Nomura International Plc v Credit Suisse First Boston International

These proceedings primarily raise a question of construction which will determine whether or not the claimant (“Nomura”) was entitled to deliver to the defendant (“CSFB”) Railtrack plc 3.5% Exchangeable Bonds due 2009 (“the Exchangeable Bonds”) by way of physical settlement of a credit derivative transaction. By that transaction Nomura “bought” from CSFB as “seller” credit protection referable to Railtrack plc in a principal amount of US$ 10m. Nomura paid 0.47% of $10m per annum for the protection. If it was entitled to deliver the Exchangeable Bonds Nomura also seeks damages ($ 257,475 and £1,023,129) and interest following CSFB’s refusal to accept delivery. Entitlement to the US$ part of that claim is also disputed (“The Quantum Issue”).

The terms of the transaction are to be found in a letter agreement (the Confirmation) signed by CSFB and Nomura with an effective date of 18 January 2000. In simple but sufficient terms the agreement is one which entitles Nomura on the occurrence of a “Credit Event” occurring in relation to Railtrack plc (the “Reference Entity”) to deliver to CSFB bonds up to a value of $10m having certain “deliverable obligation characteristics” including the characteristic of “Not Contingent”. On such a delivery CSFB is obliged to pay Nomura the value of the bonds. The applicable Credit Events were “Bankruptcy”, “failure to pay” and “Repudiation/Moratorium” and the like.

The expressions I have placed in quotation marks were defined and/or used in the 1999 ISDA Credit Derivatives Definitions published by the International Swaps and Derivatives Association Inc (“The ISDA Definitions”). The Confirmation was expressly subject to the provisions and definitions in the ISDA Definitions unless they were inconsistent with the terms of the Confirmation itself. It is not suggested that there were any relevant inconsistencies.

The Confirmation also refers to the “Reference Obligation” which was identified as Railtrack 5.875% bonds due 2009. I shall refer to these bonds as “the Non-Exchangeable Bonds”.

The Confirmation was expressly subject to a Master Agreement dated 7 February 1991 agreed between Nomura and CSFB to apply to transactions between them of this type.

The terms of the ISDA Definitions, and in particular the definition of “Not Contingent” give rise to the construction issue.

“Deliverable Obligation” was defined in Section 2.15 to mean:

The Exchangeable Bonds did not fall within either (b) or (c), albeit they could have done so if so agreed, and so the question is whether or not they fell within (a) and thus Section 2.19.

Section 2.19 provided:

Section 2.18 (b) provided:

The issue is whether or not the Exchangeable Bonds satisfied the Obligation Characteristic of “Not Contingent” and in particular whether or not they complied with the words I have emphasised by underlining in Section 2.18(b)(vii) namely whether the payment of principal in respect of the Exchangeable Bonds was or was not “subject to any contingency”. In all other respects it is agreed that the Exchangeable Bonds satisfied the requirements of “Deliverable Obligations”.

For the purposes of addressing the Construction Issue although the terms of the Exchangeable Bonds are extensive and detailed essentially they entitled the bondholder to interest and payment of the principal amount on final maturity (18 March 2009). Railtrack plc had no relevant rights to exchange or convert that payment obligation to any other form of obligation or security. But in certain circumstances the bondholder and “the Trustee” did have such rights. The Trustee was trustee for the bondholders under the terms of the Trust Deed by which the Exchangeable Bonds were constituted. Exchangeable Bonds giving such rights to the holders but not to the issuer are commonly referred to as “vanilla convertibles”. In contrast the “Reference Obligation” Non-Exchangeable Bonds contained no exchange or conversion rights for either the holders or the issuer. Such bonds are commonly referred to as “pure vanilla” bonds.

It is CSFB’s case that it was these rights of the holder and Trustee which made the Exchangeable Bonds “Not Contingent” and so not deliverable under the Confirmation.

