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In re Credit Default Swaps Antitrust Litigation

United States District Court, S.D. New York

September 4, 2014

IN RE CREDIT DEFAULT SWAPS ANTITRUST LITIGATION

Daniel L. Brockett, Steig D. Olson, Justin T. Reinheimer, Nick T. Landsman-Roos, QUINN EMANUEL URQUHART & SULLIVAN, LLP, New York, NY, Bruce L. Simon, George M. Sheanin, Aaron M. Sheanin, PEARSON, SIMON & WARSHAW, LLP, San Francisco, CA, for plaintiffs.

Robert F. Wise, Jr., Arthur J. Burke, Jeremy T. Adler, DAVIS POLK & WARDWELL LLP, New York, NY, for defendants Bank of America, Corporation and Bank of America N.A.

Todd S. Fishman, Michael S. Feldberg, M. Elaine Johnston, ALLEN & OVERY LLP, New York, NY, for defendant Barclays Bank PLC.

David Esseks, Brian de Haan, ALLEN & OVERY LLP, New York, NY, John Terzaken, Molly Kelley, ALLEN & OVERY LLP, Washington, DC, for defendant BNP Paribas.

Benjamin R. Nagin, Eamon P. Joyce, SIDLEY AUSTIN LLP, New York, NY, David F. Graham, David C. Giardina, Jennifer E. Novoselsky, SIDLEY AUSTIN LLP, Chicago, IL, for defendants Citigroup Inc., Citibank, N.A., and Citigroup Global Markets Inc..

J. Robert Robertson, Benjamin Holt, HOGAN LOVELLS U.S. LLP, Washington, DC, for defendant Credit Suisse AG.

David P. Wales, JONES DAY, Washington, DC, Tracy V. Schaffer, Eric P. Stephens, JONES DAY, New York, NY, Paula W. Render, Alex P. Middleton, JONES DAY, Chicago, IL, for defendant Deutsche Bank AG.

Richard C. Pepperman II, Bradley P. Smith, Mark S. Geiger, SULLIVAN & CROMWELL LLP, New York, NY, Robert Y. Sperling, WINSTON & STRAWN LLP, Chicago, IL, Seth Farber, WINSTON & STRAWN LLP, New York, NY, Elizabeth P. Papez, WINSTON & STRAWN LLP, Washington, DC, for defendant Goldman, Sachs & Co.

Richard A. Spehr, Michael O. Ware, MAYER BROWN LLP, New York, NY, Andrew S. Marovitz, Britt M. Miller, MAYER BROWN LLP, Chicago, IL, for defendants HSBC Bank plc and HSBC Bank USA, N.A.

Peter E. Greene, Peter S. Julian, Boris Bershteyn SKADDEN, ARPS, SLATE, MEAGHER & FLOM LLP, New York, NY, Patrick J. Fitzgerald, SKADDEN, ARPS, SLATE, MEAGHER & FLOM LLP, Chicago, IL, for defendants JPMorgan Chase & Co. and JPMorgan Chase Bank, N.A.

Evan R. Chesler, Daniel Slifkin, Michael A. Paskin, Vanessa A. Lavely, CRAVATH, SWAINE & MOORE LLP, New York, NY, for defendant Morgan Stanley & Co. LLC.

David C. Bohan, KATTEN MUCHIN ROSENMAN, LLP, Chicago, IL, James J. Calder, KATTEN MUCHIN ROSENMAN, LLP, New York, NY, for defendants UBS AG and UBS Securities LLC.

Charles F. Rule, Joseph J. Bial, Amy W. Ray, CADWALADER, WICKERSHAM & TAFT LLP, Washington, DC, for defendants Royal Bank of Scotland PL and Royal Bank of Scotland N.V.

Matthew J. Reilly, Abram J. Ellis, SIMPSON THACHER & BARTLETT LLP, Washington, DC, Michael J. Garvey, SIMPSON THACHER & BARTLETT LLP, New York, NY, for defendant International Swaps and Derivatives Association.

Colin R. Kass, Scott M. Abeles, PROSKAUER ROSE LLP, Washington, D.C., Alan R. Kusinitz, PROSKAUER ROSE LLP, New York, NY, for defendant Markit Group Ltd.

Colin R. Kass, PROSKAUER ROSE LLP, Washington, D.C., Alan R. Kusinitz, PROSKAUER ROSE LLP, New York, NY, for defendant Markit Group Holdings Limited.

OPINION & ORDER

DENISE COTE, District Judge.

