Court Cases Regarding Derivatives

Italian Court Orders Disclosure of Swap Settlement


In a ruling published on September 26th, an Italian court ordered the disclosure of the terms of a settlement between the city of Cassino and J.P. Morgan Chase & Co. (“JPM”), notwithstanding a confidentiality provision in the settlement agreement between the parties. According to reports, the city had entered into an interest rate swap in 2003 with a Bear Stearns entity (which JPM purchased in 2008) under which the city paid a LIBOR-based floating rate and received a fixed rate in connection with some €22 million of debt. As interest rates increased, the city found itself owing a large termination payment to JPM.

It is not clear whether governmental officials fully understood the implications of the transaction at the time of its execution. Indeed, the sophistication of— and risk disclosure and representations made by dealers to—government decision-makers in connection with swaps has been a global concern in the wake of the financial crisis and has led to calls for additional protection of public entities.[1] (In Italy alone, according to Bank of Italy data, some 300 municipalities reportedly had negative marks-to-market on swaps totaling close to €1 billion as of March 2011.) As a result, legislators have engaged in efforts to reform the governmental swap market both in the United States and in Europe, including through the implementation of financial reforms such as the Dodd-Frank Act.[2]

[1] As we have previously reported (see DMIR March 2010 and DMIR May 2009), in March 2011, four banks, eleven bankers and two former city officials were charged with fraud in connection with derivatives transactions entered into by the city of Milan, Italy.

[2] For example, in March 2010, the Italian Senate Finance Committee unanimously approved a proposal that would restrict the use of derivatives by municipalities (see DMIR March 2010). For additional information on the protections afforded to governmental entities and other “special entities” entering into swaps under the Dodd-Frank Act, please see DMIR July 2010 and Orrick Alert: Derivatives Regulation Reform and Provisions Affecting Governmental Entities in the Dodd-Frank Act.

UK Supreme Court Upholds “Flip” Clauses


Structured finance transaction documents have typically included subordination provisions in their post-default waterfalls, effectively changing a swap counterparty’s right to get paid from above that of the noteholders to below that of the noteholders. In January 2010, in a case relating to the “Dante” credit-linked note program, a New York bankruptcy court voided certain document provisions providing for the subordination of Lehman Brothers Special Financing Inc.’s rights as swap counterparty to an early termination payment when the swap counterparty or one of its close affiliates went into bankruptcy. In effect, the bankruptcy court held that such clauses altering the priority of payment constitute unenforceable ipso facto clauses under the U.S. Bankruptcy Code (the “Bankruptcy Code”). After an appeal was filed, the parties settled the matter later that year, leaving market participants with substantial uncertainty in connection with similar clauses.[1]

The same issues have arisen in the United Kingdom, but with a different outcome. In Belmont Park Investments Pty Limited & ors v. BNY Corporate Trustee Services Limited and Lehman Special Financing Inc., the U.K. Supreme Court decided on July 27th that a “flip” clause in the relevant documentation did not violate the common-law principle of “anti-deprivation,” which (similar to the Bankruptcy Code’s ipso facto rule) invalidates contractual provisions having the effect of transferring the property of a debtor upon its insolvency, hence depriving the bankruptcy estate of that asset. In its decision, the court first reviewed the anti-deprivation principle’s development to describe its nature and limits. In doing so, the court noted that the absence of good faith, or an intention to obtain an advantage over creditors in the bankruptcy, was an essential element in the application of the principle. Indeed, the court pointed out that, historically, where the principle has been held not to apply, good faith and commercial sense of the transaction have been important factors. Applying this understanding to the transaction at issue, the court concluded that there was no evidence that the “flip” clauses were deliberately intended to evade insolvency law (as evidenced by the numerous other non-bankruptcy defaults that also would trigger a change in priority). The court further noted that Lehman itself had designed, arranged and marketed the Dante program, and that the flip clauses (more specifically, noteholder priority to collateral upon a Lehman bankruptcy) was a very material factor in the notes obtaining a triple-A rating, hence enabling Lehman to sell them to non-banks. In addition, the collateral was purchased with funds supplied by the noteholders, not Lehman. In bolstering its conclusion, the court also emphasized that “party autonomy” (i.e., the ability of sophisticated counterparties to agree to commercial terms at arms’ length) was at the heart of English commercial law, particularly where complex financial instruments are involved.

