has boasted he holds very little collateral against these products”).
4. Press Release, U.S. Dep’t of the Treasury, Regulatory Reform Over-the-Counter
(OTC) Derivatives (May 13, 2009), http://www.ustreas.gov/press/releases/tg129.htm;
see also Sarah N. Lynch & Serena Ng, U.S. Moves to Regulate Deri (...truncated)