Has a Restructuring Event Occurred With Respect to the Hellenic Republic?, Decisions No. 2012022901 and No. 2012022901 (ISDA Credit Derivatives Determinations Committee for Europe, the Middle East and Africa, decided on March 1, 2012)

Summary

      Normally this blog only covers litigation in United States courts between counterparties to a derivatives contract. However, I wanted to step out for a second to cover litigation in a different venue – in front of the International Swaps and Derivatives Association (ISDA) Determinations Committee. That committee recently made a decision that may cause counterparties to regret giving the ISDA such authority. The committee decided on March 1, 2012 that there had been no default on Greek debt and thus holders of credit default swaps (CDS) on Greek debt would not receive payment.

      Before discussing the decision I wanted to describe how things worked previously. There was a very similar case filed in 2002, regarding Argentina’s debt exchange. That case, Eternity v. Morgan, was blogged here. There the parties had entered into CDS on Argentine debt, and they disagreed about whether Argentina’s 2001 debt exchange constituted a default (specifically a restructuring credit event) entitling the protection buyer to receive payment. Back then there were no ISDA Determinations Committees and so the parties had to resolve the question in New York Federal District Court. The court ruled that since the exchange was “voluntary” there was no default. Eternity appealed, and the Second Circuit Court of Appeals overturned the decision, stating that the bonds received in the exchange “undeniably provide a lower return over a longer maturity than the original bonds.” Although that alone does not reveal whether the exchange was voluntary, the Appeals Court reminded the District Court that there may have been economic coercion and raised a number of other questions. The Appeals Court sent the case back to the District Court for further deliberations. The case was settled in late 2006, before the District Court could issue a new opinion.

      As demonstrated above, one problem with letting the courts answer these questions is that courts disagree with each other. Different courts can have different answers, and there is no uniformity. Another problem is that the process took years, and if the derivatives market is going to grow things have to move much more quickly. Ideally, parties would know whether a default had occurred near instantaneously and such a determination would affect all CDS whose payoffs were conditioned on the default.

      In response to this wish for a quick and uniform answer, in 2009 the ISDA created the “Auction Hardwiring” a.k.a. the “Big Bang Protocol” framework. This new regime provided for a quick and automated settlement of derivatives contracts. Among other things, it created the Determinations Committees which would issue binding decisions on various questions, including whether a credit event had occurred. The committee would be made up of the ten largest dealers and five largest non-dealer users of derivatives. Auction Hardwiring would be incorporated into ISDA contracts created after 2009, and parties to previous contracts were allowed to incorporate it via amendment. Of course parties were free to ignore this change, and to write their own derivatives contracts subject to the prior regime. But the new regime was highly popular as virtually all members of the derivatives community signed up for it.

      Thus far, there were no notable decisions by the committee (although there were controversial decisions and numerous split votes). However, their decisions on March 1 raised a stir. For example, see this article “If Greece Isn’t a ‘Credit Event,’ What Is?” by Richard Quest and the article “Greece and Credit Default Swaps: Bucking the ISDA Cartel” by derivatives expert Janet Tavakoli.

      Moving on to the details of those decisions, decision no. 2012022401 decided whether Greece’s debt exchange with the European Central Bank (ECB) constituted a restructuring credit event. In preparation for the transactions that would give Greek bondholders less than they were owed (i.e. a “haircut”), Greece did a debt exchange with the ECB to shield the ECB from the haircut. The committee ruled that this effective subordination was not a credit event. In decision no. 2012022901 the committee said that the Greek debt exchange offer of February 24, 2012 was also not a credit event.

      The precise questions submitted to the committee are provided below, but I cannot provide the committee’s explanation for their decisions because no such explanation was released. The committee’s decisions are communicated as a vote tally (which in this case was 15-0 on both questions). When deciding whether a credit event had occurred in the Eternity v. Morgan case discussed above, the courts issued long and well articulated opinions. However here there is only yes or no answer which can potentially make the decision seem a bit capricious and, more importantly, does not provide guidance to parties who want to predict how the committee will rule in the future.

