Locations
In this article we consider the English court case of The State of the Netherlands v Deutsche Bank AG1, the applicability of that case to 1995 CSAs, how it might be possible to distinguish that case and, if not, whether a party who has paid negative interest under a CSA can reclaim it.
The Netherlands Case
We have previously published three articles2 on the case but here is a brief reminder.
Deutsche Bank AG (the "Bank") and The State of the Netherlands (the "State") entered into an ISDA Master Agreement and a related 1995 ISDA Credit Support Annex in March 2001, which they amended in 2010. Under that CSA, the Bank posted cash collateral on a one-way basis to cover the mark-to-market risk to which the State was exposed under the Master Agreement. The State was required to pay interest to the Bank on cash collateral held by it at the rate of EONIA less four basis points.
The European Central Bank's introduction of negative interest rates for EUR in June 2014 meant that parties like the Bank and the State had to consider their obligation to pay, or entitlement to receive, negative interest under standard ISDA CSAs, amongst other financial contracts. The derivatives market relatively quickly coalesced around negative interest being payable, which was already the normal position with payments under derivative transactions by virtue of Definitions published by ISDA.
Although ISDA had published its Collateral Agreements Negative Interest Protocol in May 2014, the State did not adhere to it (and, even if it had, this CSA would have been out of scope as this was a one-way CSA and carried a spread). The Bank did not pay negative interest to the State.
The State took the issue to court and in July 2018 the English High Court found in favour of the Bank. The State appealed and, in May 2019, the English Court of Appeal upheld the earlier decision deciding that negative interest was not contemplated, nor payable, under that 1995 CSA.
It was an unhappy but perhaps inevitable outcome for the market. Although the words on the page have always been relatively clear on the point, it was completely contrary to what the entire derivatives market considered to be the correct economic position and which the vast majority of market participants were doing, even if they had not adhered to the ISDA Negative Interest Protocol.
Distinguishing the Netherlands case
Whilst almost two years have passed since the Court of Appeal gave judgment in the Netherlands case, we are still seeing new disputes arising between parties as to whether negative interest is payable under 1995 CSAs, and whether there are legal grounds for demanding repayment of historic negative interest that has been paid. Having looked at this afresh in that context we wanted to share a few ideas.
Where a dispute exists, the first step is to closely consider whether the conclusions reached in the Netherlands case actually apply to the CSA you have in place with your counterparty.
It is very unlikely that a CSA contains amendments to the contractual provisions upon which the conclusion in the Netherlands case was reached. However the judgment was at least in part explained and justified based upon market knowledge and practice at the time the CSA was entered into. There were a series of statements and recommendations made by ISDA in the run up to the publication of the Negative Interest Protocol and it is clear that the market position (or at least the ISDA recommendations based upon its view of that market position) changed over time. The timing of entering into a CSA may therefore give a basis to distinguish the Netherlands case.
It may also be possible to argue that, despite the wording of the standard CSA, the parties nevertheless intended that negative interest should be paid. Ordinarily this must be established at the time the contract was entered into but, with an ISDA Master Agreement and CSA of course, the parties are continuously or frequently entering into more and more contracts when they trade under the ISDA Master Agreement. For example, it might well be the case that the parties continued to trade in a negative interest rate environment without pricing in a zero floor on the collateral interest rate. Whether these arguments based upon sequencing the trading activity can be made is fact-specific. No such argument seems to have been raised in the Netherlands case, perhaps because the facts did not lend themselves to it.
Legal entitlement to the return of negative interest
As a natural response to the Netherlands case, a number of counterparties used this as an opportunity to stop paying negative interest under their CSAs (or to be compensated for the removal of the zero interest rate floor). However, some parties have gone a step further and asserted a claim for repayment of negative interest already paid.
Whilst, under English law, there is no general legal right for the recovery of money on the ground that payment of it was not due, there are grounds for recovery in equity based upon a claim for restitution on the grounds of "unjust enrichment". As with any claim founded in equity, it is discretionary and the Court will deal with each claim on a case-by-case basis. It is therefore crucial that parties undertake a full analysis of the chronology, market backdrop, documentation and parties' intention in establishing whether they have a viable claim for the return of negative interest (or an effective defence to such a claim).
Even if a fact pattern is not sufficient to distinguish the decision in the Netherlands case, so that negative interest cannot be claimed going forwards, it may well be sufficient to assert one of the various defences available to a claim for the return of negative interest previously paid.
Provisioning for potential claims
Given the number of unresolved CSAs in the market, a market participant which may have been happily paying or receiving negative interest should reassess its portfolio of 1995 CSAs where the zero floor has not been removed, either bilaterally or through the application of the Protocol.
Having identified the population of unresolved CSAs, there is a financial impact evaluation to make in case it or the counterparty decides to assert the floor. There is also legal analysis which should be undertaken to assess the chances of that CSA being distinguished from Netherlands case, as well as a separate analysis of the being able to assert or defend a claim for the repayment historic negative interest.
There is nothing short of a manual audit that can make this assessment.
Please look out for our next instalment of this series which will consider how the decision in the Netherlands case, together with other recent legal and market developments, has led firms to take action in respect of their CSAs.
1 The Court of Appeal decision can be found here and the first instance decision can be found here.
2 No negative interest payable under standard ISDA Credit Support Annex says English court
Derivatives Alert: Appeal Fails on Negative Interest under CSA