Solstice II: SDNY Determines Early Termination Payment for ABS Swap under ISDA® Master Agreement

Practical Law Legal Update 9-524-0241 (Approx. 7 pages)

Solstice II: SDNY Determines Early Termination Payment for ABS Swap under ISDA® Master Agreement

by PLC Finance

Key Litigated Issues

The key litigated issue was how to calculate the transaction's early termination payment under the ISDA Master Agreement.

Facts and Procedural History

In May 2002, Solstice ABS CBO II, Ltd. (the issuer) issued three classes of notes and two classes of equity securities in a traditional, non-synthetic collateralized debt obligation (CDO) transaction that was collateralized by a portfolio of residential mortgage-backed securities (RMBS), among other investments. As in a typical securitization, the CDO asset portfolio generated revenue, which was deposited into a trust account in the name of the issuer for the benefit of the noteholders and used by the trustee, Bank of New York Mellon, to distribute to the CDO noteholders on biannual payment dates the principal and interest (P&I) on the CDO notes, all as set forth in the CDO indenture. Also as is typical, the securitized asset portfolio was pledged to the noteholders as collateral for their investment in the notes. (For information on the mechanics of CDOs and other basic securitizations, see Practice Note, Securitization: US Overview.)

In connection with the CDO, the issuer entered into a credit enhancement/liquidity facility swap, the "cashflow swap" (CFS), with Natixis Financial Products Inc. (Natixis) under which the issuer was to pay Natixis a fee and Natixis was to advance funds to the issuer to make any interest payments to the Class A and B noteholders on any payment date when the proceeds from the securitized asset portfolio were insufficient to make the required payments on the CDO notes. The CFS consisted of an ISDA Master Agreement (ISDA Master), a Schedule to ISDA Master Agreement (ISDA Schedule) and a transaction confirmation, both of which supplemented and formed part of the ISDA Master (as in a typical swap). Also at the closing of the CDO transaction, MBIA Insurance Inc. (MBIA) sold credit protection to the Class A-1 noteholders under a credit default swap (the Solstice II CDS), under which MBIA agreed to purchase the Class A-1 notes if the issuer did not make the required payments of P&I on them, as is standard under most CDS.

In October 2009, an event of default (EOD) occurred under the CDO indenture, triggered by failure of a standard overcollateralization (OC) test contained in the indenture when the underlying securitized asset portfolio failed to collateralize the notes at a value of 101%. The trustee issued a notice of EOD under the CDO indenture, causing an Additional Termination Event (ATE) under the CFS. As is provided for under the ISDA Master, Natixis, as the "Non-affected Party" with respect to the ATE under the CFS ISDA Master, issued an early termination notice on November 4, 2009 designating an early termination date of November 9, 2009. (The non-affected party in a termination event under an ISDA Master Agreement is equivalent to the non-defaulting party in an EOD.) Natixis asserted that the issuer owed it a termination payment of $2.2 million under the CFS.

Meanwhile, on November 9, 2009, the next noteholder payment distribution date under the indenture, the issuer had insufficient funds to make interest payments on the Class A and B notes, requiring MBIA to purchase the Class A-1 notes under the Solstice II CDS for their outstanding face amount. The interests of MBIA and the trustee, acting on behalf of the noteholders, were therefore aligned, as MBIA held the most senior class of notes issued in the transaction after purchasing the A-1 notes. Accordingly, MBIA was also a third-party beneficiary of the CFS.

On November 12, 2009, the trustee commenced an interpleader action in the SDNY court seeking clarification from the court on the proper early termination payment under the CFS.

Section 6(e) of the ISDA Master Agreement: Early Termination Payments

Section 6(e) of the 1992 ISDA Master Agreement governs swap early termination payments and requires parties to elect a payment measure of either "Market Quotation" or "Loss" and a payment method of either "First Method" or "Second Method." Natixis and the issuer agreed in the ISDA Schedule that Market Quotation and Second Method would apply, as is common under the 1992 ISDA Master.

Under Second Method, the termination payment is due regardless of the party owing the payment (under First Method, the payment is only due if the selected party owes the payment).