      As additional events occur the committee could issue a ruling declaring a default. Some expect this to happen when Greece uses the Collective Action Clause (CAC) to force holdout bondholders to accept the exchange. A CAC states that as long as some majority (e.g. 70%) of creditors agrees to modify the debt agreement, such modification will be forced upon the holdouts. This induces holdout bondholders to exchange their old debt for new debt, because after the old debt is modified via the CAC, it will have the same terms as the new debt. However, the old debt will be illiquid. Thus between the modified old debt and the new debt, you might as well take the new debt. It is seemingly coercive upon the holdouts and so an amendment of Greek debt pursuant to the CAC is expected to be a credit event. But even if such a default decision is made, it leaves lingering questions as to why the events that have occurred thus far were not a default. Thus the decisions raise serious questions about the value of ISDA documented CDS as a hedging tool.

Documents excerpted below:

·        Question No. 2012022401 posed to the ISDA Credit Derivatives Determinations Committee for Europe, the Middle East and Africa, Feb. 27, 2012

·        Question No. 2012022901 posed to the ISDA Credit Derivatives Determinations Committee for Europe, the Middle East and Africa, Feb. 27, 2012

Citibank N.A. v. Morgan Stanley & Co. International PLCX, No. 09-8197 (S.D.N.Y. filed Sep. 25, 2009)

Citibank files its appeals brief and Morgan Stanley files its reply     

      See prior coverage here. Citibank filed its Appeals Court brief on Jan. 10, 2012, and Morgan Stanley replied on Feb. 7, 2012. In a document reminiscent of the District Court opinions that ruled in its favor, Citibank explains why its distinguishing between the terms “consent” and “direct” is not a semantic game, but rather the manifestation of terms that were carefully negotiated by two sophisticated parties. Citibank also reminds the court of the high burden placed on parties who want to reform a contract.

      One of the most interesting points related to the pricing and economics of the contract. Citibank states that that had Morgan Stanley been able to veto Citibank’s request to liquidate the CDO’s collateral, the credit default swap (CDS) would have been nearly worthless. Citibank writes:

In a standard setting, where a CDS and reference obligation are coterminous, passing Controlling Class rights to the protection seller merely permits the seller to determine when, not if, it will pay any loss of principal. That is because the protection remains in place until the obligation matures. If there is a loss, the seller must provide the protection upon maturity, if it has not done so earlier. Where, as here, the Swap expires decades before the Reference Obligation, passing Controlling Class rights would permit the seller to avoid ever paying losses for an FTPP. The seller could easily accomplish this by vetoing events that would result in a loss of principal. That is what MSIP is saying it would have done here. On this reading, Citibank paid for protection for an FTPP and received none. Citibank did not agree to this.

      Morgan Stanley responded that such a CDS still value commensurate with the premium paid by Citibank. Bolstering their point, Morgan Stanley notes how Citibank agreed to another CDS (the Tallships swap) with the exact feature that supposedly makes this case’s CDS nearly worthless. Morgan Stanley also notes that Citibank paid the same premium for the Tallships swap as it did for this case’s swap.

As Citibank acknowledges, it passed Controlling Class rights to Morgan Stanley in the non-coterminous (3-year) Tallships Swap, such that Morgan Stanley had an absolute right to prevent the occurrence of a FTPP Credit Event during that 3-year period. Citibank’s transfer of control over the exercise of Controlling Class rights in Tallships shows conclusively that Citibank did not believe that such transfer “[v]itiate [d] the [p]urpose of [either] [c]ontract.”

In any event, the fact that Morgan Stanley could determine whether to liquidate the CDO’s collateral . . . does not render FTPP protection illusory in practice. . . . [W]hile the CDO’s collateral had declined in market value at the time Citibank unilaterally directed liquidation, there was no actual failure to pay principal, and the value may well have rebounded prior to maturity, such that there would have been no actual principal losses. Citibank short-circuited this process by directing liquidation in order to avoid potential future principal losses, which might have occurred after the Capmark Swap expired. . . .

It is difficult to understand--and Citibank nowhere explains--why Citibank would be willing to pay the same price for credit protection in both swaps if it believed it was ceding rights in Tallships that it had not ceded in Capmark only six months earlier.

