In The State of The Netherlands v Deutsche Bank AG  EWHC 1935 (Comm), the High Court ruled that the Transferor of cash collateral under a standard form 1995 ISDA Credit Support Annex was not obliged to pay, or otherwise account for, interest to the Transferee where the contractually stipulated rate was negative. The decision provides certainty to an issue that the market has sought to deal with contractually by way of ISDA's 2014 Collateral Agreement Negative Interest Protocol.
Background - Current Market Practice
For some time market consensus has been that the terms of the 1995 ISDA Credit Support Annex (the "1995 CSA") (commonly used if collateralised derivatives transactions are to be entered into under an English-law governed ISDA Master Agreement) do not oblige a collateral-poster (the "Transferor") to pay interest to a collateral-receiver (the "Transferee") if the reference rate for interest in respect of cash collateral is negative.
The Facts of the Case
On 14 March 2001, the State of the Netherlands (the "State") and Deutsche Bank AG ("DB") entered into an ISDA Master Agreement with a 1995 CSA. The parties agreed to a "one-way" credit support under the 1995 CSA, whereby DB would provide credit support to the State where the State had a net credit exposure to DB under the various derivative transactions entered into between the parties, but not vice versa.
Throughout the period relevant to the dispute, the State had a net credit exposure to DB and, in accordance with its obligations under the 1995 CSA, DB provided cash collateral as credit support.
The 1995 CSA required the Transferee (i.e. the State) to pay interest on that cash collateral to the Transferor (i.e., DB). However, the agreed rate of interest, EONIA minus 0.04%, had been less than zero for the larger part of the time since 13 June 2014.
Therefore, an important question arose as to whether the standard 1995 CSA required DB, as the Transferor of the cash collateral, to pay negative interest, to the State, the Transferee. (The parties had not signed up to ISDA's 2014 Collateral Agreement Negative Interest Protocol.)
Given the persistence of ultra-low interest rates, by historical standards, and therefore the general importance for the derivatives market of the question raised in the dispute, the case proceeded on the Financial List, a specialist English Court List set up to handle claims related to the financial markets.
The parties' submissions
DB's position was straightforward: the express wording of paragraph 5(c)(ii) of the 1995 CSA provided only for the Transferee, and not the Transferor, to transfer Interest Amounts. Had the parties intended negative interest to be payable, so argued DB, the agreement would have expressly provided for the transfer of Interest Amounts from the Transferor to the Transferee, which it did not.
DB also referred to the following passage in the ISDA User's Guide in support of its contention that the focus of the agreement was on what the Transferee was to do in return for holding cash collateral, rather than the other way round:
- "Paragraph 5(c) [of the 1995 CSA] provides that the Transferee will pass through to the Transferor any distributions of assets or rights it receives in relation to transferred securities and will pay interest on any cash collateral at the rate (which may be zero if the parties do not want to provide for interest), and in accordance with the method, specified in Paragraph 11."
Whilst broadly accepting the force of that point, the State relied on the definition of Credit Support Balance in the 1995 CSA (essentially, the aggregate of all credit support received by the Transferee), which included the following words:
- “Any Equivalent Distributions or Interest Amounts (or portion of either) not transferred pursuant to Paragraph 5(c)(i) or (ii) will form part of the Credit Support Balance.”
The State argued that this required the Transferor to "account" for negative interest by reducing the Credit Support Balance by the absolute amount of such negative interest. Since the Transferor was obliged from time to time to ensure that the Credit Support Balance was sufficient to cover the Transferee's credit exposure, the Transferee would thereby effectively receive the benefit of negative interest indirectly by way of additional credit support from the Transferor.
The State also argued that the commercial purpose of the interest provisions in the 1995 CSA was "equivalence"; that is, to bring about a situation in which neither the Transferor nor the Transferee suffers or benefits from the fact that the Transferee holds collateral (in addition to the fact that such collateral is to be available to the Transferee in the event of termination for default).
The State also relied on ISDA's 2013 Statement of Best Practice for the OTC Derivatives Collateral Process (the "2013 Statement of Best Practice") (which suggested that negative rate should be used in the Interest Rate and Interest Amount calculations and therefore negative Interest Amounts may be computed) and ISDA's 2014 Collateral Agreement Negative Interest Protocol (to which the parties had not adhered).