Market Quotation requires, for each transaction being terminated under the ISDA Master, that the party making the determination of the transaction's Settlement Amount (the early termination payment) obtain quotes from "Reference Market-makers" (leading broker-dealers) which reflect the costs to the determining party (the non-defaulting party or the non-affected party), in this case Natixis, of entering into a replacement transaction with that Reference Market-maker that is the "economic equivalent" of the swap transaction being terminated. If a party is not able to obtain the necessary quotations from Reference Market-makers, the Loss computation applies instead.

The definition of "Loss" under the 1992 ISDA Master requires the party to determine an amount it reasonably determines in good faith to be its total losses and costs as a result of termination of the transaction, including "loss of bargain." Natixis used the Loss measure in claiming it was owed a $2.2 million termination payment under the CFS. The $2.2 million figure included unreimbursed amounts previously advanced by Natixis under the CFS, along with interest, fees and expenses but did not include a discounted cashflow analysis of payments likely due to or from Natixis under the CFS after the early termination date.

For details on the various methodologies for calculating early termination payments under the ISDA Master Agreement, see Practice Note, Comparison of 1992 and 2002 ISDA Master Agreements.

Outcome

Judge Batts held that in calculating the early termination payment for a terminated transaction under the Loss methodology of Section 6(e) of the 1992 ISDA Master Agreement, Natixis was required to assume that no early termination date had been designated for the transaction and thus that the obligations under the CFS would have continued as set out in the transaction confirmation. Judge Batts focused on the "economic equivalent" language in the "Market Quotation" definition and the "loss of bargain" language in the "Loss" definition under the 1992 Master and held that Natixis, as the determining party under the swap, was required to include projections of future losses and gains that would have occurred under the CFS assuming all other conditions precedent were satisfied under the swap until its likely expiration, based on commercially reasonable assumptions.

In an ABS transaction such as Solstice II, this requires that the determining party (in this case Nataxis) reflect in that determination:

The ability of the issuer to fulfill its future obligations to the holders of the ABS, based on an analysis of the underlying securitized asset portfolio and the impact this would have had on the parties' contingent payment obligations under the swap had it not been terminated, based on commercially reasonable assumptions.
The anticipated date, based on commercially reasonable assumptions, on which the assets remaining in the securitized asset portfolio would reach a de minimis level that would cause the notes to be liquidated under the terms of the indenture and the swap to therefore terminate, had it not been terminated prior to that date.

Accordingly, Judge Batts found that Natixis' proposed termination payment of $2.2 million owed to Nataxis under the CFS was not proper because it did not account for these calculations in its determination of the early termination payment under the CFS. Judge Batts referred the matter to magistrate Judge Peck to determine the proper amount of the termination payment, including whether the termination payment should be a payment to or from Natixis.

Judge Peck analyzed three different CFS early termination payment models put forth by experts for Natixis and one by an expert for MBIA. Judge Peck excluded three of the termination payment models because they relied on "faulty" assumptions. In one case, for example, it was assumed that the issuer would make reimbursement payments to Natixis, as required by the CFS, even when there were no P&I proceeds available from the underlying asset portfolio to do so.

Natixis' "Model C" termination payment calculation included all future contingent payments that would have been made by both parties under the CFS had it not been terminated, but only the future payments that the issuer could make until the underlying securitized asset portfolio stopped generating enough cash to allow the issuer to meet its P&I payment obligations to the noteholders under the notes. Natixis, therefore, in Model C, valued the CFS through May 2018, when the last meaningful reimbursement payment from the issuer would be received (because the cashflows generated by the asset portfolio would at that time be de minimis), and, alternatively, through May 2020, when the value of the assets remaining in the CDO asset pool were expected to be less than $1 million.

Judge Peck found this commercially reasonable, rejecting MBIA's assumption that the early termination payment must be valued through May 2038, the legal maturity of the notes, finding that it would be commercially reasonable to assume that the CFS would terminate when the CDO asset pool would be generating de minimis cashflows, causing the transaction to liquidate and the CFS to terminate. Judge Peck, therefore, adopted May 2020 as the anticipated termination date for the CFS, had it not been terminated early, and therefore held that Nataxis' Model C termination payment calculation was the only admissible one. On that basis, he found that a termination payment of $10,538,773 was due from Natixis under the CFS.

