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Good Faith Counterparty Dealings in Zero-Sum Contracts

In October, Bloomberg reported a delightful trade in which a unit of Blackstone (1) bought short-dated CDS on a troubled global gambling concern called Codere SA; (2) took over Codere’s revolver on the condition that Codere delay an interest payment sufficiently to trigger a credit event under the CDS contracts; and (3) made a whole bunch of money doing so. [1] 

There are two ways to view the trade.  One is that it is a hilarious bit of creative maneuvering in an everyone-for-themselves market. [2]  The other is that, well, the whole thing smacks of bad-faith collusion (especially since Codere got advance permission from the majority of its US and EU bondholders prior to entering the new loan agreement, and as part of that permission the bondholders agreed not to accelerate bond obligations upon the specifically-contemplated default).  Here are two quotes reported in the story that highlight those views: 

“As a lender, the idea is to help somebody make payments on their debt. . . . It’s generally not to pay them not to make payments on their debt so that you can benefit via a derivative instrument.” 

True! But: 

“If you’re going to trade CDS, you’ve got to be fully aware. . . .  The only losers are the guys who seemed to play the CDS market incorrectly or didn’t see this as a potential outcome.” 

Also true! 

The legal hook that intrigues me is the general American principle (ignore for the moment that U.S. law may not have governed this trade in any significant manner, if at all) that parties to a contract owe one another a duty of good faith and fair dealing.  The essence of any single CDS contract is that the protection seller is betting against the occurrence of a credit event, and the protection buyer is betting that there will be one.  So does the implied duty of good faith and fair dealing form a basis for a breach of contract action for the CDS seller?  If so, did Blackstone breach? 

A review of CDS litigation in the U.S. doesn’t shed any light on the question – perhaps because the standard ISDA agreement includes a mandatory arbitration clause, and perhaps because the losing traders are too embarrassed or too busy to complain publicly that they were outmaneuvered.  The best analog that comes to mind is insurance contracts – which CDS roughly approximates, at least in concept if not always in practice.  You have an insurer and insured betting on whether a contemplated risk may occur.  If it does, the insured wins; [3] if it doesn’t, the insurer wins. 

So: do we see insureds going and burning their houses down to win their bet?  Usually not!  And when they do, the insurance doesn’t pay!  But in the cases where that happens nowadays, the insurer invariably relies on a pesky don’t-burn-your-house-down-or-we-won’t-pay-you clause in the insurance contract.  What if that provision weren’t there? 

As it turns out, it doesn’t matter in any way material to our question here.  For instance, in 1898, the U.S. Supreme Court assumed that a life insurance contract did not include a valid exclusion for suicide, and queried whether the insurer must pay on that contract following suicide. [4]  The Court, in its old-timey glory: 

“It is contended that the [trial] court erred in saying to the jury, as, in effect, it did, that intentional self-destruction, the assured being of sound mind, is in itself a defense to an action upon a life policy, even if such policy does not in express words declare that it shall be void in the event of self-destruction when the assured is in sound mind.  But is it not an implied condition of such a policy that the assured will not, purposely, when in sound mind, take his own life, but will leave the event of his death to depend on some cause other than willful, deliberate self-destruction?  Looking at the nature and object of life insurance, can it be supposed to be within the contemplation of either party to the contract that the company shall be liable upon its promise to pay, where the assured, in sound mind, by destroying his own life intentionally precipitates the event upon the happening of which such liability was intended to arise?”  (Emphasis added).

I’m confident you can guess how the Court answered its rhetorical question. 

Now, suicide and triggering credit events clearly implicate public policy issues of different levels of moral import.  But that’s not what the Court was concerned about in the passage above (it got to that issue later in the opinion).  In the passage above, the Court was concerned about whether the parties really agreed that the insured could cause the occurrence of the contemplated risk.  The Court said “no,” although, notably, the Court also found supported by the evidence the conclusion that the insured purchased the insurance with the intent to commit suicide and have the insurer pay off his debts, so one of the parties obviously thought that was the deal.

That’s not so far off from what it looks like Blackstone did here: buying CDS with a premeditated plan to trigger a credit event.  I guess the question the Court would ask, then, is whether such intentional activity was truly contemplated by both parties to the CDS contract.  Probably not?  I don’t really know. 

Where this gets especially interesting for most of us is its implications for other types of contracts.  Say two entities contemplating a merger have gotten far enough along that they have an agreement with a walk-away fee and a material adverse change provision.  Can a party who wants out of the agreement trigger a material adverse change with its competitor or the market to avoid the walk-away fee?  That would be great fun!  Maybe with some luck, somebody will try it soon and we’ll get to see how the litigation shakes out.  Until then, though, we are left to speculate.

[1] I say “a whole bunch of money” because I’m a lawyer.  In the financial world, people would probably call it “some money.”  In raw terms, it was probably about EUR11MM. 

[2] It is clearly that. However, Matt Levine has an eloquent explanation of why this wasn’t (and isn’t) really a risk-free trade for Blackstone, and why triggering the credit event wasn’t itself enough to make this a win for the firm.  http://www.bloomberg.com/news/2013-12-05/blackstone-made-money-on-credit-default-swaps-with-this-one-weird-trick.html.

[3] Sort of.  Depending on the risk insured against, it may or may not be a “win.”

[4] Ritter v. Mut. Life Ins. Co. of N.Y., 169 U.S. 139