Negative interest determined not to be payable under an ISDA Credit Support Annex

Transcription

1 August 2018 Negative interest determined not to be payable under an ISDA Credit Support Annex On 25 July 2018, the English High Court handed down its judgment in The State of the Netherlands v Deutsche Bank AG [2018] EWHC 1935 (Comm). The case concerned the interpretation of a 1995 ISDA Credit Support Annex in a negative interest environment and raised a novel issue about whether the payment of negative interest on cash collateral is required. Given the Credit Support Annex s widespread use as a standard market document, the case is highly significant for the derivatives market as a whole. Contents Facts... 1 DSTA s position... 1 Decision... 2 Comment... 4 Facts The State of the Netherlands ( DSTA ) had entered into a series of derivatives transactions with Deutsche Bank AG ( DB ) under an ISDA Master Agreement and Credit Support Annex ( CSA ), both governed by English law. Under the CSA, DB was required to provide collateral to cover any credit risk to which DSTA was exposed and, as the transactions were heavily in the money for DSTA, it was holding a substantial amount of collateral in the form of cash. The CSA required DSTA to pay interest on such collateral at the rate of EONIA less 4 basis points. However, since 2014 the rate had been negative and the question that arose was whether negative interest could accrue, in favour of DSTA, on the collateral held by it. DSTA s position The key provision of the CSA relating to interest is Paragraph 5(c)(ii), which states: Unless otherwise specified in Paragraph 11(f)(iii), the Transferee will transfer to the Transferor at the times specified in Paragraph 11(f)(ii) the relevant Interest Amount to the extent that a Delivery Amount would not be created or increased by the transfer. Negative Interest determined not to be payable under an ISDA Credit Support Annex 1

2 The CSA entered into between DB and DSTA had been modified in that it contained an asymmetric obligation for DB to post collateral to DSTA but did not require DSTA to do the same. Accordingly, the CSA stated that all references to the Transferor were to DB and all references to the Transferee were to DSTA. DSTA relied on the last sentence of the definition of Credit Support Balance (effectively, the aggregate amount of collateral held by DSTA from time to time), which states that: Any Equivalent Distributions or Interest Amounts (or portion of either) not transferred pursuant to Paragraph 5(c)(i) or (ii) will form part of the Credit Support Balance. This, it argued, required any negative Interest Amount to be added to the Credit Support Balance, resulting in a deduction from the collateral comprised in it. As DB was required to top up the Credit Support Balance if it was insufficient to cover DSTA s exposure, this meant that DSTA would indirectly receive the benefit of a negative Interest Amount. A negative Interest Amount could arise, DSTA suggested, because, with respect to any Interest Period, it is defined as: the aggregate sum of the Base Currency Equivalents of the amounts of interest determined for each relevant currency and calculated for each day in that Interest Period on the principal amount of the portion of the Credit Support Balance comprised of cash in such currency, determined by the Valuation Agent for each such day as follows: (x) the amount of cash in such currency on that day; multiplied by (y) the relevant Interest Rate in effect on that day; divided by (z) 360 (or, in the case of pounds sterling, 365). If the Interest Rate in effect on such a day is negative, it said, the amount to be included in the calculation would itself be negative and so could produce a result that is negative for the Interest Period as a whole. Decision Robin Knowles J ruled in favour of DB and dismissed DSTA s claim. In his view, although the technical definition of Interest Amount was capable as a matter of language of allowing for a negative figure, he concluded that: that is simply a starting point, reached by looking at the definition alone, rather than the agreement as a whole. The question at issue is whether the agreement includes an Negative Interest determined not to be payable under an ISDA Credit Support Annex 2

3 obligation on the Transferor if the Interest Amount is negative. I cannot see that the agreement does include such an obligation. I consider the Bank to be correct in its submission that if there were such an obligation it would be spelled out. The judge also noted that a modification that the parties had agreed to make to the CSA provided that the Interest Rate would be zero on cash collateral paid by DB otherwise than to DSTA s preferred account (effectively disincentivising DB from paying into the wrong account). He concluded from this that the parties could not have contemplated that negative interest would be payable as, in such circumstances, the incentives would be reversed (zero interest in such circumstances being the better outcome for DB). Regarding the last sentence of Paragraph 5(c)(ii), the judge agreed with DB s submissions that references to interest not transferred could refer only to interest that was actually transferable (or required to be transferred) but not yet transferred, which did not include any obligation on the part of DB. The provision simply reflected the fact that there might be circumstances in which an obligation to pay interest under that paragraph (i.e. an obligation of the Transferee) had arisen but had yet to be performed. It did not recognise an obligation on the part of the Transferor to account for negative interest when no such obligation had been spelled out. The judge pointed out that the contrary view would mean that, while positive interest amounts would be dealt with through the machinery of Paragraph 5(c)(ii), negative interest would be dealt with by a completely different mechanism. He could see no credible commercial rationale for the parties to have made such a choice; if negative interest was to be payable, the obvious solution was to bring it within Paragraph 5(c)(ii). In his view, the Credit Support Balance was concerned with handling amounts of principal. He rejected DSTA s argument that it would make little commercial sense for negative interest not to be payable where there is a cost associated with holding cash collateral, observing that it does not necessarily follow from an agreement to pass on part of the benefit of holding collateral that the parties also intended to pass on any burden that might arise. In any event, the parties may simply have wanted simplicity in the arrangements. DTSA had also attempted to rely on the ISDA 2013 Statement of Best Practices for the OTC Derivatives Collateral Process and the ISDA 2014 Collateral Agreement Negative Interest Protocol. Robin Knowles J held that these provided no assistance as (i) they were not available to the parties at the time they made their agreement, (ii) the Statement of Best Practices, in any case, was merely that and was not intended to create Negative Interest determined not to be payable under an ISDA Credit Support Annex 3

