Credit Default Swap Class Action Clears Motions To Dismiss And Proceeds To Discovery

By David Golden

On Thursday, Judge Denise Cote of the U.S. District Court for the Southern District of New York refused to dismiss a class-action antitrust lawsuit involving the $21 trillion credit default swap (“CDS”) market, permitting the case to proceed to discovery.

The plaintiffs in In re Credit Default Swaps Antitrust Litigation allege that some of the largest investment banks in the United States – including Bank of America, Citibank, Goldman Sachs, JPMorgan and Morgan Stanley – conspired to prevent price transparency and competition in the CDS market.  The individual plaintiffs are groups of CDS investors, including several public pension funds.

A CDS is a financial tool to hedge credit risk.  The buyer of a CDS purchases the seller’s promise to pay if a “credit event,” such as a credit default, occurs during a specified time period.  In effect, a CDS is an insurance policy.

The inner workings of the CDS exchange market lie at the heart of the complaint, which was filed on May 3, 2013.  CDSs are bought and sold in CDS exchanges, which the defendant banks are alleged to dominate and to control tightly.  The plaintiffs allege that the defendant banks deliberately kept the terms of CDS opaque and resisted the introduction of real-time CDS exchanges.  As a result, the defendant banks allegedly earned billions of dollars in supracompetitive profits from inflated “bid/ask spreads.”

Plaintiffs alleged that when competitor exchanges emerged to challenge the defendants’ market dominance, the defendants engaged in coordinated, anticompetitive conduct to block rival exchanges from entering the CDS market.  These alleged anticompetitive tactics included group boycotts of derivative clearinghouses that defendants did not control and preventing industry organizations from licensing competitor exchanges.

Judge Cote’s opinion is a helpful example of how plaintiffs can survive the inevitable motion to dismiss based on the Supreme Court’s Twombly decision.  In denying the defendants’ motions to dismiss the Sherman Act Section 1 claim, the court found that plaintiffs had alleged facts that showed a plausible conspiracy, including a series of secret meetings and communications between defendant banks that occurred at specific times and places and that resulted in illegal agreements.  Notably, the court did not require plaintiffs to identify the individual employees involved in each and every meeting or communication.  Instead, allegations that “senior-level employees of each [defendant bank] participated” were deemed sufficient when combined with lists of defendant employees who plaintiffs believed were likely to be present at different meetings.

Plaintiffs were also able to allege so-called “plus factors,” which are facts that tend to exclude independent self-interested conduct by defendants.  For example, the plaintiffs alleged (1) defendant banks had a common motive to conspire (all defendants would gain advantage from preventing the entry of competitor exchanges to the CDS market but could not succeed alone); (2) the parallel acts of defendant banks were against their individual economic interest (defendant banks could have joined competitor exchanges and gained first mover advantages); and (3) there was a high level of inter-firm communications (representatives of defendant banks  held strategic positions in other CDS industry organizations and facilitated communications).

The plaintiffs also asserted a claim based on a conspiracy-to-monopolize violation of Section 2 of the Sherman Act, but the court dismissed that claim because the plaintiffs had not alleged the aim of defendants’ conspiracy was to form a single entity with monopoly power or to allocate the CDS market among themselves.  The court also limited plaintiffs’ damages to the period after the fall of 2008 because no anticompetitive conduct was alleged prior to that date.

Mortgage-backed CDSs gained notoriety in the wake of the 2008 financial crisis.  The plaintiffs’ allegations that senior personnel of the defendant banks met secretly and routinely around that time are in part based on a December 2010 New York Times article, “A Secretive Banking Elite Rules Trading in Derivatives,” that described the defendants’ meetings and control structure. Indeed, the plaintiffs characterized the defendants’ alleged conspiracy as “corrupt[ing] a critical derivatives market and undermin[ing] the stability of U.S. financial markets at a time when those markets were particularly vulnerable.”

The CDS market has been investigated by both the U.S. Department of Justice and the European Commission. According to reports, the DOJ does not plan any further actions.

The Commission, on the other hand, issued a statement of objections in July 2013 informing several large investment banks, including some of the defendants in the American litigation, that the Commission had reached a preliminary conclusion that they had infringed European Union antitrust rules that prohibit anticompetitive agreements by colluding to prevent exchanges from entering the credit derivatives business between 2006 and 2009.

The statement of objections was addressed to Bank of America, Merrill Lynch, Barclays, Bear Stearns, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Morgan Stanley, Royal Bank of Scotland, UBS, as well as the International Swaps and Derivatives Association (ISDA) and data service provider Markit.

According to the Commission’s statement of objections, the banks acted collectively to shut out exchanges from the market because they feared that exchange trading would have reduced their revenues from acting as intermediaries.

– Edited by Gary J. Malone