       After reading all of the arguments, I am inclined to predict that the Appeals Court will rule in Citibank’s favor. As time progresses, contracts can transform from what seemed like a fair deal into an unforeseen calamity. That is why the onus is on the contracting parties to clearly describe their agreement. Courts do not like to re-write these instruments after time has had its effect. While Morgan Stanley unambiguously gave itself Controlling Class rights in the later Tallships swap, it failed to do so in the swap being litigated in this case. That left Morgan Stanley open to the “consent” vs. “direct” argument that went in Citibank’s favor at the District Court level. I can’t imagine the Appeals Court stepping in and reversing matters at this stage.

      This case’s legacy will ultimately be as an exemplar for the need to carefully list every possible outcome and to make sure that the derivatives contract declares each party’s rights under each of those outcomes, using obvious and unambiguous language.

Documents excerpted below:

·         Appeals Court Reply Brief filed by Citibank on January 10, 2012

·         Appeals Court Reply Brief filed by Morgan Stanley on February 7, 2012

Wailea Partners, LP v. HSBC Bank USA N.A., No. 11-3544 (N.D. Cal. filed July 19, 2011)

The judge dismisses Wailea’s case, and Wailea appeals

      See prior coverage here. On Dec. 15, 2011 the court ruled on HSBC’s motion to dismiss.

      First the court agreed to apply New York law to the matter, per the contract’s choice of law provision. The court did so because (a) HSBC had sufficient connection to New York State (New York is its principal place of business) and (b) because Wailea did not claim that its agreement to the choice of law provision was due to mistake or misrepresentation. Next the court dismissed all of Wailea’s claims, as described below:

·         Wailea’s claim that the contract should be rescinded because either both parties (mutual mistake) or Wailea (unilateral mistake) were mistaken in their belief that The Senator Fund’s returns followed the split-strike conversion strategy. The court dismissed this claim because (a) under their contract Wailea accepted the risk that The Senator Fund’s returns could be illegitimate, or alternatively, (b) because Wailea acted as if it had sufficient knowledge of the matter, as demonstrated by its statement that it was not relying on HSBC’s representations.

·         Wailea’s claim that the contract should be rescinded because HSBC innocently misrepresented the nature of The Senator Fund’s returns. The court dismissed this claim because the contract disclaimed any representations regarding the matter, and also stated that Wailea would be “solely responsible for making an independent appraisal of the financial condition and business of the Senator Fund.”

·         Wailea argued that the contract was conditioned on The Senator Fund investing using the split-strike conversion strategy, and since that did not occur the contract should be rescinded. The court disagreed, saying that “the unmistakable language of condition such as if, unless and until and/or null and void,” was missing, and so the parties did not “inten[d] to expressly condition the existence of the Agreement upon the Senator Fund’s investment strategy.” Further, the court said it could not recognize any alleged oral statement by HSBC creating the condition, because (a) in the contract Wailea said they were not relying on any of HSBC’s oral representations, or alternatively, (b) the contract contained a merger clause (a clause stating that the contract contains all of the agreed upon terms).

·         Wailea argued that the agreement violates Section 25401 of the California Corporations Code, which is essentially California’s securities fraud statute, because of HSBC’s misrepresentations. The court dismissed this claim because Wailea had disclaimed reliance on HSBC’s representations.

      On Dec. 21, 2011 Wailea appealed the decision to the Ninth Circuit Court of Appeals, where it was assigned Case No. 11-18041.

Documents excerpted below:

·         Opinion by the Honorable Conti, Dec. 15, 2011

Securities and Exchange Commission v. Citigroup Global Markets Inc., No. 11-7387 (lead docket for related case No. 11-7388) (S.D.N.Y. filed October 19, 2011)

The court refuses to approve the settlement

      See prior coverage of the case here. On Nov. 28, 2011 the court refused to approve the settlement between the SEC and Citigroup.

      In this case, like it did in the similar Goldman Sachs case, the SEC wanted to settle with the bank but continue litigation against the particular trader that it felt was most responsible for the alleged fraud. In the Goldman case the bank was Goldman Sachs, with whom the SEC settled on July 20, 2010, and the trader was Fabrice Tourre, against whom the SEC continues to litigate. Here the bank is Citigroup and the trader is Brian Stoker.

      Of course in both cases, the court had to approve the settlement. In the Goldman case, Judge Jones accepted Goldman’s settlement with the SEC. (Incidentally, Judge Jones also presided over a third case with a similar fact pattern, filed against Morgan Stanley, and in that case she dismissed the plaintiff’s claims.)

