Litigation between UBS, KWL, Depfa and LBBW - [2014] EWHC 3615 (Comm) (Part 2)

Our recent update "Fraudulent misrepresentation by a bank and the ISDA Master Agreement" dealt with the consequences of certain fraudulent misrepresentations impliedly made by UBS to Depfa in the litigation between them and the German water company Kommunale Wasserwerke Leipzig GmbH (KWL).

In this further article, we consider the decision of the Judge (Mr Justice Males), in relation to a further dispute between UBS and Depfa, as to the construction of a Single Tranche Collateralised Debt Obligation (STCDO). We also refer to the Judge's treatment of a difficult issue as to the practical consequences of rescission as a remedy.

Factual background 

The full background is set out in "Fraudulent misrepresentation by a bank and the ISDA Master Agreement". In summary, UBS and KWL had already entered into a STCDO transaction directly when, in late 2006, UBS approached Depfa to ask it to intermediate in a further, similar, transaction. 

UBS was unable to obtain internal approval to enter into this trade itself. The explanation given to Depfa for this was that UBS had no further credit lines available to KWL. Depfa agreed to intermediate between UBS and KWL, with the result that in March 2007, Depfa and KWL entered into two STCDO transactions with a total notional amount of approximately US$116 million (referred to at trial as the "front swaps"). Depfa and UBS also entered into so-called "back swaps" on the same terms. The effect was that the net payment flows under the STCDOs were to be between UBS and KWL, with Depfa taking a one-off fee of €1.3 million for its role.

The portfolio underlying the STCDO was hit badly by the financial crisis, leading to a complete loss for KWL of the notional amount at stake. While Depfa, UBS and LBBW (which had taken a similar role to Depfa) sought to recover the sums they alleged to be due from KWL contractually, KWL defended those claims and sought rescission of the various agreements into which it had entered, on the basis (among other arguments) of its directors' lack of authority, and of the bribery of one of them.

Status of the front swaps

For the reasons explained in our earlier article, the Judge determined that Depfa was entitled to rescind the back swaps on the grounds of UBS's fraudulent misrepresentation. He did not, however, find that KWL was entitled to rescind the front swaps with Depfa.

This left the possibility that Depfa would suddenly find itself in the windfall position of being entitled to recover the amount it was owed by KWL, without then needing to pass that money on to UBS. This was agreed not to be a scenario which was within the intention of the parties when they entered into the STCDOs. 

Depfa did not, therefore, claim to be entitled to retain the money. The Judge agreed, however, that "it is not obvious what the correct legal analysis in relation to the Front Swaps would be in this situation". It was submitted on behalf of KWL that, as the front swaps and back swaps were part of a single package, the mere fact that Depfa had rescinded the back swaps meant that KWL was entitled to rescind the front swaps. The Judge agreed with Depfa that there was no clear legal basis for such an argument.

He took the view that because rescission is an equitable remedy, "the court has a degree of flexibility in order to ensure that practical justice is achieved". The Judge went on to find that the effective way of doing this was to require Depfa, as a condition of its right to rescind the back swaps, to undertake not to enforce the front swaps against KWL.

This is not the only occasion in this judgment where the Judge demonstrated the court's willingness to use the flexibility of rescission as a remedy in order to ensure a practical solution. He referred repeatedly in the judgment to the need to ensure that rescission provided "practical justice".

Clause 6 of the back swaps

This resolution meant that the outcome of the litigation did not depend on a further dispute between UBS and Depfa as to the construction of the back swaps. That dispute was interesting however, and as it was fully argued, the Judge set out the findings he would have made had he needed to do so. 

The issue was as follows. Depfa terminated both the front swaps and the back swaps early, because of KWL's failure to pay the first amount which became due once entities within the reference portfolio began to default. The payments due on early termination of the back swaps were determined pursuant to clause 6 of the confirmations by which the back swaps were documented (the Confirmation).

Clause 6 provided that: "The occurrence of an early termination in respect of [the front swap] shall constitute an Additional Termination Event …; and (iv) for the purposes of Section 6(e) of the [ISDA Master] Agreement … (B) where an amount is paid to [Depfa] under the [front swap], an amount shall be payable by [Depfa] to UBS under this Transaction, equal to that amount." (emphasis added)

The confirmation between LBBW and UBS, which was materially identical to the Confirmation, contained the same wording.

The parties' competing constructions of clause 6 and principles of construction

Each of Depfa, LBBW and UBS offered different interpretations of what clause 6 meant.

