[Updated 1/6/2017: The day after this post, the parties stipulated to an adjournment of the trial until April 2017, which Justice Bransten granted. We will continue to follow the case and report on any developments.]
In a case with potentially broad implications for participants in the leveraged loan and derivatives markets, Justice Eileen Bransten will conduct a bench trial starting next week in the long-running dispute between a prominent Greenwich-based hedge fund, BDC Finance L.L.C. (“BDC”) and Barclays Bank PLC. The case, BDC Finance LLC v. Barclays Bank PLC, Index No. 650375/2008, involves a derivatives transaction that—like more than 90% of derivative transactions around the world—is governed by the industry standard forms promulgated by the International Swaps and Derivatives Association (“ISDA”). Following years of litigation and a trip to the New York Court of Appeals, the trial will focus, in large measure, on a relatively narrow question of contractual interpretation: are parties to an ISDA agreement held to its literal terms?
The case stems from Barclays’ response to a collateral call from BDC in the midst of the 2007-2008 financial crisis. In 2005, BDC and Barclays entered into a total return swap transaction using industry-standard ISDA’s forms supplemented by an annex with specifically negotiated terms and conditions. A total return swap generally mimics the economic effect of owning a particular asset in exchange for a financing payment. Under the parties’ agreement, BDC was required to make payments based on a financing rate and to post cash collateral. In exchange for that, Barclays was required to make payments to BDC based on the return of the underlying asset. Here, a portfolio of corporate loans and high yield bonds comprised the swap transaction. As market conditions and asset values fluctuated, the amount of the cash collateral required by the agreement would change.
What is highly unusual about this case is that both BDC and Barclays had the right to call collateral from the other as the value of the swap moved up and down. In most cases, only the bank has this right. This was a bespoke term negotiated by the parties.
On October 6, 2008, BDC determined that Barclays was over-collateralized by approximately $40 million and sent the bank a collateral call in that amount. Under the agreement, a party had the choice to wire the full amount requested by the next business day or start the contractual dispute resolution process. That process meant that the parties would undertake a re-valuation process, but only if the amount that was undisputedly owed — called the “undisputed amount” — was paid by the day after the collateral call. If this undisputed amount wasn’t paid on time, the full amount of the collateral call would become due.
Upon receiving BDC’s $40 million collateral call, Barclays stated that it did not agree with it. The next day, on October 7, 2008, the parties agreed that the undisputed amount—the amount both parties agreed was due—was $5.08 million. Although that amount was required to be wired to BDC by close of business that day, Barclays did not do so until the following day, October 8, and sent only $5 million. Barclays claims that the $80,000 shortfall was an offset for one of its own collateral calls against BDC.
On October 8, 2008, BDC sent Barclays a “Notice of Failure to Transfer Return Amount,” stating that Barclays had failed to either pay the $40 million or notify BDC that Barclays disputed BDC’s calculation and pay the undisputed amount. BDC warned Barclays that it would consider this failure an “event of default” under the parties’ agreement if Barclays did not cure the problem within two business days.
On October 14, 2008, having received no additional payments from Barclays, BDC sent Barclays a notice of termination and declared that Barclays had defaulted on the parties' agreement because it had not paid $40 million.
On October 17, 2008, BDC commenced its lawsuit against Barclays seeking the return of its cash collateral. In turn, Barclays counterclaimed based on BDC’s failure to comply with collateral calls the bank had made against BDC. Both BDC and Barclays moved for summary judgment. The Commercial Division denied BDC’s motion, and granted Barclays’ motion, in part, dismissing a portion of BDC’s claim.
The Appellate Division, with two justices dissenting in part, overturned the Commercial Division’s decision. The court granted BDC’s motion for summary judgment and denied Barclays’ motion, finding “as a matter of law” that Barclays did not properly dispute the October 6th collateral call because it did not notify BDC of the dispute or timely and fully transfer the undisputed amount of $5.08 million. The court found that Barclays’ payment of $5 million was not timely. It found that Barclays lost any right it had to suspend the payment of the full $40 million because it had failed to pay the undisputed amount by the deadline. The court held that Barclays’ default entitled BDC to terminate the transaction and demand return of its more than $300 million in cash collateral.
The Court of Appeals reversed the Appellate Division, finding that questions of fact existed as to whether Barclays complied with the undisputed amount provision of the agreement, and “whether BDC received the full benefit of the amount it was owed when Barclays paid the $5 million and reduced the amount of its collateral call to BDC by the additional $80,000.” The Court also found that Barclays was not entitled to summary judgment because issues of fact exist as to whether Barclays had defaulted.
The trial in this case may have broader implications for market participants that use standard ISDA form agreements. Specifically, the trial will address two important issues under the industry-wide agreements: (1) whether the doctrine of substantial compliance applies to payment obligations; and (2) whether parties can apply offsets to collateral calls.
Trial is scheduled to begin on January 9, 2017.