      However in this case, Judge Rakoff rejected the settlement. On Nov. 28, 2011 Judge Rakoff said the SEC’s request that the court enforce the settlement requires that the court be satisfied that “it is not being used as a tool to enforce an agreement that is unfair, unreasonable, inadequate, or in contravention of the public interest.” The court then said that the settlement was “[based on] allegations unsupported by any proven or acknowledged facts whatsoever, is neither reasonable, nor fair, nor adequate, nor in the public interest.”

      The court seemingly did not like the SEC changing its role from that of prosecutor to judge and jury. The court stated:

Purely private parties can settle a case without ever agreeing on the facts, for all that is required is that a plaintiff dismiss his complaint. . . . But when a public agency asks a court to become its partner in enforcement by imposing wide-ranging injunctive remedies on a defendant, enforced by the formidable judicial power of contempt, the court, and the public, need some knowledge of what the underlying facts are: for otherwise, the court becomes a mere handmaiden to a settlement privately negotiated on the basis of unknown facts, while the public is deprived of ever knowing the truth in a matter of obvious public importance.

      After rejecting the settlement, the court consolidated this case with the case against Brian Stoker (Case No. 11-7388, also filed in the S.D.N.Y.). The consolidated case is now scheduled for trial on July 16, 2012. It will be interesting to see how the SEC and Citigroup respond, but if it's litigated to the end it will be an important case in determining a bank’s obligations when it enters into derivatives contracts.

Documents excerpted below:

·         Opinion by the Honorable Rakoff, Nov. 28, 2011

In re Lehman Brothers Holdings Inc., No. 08-13555 (Bankr. S.D.N.Y. filed Sep. 15, 2008) (this entry deals only with Lehman’s adversary proceeding No. 09-01241 against Harrier Finance Limited, a.k.a. Rathgar Capital Corporation)

Lehman voluntarily dismisses the case

      See prior coverage here. On November 21, 2011 Lehman Brothers Special Financing voluntarily dismissed the case. It’s not clear why they dismissed the case, but I imagine it was the result of a settlement.

Documents excerpted below:

·         Plaintiff’s Notice of Voluntary Dismissal, filed by Lehman Brothers Special Financing on November 21, 2011

Employees’ Retirement System of The Government of The Virgin Islands et al. v. Morgan Stanley & Co. Incorporated, No. 09-10532 (S.D.N.Y. filed Dec. 24, 2009)

The court dismisses plaintiff’s claims

      See prior coverage of this case here. On Sep. 30, 2011 the court dismissed the plaintiff’s complaint for the reasons described below:

·         Regarding plaintiff’s claim that the AAA ratings were fraudulent, the court stated that these AAA ratings were not in any materials that were both prepared by Morgan Stanley and received by plaintiffs. The court stated that (a) Morgan Stanley did not create the ratings, (b) although plaintiffs claim that Morgan Stanley created them covertly by colluding with the rating agencies, plaintiffs offered no evidence for this allegation (c) although the offering memorandum stated the AAA ratings, it was not a statement by Morgan Stanley and in fact Morgan Stanley stated in the offering memorandum that they did not verify its contents, (d) although Morgan Stanley prepared a March 2007 presentation, that stated the AAA rating, this presentation was never received by plaintiff.

·         Regarding plaintiff's claim for unjust enrichment, the court stated that under New York law, unjust enrichment claims relating to the distribution or sale of securities are preempted by the Martin Act.

      The court allowed plaintiff to amend their complaint to add additional facts that would overcome the above concerns. However, the plaintiffs did not amend their complaint and so on Nov. 3, 2011 the court dismissed plaintiff’s claim with prejudice.

Documents excerpted below:

·         Opinion by the Honorable Jones, September 30, 2011

CDO Plus Master Fund Ltd. v. Wachovia Bank, No. 07-11078 (S.D.N.Y. filed Dec. 7, 2007)

The court dismisses CDO Plus’s remaining arguments

      See prior coverage here. On Sep. 29, 2011 the court disposed of CDO Plus’s remaining arguments as described below:

·         CDO Plus had argued that the “market quotation” method could not be used because there was no market for this swap, as demonstrated by Wachovia’s inability to secure more than one firm quotation. The court dismissed this argument, saying that one firm quotation, and two indicative were a “stable foundation for Wachovia's computation of the Settlement Amount.”

