On January 24, 2017, the New York Supreme Court, Appellate Division, First Department (appellate court) upheld the decision of the trial court (trial court) in Good Hill Master Fund L.P., et al. v. Deutsche Bank AG that a credit default swap (CDS) contract entered into under an ISDA® Master Agreement was subject to an implied duty of good faith and fair dealing.

Good Hill Master Fund L.P. and Good Hill Master Fund II L.P. (collectively, Good Hill) purchased several tranches of synthetic residential mortgage-backed securities (RMBS) issued through a special purpose vehicle (SPV) in a securitization transaction undertaken by Bank of America (BofA) (a non-party to the litigation). In a separate transaction, Good Hill and defendant Deutsche Bank AG (DB) entered into CDS contracts in which the notes issued in the synthetic RMBS transaction were named as the reference obligation (the ref ob notes).

Under the CDS contracts, Good Hill was the credit protection seller while DB was the credit protection buyer. The CDS contracts were executed using an ISDA Master Agreement and ISDA Schedule (collectively, ISDA Master). The CDS contracts provided credit protection for DB, as protection buyer, against specific risks – credit events – which included a writedown of the ref ob notes. The occurrence of a credit event would trigger a payment by Good Hill to DB from a collateral pool posted to DB by Good Hill.

In 2009, BofA repurchased the ref ob notes from Good Hill in an effort to unwind and terminate the securitization in light of adverse market conditions. As part of the purchase agreement, Good Hill and BofA allocated the final price across all of the note tranches issued in the transaction, with the ref ob notes receiving 83% of the allocation of the final price (resulting in a 17% write down of the principal value of the ref ob notes).

The sale of the notes to BofA for an amount lower than their principal amount was a floating amount event, which triggered a payment from Good Hill to DB under the terms of the CDS contracts.

DB acknowledged that the 17% writedown occurred under the CDS contracts but refused to return the collateral retained in connection with the CDS contracts. In the ensuing lawsuit, Good Hill asserted that DB breached the terms of the CDS contracts by failing to return the collateral.

DB counterclaimed that the majority price allocation to the ref ob notes was designed to minimize the payments due from Good Hill under the terms of the CDS contract and that Good Hill had, among other things, not acted in good faith and a commercially reasonable manner under the CDS contracts by allocating 83% of the final price to the notes named as the reference obligation.

The trial court found that price allocation by tranche is standard practice, and that both Good Hill and BofA had engaged in good faith, arm's length negotiations in which each party pursued its own interests in a reasonable manner. Further, Good Hill was expressly permitted under the CDS contracts to negotiate the sale of the notes without regard to the existence of the CDS contracts or any adverse effects the negotiations might have had on DB's positions under the CDS contracts, so long as the negotiations were not carried out in bad faith.

The trial court noted that Section 9.1(b)(iii) of the 2003 ISDA Credit Derivatives Definitions (2003 Definitions), which governed the CDS contracts, expressly provided for each party's authority to deal in its own self-interest.

The appellate court sided with the trial court's findings that:

The appellate court rejected DB's argument that Good Hill could have obtained a more favorable interest rate on loans from the third-party investors, noting that the chief financial officer for Good Hill submitted a certification to support the interest rate and that Section 14 of the ISDA Master states that the default rate is certified "without proof or evidence of any actual cost."

The appellate court's decision in Good Hill reaffirms the extent to which parties to CDS contracts are free to negotiate at arm's length and in their own interest with respect to the reference obligation or other aspects of a CDS contract, regardless of any detriment to the opposing party to the CDS contract, so long as the negotiation is conducted in good faith.

For a detailed discussion of the trial court's decision, see Legal Update, Good Hill v. Deutsche Bank: Good Faith Obligation Under ISDA Master Not Breached by Holder of CDS Reference Obligation.