On January 24, 2017, the New York State Supreme Court, Appellate Division, First Department, issued an opinion in a widely-watched case involving the interpretation of credit default swap contracts, Good Hill Master Fund, L.P. v. Deutsche Bank AG. The court upheld the trial court's findings and decision in several respects: the hedge fund's efforts to improve its position under a credit default swap contract, while aggressive, were made in good faith and in a commercially reasonable manner; expert testimony could be excluded on the issue of contract interpretation; and the prejudgment interest rate at 21% was awarded properly to the hedge fund who prevailed in the breach of contract suit.
The decision may be a triumph of the "plain meaning" interpretation of credit default swap contracts, but it also highlights some of the inherent risks in derivatives transactions. In particular, when one party to a derivatives transaction has the ability to influence an external event having a direct impact on the transaction, that party is permitted to act in its self-interest and improve its position under the derivative transaction. In addition, because ISDA Master Agreements typically require no proof of the cost of funds from the payee in the default interest rate calculation and provide for daily compounding of default interest, a party to a derivatives transaction should carefully evaluate the risk of not making a payment that may be determined, much later, to be due.
As it stands, this decision would likely have a significant impact on the credit default swap market and derivatives markets in general. While Deutsche Bank AG (Deutsche Bank) may seek an appeal, this note offers a brief summary of the facts, the decisions, and a few lessons learned so far.
FACTS OF THE CASE
In 2007 Good Hill Master Fund, LP. and its sister fund (Good Hill) purchased approximately $54 million principal amount of notes backed by residential mortgage-backed securities, designated as B6 through B12 tranches of notes (of which only the B6 notes were investment grade). The issuer1, Bank of America Securities, LLC (Bank of America), retained all the other tranches of notes and is not a party to the litigation.
In early 2008 Good Hill and Deutsche Bank entered into credit default swap agreements that referenced the B6 notes. Under those agreements, Good Hill was the protection seller, and would be obligated to make a protection payment to Deutsche Bank, upon the occurrence of, among other things, a writedown or forgiveness of the principal, in an amount equal to such writedown or forgiveness. Good Hill posted collateral to Deutsche Bank to secure its obligation to make that payment should any of the specified events occur.
By April 2009 the B6-12 notes were downgraded to well below investment grade. Bank of America decided to unwind the securitization and offered to buy back Good Hill's B6-12 notes. Good Hill engaged in negotiations with Bank of America to set the buyback price and asked Bank of America to treat the repurchase as a redemption (which would not have triggered a payment under the credit default swap). Bank of America refused to treat it as a redemption but agreed to purchase the notes at a price of $.29 on the dollar for the entire "stack" of B6-12 notes. Good Hill then sought Bank of America's agreement to allocate the aggregate purchase price so that the B6 notes, which were referenced in the credit default swap with Deutsche Bank, would be paid at 100% of par (which, again, would have resulted in no payment to Deutsche Bank under the credit default swap), whereas the remaining tranches little to nothing. Bank of America eventually agreed to allocate the purchase price so that the B6 notes were deemed to be paid at $.83 on the dollar, resulting in a writedown of $.17 on the dollar.
Deutsche Bank demanded that Good Hill make protection payments, but refused to accept the servicer report which showed that the B6 notes had been written down by 17%. Deutsche Bank claimed that the principal paid on the notes was "allocated in a manner that appears to be potentially arbitrary and inconsistent with our understanding of the market valuation of the certificates prior to such allocation," and that the allocation was "contrary to the market valuation" of B6-12 notes. Deutsche Bank refused to return $22 million in excess collateral that Good Hill had posted. Good Hill sued, alleging breach of contract based on the failure to return collateral.
ISSUES DECIDED BY TRIAL COURT AND UPHELD BY APPELLATE DIVISION
The trial court found that Good Hill's actions in connection with the buyback of the B6-12 notes and allocation of purchase price, while aggressive, were in good faith and in a commercially reasonable manner. Indeed the court found that Section 9.1 (b)(iii) of the ISDA 2003 Credit Derivatives Definitions2 expressly permitted Good Hill to act as it did - "that is, 'to trade in the [B6 notes] without regard to the existence of the swap or any adverse effect it might have on Deutsche Bank's position in the swap."'
