On March 13, 2017, Justice Marcy Friedman of the New York Commercial Division denied a motion for summary judgment seeking to dismiss claims of fraud, breach of the covenant of good faith and fair dealing, and fraudulent conveyance brought against a hedge fund, Highland Capital Management, and related entities. The case, UBS Securities LLC v. Highland Capital Management, No. 6500097/09, 2017 BL 98450 (Sup. Ct. Mar. 13, 2017), is a long running dispute arising from a failed securitization of collateralized loan obligations (CLOs) and credit default swaps (CDS) that dates to the early days of the Great Recession. The denial of summary judgment means that the next step in this eight-year long saga will be a jury trial where $686 million in damages will be at stake.
In 2007, Highland Capital, along with entities allegedly controlled by Highland Capital (the “Fund Counterparties”), entered into an agreement with UBS Securities to establish a Warehouse Facility that would hold CLOs and CDS until these investments were securitized. The securitization never closed and UBS claimed that the underlying assets lost in excess of $86 million in value. In 2008, UBS and Highland Capital restructured the transaction and entered into a series of agreements, known as the “Warehouse Agreements.” The Agreements provided that UBS would act as arranger and placement agent for the CDO transaction, and Highland Capital would act as servicer. The parties committed to create a special purpose vehicle to issue approximately $818 million in securities. Under the terms of the Agreements, the Fund Counterparties agreed to bear 100% of the risk arising from any CDO losses.
Under the Agreements, the Fund Counterparties were also required to transfer $10 million to UBS if the Warehouse Facility had loss exposures of greater than $100 million. In September to November 2008, at the height of the financial crisis, UBS made a series of margin calls. The Fund Counterparties satisfied the first two margin calls but were unable to post the collateral needed to satisfy the third margin call. UBS terminated the parties’ Agreements in December 2008 and auctioned off the warehoused assets. UBS determined that Highland Capital and the Fund Counterparties owed UBS over $686 million in losses on the investments.
UBS’s litigation position was: (1) the Warehouse Agreements required Highland Capital to ensure that the Fund Counterparties would be able to cover any CDO losses; and (2) Highland Capital had dissipated assets and restructured the holdings in the Fund Counterparties to avoid paying UBS. UBS filed two separate actions—the first filed in 2009, alleged various causes of action, including fraud and breach of contract against the Fund Counterparties, and fraudulent conveyance against the Fund Counterparties and Highland Capital and related entities. UBS brought a second action in 2010 against Highland Capital, alleging fraud, breach of covenant of good faith and fair dealing, fraudulent conveyance, and tortious interference with contractual relations. In the course of litigation, the First Department limited the scope of UBS’s claims to conduct occurring after February 2009, and the two cases were consolidated.
In the summary judgment motions before Justice Friedman, the Fund Counterparties and Highland Capital raised several arguments for dismissal.
First, the Fund Counterparties argued that UBS had suffered no damages from the failed securitization. According to the Fund Counterparties, UBS’s damages could only be calculated based on realized losses, not unrealized losses, or if the underlying security was a defaulted security or had been written down in value. Applying black-letter contract principles, Justice Friedman determined that the Warehouse Agreements did not by their plain terms limit damages to realized losses. Noting the “sharply conflicting expert reports” regarding how to calculate UBS’s damages, Justice Friedman determined that the Warehouse Agreement was ambiguous on the question of whether UBS could recover unrealized losses.
Second, the Fund Counterparties argued that UBS committed prior material breaches of the Warehouse Agreements that precluded UBS’s claims. According to the Fund Counterparties, UBS improperly calculated the exposure relating to swaps in the wake of the Lehman Brothers collapse and prematurely issued a margin call. Justice Friedman assumed, without deciding, that the Fund Counterparties could invoke the doctrine of prior material breach notwithstanding the fact that the Fund Counterparties did not repudiate the contracts. Nevertheless, Justice Friedman denied summary judgment because the Fund Counterparties had “fail[ed] to make a prima facie [case] showing that UBS’s conduct was impermissible under the Warehouse Agreements.” Justice Friedman noted that the parties cast one another in the role of “primary contract offender” and the issue of whether UBS had committed a prior material breach was for the finder of fact to decide.