The inconsistency of the New York and U.K. decisions leaves market participants with a stark difference of opinion across jurisdictions and may raise the possibility of forum-shopping in connection with future structured finance transactions.

[1] For a detailed summary of this litigation, please see DMIR November 2010, DMIR October 2010 and DMIR January 2010.

Appellate Court Decides CSX Total Return Swap Case


On July 18th, the U.S. Court of Appeals for the Second Circuit (the “Second Circuit”) issued its long-awaited opinion in CSX Corporation v. The Children’s Investment Fund Management (UK) LLP, et. al.[1] The issue that made the case so closely-monitored by derivatives market participants was whether, and under what certain circumstances, a total return receiver (i.e., the “long” party) under a cash-settled total return equity swap should be deemed to be the “beneficial owner,” for purposes of Section 13(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”),[2] of the underlying shares its counterparty (i.e., the “short” party) purchases to hedge its position.

CSX Corp. (“CSX”) had attempted to enjoin two hedge funds (collectively, the “Funds”) from voting their shares in a proxy contest to elect certain candidates to its board of directors. CSX claimed that the Funds acted together as a “group” and should have been deemed to have beneficially owned, in the aggregate, more than 5% of CSX’s stock, both outright and as long parties to cash-settled total return equity swaps with various banks. As such, the Funds should have disclosed that they had formed a “group” that owned more than 5% of CSX’s shares, as required by the Exchange Act. The U.S. District Court for the Southern District of New York (the “District Court”) concluded that: (i) the Funds failed timely to disclose that they had formed a “group” (based on evidence that the Funds communicated regarding their efforts to exert control over CSX and taking “concerted action”); and (ii) one of the Funds failed timely to disclose that it was the beneficial owner of more than 5% of CSX’s shares (based on evidence that it had violated Rule 13d-3(b) under the Exchange Act by engaging in a “plan or scheme” to evade Section 13(d) disclosure requirements).[3] However, the District Court did not conclude definitively that the Funds, as long parties to the equity swaps, obtained beneficial ownership in the shares acquired by their counterparties as hedges. The District Court also refused to enjoin the Funds from voting their shares because they had disclosed their share ownership for a sufficient period of time prior to the vote.

The Second Circuit only considered the issues concerning a “group” violation of Section 13(d)(3) with respect to the CSX shares owned outright by the Funds, without regard to any beneficial ownership they might have acquired as long parties to the equity swaps. As to that issue, the Second Circuit remanded the case to the District Court to make findings as to whether the Funds specifically formed a “group” for the purpose of “acquiring, holding, voting or disposing” of CSX shares owned outright and, if so, the latest date by which such a group was formed. The Second Circuit found that “[o]nly if such a group’s outright ownership of CSX shares exceeded the 5 percent threshold prior to the filing of a section 13(d) disclosure can a group violation of section 13(d) be found.”

The Second Circuit also affirmed the District Court’s denial of the voting injunction sought by CSX. However, significantly for the derivatives market, the Second Circuit did not address the issues that “would require decision as to the circumstances under which parties to cash-settled total-return equity swap agreements must comply with the disclosure provisions of section 13(d),” noting that the panel was divided on numerous issues relating to the treatment of equity swaps.[4]

[1] 2011 WL 2750913 (2d Cir. July 18, 2011).

[2] Section 13(d) generally requires that a party acquiring, directly or indirectly, the beneficial ownership of more than 5% of certain classes of equity securities, within ten days of such acquisition, send to the issuer of the securities and to each exchange where the securities are traded, and file with the Securities and Exchange Commission (the “SEC”), a statement containing certain specified information and such additional information as the SEC may prescribe as necessary or appropriate in the public interest or for the protection of investors.

[3] See CSX Corp. v. The Children’s Inv. Fund Mgmt., 562 F. Supp. 2d 511 (S.D.N.Y. 2008).

[4] Nevertheless, in a concurring opinion, one member of the panel stated that:
any agreement or understanding between long and short swap parties regarding: (i) the purchase of shares by the short party as a hedge; (ii) the sale of such shares to the long party when the swaps are unwound (as in settled-in-kind equity swaps); or (iii) the voting of such shares purchased by the short party, would cause the shares purchased as a hedge and any shares owned by the long party to be aggregated and counted in determining the 5 percent trigger.