The rights are contained in Condition 9 of the Exchangeable Bonds. It is 9(a) and 9(d) on which CSFB relies. So far as material they provided that:

The relevant number of Ordinary Shares to be issued on exercise of the exchange right was determined by dividing the principal amount of the bond being exchanged by the “Exchange Price” which was initially fixed at £18.40 a share and adjustable in certain limited circumstances such as capital distributions and share issues.

If, therefore, a bondholder chose to exercise this right of exchange, in effect Railtrack plc’s obligation to repay the value of the bond would be replaced by an obligation to deliver that number of shares (in fact in Railtrack Group plc) which could be acquired by dividing the principal value of the bonds exchanged by £18.40.

The purpose of Condition 9(a) is self-evident. In simple terms, a bondholder has the option to convert a debt of $10m into shares costing (usually) £18.40 a share. In commercial terms no bondholder is likely to do so unless the shares can be realised for more than £18.40 at the time of exchange. The figure of £18.40 was, on the evidence and as would be expected, a figure significantly in excess of the current market price of the shares when the bonds were issued. The holder of Exchangeable Bonds has, however, the potentially valuable right to make the exchange and profit from it. There is also evidence that the value of that right may well be reflected in the price of Exchangeable Bonds and the interest coupon. The coupon on the Exchangeable Bonds was in fact less than on the Non-Exchangeable Bonds. On the other hand many other considerations may be relevant to the price and I do not think price is a significant factor in addressing the Construction Issue. If it were it could have been referred to as such. The only requirement as regards interest was stated in Section 2.18(b)(vii) itself namely that it should be payable but not at any specific rate.

It is, I think, of importance that the predicate to the exercise of the exchange right is the holder’s own decision to take the benefit of it for himself whereas the predicate to the operation of the credit derivative transaction is a “Credit Event” in relation to Railtrack plc which leads the holder to deliver the bonds to the seller of protection in exchange for payment. In all probability the “Credit Event” itself will reflect and crystallise the lack of benefit to be derived from the exchange right and the fact that the holder chooses to deliver the bonds will reflect the commercial reality that they are worth less than the obligation of the seller of protection. That, after all, is what the buyer has bought: protection against the credit risk of the issuer.

The purpose of Condition 9(d) is also not in doubt. It is reflected, with a degree of political incorrectness, in the colloquial name for the Condition: “the widows and orphans clause”. 9(d) is an extension of 9(a) and designed to protect bondholders from losing the opportunity to benefit from the exchange right through ignorance or apathy when that right is about to expire and is worth at least 5% more than the cash sum which would otherwise be paid on expiry. The Trustee may then exchange the bonds for shares and must also then sell the shares “as soon as practicable” and account to the bondholder for the enhanced proceeds.

Although Lord Grabiner QC, for CSFB, submitted that there was always a chance that the Trustee might be caught out between exchange and sale by a weekend catastrophe destroying the share price just as there was always a chance that despite a Credit Event a rapid recovery could infuse the exchange right with real value, those seem to me to be mystical prospects and certainly not ones the sophisticated dealers in transactions of this sort would have in mind when seeking to provide for their respective rights.

There is no dispute that the Non-Exchangeable Bonds were deliverable obligations under the Confirmation, not just because they were the Reference Obligation but also in principle because they satisfied the “Not Contingent” Deliverable Obligation Characteristic.

Condition 14 of the Non-Exchangeable Bonds provided that an Extraordinary Resolution of Bondholders could, for example, determine to reduce or cancel the principal amount payable on the bonds and that such a decision would be binding on all Bondholders. Condition 17 of the Exchangeable Bonds was to the same effect. The evidence is that such Conditions are “standard” in both “plain vanilla” and “vanilla convertible” bonds. Mr Potts QC, for Nomura, referred to the Condition to make the point that in a sense the lack of such an Extraordinary Resolution could be said to be a “contingency” to which the payment of principal was subject. Yet no one suggested that it was a contingency within the meaning of Section 2.18(b)(vii) of the ISDA Definitions.