·         CDO Plus argued that the “loss” method calculation was inapplicable because this was a naked credit default swap. In other words, Wachovia did not have a long position on the credit default swap’s underlying obligations and so would not suffer any “loss.” The court dismissed this argument, stating that the contract did not require Wachovia to hold the long position.

·         CDO Plus argued that the attorney’s fees should be reduced due to lack of sufficient supporting documentation. The court disagreed, saying that while some of the billing detail had been redacted on grounds of privilege, these redactions were “too few in number and dollar value relative to the rest of the submission to necessitate in-camera review or denial of the claims.” The court also said the paralegal entries had sufficient detail, and that a review by a senior partner was not duplicative because “such review is an essential prerequisite to providing informed advice.”

      The court awarded the $1.08 million that Wachovia requested, interest of $75 thousand and attorney’s fees and costs of $1.03 million. On Oct. 27, 2011 Wachovia confirmed that CDO Plus had paid the judgment. Note that during the course of the litigation, CDO Plus had changed its name to VCG Special Opportunities Master Fund Ltd.

Documents excerpted below:

·         Opinion by the Honorable Taylor Swain, September 29, 2011

Securities and Exchange Commission v. Citigroup Global Markets Inc., No. 11-7387 (S.D.N.Y. filed October 19, 2011)

Summary

      This is another case in which plaintiffs allege that one of the parties involved in a derivative transaction gained advantage by manipulating a neutral referee.

      In 2007, Citigroup structured a transaction called the Class V Funding III CDO (Class V III). This vehicle allowed certain parties to invest in (go long) a portfolio of residential mortgage debt instruments. It was mostly a synthetic arrangement; In other words the long parties did not actually lend money to the mortgage borrowers. Rather, they entered into credit default swap derivatives contracts where another party (the short party) would pay them a periodic premium. In exchange for receiving this premium, the long party would pay the short party an amount if the reference obligation defaulted. A credit default swap can synthetically mimic the experience of lending money, because in both cases the long party receives a periodic amount so long as the reference loan is being paid (the premium in the case of a credit default swap, or the interest payment in the case of a loan), and risks losing a sum of money if the reference party defaults (either the notional amount in the case of a credit default swap or the amount lent in the case of a loan.) The only difference is that in the case of a loan, the long party has to hand the principal over at the start of the transaction, where as in a credit default swap, the long party does not have to hand over the principal until there is a default. This difference is accounted for, generally, by paying a credit default swap premium equal to the interest rate required by the reference loan minus the risk free rate of return.

      Thus a synthetic CDO is another way to match parties who want to go long an asset, with parties who want to go short an asset. Since this arrangement is similar to a loan, the key question asked by parties who go long synthetically is the same question asked when one lends money – who are you lending money to? In other words, what is the reference obligation? And that leads us to the crux of this case.

      The SEC alleges that as the structuring party, Citigroup selected reference obligations that it knew were of poor quality. You might be wondering why a banking intermediary would do such a thing. The intermediary’s job is to match longs with shorts and not to tip the scales in favor of either of those two parties. In the similar case of Securities and Exchange Commission v. Goldman Sachs & Co. and Fabrice Tourre, No. 10-3229 (S.D.N.Y. filed April 16, 2010) the SEC alleged that Goldman Sachs’s motivation was to make fees by structuring the deal. However, in this case the motivation is easier to allege. Here, Citigroup not only made fees by structuring the deal, but Citigroup was also the short party who would profit at the expense of the long parties. Citigroup was short $500 million in this transaction. But even Citigroup’s short position in and of itself does not prove anything because banks regularly eschew their role as intermediary to take short or long positions. This is called proprietary trading.

      The problem here is that Citigroup allegedly did not disclose their role as portfolio selector or short party. Citigroup told investors that an independent third party, Credit Suisse Alternative Capital, Inc. (CSAS), selected the reference obligations. Quoting from paragraph 27 of the complaint,

On or about November 3, 2006, the senior CDO structurer drafted an engagement letter for CSAC and circulated it internally with the subject line “CSAC CDO-squared.” Later that day, in response to receiving the draft engagement letter, the senior CDO structurer’s immediate supervisor inquired, “Are we doing this?” The structurer responded: “I hope so. This is [Trading Desk Head]’s prop trade (don’t tell CSAC). CSAC agreed to terms even though they don’t get to pick the assets.” The term “prop trade” is shorthand for “proprietary trade,” meaning a trade undertaken for a firm’s own account, rather than on behalf of the firm’s customer(s).