Practical Implications

Issues with ISDA Master Settlement Mechanics

This case highlights the complexity and subjectivity of making an early termination payment calculation under the ISDA Master Agreement. It is a scenario that has become more common post-crisis, yet as the Court noted, there is still very little judicial guidance in this area. As the case illustrates, even financial-forensic experts can disagree as to commercially reasonable cashflow models under a given ABS-related swap because future cashflows under an ABS-related swap are subject to many variables, including the ABS cashflows, which are in turn dependent upon the cashflows generated by the underlying securitized assets.

The case also illustrates, as most recent post-crisis ISDA cases have shown, the shortcomings of the Market Quotation methodology for calculation of an early termination payment under the 1992 ISDA Master Agreement. During the period from the mid-1990s through the onset of the financial crisis in early to mid-2008, when the use of derivatives and thus the ISDA Master Agreement grew exponentially, the close-out early termination settlement methodology of the ISDA Master Agreement had rarely been tested. However, as the financial crisis ensued and parties began to default under their ISDA documents, it became clear that the Market Quotation methodology commonly selected by market participants to govern the calculation of termination payments under their 1992 ISDA Master Agreements, as in this case, proved inefficient, prone to breakdown and often unworkable. (As discussed in the case, Market Quotation requires the non-defaulting or non-affected party to determine the replacement value of the swap by obtaining quotes from market makers.) Because it is common for parties to 1992 ISDA Master Agreements to have selected Market Quotation, the Loss methodology is often invoked as the default when Market Quotation fails, as occurred in this case.

Proper Early Termination Payment Methodology for Swaps Relating to ABS Transactions

Solstice II clarifies that determining parties to terminated swaps entered into in connection with ABS transactions using the Loss methodology under Section 6(e) of the 1992 ISDA Master must include the discounted present value of all anticipated future cashflows that would have been exchanged by the parties under the swap based on a model that accounts for:

An estimate of the cashflows generated by the securitization's underlying asset pool or portfolio, based on commercially reasonable assumptions.
How the cashflows generated by the transaction's underlying asset pool or portfolio are likely to affect the P&I payments to be made to the noteholders or other securityholders in the ABS transaction and whether or not the issuer is likely to have sufficient revenue from the securitized asset pool to continue to make P&I payments to the holders of the notes or other debt securities issued in the transaction.
How these ABS cashflows would have affected cashflows between the parties under the swap, based on commercially reasonable assumptions.

The CFS was not a typical swap arrangement for an ABS transaction. Most ABS transactions use interest rate or currency swaps to mitigate interest rate risk and the risk of currency fluctuations, as well as to structure and align payment dates within the transaction. Synthetic securitizations use included swaps in the asset portfolio, usually CDS under which the issuer sold credit protection on certain debt securities, often RMBS or other ABS. In this case, the CFS was either a liquidity support or credit enhancement facility (there was some dispute as to which). Most such ABS facilities are typically in the form of a revolving loan, letter of credit or reserve account/sinking fund. However, the case has implications for calculation of early termination payments under 1992 ISDA Master Agreements for a variety of swaps entered into in connection with ABS transactions, including interest rate swaps, currency swaps and CDS.

The case has similar implications for settlement and close-out of transactions terminated under 2002 ISDA Master Agreements. This is because the Close-out Amount methodology under Section 6(e) of the 2002 Master uses the same “economic equivalent" language as is found in the 1992 Master, and the Close-out Amount methodology under the 2002 Master functions similarly to the Loss methodology under the 1992 ISDA Master.

For information on Section 6(e) of the ISDA Master, including Market Quotation and Loss, as well as other key elements of the ISDA Master Agreement, see Practice Note, Comparison of 1992 and 2002 ISDA Master Agreements. For information on ISDA documentation generally, see Practice Note, ISDA Documents: Overview (US).

For information on the role of derivatives in a securitization, see Practice Note, Securitization: US Overview: Use of Derivatives in Securitization.

Court Documents

Bank of New York Mellon Trust Company, National Association v. Solstice ABS CBO II, Ltd., et al., No. 09 Civ. 9415 (S.D.N.Y. Dec. 20, 2012).

"ISDA" is a registered trademark of the International Swaps and Derivatives Association, Inc. (ISDA). ISDA is not a sponsor of Practical Law and had no part in the development of this resource.

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