  1. LBBW argued that it meant precisely what it said: that if Depfa/LBBW were actually paid by KWL, they were liable to UBS for that amount. If KWL did not in fact pay, then UBS was not entitled to anything.
  2. Depfa argued that if KWL was obliged to make payment to Depfa/LBBW, whether or not it actually did so, Depfa/LBBW were liable to UBS for that amount. In other words, Depfa submitted that the underlined word "paid" in clause 6 should in fact be read as "payable".
  3. UBS argued that Depfa and LBBW were obliged to pay whether or not KWL paid or had any liability to do so. It argued that the only purpose of the wording was to make sure that where amounts were payable under both the front swaps and the back swaps, such amounts were identical.

All parties accepted that the usual principles of construction applied, including (as turned out to be particularly relevant in the circumstances) that: (a) the disputed clause has to be viewed in the context of the contract as a whole; and (b) where a clause is capable of bearing more than one meaning, it is appropriate to have regard to commercial common sense in order to determine the correct one, even if that correct meaning is not the one most consistent with a literal reading of the agreement.

The Judge's conclusions on construction

The Judge first made two key findings of fact. One was that the purpose of Depfa's and LBBW's involvement in the STCDOs was to take the credit risk of KWL. The second was what "credit risk" actually meant in the circumstances. This is, in itself, an interesting point for future cases, although it is one that is likely to be fact-sensitive. In this case, the Judge held that credit risk meant only the risk that KWL would not pay (e.g. because of insolvency), not that it had no obligation to do so (e.g. because it had successfully avoided the STCDOs for bribery or lack of capacity). 

In order to determine the proper construction of clause 6, the Judge considered the payment obligations pre-termination as set out in the remainder of the Confirmation. He determined that, as they submitted, Depfa and LBBW were only under an obligation to pay UBS under the back swap as and when the same amount was due and payable from KWL, and that the Confirmation would be unworkable on any other interpretation.

UBS's essential argument against this conclusion, put on a number of bases, was that Depfa and LBBW had taken not only the credit risk of KWL, but the risk that the front swaps would be held to be unenforceable. The Judge rejected this argument. He held that as UBS had arranged and presented the transactions to Depfa and LBBW, it was more likely that UBS was responsible for any flaw in them. It was at any rate not self-evident (such that it would override the express wording of the Confirmations) that Depfa and LBBW were to take that responsibility. He was also not willing to find that the fact that Depfa and LBBW obtained capacity opinions in relation to KWL meant that they assumed a risk other than credit risk. The Judge took the practical view that a bank can sensibly take steps to reassure itself as to the validity of a transaction, without accepting the risk that it is invalid.

LBBW submitted that the regime on early termination was different, such that it only had to pay UBS when actually paid itself by KWL, not when the amount was due and payable by KWL. The Judge rejected this approach on the basis that it was at odds with the commercial purpose of the transaction and therefore was not the correct construction of the clause.

He accepted Depfa's construction instead, agreeing that the word "paid" should, in the circumstances, be read as "payable".

UBS's arguments on rectification and estoppel

UBS's alternative case was that even if the Confirmation could not be construed in the manner for which it contended, the Confirmation should be rectified so that Depfa and LBBW took both credit risk and validity risk in relation to KWL. Alternatively it argued that they should be estopped from arguing the contrary.

In order to give effect to this claim, UBS argued that the underlined word "paid" in clause 6 should be replaced by the words "can be calculated as being due to [Depfa] under the terms of" the front swap. It further argued that this wording would also have to replace any references in the Confirmation to sums being payable to or by Depfa prior to termination. 

Faced with this extensive rewrite of the Confirmation as it had been agreed by the parties, the Judge unsurprisingly declined to accept UBS's case in this respect. He also declined to accept UBS's interpretation of the exchanges between the parties as evidencing an agreement that Depfa would take the risk that the front swaps with KWL were invalid.


As with any case concerning construction of a contractual clause, this aspect of the judgment is fact-specific and arises out of an intermediation trade. While the judgment does not purport to expand the already familiar principles of contractual construction, it provides a useful illustration of the operation of those principles in practice.

First, in giving detailed consideration to the payment obligations pre-termination as well as post-termination, the judgment highlights the importance of considering the meaning of a disputed clause in its context.

Second, the judgment provides a good example of a case where the most literal meaning of the disputed clause does not give effect to commercial common sense, and is therefore rejected.

Third, it shows how careful banks have to be when drafting confirmations in intermediation trades to make sure they fully understand and agree on what risks are being assumed by all participating banks.

In addition, the judgment is a useful source of reference for any litigant or lawyer interested in the flexibility of rescission as a remedy, and the way in which it can be applied.