Deutsche Bank sought to introduce expert testimony from Kimberly Summe, former general counsel at ISDA, who Deutsche Bank represented would testify that Section 9.1 (b)(iii) of the ISDA 2003 Credit Derivatives Definitions allowed the parties to transact in the B6 notes, but does not alter the obligation to act in good faith and in a commercially reasonable manner. The trial court excluded such testimony because "contract interpretation 'is a task reserved to the court and is well within the ken of judges."'
The trial court also awarded Good Hill prejudgment interest at 21 % under Sections 9(h)(i)(I) and 14 of the ISDA 2002 Master Agreement, which provide for a default interest rate at cost of funds, as certified by the "relevant payee," plus 1% per annum. This result did not change even though the relevant payee was a special purpose vehicle formed by Good Hill solely for purposes of segregating funds and costs that investors incurred at the time of Deutsche Bank's breach. Nor did the trial court find persuasive Deutsche Bank's argument that Good Hill could have obtained a more favorable rate. 3
A FEW LESSONS LEARNED
First and foremost, and perhaps not surprisingly, mere adverse effect on the position of a party to a credit default swap is not sufficient to preclude aggressive actions by the other party to the swap. Indeed the Good Hill decision instructs us that Section 9.1 (b)(iii) of the ISDA 2003 Credit Derivatives Definitions means what it says - each party may act with respect to its business in the same manner as if the swap did not exist. A party's actions may be aggressive in seeking to improve its position but still comport with its obligations under the swap.
Implicit in the decision, however, is the court's recognition that Section 9.1 (b)(iii) does not trump a party's duty to act in good faith and in a commercially reasonable manner. Instead, the trial court found that Good Hill engaged in arms' length negotiations with a third party, Bank of America, who could, and did initially, reject Good Hill's proposals. As such Good Hill's negotiations were conducted in good faith and in a commercially reasonable manner.
The trial court jealously guards its purview of contract interpretation. Expert testimony on whether a contract should be interpreted to include a "good faith and commercial reasonableness" standard may properly be precluded. So a proffer should at least be based on what actions satisfy or fail the "good faith and commercial reasonableness" standard.
For those who think "possession is nine tenths of the law" when it comes to a disputed payment, think again. The court interpreted the default interest rate provision under the ISDA Master Agreement quite literally, and upheld a punitively high cost of funds rate without any proof of actual cost. The default interest also compounded pursuant to the ISDA Master Agreement, making the result even more dramatic. In this case, Deutsche Bank withheld a $22 million collateral return, but would end up paying $94 million (including $3.75 million in attorneys' fees and litigation expenses) in damages.
The magnitude of the default interest presents a substantial risk to parties who wish to dispute a payment and resort to lengthy litigation. If parties to ISDA Master Agreements want to mitigate this risk, they may consider modifying the standard terms of their agreements. Derivatives dealers, banks or other financial institution with a stable funding source may consider this risk asymmetrical when they face counterparties who do not have stable funding sources and whose cost of funds could rise exponentially in market distress.
It also remains to be seen whether the default rate aspect of the finding would have an effect on the litigation currently in progress in the liquidation of assets of Lehman Brothers International (Europe) in the United Kingdom. The issues being litigated there include the appropriate default interest rate under ISDA Master Agreements. If the UK court adopts a different reading of the same default interest rate provision, it may further influence parties' forum selection and governing law provisions when they enter into derivatives transactions.
The Appellate Division's decision in Good Hill, if remaining good law, will have a significant impact on the derivatives market. On the most basic level, it reinforces the market's notion that derivatives contracts should be interpreted strictly, and literally, within the four-corners of the documents. Nonetheless, the outcome of the case serves as a reminder that a certain degree of risk is inherent in a swap transaction, particularly when one party has the ability to alter the result of an event external to, but having a substantial and direct impact on, the swap but the other party does not. It also reminds market participants that the default interest rate provisions in the ISDA Master Agreements can have a real economic impact, and must be taken into account in any dispute resolution. As always in the derivatives market, buyer, as well as seller, beware.