The opinion of the court was delivered by: Denise Cote, District Judge
This is a dispute over a complex transaction between two sophisticated financial institutions. Although the instruments involved are somewhat abstruse, the central issue can be boiled down to a relatively straightforward question of contract interpretation: When was plaintiff Deutsche Bank AG ("DB") required to deliver a group of bonds to defendant Ambac Credit Products, LLC ("ACP")? DB claims that although the documents governing the disputed transaction set out a detailed timeline for delivery of the bonds, industry practice and other contractual provisions allowed for delivery well past the nominal deadline. Therefore, according to DB, ACP breached the contract when it refused to pay for the bonds DB tendered one month after the putative delivery date.
A bench trial was held on June 26, 27, and 29. This Opinion presents the Court's findings of fact and conclusions of law and concludes that ACP did not breach its contract with DB, since it was under no obligation to pay for bonds that were not delivered in accordance with the contractual terms. As a result, DB's common law claims for breach of contract, breach of the implied covenant of good faith and fair dealing, and equitable estoppel fail.
DB filed this action on July 19, 2004, alleging breach of contract against defendants ACP and Ambac Assurance Corporation ("AAC").*fn1 After the completion of fact discovery, defendants filed a motion for summary judgment or to bar DB from introducing evidence of industry custom. The motion was denied in a Memorandum Opinion of August 22, 2005. Deutsche Bank AG v. AMBC Credit Products, LLC, No. 04 Civ. 5594 (DLC), 2005 WL 2033379 (S.D.N.Y. Aug. 22, 2005). On November 15, 2005, DB filed its first amended complaint, adding two claims against ACP: (1) breach of the implied covenant of good faith and fair dealing, and (2) equitable estoppel. On February 15, 2006, DB filed a second amended complaint, augmenting its breach of contract claims.
The trial was conducted without objection in accordance with the Court's customary practices for the conduct of non-jury proceedings. The parties submitted a Joint Pretrial Order and proposed findings of fact and conclusions of law on June 12, 2006. The parties also served affidavits containing the direct testimony of their witnesses, as well as copies of all the exhibits and deposition testimony that they intended to offer as evidence in chief at trial.
With its Pretrial Order submissions, plaintiff presented declarations constituting the direct testimony of Kenneth Brougher ("Brougher"), vice president of Deutsche Bank Securities, Inc., a subsidiary of DB; Steven Horn ("Horn"), director of Deutsche Bank Securities, Inc.; Boaz Weinstein ("Weinstein"), head of credit trading for the Americas in DB's New York branch; Roman Shukhman, a trader on the credit derivatives desk at JP Morgan Chase ("JPMC"); Mei-Mei Sandy Wong, a member of JPMC's settlement group; and Lisa Sloan ("Sloan"), former chief administrative officer and director of operations for M. Safra & Co., a hedge fund manager. With the exception of Shukman, who defendants chose not to cross-examine, each of these witnesses appeared at trial and was cross-examined.
Defendants offered the testimony of Peter Campbell ("Campbell"), the manager of Financial's treasury operations group; Thomas Gandolfo, chief financial officer of Financial and its subsidiaries during the relevant period; David Gleeson ("Gleeson"), an accountant for Financial's credit derivatives business line during the relevant period; Cynthia Parker ("Parker"), managing director for credit derivatives for Financial and its subsidiaries; Douglas Renfield-Miller, senior managing director of AAC during the relevant period; David Weissman, a senior executive at AAC and ACP; Joseph Swain ("Swain"), a senior officer of Assured Guaranty Corporation ("Assured"); and M. Holland West ("West"), a former partner at Shearman & Sterling LLP and former head of its global derivative, hedge fund, structured finance, and private equity practices. Each of these witnesses appeared at trial and was cross-examined.
Excerpts from the depositions of testifying witnesses, as well as the following individuals, were offered and received into evidence at trial. Plaintiffs offered excerpts from the depositions of Kirk Ballard ("Ballard"), a senior analyst covering North American settlements for DB; David Barranco, an employee of Financial; and Maria Ruf, a back office clerk for DB in the international bond market during the relevant period. Defendants offered excerpts from the depositions of Ballard; Ruff; and Ernest Goodrich, Jr., managing director and senior counsel in DB's credit derivatives business.