4 legal obligations and (iii) in the context of a one-way collateral agreement, the 2014 Protocol envisaged bilateral discussion and amendment to achieve its ends (which had not occurred in the present case). By contrast, DB had emphasised a passage in the ISDA User s Guide, which has been held to be available as an aid to interpretation, which reinforced the judge s view that the focus of Paragraph 5(c)(ii) was on what the Transferee was to do in return for holding cash collateral. Comment Although the decision is confined to the particular CSA between the parties, under which a number of amendments had been made to the standard form, most of the reasoning in the case would be equally applicable to the standard document. As the standard form CSA does not contain an obligation on the part of the Transferor to pay negative interest on cash collateral, if the parties want negative interest to be payable, they need to make express provision for this in the document. This can be done by adhering to the Negative Interest Protocol (if the CSA in question falls within its scope) or by including a bespoke provision amending Paragraph 5(c)(ii) so as to require the Transferor to account for negative interest. Where the parties have amended the CSA to change the way in which interest is calculated (for example, by including a spread, an interest rate floor or other modifying language), as noted in ISDA 2013 Statement of Best Practices, a bilateral discussion will be required. The same is true where only one party is required to post collateral. This reflects the fact that, where certain modifications to the standard form have been made, the Negative Interest Protocol does not apply. The decision itself is not particularly surprising. It is true that the definition of Credit Support Balance states that any Interest Amounts not transferred will form part of the Credit Support Balance. However, these words do not easily accommodate a deduction from the Credit Support Balance and, as the judge pointed out, if the parties wanted to provide for the payment of negative interest, it is difficult to see why they would have chosen such a circuitous route of achieving this rather than simply providing for it in Paragraph 5(c)(ii). This is particularly true given that, even at the time of the publication of the CSA, negative interest rates were not unheard of and, indeed, had been identified as an issue in the context of interest rate swaps. Negative Interest determined not to be payable under an ISDA Credit Support Annex 4

5 It is also logical that negative interest should be disregarded in the Interest Amount calculation completely. It would be somewhat arbitrary if negative interest were capable of offsetting any positive amounts that happen to fall within an Interest Period but must be disregarded where the Interest Rate is negative for the whole of the Interest Period. Such a conclusion can also be justified by the language used in the definition of Interest Amount, which refers to the amounts of interest calculated for each day in the Interest Period. The classical meaning of interest is payment by time for the use of money (Bennett v Ogston (1930) 15 TC 374), whereas in a negative interest environment what is claimed is essentially compensation for the cost of holding the money. The phrase negative interest is therefore something of a misnomer. Some market participants will no doubt regard the decision as controversial on the basis that it is reasonable to expect a party that has incurred a cost for holding cash collateral to be compensated by the other party in return. Such a conclusion has in fact been recognised in the ISDA 2013 Statement of Best Practices. Ultimately, however, the interpretation of the CSA, as with any agreement, is guided by what an objective observer would consider the parties to have agreed, not what it would have been reasonable for them to have agreed. On the basis of the contract they entered into, what DB and DSTA had agreed was that negative interest would not be taken into account. Please click here for a copy of the judgment. Linklaters LLP acted for DB in this case. Simon Firth Contacts For further information please contact: Chin-Chong Liew (+852) chin-chong.liew@linklaters.com Victor Wan (+852) victor.wan@linklaters.com Stephen Song (+852) stephen.song@linklaters.com I-Ping Soong (+852) i-ping.soong@linklaters.com Kenneth Lam (+813) kenneth.lam@linklaters.com Authors: Simon Firth This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters LLP. All Rights reserved 2018 Linklaters LLP is a limited liability partnership registered in England and Wales Wales with registered number OC It is a law firm authorised and regulated by the Solicitors Regulation Authority. The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP together with a list of those non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ or on and such persons are either solicitors, registered foreign lawyers or European lawyers. Please refer to for important information on Linklaters LLP s regulatory position. We process your data in line with our Global Privacy Notice. You can view this at To opt-out of receiving any marketing s from us, or to manage your preferences and the personal details we hold for you, please contact: marketing.database@linklaters.com. Sonia Lim (+65) sonia.lim@linklaters.com 10th Floor, Alexandra House Chater Road Hong Kong Telephone (+852) Facsimile (+852) / Linklaters.com Negative Interest determined not to be payable under an ISDA Credit Support Annex 5