      Further, Citigroup allegedly did not tell investors that they were shorting these reference obligations. Citigroup called itself the “Initial CDS Asset Counterparty,” implying that it was acting as an intermediary for the ultimate short party.

      The most damning allegation describes the way Citigroup responded when one of the potential investors asked about the process used to select the reference obligations. Quoting from paragraph 41 of the complaint,

On or around February 6, 2007, a prospective investor in Class V III asked Citigroup to arrange a call with CSAC, to seek an explanation as to why CSAC had chosen to invest in several “static” deals (i.e. deals with non-managed portfolios). Each of the static transactions in the portfolio seen by the potential investor had been selected by Citigroup on January 8. After hearing that the potential investor was raising questions, the head of Citigroup’s CDO syndicate desk sent an internal email to several recipients, including the senior CDO structurer stating: “[CSAC] bought these static bonds and ... should have a rationale as to why [CSAC] found them attractive.” One of the structurers who had been on the call with the potential investor and CSAC responded, “[CSAC] can come up with some stories for some of the static deals in Class V pool, but not all of them.”

      Getting back to the numbers, the size of this transaction was $1 billion. In other words the long parties risked losing a total of $1 billion. The party with the largest long position was Ambac, who had risked $500 million. BNP Paribas (“BNP”) had intermediated Ambac’s position, and so guaranteed Ambac’s $500 million commitment. As described above, Citigroup was short $500 million. The Class V III deal closed on February 28, 2007 and by November of 2007 the reference obligations defaulted. Citibank made $160 million on this deal.

      Citigroup did not litigate this case very long, and came to an agreement with the SEC before the case was filed. Attached to the SEC’s complaint is a proposed judgment that Citigroup agreed to, in which Citigroup would pay a $160 million disgorgement, $30 million in interest and a $95 million fine. Under the terms of the settlement, Citibank neither admits nor denies liability. The court now has to approve this agreement.

Documents excerpted below:

·         Complaint and proposed settlement, filed together on October 19, 2011

Citibank N.A. v. Morgan Stanley & Co. International PLCX, No. 09-8197 (S.D.N.Y. filed Sep. 25, 2009)

Morgan Stanley files its appeals brief

      See prior coverage here. Morgan Stanley filed its Appeals Court brief on Oct. 11, 2011. Their argument essentially restates the points they made to the District Court. Two interesting passages are quoted below.

      One passage articulates how, in Morgan Stanley’s viewpoint, the District Court is playing semantic games regarding the definitions of the words, “consent”, “direct” and “authorize” to achieve an “absurd” result. Quoting from Morgan Stanley’s brief:

[T]he district court’s interpretation creates the absurd result that Morgan Stanley’s rights are contingent upon the manner of Citibank’s authorization under Section 6.07 (i.e., whether it acted by “consent” or “direction”). Under the district court’s interpretation, Citibank would be obligated to obtain Morgan Stanley’s consent if Citibank “consented” to the exercise of Controlling Class rights, but Citibank would have no such obligation if it “directed” the exercise of Controlling Class rights. But the manner in which Citibank authorizes the exercise of Controlling Class rights has no bearing on how the exercise of those rights will affect Morgan Stanley, which bears the ultimate risk. The district court’s interpretation therefore should be rejected. See, e.g., Bank Julius Baer, 424 F.3d at 283.

      Morgan Stanley also claims that it was industry practice for the protection buyer (Citibank) to pass liquidation rights to the protection seller (Morgan Stanley), which lends credence to Morgan Stanley’s claim that the parties intended to transfer these rights in this case. Morgan Stanley’s brief states:

[I]t is standard industry practice for Controlling Class rights to be transferred to the party bearing the risk on the super-senior tranche, JA692-93, JA707-08, and, as the district court itself recognized, it was Citibank’s own customary practice to “cede[] control over liquidation to protection sellers” in “every other CDO where Citibank purchased super senior credit protection.”