Plaintiffs bring this antitrust action individually[1] and on behalf of all persons who, during the period from January 1, 2008 through December 31, 2013, which plaintiffs define as the "Relevant Period, " purchased credit default swaps ("CDS")[2] from, or sold CDS to, certain banks in the United States. The Second Consolidated Amended Class Action Complaint ("Complaint") names as defendants those banks (the "Dealer-Defendants"), [3] as well as the International Swaps and Derivatives Association ("ISDA"), and both Markit Group Holdings Limited and its subsidiary Markit Group Ltd. (collectively "Markit"). Plaintiffs bring claims under Sections 1 and 2 of the Sherman Antitrust Act ("Sherman Act"), 15 U.S.C. ยงยง 1-2, and under state unjust enrichment law. Defendants have moved under Fed.R.Civ.P. 12(b)(6) to dismiss the Complaint for failure to state a claim on which relief can be granted. For the reasons stated below, defendants' motions are granted in part.

BACKGROUND

The following facts are drawn from the Complaint and are accepted as true for purposes of this motion. LaFaro v. N.Y. Cardiothoracic Grp., PLLC, 570 F.3d 471, 475 (2d Cir. 2009).

I. The CDS Market Generally

A CDS is a type of derivative, which is a financial instrument whose value depends on the value of some underlying asset. In the case of CDS, the underlying asset is a debt instrument. CDS are tools for hedging credit risk. The buyer of the CDS purchases the seller's promise to pay on the occasion of a "credit event, " such as a default on the debt instrument by a third party, who is known as the "reference entity."

When they originated in the 1990s, trading of CDS was largely ad hoc. Because CDS instruments were not standardized, their terms were individually negotiated, resulting in high transaction costs. One such cost came from searching for a counterparty: a party willing to buy or sell the credit protection that the investor was offering or seeking.

In response to this situation, market makers arose. Market makers - also referred to as "dealers" - sell to buyers, buy from sellers, and hold inventory until a match emerges. In other words, dealers (the "sell-side" of the market) sell CDS investors (the "buy-side" of the market) liquidity: the ability to trade without having to wait for a counterparty. A dealer offers a "bid" price at which the dealer will purchase and an "ask" price at which the dealer will sell. By keeping their bid lower than their ask, dealers can capture the difference, known as the "bid/ask spread." The primary CDS dealers are the large investment banks: the Dealer-Defendants.

II. Dealer-Defendants Take Control of the CDS Market.

By the early-2000s, Dealer-Defendants had established their position as prominent over-the-counter CDS dealers. In those days a dealer's role as market maker was valuable because a dearth of buyers and sellers created a need for liquidity. Moreover, there were substantial barriers to entry in the overthe-counter dealer market. Due to low trading volume and unstandardized products, dealers faced the possibility of holding undesirable CDS exposure, a risk that only large financial institutions, like Dealer-Defendants, could manage. Under these circumstances Dealer-Defendants were able to charge high prices in the form of bid/ask spreads.

By the mid-2000s, however, several changes in the CDS market increased liquidity, threatening Dealer-Defendants' positions of prominence. For one thing, the volume of CDS transactions increased significantly. Standing alone, increased trading volume could have benefited Dealer-Defendants by creating economies of scale and scope.

In addition to increased volume, however, the structure of CDS transactions was standardized under a "Master Agreement" created by ISDA, a financial trade association representing institutions involved in the derivatives market. Most of the terms of the Master Agreement applied automatically, obviating the need for negotiation in each transaction. CDS products themselves became standardized as well. As

CDS markets grew, two types of products emerged as highly liquid options: single-name CDS and CDS indices. Single-name CDS are based on a debt instrument issued by a single reference entity. The vast majority of single-name CDS contracts follow the Master Agreement. CDS indices are keyed to a basket of reference entities. In November 2007, the two major CDS indices were purchased by Markit, a private financial information company. Markit standardized not only the CDS indices themselves by selecting their baskets of reference entities, but also the indices' contract terms. Dealer-Defendants came to occupy seats on the boards of both ISDA and Markit.

With increased standardization, the market was ripe for alternative means of CDS trading, such as an electronic exchange. Such alternative means would have diminished the buyside's dependence on the over-the-counter trading services offered by Dealer-Defendants.

To protect their positions of prominence, Dealer-Defendants restricted pre- and post-transaction price transparency. Before a transaction, Dealer-Defendants strove to keep investors in the dark about both the volume of supply and demand and the real price at which CDS were trading. For instance, investors could not see Dealer-Defendants' solicitations of bids and asks.

And after a transaction, virtually no CDS data could be shared without Dealer-Defendants' consent. Formal processing of Dealer-Defendants' CDS trades was handled by subsidiaries of the Depository Trust & Clearing Corporation ("DTCC"), whose board of directors included representatives of Dealer-Defendants. DTCC was privy to the terms of Dealer-Defendants' CDS trades and could have disseminated that information to data vendors, but Dealer-Defendants used their positions as board members to promulgate rules that prevented such dissemination.