I mean no criticism of either of the two witnesses (both of whom were experienced and plainly truthful) when I say that their evidence did not advance matters far if at all. Indeed counsel acknowledged as much but sensibly avoided seeking to exclude it as inadmissible. What may be of minor significance (in addition to the pricing to which I have referred) is that I think it is clear that there were known uncertainties at the time about the ISDA Definitions, including “Not Contingent”, and that CSFB had devised a wording which would, if used, have removed any doubts that vanilla convertibles were “Not Contingent” and so were Deliverable Obligations. But the evidence does not establish any uniform market practice or understanding and Mr Gupta (a Managing Director of CSFB) readily accepted that as a matter of commercial practice in his opinion vanilla convertibles should satisfy the “Not Contingent” definition albeit he said CSFB did not believe that they did at the time. In substance it was always open to the parties to such a transaction to put the matter beyond doubt either way but the fact that they did not do so in this case does not advance the resolution of the Construction Issue.

I was referred to a limited number of authorities. Mr Potts relied in particular upon the decision of the House of Lords in Re Sutherland [1963] AC 235 where the House considered the meaning of “contingent liability” in tax legislation. I do not, however, think the passages in the speeches to which Mr Potts referred me are of any real assistance to the proper construction of the words “repayment is not subject to any contingency” in a derivative transaction.

Lord Grabiner sought to draw an analogy with the authorities which decide that documents presented under a letter of credit must strictly conform to the wording of the credit regardless of whether any discrepancies serve any commercial or practical purpose. He also referred to similar principles which apply to the exercise of options. But I do not think the present issue is an analogous one. The issue raises a question of construction as to the meaning of “Not Contingent”. The authorities to which Lord Grabiner referred proceeded on the basis that the terms of the letters of credit and options were themselves clear but had not been complied with. If the Exchangeable Bonds did not satisfy the “Not Contingent” definition they could not be delivered but the question is whether or not they did satisfy it.

In my judgment, Nomura was entitled to deliver the Exchangeable Bonds. It is true that the words “repayment in respect of which is not subject to any contingency” are wide ones but I do not think a provision which operates in favour of a bondholder and is exercisable at his option can sensibly let alone commercially be described as a contingency to which the holder’s right of repayment is subject. It is within the control of the bondholder and depends on no external decision or event. If he chooses to claim repayment he is entitled to it. In contrast a bond convertible at the option of the issuer is a real contingency affecting payment of the principal amount of the bond: real both because it depends on an event over which the bondholder has no control and because commercially it is at the very least likely to be operated to deprive the holder of payment in exchange for an asset of less value. Moreover it must have been in the contemplation of Nomura and CSFB that a Credit Event in respect of Railtrack plc such as to trigger the Confirmation would in reality operate so that at the time of delivery of Exchangeable Bonds to CSFB the exchange right would have been rendered commercially otiose. The right is only valuable in a context other than the context in which the buyer of credit protection is entitled to and claims the benefit of the protection he has bought. The purpose of requiring that the Deliverable Obligation be “Not Contingent” is, I think, plainly to secure a right to payment of the principal amount as such which cannot be affected in amount by extraneous factors over which the seller of credit, as holder, has no control.

It follows, in my judgment, that Condition 9(a) does not deprive the Exchangeable Bonds of the “Not Contingent” characteristic for which the Confirmation stipulated.

Condition 9(d) does, however, contain the extra factor that the exercise of the exchange right depends on an independent decision of a third party, the Trustee. But, I think, on analysis, the same considerations apply. The Condition was plainly intended to give effect and substance to the exchange right in Condition 9(a) in circumstances where the bondholder ought to exercise the right as it would be plainly beneficial to do so. The Trustee acts “on behalf of” the bondholder and the value of the benefit and limit on the discretion is secured by providing not only for the 5% margin and the limited window to exercise the right but also by the obligation to sell the exchanged shares as soon as practicable.

I do not think therefore that the fact that the bondholder would not be entitled to repayment of principal if the Trustee exercised the right in Condition 9(d) makes repayment subject to “a contingency” within the meaning of the word in this transaction. Again, the reality is that in a context in which the seller of protection is required to perform his bargain he will acquire as holder the right to payment under the Exchangeable Bonds without that right being subject to any contingency because the Trustee’s right of exchange is only exercisable in the holder’s interest and in commercial terms has lost its purpose.

