Security Faces Suit over Swap Contract

A failed New Zealand merchant bank is about to launch court proceedings against a Security Pacific Corp. subsidiary over a swap arrangement that went sour.

Although the amount at issue is not large - between $3.8 million and $7.1 million - the outcome could shake up the $3 trillion swap market. If the High Court in Auckland directs the Security Pacific unit to satisfy the plaintiff, DFC New Zealand, a frequently used type of contract could lose its appeal.

"Our proceedings will be followed closely by major swap houses concerned about the effects on an orderly market of parties walking away from contracts and taking windfall profits," said Sandy Maier, DFC's court-appointed statutory manager - a title similar to bankruptcy trustee in the United States.

Pact Broken After Bankruptcy

DFC is charging that Security Pacific Australia Ltd. broke a swap contract shortly after the New Zealand firm declared bankruptcy in 1989.

At the time, DFC had swap contracts outstanding with several dozen institutions, market sources said.

The terms of those contracts allowed for so-called limited two-way payments. Under such contracts, if one party to the swap defaulted, the other was not liable for any payments under the contracts.

Theoretically, all the institutions in swap contracts with DFC could have walked away from any obligations. But most of them agreed to make any payments they would have owed had DFC not defaulted.

Swap market specialists offered two reasons why counterparties volunteered to make good on these liabilities: They wanted to make sure DFC had enough cash to meet other obligations, and they were nervous about whether their legal position would stand up in court.

A court could rule that the counterparties unfairly reaped a windfall by walking away from obligations of their own making.

"If these were to go to court, the judges would look through and see that counterparties would be unduly enriched," said Richard Stein, a first vice president at Banque Indosuez.

Only Security Pacific refused to make such payments, market sources said.

Frivolous Defaults Targeted

Limited-payment contracts that DFC entered into were originally designed to discourage frivolous defaults, according to Jo Anne Bradbury, general counsel at Fuji Capital Markets. If parties knew they would not be legally entitled to receive payments on any swap contracts if they defaulted, they would be less inclined to consider defaulting to get out of such arrangements, she said.

"Many people have limited two-way payment provisions in the contracts that would technically give them the right not to pay, but they mainly use them as leverage."

Swap users have recently become wary of the limited-payment contract, one swaps specialist said. Bankruptcies and defaults by big swap users such as Drexel Burnham Lambert and Bank of New England Corp. have made market participants more nervous about the credit-worthiness of others involved in swaps.

Already, several New York banks have reportedly looked at changing over to so-called full two-way payment contracts, under which both parties are obligated to make full payments under the swap contract even if one party defaults on other obligations.

"Most institutions are moving away from limited two-way contracts," said Leslie Rahl, president of the swap consulting firm Leslie Rahl Associates.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.