On 2 May 2019, the English Court of Appeal handed down its judgment in The State of the Netherlands v Deutsche Bank AG [2019] EWCA Civ 771. The case concerned the interpretation of an ISDA Credit Support Annex in a negative interest environment and raised a novel issue as to whethe parties must account for negative interest on cash collateral. The Court of Appeal reached the same view as the trial judge and dismissed the appeal, holding that the Credit Support Annex does not contemplate the payment of negative interest. Given the Credit Support Annex’s widespread use as a standard market document, the case is highly significant for the derivatives market as a whole. Linklaters LLP acted for Deutsche Bank in this case.

Facts

The State of the Netherlands, acting through the Dutch State Treasury Agency (“DSTA”), had entered into a series of derivatives transactions with Deutsche Bank AG (“DB”) under an ISDA Master Agreement and Credit Support Annex (“CSA”), both governed by English law. Under the CSA, DB was required to provide cash collateral to cover any credit risk to which DSTA was exposed and, as the transactions were heavily in the money for DSTA, it was holding a substantial amount of cash collateral. The CSA required DSTA to pay interest on such collateral at the rate of EONIA less four basis points. Since 2014 the rate had been negative and the question that arose was whether “negative interest” could accrue, in favour of DSTA, on the cash collateral held by it such that it affected the level of Delivery Amounts and Return Amounts to be paid under the CSA.

CSA Terms

The case concerns the construction of the CSA, and in particular the following terms (a full list of the key terms can be found at page three of the judgment):

  • The CSA entered in to between DB and DSTA was modified in that it contained an asymmetric obligation for DB to post collateral to DSTA but did not require DSTA to do the same. Accordingly, the CSA provided that all references to the “Transferor” were to DB and all references to the “Transferee” were to DSTA.
  • The CSA contained the usual provision that the aggregate amount of collateral held by DSTA (the “Credit Support Balance”) was to equal its net exposure to DB, less a certain threshold (the “Credit Support Amount”). To achieve this, it required that regular equalisation payments be made from DB to DSTA (“Delivery Amounts”) or DSTA to DB (“Return Amounts”).
  • Paragraph 5(c)(ii) of the CSA provided as follows: “Unless otherwise specified in Paragraph 11(f)(iii), the Transferee will transfer to the Transferor at the times specified in Paragraph 11(f)(ii) the relevant Interest Amount to the extent that a Delivery Amount would not be created or increased by the transfer.”
  • Interest Amount” was defined as follows: “with respect to an Interest Period, the aggregate sum of the…amounts of interest… calculated for each day in that Interest Period on the principal amount of the portion of the Credit Support Balance comprised of cash… determined by the Valuation Agent for each such day as follows: (x) the amount of cash…; multiplied by (y) the relevant Interest Rate in effect for that day; divided by (z) 360 (or in the case of pounds sterling, 365).”
  • The “Credit Support Balance” was defined as follows: “with respect to the Transferor on a Valuation Date, the aggregate of all Eligible Credit Support that has been transferred to or received by the Transferee under this Annex, together with any Distributions and all proceeds of any such eligible Credit Support or Distribution, as reduced pursuant to Paragraph 2(b), 3(c)(ii) or 6. Any Equivalent Distributions or Interest Amounts (or portion of either) not transferred pursuant to Paragraph 5(c)(i) or (ii) will form part of the Credit Support Balance.”

The parties’ submissions

DSTA contended that interest was to be accounted for principally through the daily calculations of the Credit Support Balance and the payment of Delivery Amounts and Return Amounts.

DSTA relied on the last sentence of the definition of “Credit Support Balance” which states that:

Any Equivalent Distributions or Interest Amounts (or portion of either) not transferred pursuant to Paragraph 5(c)(i) or (ii) will form part of the Credit Support Balance.” (emphasis added)

This, it argued, required any negative Interest Amounts to be added to the Credit Support Balance, resulting in a deduction from the collateral comprised within it. This would create a gap between the Credit Support Balance and the Credit Support Amount, triggering a “top-up” requirement for DB to pay a Delivery Amount. Accordingly, DSTA would indirectly receive the benefit of the negative interest even though DB did not have a direct obligation to “transfer” such amounts to it under paragraph 5(c)(ii).

DB’s position was that the sole operative provision relating to interest was paragraph 5(c) (ii) of the CSA. Paragraph 5(c)(ii) directly spoke to the payment of interest at the times specified and elected by the parties in paragraph 11 (ie monthly or at the time of payment of a Return Amount). It was common ground that 5(c)(ii) imposed no obligation on DB (as Transferor) to pay negative interest. Had the parties intended for negative interest to be accounted for by way of a different mechanism, the logical place to include such wording would be paragraph 5(c)(ii). Accordingly, the definition of “Interest Amount” was to be read in light of paragraph 5(c)(ii). DB contended that the purpose of the words “not transferred pursuant to 5(c)(ii)” was to ensure that the sentence was only referring to Interest Amounts that fell within, or were transferable pursuant to, paragraph 5(c)(ii). In support of its construction, DB also referenced the fact the 2014 ISDA Collateral Agreement Negative Interest Protocol (which albeit did not automatically apply to the parties’ bespoke contract) envisaged considerable amendment to paragraph 5(c)(ii) if adopting parties wished to address negative interest.

Judgment

The Chancellor of the High Court, Sir Geoffrey Vos, delivered the judgment on behalf of the Court of Appeal.

Although the Court noted that both contrasting interpretations could, in theory, be available meanings of the words used in the contract, it dismissed DSTA’s appeal, stating that it did not think that, on its true interpretation, the CSA could be taken as providing for the payment of negative as opposed to positive interest.

It cited five primary reasons for this conclusion. Firstly, the Court was influenced by the 1999 User’s Guide and background materials published by ISDA, which in the Court’s view did not show that ISDA, at the time, thought negative interest was intended to be payable. It also noted that in subsequent publications, once negative rates had “become a reality”, “ISDA had drafted a wholesale revision to the CSA for market participants to agree if they chose to do so”.

Secondly, the Court agreed with the thrust of DB’s case that paragraph 5(c)(ii) was the correct and “most obvious place to find a reference to negative interest if it were intended”. The fact that such mention was absent from paragraph 5(c)(ii) was, in the Court’s view, “a powerful indicator that it was not contemplated as payable”.

Thirdly, the Court was of the view that some of the anomalies identified by DB, such as in respect of minimum transfer amounts and rounding, would create an “inexplicable disparity” when comparing the treatment of positive and negative interest.

Fourthly, it believed that paragraph 11(f)(iv) (a “freestanding provision”), which in this particular CSA stipulated that transfers by DB to an incorrect account would be penalised by the reduction of interest to zero, would have been amended if negative interest was contemplated by the parties, as in the absence of such amendment any disincentive would be negated.

Finally, the Court provided the overarching reason that when construing the CSA as a whole, it did not see anything that suggested negative interest would have been intended or contemplated. It accepted that the commercial background could be argued both ways, but “the structure of the CSA focuses on Valuation Dates and Delivery and Return Amounts intended to sustain the State’s collateral at an agreed level”.

With respect to the construction and interpretation of the contract, the Court found the case to be in the territory of Wood v Capita Insurance Services Limited [2017] 2 WLR 1095 citing that “where there are rival meanings, the court can give weight to the implications of rival constructions by reaching a view as to which construction is more consistent with business common sense”.

Please click here for a copy of the judgment and here for the corresponding first instance judgment.