I agree with Mr Potts that a line has to be drawn somewhere in determining what may properly be a “contingency”. As he submitted, Condition 17 could in a sense be so described (see paragraph 22) but not in the sense in which I think the word is used in Section 2.18(b)(vii) of the ISDA Rules. In my judgment the same applies to Conditions 9(a) and (d). The payment obligation under a bond is subject to a contingency when the holder may be deprived of the full benefit of it by some external event over which he has no control but not by a provision or provisions in the bond itself designed solely to protect his interests.

It follows that in my judgment the Exchangeable Bonds were Deliverable Obligations within the terms of the Confirmation and CSFB should have accepted them as such when Nomura delivered the appropriate Notices (including a Notice of Intended Physical Settlement) to CSFB on 9 November 2001 specifying the Exchangeable Bonds as the obligations it expected to deliver in settlement of the transaction. There is no dispute that a Bankruptcy Credit Event had occurred in relation to Railtrack on 7 October 2001.

The Exchangeable Bonds were denominated in sterling. Nomura selected for delivery bonds in a sterling amount just less than $ 10m as it was entitled to do under the terms of the Confirmation. On 12 November (wrongly as I have now decided) CSFB rejected Nomura’s Notices. It was agreed that Nomura would mitigate the loss it alleged it had suffered by, first, selling the Exchangeable Bonds in the market and then buying and delivering to CSFB Non-Exchangeable Bonds.

The Exchangeable Bonds realised £5,775,164.25. The Non-Exchangeable Bonds cost £6,798,293.61. The difference is £1,023,129.36 and there is no dispute that Nomura is entitled to that sum on the basis, as I have decided, that the Exchangeable Bonds were Deliverable Obligations.

The Non-Exchangeable Bonds bought by Nomura were delivered to CSFB on 20 November 2001 and the transaction was settled on that basis. The nominal sterling value of the Bonds delivered (£6,886,000) was converted to $ on that date and the sum of $9,741,480.81 paid by CSFB to Nomura accordingly.

Section 8.9 of the ISDA Definitions provides that the currency of the Deliverable Obligation (sterling) is to be converted into the “Settlement Currency” (US$) by reference to a stated exchange rate on the date that the Notice of Intended Physical Settlement is effective (9 November 2001).

On 9 November the relevant exchange rate would have produced a $ payment of $9,998,955.80. That, it is agreed, is the $ sum which CSFB should have paid on delivery of the Exchangeable Bonds. The $ payment made on 20 November was $247,475 less than this amount as a result of changes in the exchange rate between the two dates. Nomura says it is entitled to this sum in addition. CSFB says it is not.

In my judgment Nomura is right and CSFB wrong. The reason for the use of sterling in the calculation of the claim for the increased costs of the Non-Exchangeable Bonds is because Nomura’s loss was incurred in sterling. But Nomura’s entitlement was to a US$ payment on 9 November. Had CSFB performed the contract as I have decided it should have done Nomura would have received the payment which, in effect, it claims.

The claim is, as Lord Grabiner submitted, for unliquidated damages. I also agree that a court will award such damages in the currency (or currencies) expressly or impliedly provided for in the contract between the parties or, where there is no such provision, “in the currency in which the loss was felt by the plaintiff or which most truly expresses his loss”. The Despina R [1979] AC 685 (HL) at 701 (Lord Wilberforce). It is also true (and unsurprising) that there is no express clause in which unliquidated damages are to be paid, and Nomura originally made the total claim in sterling not dollars. But I do not think it can be concluded from those circumstances that Nomura recognised that sterling was the currency which most truly expressed its loss. It made a mistake. It has corrected it. Both the contract and its true loss point to dollars. In my judgment it is entitled to the sums it now claims.

I will hear the parties when this judgment is handed down on the terms of an appropriate order, interest, costs, and any other ancillary matters which may arise.