The First Department of the New York Appellate Division upheld a lower court determination that the seller of protection under a credit default swap ("CDS") did not act in bad faith when it took certain actions affecting the price of a security (the "Reference Obligation") that effectively reduced the settlement amount owed by the seller under the CDS. In his Opinion, Judge O. Peter Sherwood concluded that these actions were within the scope of standard ISDA language permitting parties to a CDS to engage in activity concerning a Reference Obligation without regard to the existence of the CDS or any adverse effect that such activity might have on the other party's position in the CDS.
Deutsche Bank A.G. ("Deutsche Bank") bought protection under a CDS from two funds managed by Good Hill where the Reference Obligation was a single tranche of a residential mortgage-backed security ("RMBS") securitization. Good Hill also owned six other tranches of the securitization, with the Reference Obligation being the most senior. The sponsor of the securitization owned all other securities issued in the securitization.
Following the 2008 credit crisis, the sponsor wanted to unwind the securitization and negotiated a price for all seven tranches owned by Good Hill. After reaching agreement on the price for the seven tranches, Good Hill tried to persuade the sponsor to use the sale proceeds to redeem the securities, which would not have triggered a credit event (or, thus, any payment obligation owed by Good Hill) under the CDS. When the sponsor refused, Good Hill engaged in negotiations with the sponsor in an effort to allocate the largest possible portion of the total purchase price toward the cancellation of the Reference Obligation in an effort to minimize the protection payment Good Hill would owe to Deutsche Bank under the CDS. The ultimate allocation of 83% was far greater than the 8.7% price used by Deutsche Bank to determine the market price of the CDS for collecting margin (and the 6.45% to 8.64%, at which the securitization sponsor marked the seven tranches owned by Good Hill). The agreed-on allocation of the purchase price then was used to establish the writedown reported by the servicer for the securitization. In turn, that report determined the amount owed by Good Hill under the CDS.
After the sponsor cancelled the securitization tranches, including the writedown of 17% of the principal of the Reference Obligation, Deutsche Bank refused to calculate the amount due under the CDS or to return the portion of the collateral it was holding in excess of the 17% writedown, and claimed that Good Hill had failed to act in good faith or in a commercially reasonable manner. Good Hill brought suit on the basis that Deutsche Bank was in breach of its obligation under the CDS to return the excess collateral.
The appeals court upheld the trial court's determination that (i) Deutsche Bank had breached the credit default swap agreements, (ii) "however aggressively, Good Hill acted in good faith and in a commercially reasonable manner," and (iii) Deutsche Bank failed to prove that Good Hill had breached "implied covenants of good faith and fair dealing." The court also awarded default interest to the seller, at a rate of 21% per annum, under standard provisions of the ISDA Master Agreement that do not require "proof or evidence of any actual cost" other than a certification by "the relevant payee," which was a special purpose vehicle formed, solely for administrative purposes, by Good Hill at the time of the breach of the agreement.
Commentary / Lary Stromfeld
The seemingly harsh result of this case is dictated by the trial court's conclusion that the protection seller acted in good faith in several respects, including its negotiation of the price of the Reference Obligation relative to the other tranches, and the issuance of the servicer's report based on that price. The result was made worse by the calculation of "default interest" at a rate of 21% per annum based on the cost of funds of a payee, which apparently was not a party to the transaction. Indeed, the court tacitly acknowledged that the cost of funds was high because the payee was a special purpose vehicle set up by the seller. This interpretation seems punitive, since a party to a swap transaction generally is permitted to assign its right to payment to any payee without the consent of the other party.
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