Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Litigation, June 2008
As widely reported, multibillion-dollar write-downs continue in the worldwide financial market. Given the significant tightening of credit markets, issues of creditworthiness, including the rights and obligations of parties, are increasingly important, particularly in relation to seeking credit assurances and termination of contracts.
Significant credit exposures arise under derivative contracts. Derivatives are used by a wide variety of market participants, including sovereigns, banks, corporations and other institutions, to manage their interest rate and currency risks, reduce funding costs, manage the cost of raw materials, hedge exposures to equity markets, increase asset yields and manage nearly every conceivable credit or other financial category of risk. Generally speaking, derivatives are contracts whose value is linked to the price of an underlying commodity, rate, index or the occurrence of magnitude of some event. The term "derivative" refers to the fact that these instruments are valued on the basis of movements and price derived from the underlying subject matter of the transaction often referred to as the category of risk.
The derivative market has grown exponentially in recent years from an estimated $5-billion in 1982 to approximately $45-trillion in trades outstanding today. Derivative products are traded in two formats: exchange traded on a particular exchange such as NYMEX, or over-the-counter (OTC) which are privately negotiated bilateral contracts. OTC contracts are typically similar in form and structure to exchange traded products, with a few important exceptions.
For example, trading in derivative products over a public exchange requires both sides to the transaction to have posted security in advance (as a condition of exchange trading), so that the risk of non-payment by counterparty default is minimal. However, under more flexible and largely unregulated OTC contracts, credit support provisions have evolved as a matter of negotiation and industry practice, and have long been reflected in standard OTC documentation developed by the International Swaps and Derivatives Association (ISDA) and other industry bodies.
Moreover, credit issues, including counterparty risk, are far more prevalent in OTC transactions which are typically negotiated, bilateral contracts as opposed to exchange traded instruments, where counterparty and other risks are less prevalent.
A form of derivative transaction, known as a credit default swap (CDS), has placed particular focus on counterparty credit. The documentation utilized to facilitate a CDS on asset-backed securities and collateralized debt obligations may soon be tested as part of the resolution of a handful of recent disputes. Generally, a CDS transaction is used to manage or create certain risks with respect to financial assets (known as "reference obligations") where one party agrees to make a payment to if a stated credit event occurs. They are analogous to insurance of counterparty risk related to the occurrence of default under the reference obligation. Under a typical CDS, Party A (the "protection buyer") pays periodic fixed amounts determined by reference to a specified amount of the reference obligation while Party B (known as the "protection seller") pays the protection buyer certain amounts as specified credit events occur with respect to the reference obligation or the obligor thereof (known as the "reference entity"). Unlike some other derivatives, a CDS transaction does not require either party to hold or deliver the underlying reference obligation.
Given the magnitude of the derivatives market and associated credit issues arising, particularly in the CDS context, disputes over derivative contracts may become more common. As evidence of that, and by way of recent example, is the action by VCG Special Opportunities Master Fund Ltd. (formerly CDO Plus Master Fund), a hedge fund which filed litigation in the U.S. District Court Southern District of New York in early March 2008, claiming approximately US$10-million against Wachovia Corp. (Wachovia) over its conduct in the closing out of a CDS.
The transaction at issue before the New York court involved the hedge fund having sold credit protection to Wachovia against the risk of a credit default arising under a collateralized debt obligation, up to a maximum of US$10-million. Under the transaction, the hedge fund, in turn, was to be paid a fee of 2.75% per annum for the swap, calculated on the notional amount of US$10-million which was secured by a deposit of US$750,000 to collateralize the CDS.
It is alleged that within weeks of the trade, Wachovia demanded unreasonably high amounts of additional collateral even though the hedge fund was purportedly not under an obligation to post any collateral after depositing the initial margin of US$750,000. The hedge fund alleges that under the accompanying confirmation letter, Wachovia was only entitled to demand payments upon the occurrence of an actual credit default, being a failure of the obligor to make a required principal payment, the occurrence of an interest shortfall or a write-down taking place under the reference obligation.
The hedge fund alleged that Wachovia made multiple demands for additional collateral over a period of five months in the amount of US$8,920,000 against a total credit risk of US$10-million from an investment-grade instrument. The hedge fund alleged that Wachovia breached the CDS by requesting additional collateral when not entitled to do so and wrongfully terminated the contract. Wachovia denied the allegations and claimed, inter alia, that the hedge fund failed to meet its obligations under the contract to post collateral and, as a result of the hedge fund's default, caused an early termination of the agreement. In addition, Wachovia filed a counterclaim claiming approximately US$10-million arising out of the early termination of the contract.
The same hedge fund also filed a similar lawsuit against Citibank N.A. (Citibank), under a separate CDS. Again, the hedge fund entered into a CDS with Citibank by which the hedge fund sold credit protection to Citibank against the risk of credit default by a collateralized debt obligation, up to a maximum of US$10-million. Under that contract the hedge fund, in turn, was to be paid a fee of 5.5% per annum for the swap, again calculated on the notional amount of US$10-million which was secured by a deposit of US$2-million to collateralize the CDS.
The hedge fund similarly claimed that Citibank made additional unwarranted demands for collateral over a five month period of US$9,960,277.78 as compared to the total alleged credit risk of US$10-million from what was an investment-grade instrument. The hedge fund similarly alleged that Citibank breached the contract by requesting additional collateral while not entitled to do so and in ultimately terminating the transaction. Citibank denied the allegations and put forth similar defence to that advanced by Wachovia and also counterclaimed against the hedge fund claiming that it had defaulted and caused an early termination of the contract for which Citibank has claimed damages.
In both matters, the causes of action asserted by the hedge fund against the banks include breach of contract and breach of an implied covenant of good faith. Both raise issues relating to industry practice. The extent and degree to which industry practice will influence a court's decision is an open issue. While industry practice is generally not admissible for interpretive purposes if it contradicts the express wording of the agreement or is tendered in support the parties' subjective intent, industry practice has and continues to be used by the courts to place an agreement in its proper commercial context and surrounding circumstances, including to determine the origins, aim and/or purpose of the transaction, to determine the reasonable expectations of the parties and in construing the meaning of technical terms or phrases. While certain contracts (including the ISDA Credit Support Annex), expressly or by implication, mandate the exercise of good faith in the exercise of the ability to call for collateral and/or terminate an agreement, judicial consideration of how those obligations will be extended in the context of derivative agreements has also been limited.
As these cases demonstrate, the relationship between termination rights and margin call or other credit-related provisions is a critical issue in the administration of derivative contracts. Blakes recently completed a lengthy $100-million trial involving existing and former global energy trading companies involving these and a plethora of other issues which will hopefully provide some judicial guidance on these topics.
For related issues arising in connection with MAC provisions, please see our April 2008 Blakes Bulletin on Litigation: Litigation of Material Adverse Change Clauses in Derivatives Contracts and our April 2008 Blakes Bulletin on Mergers & Acquisitions: Recent Developments in Market Practice and the Law Governing Material Adverse Change Clauses.
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