The question of whether ‘negative interest’ will be payable by a transferor of cash collateral in the context of a standard form ISDA 1995 Credit Support Annex (Bilateral Form – Transfer) (“CSA“) has been considered by the Commercial Court in The State of the Netherlands v Deutsche Bank AG  EWHC 1935 (Comm). The court found that there was no obligation on the transferor of cash collateral to account to the transferee for negative interest on that collateral.
Many market participants will already have been aware of the uncertainty surrounding negative interest rates under the CSA given the lack of express terms. It was this uncertainty which led ISDA to publish the ISDA 2014 Collateral Agreement Negative Interest Protocol (the “2014 Protocol“), containing express terms dealing with negative interest rates. As such, the decision is not entirely unexpected, but will provide clarity on this point.
The decision raises an interesting question as to the position in circumstances where the interest rate is not negative for an entire Interest Period (as was the case here). If the interest rate is fluctuating daily between negative and positive amounts in a given Interest Period, should negative interest be taken into consideration in calculating the daily Interest Amount? While the judgment does not cover this fact pattern specifically, it may be thought to be anomalous to take account of negative amounts on a daily basis (netting them off against any positive amounts within the same Interest Period, rather than ascribing a zero value), when the instant judgment confirms that a negative amount at the end of the Interest Period does not need to be accounted for/paid (in the absence of an express obligation).
Central to the court’s decision was its finding that an obligation to pay negative interest would have to be “spelled out“. This was not done in paragraph 5(c)(ii) of the CSA (the obvious place for such an obligation to appear), which only contemplated payment of interest from the transferee of collateral to the transferor.
In reaching its conclusion, the court emphasised the objective nature of the task of construction of the ISDA documentation. It determined that the 2013 Statement of Best Practice for the OTC Derivatives Collateral Process and the 2014 Protocol (which address negative interest), could not be considered part of the context of the agreement between the parties, as they were not available to the parties at the time the relevant agreement was made. In any event, those statements were not offered by ISDA as a view on interpretation (and the 2014 Protocol expressly envisaged amendments which parties could make). By contrast, the ISDA User’s Guide – which was available to the parties at the time of the agreement – could be used as an aid to interpretation. The ISDA User’s Guide reinforced the point that the focus of the agreement was on what the transferee would do in return for holding cash collateral.
In March 2001 the State of the Netherlands (the “State“) and Deutsche Bank (the “Bank“) entered into an agreement comprising the 1992 ISDA Master Agreement (Multicurrency – Cross Border), Schedule and CSA (together the “Agreement“). The CSA was amended in 2010 to delete and replace paragraph 11.
Pursuant to the Agreement, the parties entered into a number of derivative transactions. Under these transactions, where the State had a net credit exposure to the Bank: (i) the Bank was required to provide credit support to the State by way of cash collateral (the “Collateral“); and (ii) the State was required to pay the Bank interest on the Collateral.
The State did, in fact, have a net credit exposure to the Bank and the Bank accordingly posted Collateral. However, from June 2014, the interest rate applicable to the State’s obligation to pay interest on the Collateral was less than zero.
The State brought a claim against the Bank for negative interest in respect of the Collateral.
The State acknowledged that paragraph 5(c)(ii) of the CSA only required the transferee (defined in the Agreement as the State) to pay interest to the transferor (defined in the Agreement as the Bank); there was no reciprocal obligation. Accordingly, rather than rely on CSA paragraph 5(c)(ii), the State argued that the Bank was obliged to ‘account’ for negative interest in calculating the Credit Support Balance (broadly speaking, the aggregate of the Collateral received by the State, i.e. the valuation of the Collateral). The State relied on the final line of the definition of Credit Support Balance which states that Interest Amounts “not transferred pursuant to Paragraph 5(c)(i) or (ii) will form part of the Credit Support Balance“. The State contended that unpaid interest should increase – or in the case of negative interest, decrease – the value of the Credit Support Balance.
The court held that the State’s claim for negative interest failed. In reaching its decision, it set out in brief the basic requirements for interpreting an ISDA standard form agreement (commenting that there was no sound reason for any different approach in the case of a CSA that takes an ISDA standard form). This included:
- The requirement to look at the language, and investigate the commercial consequences, when interpreting any provision of a commercial contact (Wood v Capita Insurance Services Ltd  UKSC 24).
- The need for clarity, certainty and predictability in interpreting the ISDA standard form Master Agreement (Lomas and Ors v JFB Firth Rixson Inc and Ors  EWHC 3372 (Ch)).
- The court also noted that the choice to use ISDA documentation is itself “a powerful point of context” (In Re Lehman Brothers International (Europe) (in administration) (No. 8)  EWHC 2417 (Ch)).
The court considered the specific terms of the Agreement (and in particular the CSA) and found that the State failed to show that the Agreement included an obligation for the Bank to pay negative interest.
In coming to this conclusion, the court considered the following factors in particular:
- The court agreed with the Bank that if there was an obligation to pay negative interest “it would be spelled out“. The terms of paragraph 5(c)(ii) of the CSA contemplated payment of interest from the State to the Bank only. Had the parties wished to, they could have included an obligation on the Bank to pay negative interest. Illustrating the point that there was nothing to suggest the parties had intended negative interest to be payable, the court noted that (under paragraph 11 of the CSA), the parties had provided for a zero interest rate, rather than the payment of negative interest, if the Bank transferred the Collateral to the wrong account.
- The final sentence of the definition of Credit Support Balance was explained by providing for amounts of interest the State was obliged to pay under paragraph 5(c)(ii) but had not yet transferred, without requiring an obligation in respect of negative interest where none was “spelled out“.
- Paragraph 5(c)(ii) of the CSA was the obvious place for any obligation to pay negative interest to appear. There was no credible commercial rationale for the parties having chosen different mechanisms to deal with positive and negative interest.
- The court also considered potential reasons why commercial parties may have been concerned only with positive and not negative interest, including that payment of interest on the Collateral by the State was “a price for having use of the [Collateral]“. It said this reflected the fact that the Collateral, being in cash, could be expected to make money solely by being held (by the State). Conversely, if cash Collateral was held in a negative interest rate scenario, it did not follow that the State could be expected to lose money and so that burden should be shouldered by the Bank. In this context, the court noted that the parties had agreed that the State could freely use the Collateral to generate a return elsewhere, such that the State would not necessarily incur loss by holding cash where interest rates were negative.
- The court did not accept that the exercise of interpretation was assisted by either ISDA’s 2013 Statement of Best Practice for the OTC Derivatives Collateral Process, or ISDA’s 2014 Protocol, given that these post-dated the agreement. In any event, they did not assist the State since the protocol envisaged parties making amendments in order to bring about the payment of negative interest. This was contrasted with ISDA’s User Guide, which was available as an aid to interpretation.