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Passing the Test: Enforceability of standard CDS contracts


01 December 2008

The complexity of the inter-related documents that described the CDS transaction and plaintiff's conclusory allegations of bad faith and unjust enrichment failed to create any serious issue.  

Instead, the Court dismissed the protection seller's claims before any pretrial discovery and entered judgment in favor of the protection buyer on its counterclaim.


In July 2007, VCG Special Opportunities Master Fund ("VCG") entered into a CDS transaction with Citibank in which VCG sold credit protection to Citibank on USD10,000,000 of certain Class B Notes issued by Millstone III CDO Ltd. III-A ("Millstone").

To document the CDS transaction, VCG and Citibank used a 2002 ISDA Master Agreement, the 1994 ISDA Credit Support Annex, and a confirmation letter that incorporated the ISDA Credit Derivative Definitions and the Standard Terms Supplement for Pay-As-You-Go or Physical Settlement. The confirmation letter and Credit Support Annex required VCG to pay USD2,000,000 to Citibank as the "independent amount," which served as initial collateral on VCG's potential USD10,000,000 obligation to Citibank. At the same time, Citibank agreed to pay VCG a premium of USD550,000 per year for credit protection on the Class B Notes.

Only one month after the parties entered into the CDS transaction, Citibank demanded that VCG deposit additional collateral as a result of decreased market value of the Class B Notes. In addition to its role as protection buyer, Citibank also served as calculation agent for purposes of determining additional required collateral and, under certain circumstances, the calling of a credit event. In total, Citibank demanded and received more than USD7,500,000 in additional collateral during the period from August through November 2007. Finally, in January 2008, Citibank declared a credit event based upon an Implied Writedown of the Class B Notes, and demanded payment of the full USD10,000,000 in credit protection. When VCG refused to pay, Citibank seized the collateral and was still owed approximately USD600,000 under the CDS transaction.

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