Third, the Fund Counterparties argued that UBS had unreasonably relied on representations made in the course of negotiating the Warehouse Agreements. The Fund Counterparties argued that UBS knew, at the time it entered into the restructured transaction with Highland Capital and the Fund Counterparties, that the Fund Counterparties’ credit rating was D3—the lowest rating before a default. The Fund Counterparties argued that because UBS knew they were not financially stable, UBS should not have relied on representations regarding their creditworthiness and ability to cover CDO losses. Justice Friedman ultimately denied summary judgment on this basis as well. Justice Friedman concluded that evidence that Highland Capital represented to UBS that it could move assets to make them available to UBS created an issue of fact as to the reasonableness of UBS’s reliance and the question of reasonable reliance was not properly subject to disposition on a summary judgment motion.
Finally, the Fund Counterparties argued that New York law does not recognize a cause of action for fraudulent conveyance against an alleged transferor. Justice Friedman rejected this argument, reasoning that UBS alleged that assets were transferred from Highland Capital and the Fund Counterparties to other entities.
Highland Capital and related entities also sought dismissal of UBS’s fraudulent conveyance and fraud claims against them. The gist of UBS’s claims was that Highland Capital knowingly dissipated assets and thus, made it impossible for the Fund Counterparties to pay UBS what they owed. UBS alleged that Highland Capital entities incurred debt, granted security interests to affiliated entities, and paid debts to other debtors while they were on the brink of insolvency. Specifically, UBS claimed that Highland Capital directed one of its related entities, Highland Financial, to incur debt through note offerings and that Highland Financial should be liable as an alter ego of one of the Fund Counterparties, a UBS debtor.
Like the Fund Counterparties, in arguing for dismissal, Highland Capital and its related entities argued that UBS had suffered no damages, an argument that the Court similarly rejected.
Next, Highland Capital and related entities contended that the asset transfers among the Highland entities were insufficient to plead that Highland Financial was the alter ego of one of the Fund Counterparties and that because of an earlier failed suit against Highland Capital, UBS could not rely on pre-February 2009 conduct to support fraudulent transfer claims. Justice Friedman concluded that although the First Department had previously concluded that claims arising from pre-February 2009 conduct were barred by res judicata from UBS’s first suit, pre-February 2009 conduct could provide support for UBS’s theories of post-2009 fraudulent conveyances and support alter ego liability.
With respect to the fraudulent conveyance claims, Highland Capital argued that payment of outstanding notes was fair consideration under New York law, not a fraudulent transfer. Highland Capital also argued that although some of the creditors were insiders or Highland affiliates, the payments satisfied an outstanding debt. Applying New York Debtor and Creditor Law, Justice Friedman determined that based on ownership charts of Highland Capital and its related entities, overlapping holdings and interests in the corporate structure defeated the argument that debt was repaid to non-insiders. Justice Friedman concluded that the record did not lend itself to determining on summary judgment whether the creditors were “good faith” transferees. Justice Friedman also held that even if the transfers satisfied a preexisting secured debt, a court nevertheless must evaluate whether the transfer was for fair consideration and for “legitimate business reasons.”
Justice Friedman did dismiss UBS’s claim breach of the covenant of good faith and fair dealing against Highland Capital. According to UBS, Highland Capital breached this obligation by allegedly orchestrating transfers to hide assets from UBS. Justice Friedman concluded that the facts alleged occurred after the termination of the contracts by UBS, and that a claim for a breach of this covenant accrues only while the parties are still in contractual privity.
If it goes forward, the trial in this case may have broader implications in the areas of fraudulent conveyance law and good faith transfers among affiliated entities. The trial will also address the extent to which a sophisticated party can rely on representations regarding the creditworthiness of an entity and may affect how entities with various corporates affiliates structure transactions. We will continue to monitor developments in this case.