The Court of Appeal has confirmed that negative interest is NOT payable under ISDA Credit Support Agreements CSAs, unless there is a clear contractual agreement to that effect. This important judgment is likely to be final and not appealed further to the UK Supreme Court.
Details
In the recent case of: State of the Netherlands v Deutsche Bank AG [2019] EWCA Civ 771 (02 May 2019), the Court of Appeal reviewed the 2018 decision of Mr Justice Knowles CBE in the High Court and considered whether negative interest was payable and claimable ex post under a Credit Support Agreement CSA, that did not include any explicit negative interest rate provisions, and that was incorporated, together with various derivatives transactions, into the 1992 form ISDA Master Agreement between the parties. (For general case background see our earlier discussion note.)
Economics and markets background
The Master Agreement and original old CSA between the parties were both signed in March 2001, an era when G7 interest rates (with the exception of Japanese rates) were typically strongly positive, reflecting both positive real economic growth and positive monetary inflation, and arguably in this era negative nominal interest rates would have been outside the contemplation of most Western based and focused ISDA counterparties.
However, 9 years later and in the new economic era of the Great Recession, Quantitative Easing, and ultra-low interest rates, an updated new CSA between the Netherlands and Deutsche Bank was signed on 15 March 2010, and this was an asymmetric 1-way CSA, that only provided for net Deutsche Bank collateral to be held by the Netherlands and not for net Netherlands collateral ever to be held by Deutsche Bank (although there could be 2-way collateral adjustment flows between both parties) and daily interest payable on the collateral posted at a rate of EONIA (the ECB’s overnight interest rate) minus 4 basis points (i.e. minus a spread of 0.04%. N.B. this was always a very low rate of interest for the Netherlands to be paying.)
ISDA CSA key terms
The ISDA CSA architecture (rather like the ISDA Master Agreement) is a document with standard wording and provisions in the main body, and specific bespoke elections and variables at the end, in final paragraph 11.
The Court of Appeal took the view that the description of “Interest Amount” at paragraph 5( c)(ii) of the CSA envisaged positive but not negative interest flows:
5( c) (ii) Interest Amount. Unless otherwise specified … the Transferee will transfer to the Transferor ….the relevant Interest Amount.
Arguably this is because the Transferee is the holder of the net collateral i.e. always the Netherlands, and "will transfer" then implies the Netherlands handing over something tangible such as money.
Interest Amount is a defined term at paragraph 9 of the CSA:
"Interest Amount" means, with respect to an Interest Period, the aggregate sum of the Base Currency Equivalents of the amounts of interest determined for each relevant currency and calculated for each day in that Interest Period on the principal amount of the portion of the Credit Support Balance comprised of cash in such currency, determined by the Valuation Agent for each such day as follows:
(x) the amount of cash in such currency on that day; multiplied by
(y) the relevant Interest Rate in effect for that day; divided by
(z) 360 (or, in the case of pounds sterling, 365).
The Interest Rate was a bespoke defined term in paragraph 11 of the CSA on Elections and Variables:
11 (f)(i) Interest Rate. The "Interest Rate" with exception of the condition mentioned hereafter under (iv) will be EONIA minus four (4) basis points. "EONIA" for any day means the reference rate equal to the overnight rates as calculated on an actual / 360 day count by the European Central Bank and appearing on different publication media on the first TARGET Settlement Day following that day.
So the sticking point was that all references in the CSA were to interest rates generally and there were no explicit references to either positive or negative interest rates.
A purely literal interpretation of the CSA’s "Interest Rate" definition and calculation method could clearly allow the Interest Rate to become negative. However it is not clear what the mechanism would be for the payment of such negative interest. Additionally, the zero percent interest rate floor stipulated under paragraph 11(f) of the CSA for payments into the wrong Netherlands bank account, discussed in the High Court case, might also apply to and preclude any negative interest, and also imply that negative interest was not envisaged in the contract.
Moreover the Valuation Agent tasked with determining and calculating the Interest Amount would most likely have been Deutsche Bank, which was always clear that negative interest rates were excluded.
ISDA guidance on CSA collateral best practice
For contemporary factual context on whether the new CSA envisaged and applied to negative as well as positive interest rates, the Court of Appeal considered extensive industry guidance published by ISDA on CSA collateral management best practices.
In its June 2010 note on “Best Practices for the OTC Derivatives Collateral Process”, published 3 months after the CSA was signed, ISDA included:
Best Practice 11.2: Flooring of Interest Rates [2010]
Principle: At no point should the interest accrual (rate minus spread) drop into a negative figure. If this occurs the rate should be floored at zero.
Description: Many CSA agreements were written and agreed when it was not anticipated that interest rates would reach extremely low levels. However market conditions have occurred where the interest accrual formula could result in a negative number with a collateral provider obligated to pay interest to a collateral holder. At no point should the interest accrual (rate minus spread) drop into a negative figure. If this occurs then the best practice is to floor the interest rate at zero.
This advice recognized that underlying interest rates in that environment could become negative and this could be problematic for collateral management. ISDA’s 2010 best practice advice was therefore that negative interest should not be paid on CSA collateral but that a “floor” (i.e. a specific interest rate derivative) term maintaining the collateral interest rate at zero or above zero but never below zero, should be applied to CSA collateral.