2011 WL 2750913, at *27 (Winter, J., concurring).

Lehman Reaches Settlement with Perpetual in Dante Case


On November 17th, Lehman Brothers Special Financing Inc. (“LBSF”) and its official unsecured creditors’ committee filed a joint motion to stay BNY Corporate Trustee Services Limited’s (“BNY”) appeal for 90 days in the “Dante” matter, pending final settlement of the dispute between LBSF and Perpetual Trustee Company Limited (“Perpetual”).

The reason for the motion was LBSF’s settlement in principal with noteholder Perpetual, an Australian trustee with noteholders of its own.  On September 20th, the United States District Court for the Southern District of New York granted to BNY leave to appeal the bankruptcy court’s January decision.  This decision had voided certain document provisions related to the Dante credit-linked note program providing for the subordination of LBSF’s rights as swap counterparty to an early termination payment when the swap counterparty or one of its close affiliates went into bankruptcy.‪  In effect, the bankruptcy court had held that these subordination provisions—which effectively flip LBSF’s right to get paid from above that of the noteholders to below that of the noteholders—constitute unenforceable ipso facto clauses under the U.S. Bankruptcy Code (the “Bankruptcy Code”) and that any action to enforce the subordination provisions would violate the automatic stay provisions of the Bankruptcy Code.  BNY holds the collateral subject to this dispute and had brought the appeal in its capacity as trustee.[1]

The motion for the stay was granted and, on November 24th, LBSF filed another motion seeking the court’s approval of a settlement with Perpetual.  If the final settlement between LBSF and Perpetual is approved by the court, it is expected that LBSF will then request that the BNY appeal be dismissed.  Such a dismissal will leave uncertainty as to the enforceability of similar flip clauses.

[1] For a detailed summary of the Dante matter, please see DMIR October 2010 and DMIR January 2010.

Court Grants Leave to Appeal in Lehman Dante Case


On September 20th, the United States District Court for the Southern District of New York granted BNY Corporate Trustee Services Limited (“BNY”) leave to appeal the bankruptcy court’s decision in the Lehman “Dante” matter.  In its January decision, the bankruptcy court had voided certain document provisions providing for the subordination of a swap counterparty’s rights to an early termination payment when the swap counterparty or one of its close affiliates went into bankruptcy.‪  BNY holds the collateral subject to this dispute. READ MORE

Decision on SEC’s First Insider Trading Case Involving Credit Default Swaps


On June 25th, a federal district court judge ruled against the Securities and Exchange Commission (SEC) in U.S. regulators’ first lawsuit alleging insider trading of credit default swaps (CDS).  On May 5, 2009, the SEC had charged a portfolio manager at hedge fund investment advisor Millennium Partners L.P. (Millennium) and a bond and CDS salesman at Deutsche Bank Securities Inc. (DBSI) with insider trading.  The SEC’s complaint alleged that the bond salesman became privy, through his employment at DBSI, to confidential information concerning the restructuring of an upcoming bond issuance by VNU N.V. (VNU), a Dutch media holding company, and passed that information on to a Millennium portfolio manager, who traded CDS based on that information.  DBSI was the lead underwriter for the bond issuance.

According to the complaint, based on confidential information from the bond salesman, the portfolio manager purchased CDS protection on VNU, then profited $1.2 million by closing out his positions after the public announcement was made regarding the issuance and the price of CDS on VNU surged.  In making its case, the SEC pointed to the fact that, while discussing the VNU restructuring, the two switched from their recorded work telephones to their mobile telephones, which demonstrated that they knew what they were doing was improper.  Neither DBSI nor Millennium were accused of any misconduct by the SEC.  For a more detailed description of the SEC’s claims, please click here.

The defendants first argued that the SEC lacked jurisdiction to bring the case because CDS are private contracts, not securities.  Following a civil bench trial, the judge disagreed.  The judge pointed out that the SEC has antifraud enforcement jurisdiction over “securities-based swap agreements,” which are agreements for which “a material term is based on the price, yield, value or volatility of any security or any group or index of securities, or any interest therein.”  Id.  The judge decided that the material terms of the CDS contracts at issue were, in fact, based on the price, yield, value, or volatility of VNU’s securities and, therefore, constituted securities-based swap agreements over which the SEC had antifraud enforcement jurisdiction.