DTCC provided real-time post-trade data only to its members, which included Dealer-Defendants and Markit. In exchange for receiving this data, Markit agreed to Dealer-Defendants' condition that Markit not provide pricing information to its subscribers in real-time. Instead, Markit would delay before circulating information, allowing Dealer-Defendants to quote different prices in the interim and to disavow as stale the information that Markit eventually released. This agreement with Dealer-Defendants was contrary to Markit's economic interests: Because the CDS market lacked real-time pricing data, Markit could have sold that data to investors.

Dealer-Defendants secured additional informational advantages by restricting participation in the inter-dealer market. When dealers trade CDS among themselves they use intermediaries called inter-dealer brokers ("IDBs"). IDBs receive information about the price at which one dealer is willing to buy or sell a CDS and then attempt to match that bid or ask with another dealer. The inter-dealer market was structured to provide Dealer-Defendants some of the very benefits denied non-dealers. When transacting through IDBs, for instance, dealers had access to a large array of real-time bid and ask prices. Dealers also were able to enter trades automatically at the quoted price, with no need to negotiate or to submit a counter quote. Moreover, dealers were able to post quotes anonymously. In sum, the inter-dealer market possessed some of the key attributes of an electronic exchange, demonstrating that, even before 2008, the CDS market was ripe for exchange trading.

Dealer-Defendants actively prevented non-dealers from accessing the benefits of the inter-dealer market, striving to ensure that each CDS transaction included at least one dealer. In fact, Dealer-Defendants threatened to boycott IDBs that transacted with non-dealers, a threat that, if acted upon, would effectively force an IDB to shut down.

In short, by the beginning of 2008 Dealer-Defendants had total command of CDS trading. By controlling real-time pricing data, Dealer-Defendants were able to maintain supracompetitive bid/ask spreads, even as increased liquidity and standardization should have driven those spreads down.

III. Changes Threaten the Status Quo.

Unsurprisingly, by early 2008 there was demand for greater transparency and competition in the CDS market. While considerable barriers to entry prevented direct buy-side competition with the major dealers in the over-the-counter market, clearinghouses and exchanges would have created competition on bid/ask spreads. As a result, potential CDS clearinghouses and exchanges began to emerge.

One such enterprise was the Credit Market Derivatives Exchange ("CMDX"), a joint venture between Citadel LLC ("Citadel") - a leading investor in the CDS market - and CME Group Inc. ("CME"). CME, as the operator of the world's foremost derivatives marketplace, offered exchanges for trading in derivatives and a clearinghouse. Together, Citadel and CME had the capital, experience, reputation, and knowhow to launch a successful CDS clearinghouse and exchange.

Citadel and CME heavily invested, working with buy- and sell-side parties to ensure that CMDX would be a viable electronic exchange platform. They intended CMDX membership to be generally open to dealers, banks, and institutional investors. CMDX was designed with an open architecture that would enable market participants to trade through Central Limit Order Booking ("CLOB"). In a CLOB model, customers and dealers can trade directly between or among each other. Research suggested that CMDX would support extensive trading and clearing of CDS products, including the major CDS indices and their single-name constituents. CMDX would thus have excluded Dealer-Defendants as intermediaries in many CDS transactions and made real-time pricing information available to investors.

Trades using CMDX were to be processed directly through the CME clearinghouse. A clearinghouse is an entity designed to reduce counterparty risk by turning a bilateral trade into two separate transactions: a sale from the seller to the clearinghouse, and then a sale from the clearinghouse to the buyer. Because every trade participant faces the same counterparty - the clearinghouse - traders need not evaluate counterparty risk for each deal. By serving as the clearinghouse for all CMDX trades, CME would have virtually eliminated the risk of counterparty default.

Citadel and CME offered equity in CMDX to certain sell-side parties, including six Dealer-Defendants. Parties who invested in CMDX early had the potential to realize a sizeable firstmover advantage. Accordingly, some Dealer-Defendants expressed interest in becoming involved.

Citadel and CME also targeted Markit and ISDA. To succeed, CMDX would need licenses to two types of Markit's intellectual property: the makeup of its CDS indices and its reference-entity database ("RED") codes, which identify the financial instrument and reference entity underlying a CDS. Markit stood to gain significant revenue from licensing its CDS indices and RED codes, and Markit directors expressed interest.

CMDX would also need a license to use ISDA's Master Agreement to ensure that the conventions of a CDS exchange market would mirror those of the over-the-counter analog. It was in ISDA's interest to license to CMDX: As an industry trade association, ISDA's stated goals include reducing counterparty credit risk, increasing transparency, and improving industry infrastructure. Furthermore, ISDA sought to achieve broader adoption of its Master Agreement. Accordingly, representatives indicated that ISDA was interested in licensing to CMDX.

CMDX was not the only proposal for change in the CDS market. Others were presented by Eurex Clearing and Liffe. Nevertheless, CMDX was the most advanced, and Dealer-Defendants had an economic incentive to participate in the venture, especially those that could be first movers. CMDX was fully operational and ready for market by the Fall of 2008. Modeling ...


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