      On Oct. 20, 2011 the Appeals Court set a due date of Jan. 10, 2012 for Citibank’s reply brief.

Documents excerpted below:

·         Appeals Court Brief filed by Morgan Stanley on October 11, 2011

In re: Commodity Exchange, Inc., Silver Futures and Options Trading Litigation, No. 11-2213 (Multidistrict litigation lead docket) (S.D.N.Y. MDL transfer order issued Feb. 8, 2011)

Plaintiffs file a consolidated class action complaint

      See prior coverage of this case here. On Sep. 12, 2011 the plaintiffs filed a consolidated class action complaint. The new complaint articulates the allegations in greater detail.

Documents excerpted below:

·         Consolidated class action complaint, filed Sep. 12, 2011

Elliott Associates, L.P. et al. v. Porsche Automobile Holdings, No. 10-532 (lead docket for related cases, Nos. 10-4155, 10-8073, 10-8074, 10-8084, 10-8161) (S.D.N.Y. filed Jan. 25, 2010)

Summary

      Normally, this blog covers cases where the plaintiff and defendant were the counterparties in the derivatives contract which is now the subject of litigation. However, here only one of the parties in the litigation had entered into the derivatives contract at issue. Plaintiffs entered into derivatives contracts and lost money, they allege, because of Porsche’s misstatements. However, Porsche was not a party to those contracts (There is the remote possibility that Porsche was a hidden counterparty to some of these contracts, but there is no evidence of that in the record.). Porsche was a third party, and I have labeled this category of derivatives cases as "third party" cases.

      Moving onto the case, Volkswagen (VW) is a German car company whose stock saw a sudden appreciation in 2008. This rise in price made no sense in light of VW’s fundamentals and especially did not make sense in the middle of a global financial crisis. Barron’s even ran an article on October 20, 2008 calling VW the “World's Most Overvalued Big Stock?” and predicted that VW’s stock “will likely drop like a Beetle pushed from a cliff.”

      During this time period in the Summer and Fall of 2008, expecting VW stock to fall in value, a number of hedge funds went short the stock. Specifically, they entered into derivative contracts whereby the hedge funds would be paid if VW stock declined. In exchange, the hedge funds would pay their counterparty if the value of VW stock increased. These hedge funds included Black Diamond Arbitrage Offshore Ltd., Black Diamond Offshore Ltd., Black Diamond Relative Value Offshore Ltd., Bluemountain Equity Alternatives Master Fund, L.P., D.E. Shaw Valence International, Inc., Elliott Associates, L.P., Elliott International, L.P., GCM Little Arbor Institutional Partners, L.P., GCM Little Arbor Master Fund, Ltd., GCM Little Arbor Partners, L.P., GCM Opportunity Fund, L.P., Glenview Capital Master Fund, Ltd., Glenview Capital Opportunity Fund, L.P., Glenview Capital Partners, L.P., Glenview Offshore Opportunity Master Fund, Ltd., Perry Partners International, Inc., Perry Partners, L.P., The Liverpool Limited Parternship, Seneca Capital International Ltd., Seneca Capital LP, VGE III Portfolio Ltd., Viking Global Equities II LP, Viking Global Equities LP, York Asian Opportunities Master Fund, L.P., York European Focus Master Fund, L.P., York European Opportunities Master Fund, L.P., York Global Value Master Fund, L.P., York Select Master Fund, L.P. and York Select, L.P..

      On October 26, 2008 it became clear why the stock had gone up in value. Porsche had been accumulating control of 74.1% of VW’s stock. Porsche directly owned 42.6% of VW’s stock. In addition Porsche had purchased options to buy another 31.5% of VW’s stock (The banks that sold such options generally buy the underlying stock to hedge their position.). Thus 74.1% of VW’s stock was under the effective control of Porsche. The problem was that 20% of VW’s stock was owned by the German state of Lower Saxony. Lower Saxony was required to hold these shares by law. Another 5% of VW’s shares were owned by index funds who, per German law, could not sell them. Thus only 1% (100% minus 74.1% minus 20% minus 5%) of VW stock was purchasable (“freely floating.”) Immediately after this announcement, all the parties who had shorted VW’s stock started to purchase shares to close out their positions and this caused VW’s stock price to increase by 500% during the week that followed Porsche’s October 26 announcement.