The disputed transaction here is a species of credit derivative called a credit default swap ("CDS"). Credit derivatives are akin to insurance policies for holders of corporate bonds or other securities against downgrades in the credit of the issuing companies. They do this by transferring credit risk from a "protection buyer" to a "protection seller."*fn2
A CDS is a common type of credit derivative in which the protection buyer makes a fixed payment to the protection seller in return for a payment that is contingent upon a "credit event" -- such as a bankruptcy -- occurring to the company that issued the security (the "reference entity") or the security itself (the "reference obligation"). The contingent payment is often made against delivery of a "deliverable obligation" -- usually the reference obligation or other security issued by the reference entity -- by the protection buyer to the protection seller. This delivery is known as the "physical settlement."*fn3 Some CDS transactions, such as the one at issue here, are known as "portfolio" transactions, meaning they cover multiple reference entities and reference obligations.
CDS transactions are of relatively recent origin, having been developed in the mid-1990s. They are highly negotiated and are customarily based on standard terms published by the International Swaps and Derivatives Association, Inc. ("ISDA"). These terms may be modified for a particular transaction. At the time the transaction at issue here was executed, the 1999 ISDA Credit Derivatives Definitions ("1999 Definitions") provided the foundation for most CDS agreements.
The 1999 Definitions, which contemplate a transaction involving a single reference obligation, set out a highly detailed, carefully choreographed set of procedures to be followed if the reference entity experiences a credit event. First, pursuant to Section 3.3, either party may notify the other party of the credit event by means of an irrevocable Credit Event Notice, containing "a description in reasonable detail of the facts relevant to the determination that a Credit Event has occurred." Once the Credit Event Notice has been provided, the buyer of protection has 30 days to provide the seller with a Notice of Intended Physical Settlement ("NIPS").*fn4 Under Section 3.4, NIPS means an irrevocable notice from Buyer ... to Seller that confirms that Buyer will settle the Credit Derivative Transaction and require performance in accordance with the Physical Settlement Method, and containing a detailed description of the type of Deliverable Obligations that Buyer reasonably expects to Deliver to Seller.
If a NIPS is not delivered within the 30-day window, the transaction terminates, and the buyer loses its ability to make any claim for credit protection. In the words of Section 3.4, the "thirtieth calendar day shall be the Termination Date." (Emphasis supplied.)
Assuming that a timely delivery of a NIPS has been made, the parties must settle the transaction within the Settlement Period, which is defined in Section 8.5 as: the number of Business Days specified as such in the related Confirmation or, if a number of Business Days is not so specified, the longest of the number of Business Days for settlement in accordance with then current market practice of any Deliverable Obligation being Delivered in the Portfolio, as determined by the Calculation Agent, in consultation with the parties. (Emphasis supplied.) The reference to "current market practice" allows the Calculation Agent to identify the delivery date that is customary for the securities that are at issue.
The final day of the Physical Settlement Period is known as the Physical Settlement Date, and under Section 8.1, it is the date on which the parties' obligations to each other come due:
Buyer shall ... on or prior to the Physical Settlement Date Deliver to Seller all or part of that portion of the Portfolio specified in the Notice of Intended Physical Settlement and Seller shall pay to Buyer that portion of the Physical Settlement Amount that corresponds to the portion of the Portfolio that Buyer has Delivered. (Emphasis supplied.) Thus, the seller's duty to pay is dependent on the buyer of protection's delivery of the securities identified in the NIPS.
Pursuant to Section 8.3, if delivery is completed by the Physical Settlement Date, the transaction ends. It provides that "If the entire portion of the Portfolio specified in the Notice of Intended Physical Settlement is Delivered on or before the Physical Settlement Date, the Physical Settlement Date shall be the Termination Date." (Emphasis supplied.)
