Unilateral Mistake and Waiver of Claims in the Credit Default Swap Setting

Copyright 2008.  All rights reserved.

From the United States District Court for the Southern District of New York comes a timely warning to credit default swap (CDS) protection buyers and sellers about the financial loss that can be sustained by a party that does not understand its precise obligations under these complex arrangements.  The decision in VCG Special Opportunities Master Fund Limited v. Citibank, No. 08-01563, 2008 WL 4809078 (S.D.N.Y. November 5, 2008) instructs that a party's mistaken understanding about its obligations under a CDS does not relieve it from its contractual obligations.  Further, the decision provides an example of how a party can unintentionally waive a claim by its conduct.     

The plaintiff hedge fund, VCG Special Opportunities Master Fund Limited ("VCG"), sold a CDS to defendant Citibank, N.A. ("Citibank") whereby, in exchange for periodic fixed payments from Citibank, VCG agreed to pay Citibank a "Floating Payment" up to $10 million if specified credit events occurred.  The credit events included an "Implied Writedown" with respect to the Class B Notes (the "reference obligation") of a certain collateralized debt obligation, the Millstone III CDO ("CDO" or the "reference entity").  Specifically, the CDS provided that if the reference obligation's underlying instruments did not expressly provide for "Writedowns," then Citibank was free to determine whether an "Implied Writedown" had occurred.  In accordance with the CDS, VCG deposited $2 million as collateral against the risk of VCG's default on its obligation to make the Floating Payment.  Neither VCG nor Citibank owned the CDO; instead, they merely traded in its credit risk.  

The parties disagreed about whether the CDS permitted Citibank to demand additional collateral based upon a reduction in the daily mark-to-market value of the Class B Notes.  Nonetheless, less than one month after the CDS was executed and over the weeks that followed, Citibank demanded, and VCG paid, additional collateral approaching the amount of $8 million.  Although VCG repeatedly questioned Citibank's calculations and believed that it was not obligated to make the payments demanded, VCG continued to make the payments out of concern that Citibank would otherwise declare VCG in technical default and seize the collateral.  VCG, however, failed to invoke the CDS's mandatory dispute resolution provision to challenge Citibank's demands.  When Citibank later advised VCG that a Floating Amount Event had occurred in the form of an "Implied Writedown" and that the $10 million Floating Payment was due, VCG refused to pay.  Citibank ultimately foreclosed on the collateral and demanded that VCG pay the remaining amount due under the CDS.  VCG, in turn, filed a complaint for declaratory judgment, rescission, breach of contract, breach of the implied covenant of good faith and fair dealing, and unjust enrichment.  Citibank filed a counterclaim for breach of contract.  On Citibank's motion, the court entered judgment on the pleadings in favor of Citibank on each of the claims and the counterclaim.

Turning first to the issue of whether Citibank properly declared that a Floating Amount Event had occurred, the court examined the Class B Notes' underlying instruments to determine whether there was an express provision for writedowns.  Finding that there was not, the court concluded that Citibank was authorized by the terms of the CDS to determine that a Floating Amount Event in the form of an Implied Writedown had occurred. 

Next, the court considered VCG's argument that Citibank's demand for additional collateral was improper under the terms of the CDS.  The court rejected this argument with little discussion, finding that the language of the CDS did not support VCG's position.  Significantly, the court held that, irrespective of any alleged inconsistency in the CDS on this point, VCG had waived its right to challenge the demands for additional collateral by posting the disputed collateral and accepting Citibank's regular payments under the CDS.  The court further held that VCG's claim failed because it had not invoked the mandatory dispute resolution provision in the CDS prior to filing its complaint.

Finally, the court rejected VCG's claim for rescission.  VCG had argued rescission was appropriate because it was unilaterally mistaken in believing that it had agreed "‘to sell credit protection on a credit default swap' and ‘not to take the risk of daily mark-to-market movements in the value of the reference obligation.'"  Finding that VCG was a sophisticated hedge fund and the CDS language was clear, the court held that VCG's failure "to review carefully the terms of the parties' agreement" defeated its claim for rescission.

A party's challenge to fully understand its CDS agreement may be made more difficult where, as here, it does not own the financial instrument whose credit risk is being hedged.  Nonetheless, this decision highlights the importance of understanding the obligations undertaken in these sophisticated agreements, whether it is the financial undertakings or the requirement to pursue dispute resolution.  It also instructs that parties should be cautious about their post-dispute conduct and the possibility that they may be found to have waived a potential claim or defense. 

VCG is appealing the court's order.  Stay tuned to see how the Court of the Appeals for the Second Circuit rules.