A Review Of Recent Derivatives Litigation

Fordham Journal of Corporate & Financial Law, Dec 2011

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

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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 - 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)


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John D. Finnerty, Kishlaya Pathak. A Review Of Recent Derivatives Litigation, Fordham Journal of Corporate & Financial Law, 2011, Volume 16, Issue 1,