NEW YORK (Bloomberg) — A US federal judge has made public the reasons why he found against XL Capital Assurance (XLCA) - a unit of Bermuda-based bond insurer Security Capital Assurance (SCA) - in its legal battle with US securities firm Merrill Lynch over $3.1 billion of credit-default swaps.

Merrill did not didn't give exclusive voting rights to XLCA on six collateralised-debt obligation guarantees the bank bought from the bond insurer, US District Judge Jed Rakoff in Manhattan wrote in an opinion published yesterday.

Merrill, the third-largest US securities firm, didn't affirmatively reject XLCA's voting rights when the bank bought additional insurance for the CDOs from another insurer because those rights weren't exclusive, the judge said. The decision explains a one-page order he issued on June 10 in which he ruled that XLCA must honour its credit-default swaps with the bank.

Merrill's "contract with XLCA does not, as XLCA represents, grant controlling class voting rights unconditionally to XLCA", Judge Rakoff wrote.

Mortgage-bond CDOs have been the largest source of more than $400 billion of write-downs and losses reported by the world's banks and securities firms since the beginning of last year. Losses may rise if default protection, bought from companies such as the XLCA unit of SCA, fails to pay off.

CDOs package assets such as mortgage bonds and buy-out loans and use the income from that debt to pay investors in the new securities. In exchange for being financial guarantor for the instruments, XLCA got Merrill's control voting rights over the CDO to make decisions such as whether to liquidate collateral or remove a trustee.

In his ruling, Rakoff wrote that CDOs are "seen by many as contributing to the recent deterioration in the credit markets".

Credit-default swaps offer payments if the securities aren't repaid as expected, in return for regular insurance-like premiums.

Merrill sued XLCA on March 19, asking the court to uphold the swaps. XLCA argued that New York-based Merrill breached the agreements by shifting control rights to at least one third party, XLCA competitor MBIA Inc.

Merrill said it hadn't entered an agreement that would preclude it from fulfilling XLCA's contracts.

Merrill argued that, though Armonk, New York-based MBIA was covering CDO tiers more senior to those insured by XLCA, the bank may still vote the shares according to XLCA's directions. In his opinion, Rakoff wrote that, under the contracts, Merrill may decide not to follow XLCA's instructions and repudiate the swaps.