      The hedge funds betting that VW’s stock would decline lost billions of dollars. In response they filed numerous lawsuits starting on January 25, 2010, in the Southern District of New York, alleging that:

·         Porsche committed securities fraud under Section 10(b) of the Exchange Act and related Rule 10b-5 by purposely misstating their intention to acquire 74% of VW.

·         Porsche committed securities fraud under Section 10(b) of the Exchange Act and related Rule 10b-5 by committing market manipulation.

·         As Porsche’s executives, Dr. Wendelin Wiedeking (Porsche’s CEO) and Mr. Holger P. Haerter (Porsche’s CFO) were liable Section 20(a) of the Exchange Act.

·         Common law fraud.

      Porsche responded on August 31, 2010, arguing that:

·         Section 10(b) does not cover derivative contracts based on VW stock traded in Germany, because 10(b) does not apply to such stocks, (“The most sensible reading of [the law] is that Section 10(b) covers these agreements only when the referenced security is traded on a U.S. exchange or otherwise purchased or sold in the United States . . . [and] Because Section 10(b) Does Not Reach VW Shares, Section 10(b) Does Not Reach Plaintiffs' Swap Agreements Referencing VW Shares.”)

·         Even if 10(b) applied, Porsche did not make any misstatements because Porsche reasonably believed its statements to be true at the time it made them.

·         Even if 10(b) applied, Porsche did not manipulate the market because that requires something more than misstatements. It requires “wash sales, matched orders, rigged prices, or some other manipulative act” that were not present here.

·         The common law fraud claim was not plead properly. Further, if the federal securities claims are dismissed, the fraud claim should be moved to state court because it is a state law claim.

·         Regardless of all of the above, the United States is an inconvenient forum, and so the case should be moved to a German court on a forum non conveniens basis.

      On December 30, 2010 the court ruled, agreeing with Porsche on all grounds. The court dismissed the federal securities claims, stating “I am loathe to create a rule that would make foreign issuers with little relationship to the U.S. subject to suits here simply because a private party in this country entered into a derivatives contract that references the foreign issuer's stock.” Further, it declined to address the remaining state law fraud claims, stating that they would be better addressed by a German court, stating “. . . for me to determine the merits of Plaintiffs' common law fraud claims would require the Court to analyze German law governing securities fraud, and yet Germany provides for exclusive jurisdiction of securities fraud cases in its own courts, making any judgment from this Court unenforceable in Germany.”

      The plaintiff hedge funds immediately appealed to the Second Circuit Court of Appeals. The case numbers in the appeals court are 11-397, 11-403, 11-416, 11-418, 11-428 and 11-447. These six cases were consolidated under lead case 11-397 on February 16, 2011.

      The plaintiffs and defendants filed their briefs in April and July respectively. Before the court could rule on the case, on August 3, 2011 a number of parties asked to file amicus briefs (An amicus brief is a brief filed by a third party to guide the court’s decision on an important issue.). These include the following organizations: Securities Industry and Financial Markets Association, Chamber of Commerce of The United States of America, Federation Of German Industries, Mouvement Des Entreprises De France, Economiesuisse, European Banking Federation, Association of German Banks and German Issuers. It also includes the following people (mainly law professors): Edward S. Adams, Genevieve Beyea, Ronald J. Colombo, Elizabeth Cosenza, Joseph A. Grundfest, Doctor Stefan Grundmann, Doctor Heribert Hirte, Wulf A. Kaal, Doctor Christian Kirchner, Andrew Lund, John H. Matheson, Doctor Sebastian Mock, Doctor Peter Nobel, Mr. Richard William Painter, J. Mark Ramseyer, Larry E. Ribstein, Roberta Romano, Doctor Alexander Schall, Kenneth E. Scott and Lynn A. Stout.

      On August 10, 2011 plaintiffs filed a motion opposing such amicus filings. On August 15, 16 and 19 of 2011, the amicus parties replied to plaintiffs' motion, and continued their request to file an amicus.

Documents excerpted below:

·         Third Amended Complaint, filed by one of the plaintiffs (the Black Diamond hedge fund) on July 23, 2010

·         Motion to Dismiss by Porsche Automobil Holding SE, filed August 31, 2010

·         Opinion by the Honorable Baer, Dec. 30, 2010