"Three bites at the apple is enough." So said District Judge Lawrence McKenna in his decision against hedge fund Eternity in June 2003 when deciding in favor of JPMorgan that the second amended complaint of Eternity should be dismissed.
Eternity appealed that decision to the U.S. Court of Appeals and judgment was given on July 9 on whether Morgan's motion to dismiss should succeed.
Eternity and JPMorgan entered into three credit-default swaps in mid October 2001, with JPMorgan as the credit protection seller and Argentine sovereign bonds as the reference obligation. One default swap expired Dec. 17, 2001 (for a notional of USD3 million). The other two, which had face values of USD11 million in aggregate, expired in 2002 and 2006. The credit events for all these transactions were Failure to Pay, Obligation Acceleration, Repudiation/Moratorium and Restructuring (all as defined in the 1999 Credit Derivatives Definitions published by the International Swaps and Derivatives Association).
The financial situation in Argentina was deteriorating in the autumn of 2001. On Nov. 1 the president asked sovereign bondholders to accept lower interest rates and longer maturities on USD95 billion of government debt. On Nov. 19 the government announced that a "voluntary debt exchange" would be offered to bondholders; this appeared to be an opportunity for holders to exchange their bonds for secured debt with a lower coupon and an extended maturity secured on certain tax revenues. The original obligations would be held on trust for the benefit of Argentina and would be available to bondholders if there were a default under the new secured debt.
Eternity served various notices on JPMorgan, the first on Nov. 8, alleging that a restructuring credit event had occurred. JPMorgan refused to accept that. In due course, a moratorium on public debt was announced on Dec. 24 and JPMorgan duly paid out in respect of the two CDS transactions with later maturities, as the USD3 million default swap had by then expired.
Eternity's complaint therefore appears to be about the loss of payout on the USD3 million default swap and damages relating to the delayed settlement of the other two credit-default swaps.
Eternity filed its first complaint in February 2002 and amended it shortly thereafter. Judge McKenna gave judgment in late October 2002 on Morgan's motion to dismiss the amended complaint, dismissing the case in relation to all counts (fraudulent and negligent misrepresentation in particular) other than breach of contract. Eternity amended its complaint again--to beef up the particularity of its claims for fraudulent and negligent misrepresentation--and again Morgan moved to dismiss it. In June 2003, Judge McKenna, now persuaded that the voluntary debt exchange could not amount to a mandatory exchange, which is a requirement for triggering the restructuring credit event, dismissed the complaint on all points, concluding with the bites of the apple quotation above.
The Court of Appeals affirmed the dismissal of the claims for fraudulent and negligent misrepresentation, but concluded that the breach of contract claim should survive.
The misrepresentation claims foundered on a number of points. They relate to a statement allegedly made by JPMorgan in February 2001 (some eight months before the three CDS transactions were executed) as to the existence of a secondary market in credit-default swaps referenced to Argentina and the assistance JPMorgan would give Eternity in liquidating its positions. First, it was not pleaded that the representation was false when it was made, which is a requirement to make out the fraud claim' indeed, it appears to have been true when made. Secondly, in order to make out a claim for negligent misrepresentation in a commercial context, Eternity had to show that it was in a special position of confidence and trust and relying on JPMorgan having unique and specialized expertise in this area. But it appears that Eternity's chief investment officer was somewhat of an expert himself, having developed, while at Bankers Trust, strategies, involving credit derivatives, for minimizing risk in investing in Latin American debt. Thirdly, it was clear that the original statement had been made in the context of an express disclaimer of any commitment on JPMorgan to unwind any CDS transactions. If the case now goes to a hearing on the merits, the claims based on fraudulent or negligent misrepresentation can no longer be raised.
The claim for breach of contract revolves around whether the restructuring credit event was triggered by the various announcements and proposals in Argentina in November 2001. The motion to dismiss the breach of contract claim would succeed if it could be shown that "as a matter of law ... the voluntary debt exchange was not a "restructuring credit event" covered by [Eternity's] CDS contracts with [JP]Morgan".
"Restructuring," under the 1999 Definitions, might occur if there was (1) a reduction in the interest rate; (2) a postponement or deferral of interest or principal payments; or (3) a change in ranking in priority of payment, causing subordination. If any of these changes occurred to any Obligation or occurred as a consequence of an "Obligation Exchange," then there would be a chance that the restructuring credit event had been triggered.
For an Obligation Exchange to occur there must be a "mandatory transfer" of exchange property to holders of Argentine sovereign bonds in exchange for those bonds. The Argentine offer had been styled a "voluntary debt exchange." The court held that an exchange offer could potentially be voluntary as seen from the perspective of Argentina, but mandatory (in the sense of economically coercive to the point of being compulsory) for the bondholders. As the 1999 Definitions do not prescribe which interpretation is correct (or indeed whether "mandatory" should be considered from the perspective of the investment press or community), the question would need to be determined in the light of the intentions of the parties and the customs and usages of the credit derivatives industry.
Alternatively, Restructuring--as defined in the definitions--might occur if any of the Argentine sovereign bonds were affected in any of the ways listed in (1) to (3) above, even in the absence of an Obligation Exchange. The Ministry of the Economy of Argentina issued a statement on Nov. 28, 2001, which suggested that the maturity of the original Argentine sovereign bonds exchanged for secured debt would have their average life extended by three years. The trust in favor of the Argentine state over those bonds might constitute a postponement or deferral of payment dates. Various pronouncements made by the Argentine state or its ministries might amount to subordination. There was insufficient evidence before the court to decide against Eternity on these points.
And so, because there remain some uncertainties, which could result in Eternity winning its case, the motion to dismiss failed.
The judgment has set out the relatively narrow areas in which the case can continue to be argued and these now turn on matters of fact and evidence, not law. Many concern the actual meaning and effect of announcements from Argentina. But the most interesting question relates to whether, in these circumstances, "mandatory" can be equated with "economically coercive perhaps to the point of being compulsory." The proportion of bondholders who felt sufficiently coerced into exchanging their bonds might prove a decisive factor in determining the outcome.
While this judgment and the case generally are of interest, the points are unlikely to be of huge continuing significance to the credit derivatives industry. The market now uses the 2003 Credit Derivatives Definitions, which approach Restructuring rather differently because they make no mention of "Obligation Exchange."
This week's Learning Curve was written by Patrick Clancy, counsel, and James Brown, associate at Shearman & Sterling in London and New York, respectively. It is based on the earlier publications referenced below.