Section 9.3(c)(ii), however, loosens the requirement that the buyer make delivery "on or prior to" the Physical Settlement Date:
Buyer may continue to attempt to Deliver the whole of the Portfolio specified in the Notice of Intended Physical Settlement for an additional five Business Days after the Physical Settlement Date. Subject to Section 8.1 and to Sections 9.4, 9.5, 9.6 and 9.7, if Buyer fails to Deliver any portion of the Portfolio specified in the Notice of Intended Physical Settlement on or prior to the date that is five Business Days after the Physical Settlement Date, such failure shall not constitute an Event of Default and such date shall be deemed to be the Termination Date. (Emphasis supplied.) This provision creates a five-day grace period for the delivery of deliverable obligations to account for back-office delays in the procurement and delivery of securities. If, however, the buyer fails to make delivery within that five-day window, the transaction terminates, and the buyer loses its ability to make any claim for credit protection.
Thus, once a credit event occurs, the parties have a strictly controlled time-frame in which to act. A buyer of protection must first deliver a NIPS and then the securities within the time frames allowed, or lose the right to obtain payment from the protection seller. Similarly, assuming the buyer has performed its obligations, the seller of protection must be prepared to make the required payment associated with the credit event within a defined and relatively short period of time following a credit event.
In the transaction that is the subject of this lawsuit, DB, a large international bank headquartered in Germany, functioned as the protection buyer, and ACP functioned as the protection seller. The parties entered into a Master Agreement dated December 17, 1998, as well as a Schedule and Credit Support Annex (collectively, the "Master Agreement"). AAC also issued a Financial Guarantee Insurance Policy (the "Guarantee") unconditionally and irrevocably guaranteeing "any payment of the Cash Settlement Amount due from [ACP] to [DB] pursuant to the terms of any confirmation under the Master Agreement." The Schedule provides that the Master Agreement will "be governed by, and construed and enforced in accordance with, the laws of the State of New York without reference to its choice of law doctrine."
ACP and DB then entered into a Confirmation dated April 19, 2000 issued under the Master Agreement ("Confirmation") and relating to a CDS transaction known as "Triplets." Triplets involved a portfolio of 60 reference entities and reference obligations, including 7.375% Bonds due in 2027, issued by Solutia Inc. (the "Solutia Bonds").*fn5 DB agreed to pay ACP at regular intervals for the credit protection provided under the Confirmation. The Confirmation expressly incorporates the Master Agreement, the Schedule, and the 1999 Definitions, including the right of either the protection buyer or seller to serve a Credit Event Notice. It states that "[i]n the event of any inconsistency between the Credit Derivatives Definitions and this Confirmation, this Confirmation will govern."
It was, in fact, necessary for the Confirmation to override certain provisions of the 1999 Definitions, since Triplets involved multiple reference entities and obligations, while the 1999 Definitions contemplated a single-name transaction. For example, under the 1999 Definitions, both completion of physical settlement and failure to adhere to the physical settlement timeline end the entire transaction. Here, however, the parties did not want the entire Triplets transaction to terminate upon the occurrence of a single credit event relating to a single reference entity, but to provide credit protection for a five-year term. Therefore, the Confirmation, which provides for an "Effective Date" of May 2, 2000, defines the "Termination Date" as "[t]he later to occur of the Scheduled Termination Date and the final Physical Settlement date." The "Scheduled Termination Date" is listed as May 2, 2005.
The Solutia Credit Event and Physical Settlement
Solutia filed a bankruptcy petition in the United States Bankruptcy Court for the Southern District of New York on December 17, 2003. Under the Confirmation, this filing constituted a credit event.*fn6 As a result, DB delivered to ACP a Credit Event Notice and Notice of Publicly Available Information dated December 17, 2003, informing ACP of the Solutia bankruptcy. On January 16, 2004 -- the final date on which a NIPS could be delivered -- DB sent ACP a NIPS, which stated in part:
[DB] reasonably expects to deliver to [ACP] the following Deliverable Obligation: [Solutia Bonds]. Pursuant to the terms of the Credit Derivative Transaction, [DB] will deliver such Deliverable Obligations for Physical Settlement, with the total outstanding principal balance required under the terms of the Credit Derivatives Transaction as determined by the Final Price of the [Solutia Bonds], on February 4, 2004 (the "Delivery Date"). On the Delivery Date, [ACP] will delivery to [DB] the amount required under the terms of the Credit Derivatives Transaction. (Emphasis supplied.) With this notice, DB chose*fn7 the Delivery Date and triggered the duty of ACP to pay DB upon receipt of ...