Legally this would probably correspond to a floor term interpretation being understood to be already contained in the CSA documentation or for a new floor term to implied into the CSA documentation. It might even envisage a floor term being implied in by the subsequent conduct of the parties.
Although the ISDA Best Practice note of June 2010 was not available in published form to the parties when they signed the CSA in March 2010, the underlying ISDA consultation process for market participants had been going on since at least June 2009 when ISDA published its Roadmap for Collateral Management.
And although the original CSA of March 2001 between the Netherlands and Deutsche Bank was clearly written “when it was not anticipated that interest rates would reach extremely low levels”, this background assumption was more debatable for the successor March 2010 CSA.
Finally it should be noted that the ISDA 2010 Best Practice note was indicative and advisory and did not exclude other good practice by agreement between the parties. There is likely to have been a spread and development of thinking amongst knowledgeable market participants in collateral around this time, because ISDA’s Best Practice 11.2 advice evolved and changed dramatically in their subsequent 2011 and 2013 Best Practices notes.
In its November 2011 note on: “2011 Best Practices for the OTC Derivatives Collateral Process”, ISDA amended its advice as follows:
Best Practice 11.2: Flooring of Interest Rates [2011]
Principle: In the circumstance where market conditions cause the interest accrual (rate minus spread) to drop to a negative figure and the CSA is not explicit on the flooring of interest rates, parties should bilaterally agree interest accrual handling.
Description:…parties should always follow the interest accrual rate defined in the CSA, however, in the circumstance where an existing CSA is not explicit regarding the flooring of interest rates, parties should bilaterally agree the handling of interest accruals should market conditions cause the rate to drop to a negative figure.
The Court of Appeal noted the same title being used as before, but in fact ISDA's advice was now different i.e. that absent an explicit floor provision for negative interest rates for CSA collateral, the best practice recommendation in such cases was that parties should bilaterally agree the handling of interest accruals some way or other and not necessarily apply any floor to interest rates payable.
In its subsequent October 2013 note on “Interim updated best practices for the OTC derivatives collateral process” ISDA again amended its advice as follows:
Best Practice 11.2: Negative Interest rates [2013]
Principle: Market participants should review and follow more detailed ISDA guidance that may be published on this topic. In summary, where the floating rate index (eg OIS rates such as Fed Funds, EONIA, SONIA, etc) sets in the market at a negative level, then under the standard published text of the CSA this negative rate should be used in the Interest Rate and Interest Amount calculations. Therefore negative Interest Amounts may be computed. Parties should either settle these negative interest amounts in the reverse direction to normal interest settlement or alternatively compound the negative interest into the credit support balance under the CSA, decrementing it rather than incrementing it, as would be the normal case. Where the parties have modified the relevant language within the CSA to change the way that interest is calculated (for example, by the inclusion of a spread, one-way collateral arrangements, an interest rate floor, or other modifying language) the parties should consult and decide how to address negative interest rates.
ISDA’s best practice advice (subsequently reflected and formalized in ISDA’s May 2014 "Collateral Agreement Negative Interest Protocol”) was that negative interest could in principle be paid out on CSA collateral if this was clearly agreed and an appropriate mechanism put in place between the parties.
Conclusion and comments
Dismissing the Netherlands’ appeal, the Court of Appeal concluded at para 63 of their judgment that:
“We have been careful to undertake the process of iterative checking and re-checking of the competing interpretations against each part of the CSA. We can only say that we do not think that, on its true interpretation, applying the approach required by the authorities we have mentioned, the CSA can be taken as providing for the payment of negative, as opposed to positive, interest.”
Potentially telling additional support comes from the fact that although the relevant interest rates became negative in June 2014, it was only over 3 years later in August 2017, that the Netherlands issued its original claim form against Deutsche Bank.
Although the ISDA collateral best practice notes discussed above show a range and development in thinking about the best treatment of negative interest rates for CSA collateral, they all agree on their Best Practice 11.1: Settling Interest (Standard Monthly Interest Calculation) advice, and the market norm, that any collateral interest rate differences and disputes between parties should be resolved “within 30 days of receipt”.
The c.40 times longer, 3 year delay, between June 2014 and August 2017 strongly suggests that negative interest was not programmed into the Netherland’s collateral management system in 2014, presumably because it was not part of their CSA collateral agreement with Deutsche Bank.
Indeed, having mulled over the Court of Appeal's decision for a month, Dutch Minister of Finance, Wopke Hoekstra, duly sent a letter to the Dutch Parliament on 4th June 2019, stating (in translation) that "The chances [for further appeal to the UK Supreme Court] are limited and that is why, on the advice of my legal advisers, I have decided not to lodge a further appeal. I therefore resign myself to the decision of the English Court of Appeal. As a result of the decision, a maximum of EUR 25.3 million will be written off and charged to the item of interest income under Article 11 of the budget of the Ministry of Finance."
Freshfields partner Rhodri Thomas, who helped prepare the defence case for Deutsche Bank, commented: "Ultimately, this was not a case about whether negative interest can be payable in concept. Rather, it was about whether negative interest was payable under the terms of the bespoke documents in the case."
(Rupert Macey-Dare is a commercial barrister and PhD-economist. Rupert gratefully acknowledges helpful comments from: Sharon Grennan, Rhodri Thomas, and Ulrike Verboom. These are discussion points of the author and do not necessarily reflect the views of any other individuals or organizations, and do not constitute legal or economic advice.)