However, the judge also ruled that information exchanged in the telephone calls between the two presented by the SEC as evidence did not adequately demonstrate that they had engaged in insider trading.  In fact, in his decision dismissing the case, the judge stated that there was no evidence to support either the SEC’s attempt to attribute “nefarious content” to the calls between them or that the bond salesman had any motive to provide inside information to the portfolio manager.

Third Circuit Decision on Repurchase Transaction


In a decision filed on July 7th, the United States Court of Appeals for the Third Circuit affirmed a district court decision upholding a bankruptcy court order granting summary judgment to American Home Mortgage Investment Corp. (American Home) in connection with a repurchase transaction entered into in 2007 under which American Home sold certain certificates to Bear Stearns International Ltd. (Bear Stearns) for $19,534,000 and agreed to re-purchase the certificates at a later date for $19,636,879.07.  In re American Home Mortgage Holdings, Inc., 2010 WL 2676383 (3d Cir. July 7, 2010). READ MORE

Lehman Court Limits ISDA Master Agreement Set-Off Rights


On May 5th, the United States Bankruptcy Court for the Southern District of New York issued a decision declaring that a party’s right to setoff in an International Swaps and Derivatives Association, Inc. (“ISDA”) Master Agreement is unenforceable in bankruptcy unless “strict mutuality” exists.

The dispute arose out of several ISDA Master Agreements (the “Agreements”) entered into between Lehman Brothers Holdings Inc. (“LBHI”) (sometimes as guarantor, sometimes as counterparty) and Swedbank AG (“Swedbank”).  Each of these agreements provided that bankruptcy was an event of default triggering an early termination and one of the Agreements contained a provision allowing Swedbank a right of setoff upon the occurrence of an event of default.  Shortly following the date of its bankruptcy, Swedbank placed an administrative freeze on a general deposit account LBHI had with Swedbank, blocking LBHI from withdrawing any amounts but still allowing funds to flow into the account.  As a result of post-petition deposits, the balance in the account increased.  LBHI filed a motion to prevent Swedbank from using the funds in the account to set off amounts allegedly owed by LBHI to Swedbank under the Agreements.

The main thrust of LBHI’s argument was that the funds deposited in the account after LBHI’s bankruptcy petition constituted post-petition deposits and, therefore, lacked the requisite mutuality to be set off against LBHI’s alleged pre-petition indebtedness.  Significantly, the court held that the United States Bankruptcy Code (the “Bankruptcy Code”) safe harbor provisions for derivatives, by their plain terms, “do not alter the axiomatic principle of bankruptcy law, codified in section 553, requiring mutuality in order to exercise a right of setoff.”  As a result, the court held that Swedbank violated the automatic stay of the Bankruptcy Code by freezing LBHI’s assets, purportedly to effect setoff, and ordered Swedbank to release LBHI’s funds deposited in the account post-petition.

For additional information on this decision, please see Client Alert.

Lehman Bankruptcy Court Issues Decision on Dante Case


On January 25, 2010, the United States Bankruptcy Court for the Southern District of New York issued a decision in the Lehman bankruptcy case holding that provisions that subordinate a swap counterparty’s rights to payment when the swap counterparty or one of its close affiliates goes into bankruptcy are unenforceable.  These types of provisions are used in many structured finance transactions, and thus this decision may have implications for the structured finance markets and the ratings of structured finance transactions. For more information on this case and its potential impact, read the related Orrick Client Alert.

Lehman Bankruptcy Court Addresses Withholding Scheduled Swap Payments to a Bankrupt Counterparty


On September 15, 2009, the United States Bankruptcy Court for the Southern District of New York (the “Court”) determined that Metavante Corporation (“Metavante”), a counterparty to an interest rate swap agreement with Lehman Brothers Special Financing (“LBSF”), a bankrupt Lehman entity, was no longer excused from performing under the swap (to the extent it had been at all) and no longer had the ability to terminate the swap. READ MORE