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In testimony last week before the Senate Banking Committee, SEC Chairman Cox pointed out the enormous regulatory black hole in which credit default swaps have come of age since pretty much the dawn of the 21st century. He pointed out that the SEC’s Enforcement Division was focused on using its antifraud authority in this area, and noted that credit default swaps provided a way for market participants to “naked short” the debt of companies without restriction. Cox asked that Congress “provide in the statute the authority to regulate these products to enhance investor protection and ensure the operation of fair and orderly markets,” but he didn’t say who should have such authority. Interestingly enough, I don’t recall any similar discussion of the lack of authority to regulate credit default swaps and other derivatives up until this point, while the excesses in the market – and the lack of transparency – have been known for some time.

A day earlier, New York Governor Paterson and the New York Insurance Department announced that, beginning on January 1, 2009, the New York Insurance Department would regulate some credit default swaps as a form of financial guaranty insurance, whenever the credit default swap is issued in New York or issued to a New York purchaser who “holds, or reasonably expects to hold, a ‘material interest’ in the reference obligation.” Governor Paterson also called on the federal government to regulate credit default swaps.

One interesting thing pointed out by the statements of Chairman Cox and Governor Paterson is that no one seems to know for sure how big the market is for credit default swaps. Chairman Cox cited in his testimony “the $58 trillion notional market,” while Governor Paterson referred to the “$62 trillion market.” Any estimates such as these are pretty much educated guesses, since there really isn’t any transparency into the scope of the credit derivatives market. Also, these types of notional amount estimates are often cited to state the size of derivatives markets, but really those amounts overstate the actual exposure that these derivatives present, since the notional amount is really just the basis on which payments are calculated – but not how much any counterparty owes on the actual derivative contract. Something closer to $2 trillion in fair value is perhaps a better estimate of the size of the credit default swap market, at least up until the events of the last few months.

Congress did not yet heed the calls for more federal authority over credit default swaps, as no provisions have been included in the two versions of the bailout bill that would vest regulatory authority over credit derivatives with the SEC or any other agency; however, this may be an issue that Congress will turn to quickly once the latest fire drill has died down.

While I am by no means running for president of the credit default swaps fan club, I think that now is the absolute worst time to start beating the drum for more regulation of derivatives in general and credit derivatives in particular. While speculative activity in credit default swaps no doubt contributed to some of our problems today, credit derivatives have also mitigated risk for countless institutions by spreading the risk of default around the globe. Policymakers should have been paying attention long ago, before the market has grown to the size – and level of interconnectedness – that prevails today. Now, vague talk of regulation only serves to call into question the enforceability of agreements, make counterparties even more nervous about ultimately collecting on their contracts, and put further pressure on credit markets when those markets are least able to handle the pressure.

A Change to the Audit Committee Report

Back in the summer, the SEC approved the PCAOB’s new rule regarding communications with audit committees regarding independence. Last week, the SEC made a conforming amendment to Item 407 of Regulation S-K to change the language of the audit committee report. Previously, the audit committee report referred to “Independence Standards Board No. 1 (Independence Standards Board No.1, Independence Discussions with Audit Committees), as adopted by the Public Company Accounting Oversight Board in Rule 3600T.” Now, the audit committee report must refer to “applicable requirements of the Public Company Accounting Oversight Board regarding the independent accountant’s communications with the audit committee concerning independence.” The applicable requirement is PCAOB Rule 3526, but apparently the SEC does not want to refer directly to the rule itself.

The SEC didn’t amend Item 407 Regulation S-B, which is hanging around for transition purposes until March 15, 2009. But the SEC said interpretively that any filers using Regulation S-B should follow the Regulation S-K language in their audit committee report.

The change to Item 407 of Regulation S-K was effective on September 30.

September-October Issue: Deal Lawyers Print Newsletter

This September-October issue of the Deal Lawyers print newsletter was just sent to the printer and includes articles on:

– Boards Can’t Watch a Sale Unfold from the Balcony: Nine Take-Aways from Lyondell
– Dealing with State Anti-Takeover Statutes in Negotiated Acquisitions
– Cross-Border M&A: Checklist for Successful Acquisitions in the US
– Outside Termination Dates: No Way Out from a Purchase Agreement
– Broken Deals: Validation of Naked No-Vote Termination Fee
– Lessons Learned: Seeking Block Bids as Schedule 13D Discloseable Events
– The Shareholder Activist Corner: Spotlight on Steel Partners

Try a 2009 no-risk trial to get a non-blurred version of this issue (and the rest of ’08) for free.

– Dave Lynn