On Monday, U.S. District Judge Laura Swain ruled on Wachovia's motion for judgment on the pleadings in CDO Plus Master Fund Ltd. v. Wachovia Bank, N.A., 07-CV-11078. Judge Swain dismissed 7 of the 8 claims brought against Wachovia by CDO Plus Master Fund, but refused to dismiss CDO Plus's claim that Wachovia breached the implied covenant of good faith and fair dealing. (Of course, she didn't rule on the merits of CDO Plus's claim either.) CDO Plus has now changed its name to VCG Special Opportunities Master Fund, but since Judge Swain still refers to them by their former name, so will I. I think this was a bad opinion, and that Judge Swain's decision not to dismiss CDO Plus's "good faith and fair dealing" claim was based on a flawed understanding of the transaction documents. But first, some quick background: CDO Plus sold $10mm of credit default swap protection on a CDO to Wachovia. The swap was executed under a standard ISDA Master Agreement, and included an ISDA Credit Support Annex (CSA) that provided for the posting of collateral. CDO Plus was required to post $750,000 in collateral upfront, known as the "Independent Amount." The swap also required the parties to post collateral based on the mark-to-market value of the swap, or as Judge Swain explained it:
The [contract] allowed either party to demand “Credit Support” collateral whenever the party’s “Exposure,” defined as the cost to that party to replace the Trade in the market, exceeded by more than $250,000 the value of the collateral held by the party. (Credit Support Annex ¶¶ 3, 12.)For all practical purposes, Wachovia, in its role as "Valuation Agent," was in charge of calculating each party's Exposure.¹ The long and short of it is that as the CDO market imploded, Wachovia demanded more and more collateral from CDO Plus, until eventually CDO Plus refused to post any additional collateral, and commenced litigation. Significantly, the total amount of collateral demanded by Wachovia was $10,410,000. CDO Plus claimed that Wachovia breached the implied covenant of good faith and fair dealing because it acted “arbitrarily and irrationally” in its capacity as Valuation Agent. Judge Swain, in refusing to dismiss CDO Plus's claim, reasoned:
[CDO Plus's] allegation that Wachovia acted “arbitrarily and irrationally” is not merely a “naked assertion devoid of further factual enhancement.” ... Rather, it is amplified by the allegation that the Final Demand would have required [CDO Plus] to post collateral in excess of the notional amount.It's true that Wachovia's final demand would have required CDO Plus to post collateral in excess of the notional amount of the swap, but the transaction documents specifically allow this. Paragraph 3 of the ISDA Credit Support Annex permitted Wachovia to make a demand for collateral equal to: "(i) [Wachovia's] Exposure for that Valuation Date plus (ii) the aggregate of all Independent Amounts applicable to [CDO Plus], if any, minus ... [CDO Plus's] Threshold."² (emphasis added) CDO Plus was required to post a $750,000 Independent Amount upfront, but also had a $250,000 Threshold, so Wachovia was entitled to demand collateral equal to its Exposure + $500,000. That means if Wachovia's Exposure went above $9,500,000, then CDO Plus would, in fact, have to post collateral in excess of the notional amount of the swap ($10mm). Moreover, because the swap in this case was written on a mezzanine CDO tranche, which can easily lose 100% of its value, it's likely that Wachovia's Exposure went all the way to $10mm. In that case, CDO Plus would be required to post $10.5mm in collateral on a $10mm swap. Judge Swain concluded that Wachovia's demand for $10.41mm in collateral on a $10mm swap provided "further factual enhancement" to CDO Plus's claim that Wachovia had acted "arbitrarily and irrationally" in its capacity as Valuation Agent. But it's hard to see how demanding less collateral than it was entitled to under the transaction documents could be construed as evidence that Wachovia had acted "arbitrarily and irrationally." It was perfectly rational for Wachovia to demand $10.41mm in collateral, since it had the right to demand as much as $10.5mm in collateral. Absent some other evidence that Wachovia acted "arbitrarily and irrationally," the mere fact that Wachovia exercised a right clearly given to it in the transaction documents shouldn't be remotely sufficient to survive a motion to dismiss a breach of contract claim. There, if you're a lowly associate at a big firm who's been tasked with writing a Client Alert on this case (which a partner will inevitably take credit for), then I've done most of your work for you! I don't know why. Maybe I miss writing Client Alerts. ¹ If you thought, "Hey, why would CDO Plus allow Wachovia to calculate the amount of collateral it had to post?" then congratulations! You're smarter than AIG Financial Products, as well as 95% of CDO managers. Dealers usually insisted on being the Valuation Agent, and for reasons I never, ever understood, counterparties were usually fine with that. ² Technically, any Independent Amount applicable to Wachovia would also be subtracted, but since Wachovia didn't have to post an Independent Amount, this is irrelevant for our purposes.