I was at the OMG technical meeting in Reston, VA, last week. One evening in the bar I was talking to some friends active in finance and ontology, about a High Court judgment in England, in April 2014.
The judgment was in favour of Greenclose, a privately-owned hotel group, and against National Westminster Bank PLC (NatWest). It was based on the definitions of two terms – electronic messaging system and giving notice to – in a standard, widely-used contract. The judgment was worth £456.000 ($680,000) to Greenclose.
It caused something of a stir in the derivatives world. I thought that governance authors from other types of business might find it interesting. There are some lessons on knowing what your contract says, understanding what it means, and leaving required action until the last minute. You can see the full text in the court report.
In October 2006, Greenclose agreed a £15 million loan facility with NatWest, with a variable interest rate. Two important conditions were:
- An interest rate hedge was required for £10 million of the facility
- Greenclose could not draw down any money until an interest rate hedge was in place for £5 million of that £10 million.
Lenders often impose this kind of condition. The lender wants insurance that the borrower will be able to pay the interest, and not go broke if interest rates become cripplingly high.
A lender’s variable rate usually has two parts: an agreed base rate – in this case, the 3-month London Interbank Offered Rate (LIBOR) – plus the lender’s margin, an additional percentage depending on the lender’s assessment of the risk of the loan. The actual interest rate varies as the base rate varies.
A base rate cap is frequently used as a hedge. NatWest wanted a cap of 6.0%. This would mean that if the 3-month LIBOR increased to more than 6.0%, NatWest would pay itself the excess (the hedge transaction account would pay the loan account). Greenclose would never need to pay more interest than 6.0% plus NatWest’s margin.
The problem is that a cap is expensive, usually requiring a substantial premium up front. One way to reduce the cost is to combine the cap with a base rate floor. This is a straight gamble by the borrower. If the base rate falls below the floor, the lender will pay its counterparty the difference – i.e. will lose advantage of falling base rates. The combination is called an interest rate collar.
Collar transactions often set a floor rate such that the cap and floor parts of the transaction are estimated to have equal value. If this is so, no payment need be made up front, and payments made below-the-floor are, effectively, the insurance premiums.
Greenclose entered a collar transaction with National Westminster Bank (NatWest), with a floor of 5.07% and a cap of 6.0%. This meant that:
- While the 3-month LIBOR stayed between 5.07% and 6.0%, no payment would be made either way
- If the 3-month LIBOR increased above 6.0%, NatWest’s account for the collar would pay the difference to its account for Greenclose’s loan.
- If the 3-month LIBOR fell below 5.07%, Greenclose would pay the difference to NatWest’s account for the collar.
The transaction was for five years, starting on 4 January 2007, with an option for NatWest to extend for a further two years.
The collar is a derivative product – derived from the loan, but not part of it. It could, for example, be undertaken with (or sold to) a third party. The one between Greenclose and NatWest was agreed under the International Swaps and Derivatives Association (ISDA) Master Agreement, the de-facto standard for over-the-counter (OTC) derivative trading. An OTC trade is one that is made directly between two counterparties without any intermediary, such as a clearinghouse.
The collar was a bad bet for Greenclose. By the end of 2011, the 3-month LIBOR had dropped to around 0.5%. With a floor of 5.07%, Greenclose was paying NatWest about 4.5% on the £5 million.
NatWest, of course, wanted to exercise its option to renew the collar for two years from 4 January 2012. It had to do so by 11.00 am London time on 30 December 2011.
Greenclose’s offices shut every year at around midday on the last working day before Christmas, and re-open on the first business day after New Year. Having done business with Greenclose for five years, NatWest was aware of this.
At 9.35 am on 30 December 2011 NatWest attempted to fax notice of extension of the collar to Greenclose’s fax number. It received a “NOAN” (no answer) response. The fax machine was switched off. At 9.45 am NatWest sent an email to Mr John Leach, Greenclose’s majority shareholder and managing director, followed by a voicemail message left on Mr Leach’s cell phone at 9.59 am.
NatWest’s email would have generated an automatic response “The office is closed until Tuesday 3rd January 2012. I will not be picking up emails during this holiday.” Mr. Leach did not check his voicemail until the following day, 31 December.
Greenclose claimed that, under the terms of the contract, NatWest had not made a valid notification of the collar extension. The case was settled in the High Court of Justice in London on 14 April 2014, in favour of Greenclose.
Had Greenclose lost, then, while the 3-month LIBOR remained around 0.5%, Greenclose would have paid NatWest approximately £57,000 per quarter (see §40 of the court report), about £456,000 ($680,000) over a two-year extension of the collar.
The basis of the judgment was the meanings of two terms: electronic messaging system and giving notice to.
NatWest used the 1992 version of the ISDA Master Agreement for the collar transaction. Electronic Messaging System in the 1992 version does not include email. ISDA created a new version of the Master Agreement in 2002. The judge noted that the 2002 changes include email for the first time and “the reasons given for this by ISDA itself, make it plain that the expression [in the 1992 version] was never intended to embrace email, and that specific provision had to be made to include email after it became a common form of communication” (§129 of the court report).
The 1992 ISDA Master Agreement between Greenclose and NatWest for the collar did not make specific provision for email, either in the Schedule (which defines general changes to the standard Master Agreement) or the Confirmation specified for the extension of the collar (which defines the evidence required for Natwest’s exercise of the option to extend).
“Thus the purported notice sent by email was not a valid and effective notice and it did not operate to extend the term of the Collar” (§134 of the court report).
Even if the email had been judged a valid notice, the judgment would have gone against NatWest, “because the email was not opened or seen by Mr Leach until after the deadline had passed. It is insufficient for the Bank to establish that it would have arrived in his inbox before 11am”. The right to extend the collar requires giving notice to Greenclose, not just serving a notice on Greenclose. Giving notice to involves actual communication of the subject-matter of the notice to the person who receives it. The judge said “… it seems to me to be wholly uncommercial to suggest that … the parties can be taken to have agreed that notice would be given to Greenclose by a method neither party had specified, if it was not actually communicated to someone in authority at Greenclose” (§136 of the court report).
The judge also commented “The Bank took the risk of waiting to serve until the last minute and it made the mistake of assuming (a) that service by fax was permitted and (b) there would be no problems with the fax transmission” and “Mr Leach … was not expecting any emails from the Bank and as he had been told that notice was going to be given in writing, he was not expecting a telephone call either” (§142 of the court report).
Some food for thought there, especially given the size of OTC trading. At end of June 2014 the value of OTC open contracts (only some of them for interest rate collars) was $691 trillion (Bank for International Settlements). For comparison, the Gross World Product (the sum of the GDPs of all the countries in the world) for 2013 was $74.8 trillion (World Bank).