Parties to credit default swaps (“CDS”) often own or otherwise have exposure to the debt instrument underlying the swap (the “reference obligation”) or other securities of the borrower or issuer of the reference obligation (the “reference entity”). The CDS contract typically enables the buyer of credit protection to hedge the credit risk of the reference obligation (e.g., a failure to pay coupon or interest on the debt in accordance with its terms or an insolvency of the reference entity). On the other hand, a seller of credit protection may seek to increase its long position with respect to the reference obligation or reference entity. In any case, one or more of the parties to a CDS trade may have certain voting and other rights with respect to a reference obligation or could enter into transactions outside the CDS trade that could affect the value of the swap. Further, a party may have incentive to take certain of those actions with respect to the reference obligation in order to maximize its profits or minimize its losses across its portfolio. A recent case in the New York State Supreme Court, Good Hill Master Fund L.P. v. Deutsche Bank AG, Index No. 600858/2010, 2016 N.Y. Misc. LEXIS 2317 (N.Y. Sup. Ct. Feb. 3, 2016), provides important guidance to market participants, particularly distressed-debt investors that transact in both CDS and the reference obligation or other securities of the reference entity. The case held that a party to a CDS trade was within its contractual rights, and did not act in bad faith, where it entered into arm’s length transactions with respect to the reference obligation. This was so even though the transactions in the reference obligation had the direct effect of substantially decreasing the payout it was required to make as seller of credit protection under the CDS and was solely motivated by the party’s own self-interest in that respect.
In October 2007, two hedge funds managed by Good Hill Partners L.P. (collectively referred to as “Good Hill”) purchased $54 million of synthetic residential mortgage-backed securities from Bank of America in an initial offering of $10.3 billion, of which Bank of America retained the remainder. Good Hill purchased several tranches of notes, but only the most senior tranche was investment grade.
The following year Good Hill entered into three CDS contracts with Deutsche Bank AG (“Deutsche Bank”) referencing the investment grade tranche of notes and governed by market standard documentation, as published by the International Swaps and Derivatives Association, Inc. (“ISDA”). Under the terms of the CDS confirmations, Good Hill, as seller of credit protection, was required to make a floating amount payment to Deutsche Bank upon the occurrence of certain credit events, including a write-down or forgiveness of the principal of the investment grade notes. The confirmations set forth a formula for the calculation of that floating amount payment, which was based on the amount of the write-down multiplied by the face amount of the notes and a number referred to as the “current factor,” each of which would be provided in the servicer report prepared by the servicer of the notes under the securitization. Although Deutsche Bank, as calculation agent under the CDS, was responsible for making all determinations and calculations under the confirmations, any floating amount calculation was to be made based solely on information provided in the servicer report.
In April 2009, during the financial crisis, Bank of America and Good Hill negotiated a repurchase of the notes by Bank of America, which sought to surrender and cancel the notes. In August 2009, Good Hill and Bank of America entered into a transaction for the repurchase of the notes by Bank of America at a purchase price of approximately $15 million, an amount equal to 29% of the par value of the notes but representing a significant premium to the market value on the books of each party. The parties to the note repurchase agreed to allocate the purchase price across the tranches of notes sold by Good Hill, such that the investment grade notes would receive a favorable valuation of 83% of par and each of the other tranches of notes would receive a significantly lower valuation. At the same time, Bank of America entered into an agreement with the indenture trustee to unwind the securitization and in the process forgave 17% of the principal of the investment grade notes. The servicer of the notes subsequently issued a servicer report reflecting the terms of the unwind.
In the week following the repurchase, Deutsche Bank notified Good Hill that a credit event triggering payment under the CDS contracts had occurred as a result of the write-down. Given the 17% write-down, the calculation of the floating amount under each CDS contract payable by Good Hill amounted to roughly $5 million in the aggregate. Under the ISDA credit support documentation, Deutsche Bank had required Good Hill to post collateral based on the market value for securities, which as of the time shortly prior to the note repurchase was calculated by Deutsche Bank to equal approximately $27 million.
Good Hill maintained that, given the $5 million floating amount payment required under the confirmations, Deutsche Bank was obligated to return the remaining $22 million of collateral under the ISDA credit support documentation and that the failure to do so was a breach of contract by Deutsche Bank.
Deutsche Bank refused to return the collateral (or make the required calculation) and claimed that Good Hill had failed to act in good faith and a commercially reasonable manner by virtue of negotiating a valuation of the underlying investment grade notes that did not reflect the true market value (alleged by Deutsche Bank), which directly resulted in Deutsche Bank’s CDS payout being reduced by approximately $20 million.
The Court’s Analysis and Takeaways
With respect to the commercial reasonableness defense, the court looked to the swap documentation and (somewhat unsurprisingly) found that neither the ISDA master agreement nor the credit support annex imposed any explicit commercial reasonableness standard on Good Hill with respect to the note repurchase transaction. Moreover, the court pointed to the provision in the incorporated ISDA credit definitions whereby each party to a CDS contract agrees that each other party and its respective affiliates may deal in the reference obligation or other securities of the reference entity as each of them would if the CDS did not exist, regardless of whether any such action might have an adverse effect on the position of their counterparty to the CDS or whether any such action might constitute or give rise to a credit event with respect to the reference obligation. Accordingly, the court found that with respect to the note repurchase, the swap documentation did not require Good Hill to negotiate a purchase price or the allocation of that purchase price based on a market value standard or any other standard that might be viewed as commercially reasonable.
With respect to the good faith defense, the court cited numerous cases for the long-held proposition that the implied duty of good faith does not impose additional contractual obligations on a party or override a contract’s terms. Instead, the implied obligation acts in aid and furtherance of other terms of the parties’ agreement. The court noted that in fact no obligation can be implied which would be inconsistent with other terms of the parties’ contractual relationship and, in order for a claim to be recognized for a breach of an implicit good faith obligation, a party must show that its counterparty exercised its contractual rights malevolently and in bad faith. In Good Hill, the court found that such a showing did not exist where the purchase price negotiation and allocation in the note repurchase were effected at arm’s length between Good Hill and Bank of America, and that both parties to the note repurchase acted in their own self-interest and conducted their own internal analysis for the transaction.
In this respect, Good Hill provides important guidance to market participants insofar as the court showed that the parties to CDS could rely on the terms of their CDS contracts absent a showing that a party was acting malevolently and in bad faith. To that end, the court suggested that showing a party was seeking to maximize its return across its investments to the other party’s detriment would not be a sufficient basis for proving bad faith absent some other showing, such as that the party was not dealing at arm’s length. Ultimately, however, the extent to which market participants can rely on Good Hill remains unseen as Deutsche Bank has filed an appeal as of earlier this month.