In November 2006, Deutsche Bank AG (DB) entered into an FX Prime Brokerage Agreement (the FXPBA) with Sebastian Holdings Inc (SHI), an investment fund run by Alexander Vik (AV). SHI was to act as DB’s agent in the execution of a range of currency options and other FX transactions. Another purpose of the agreement was to allow an FX trader (KS), to trade on SHI’s behalf (and AV had signed a letter of authority permitting KS to trade FX transactions on SHI’s behalf). An additional Equity Prime Brokerage Agreement was entered into between the parties in January 2008 (the Equities PBA), which allowed SHI to execute more complicated transactions, such as equity shorting.
After each transaction, DB would enter into parallel, offsetting transactions with SHI, allowing SHI to benefit from DB’s superior credit status. DB and SHI also entered into two ISDA Master Agreements: (i) the first in May 2006, for SHI to execute a credit default swap (the Equities ISDA); and (ii) the second in November 2006, to hedge exchange rate risk on its FX transactions (the FX ISDA).
During 2008, KS and AV executed substantial trades under both the FXPBA and the Equities PBA. During the financial crisis, however, the FX trades became heavily loss-making, resulting in DB issuing margin calls totalling around $500m. SHI failed to meet all of these margin calls and closed out its positions under the FXPBA and Equities PBA. This left approximately $118m due under the FX ISDA and $125m due under the Equities PBA, which DB sought to recover in its claim for breach of contract. SHI counterclaimed (for approximately $8bn) that improper conduct by DB, including incorrect margining, had forced SHI to close out its positions. SHI also attempted to establish KS’s lack of authority to act on SHI’s behalf with respect to certain trades.
The Court found in favour of DB and awarded it $236m in damages, plus significant costs. In reaching its conclusion, the Court determined the following key issues.
Were any oral agreements entered into?
SHI alleged that various oral agreements had been struck which had the effect of limiting the extent of SHI’s ability to trade beyond a certain threshold and KS’s authority to trade on SHI’s behalf. The Court criticised SHI’s evidence on this point, and found VS to be an unreliable and dishonest witness.
What was the proper construction of the written agreements, and did they contain implied terms alleged to have governed DB’s conduct?
SHI alleged that the FXPBA contained implied terms that DB would have to provide SHI with full and accurate reports from records DB ought to have compiled for each transaction, including data on cash flows, profit/loss, margin and mark-to-market values. This aspect of the counter-claim was relevant insofar as DB had admitted to failings in its ability to accurately compute and record certain features of the more complex transactions (referred to as Exotic Derivative Transactions), particularly with regard to margining the transactions and providing SHI with mark-to-market valuations. SHI claimed that this impaired its ability to properly evaluate its risk exposure for each of these transactions.
The Court held that a proper construction of the FXPBA contained an implied term that DB fulfil a limited reporting obligation (with regard to valuation and margin), but stated that this did not extend to the provision of mark-to-market values or data setting out SHI’s actual exposure for each separate transaction. The FXPBA was held to have been established to perform a basic clearing function, and did not go so far as to require DB to effectively give advice to SHI on individual trades.
Further, the terms and conditions of SHI’s use of DB’s online system contained a valid exclusion of liability in connection with the bank’s record-keeping and reporting to SHI, except in cases of wilful misconduct or gross negligence, which had not been evidenced on the facts. The Court did hold that DB’s failings in terms of properly booking KS’s trades would have constituted gross negligence, had SHI not known of these exact same failings. Accordingly, SHI was deemed to have waived DB’s obligations in this regard. Finally, it was held that KS, in executing the Exotic Derivative Transactions, had relied on his own judgment and evaluation of risk. Losses claimed by SHI in this regard could not be said to have been caused by the performance, or lack thereof, of DB’s implied reporting obligations.
Did KS have the requisite authority to bind SHI in trades he had executed?
This issue hinged on a proper construction of the Letter of Authority signed by AV and also the FXPBA. SHI contended that a wide range of substantial transactions executed by KS, particularly in connection with the more complicated Exotic Derivative Transactions which formed a large part of SHI’s alleged loss, were not binding on SHI. SHI argued that DB should have declined instruction regarding these transactions, as they went beyond the limited scope of KS’s authority.
The Court held that KS’s authority was restricted exclusively to that which the Letter of Authority and the FXPBA prescribed, under the definition of “currency options” and “FX and Options Transactions”. The Court was therefore required to rule on the proper construction of these terms, based on its interpretation of both documents and an evaluation of evidence of market usage of the terms. It held that DB had been entitled to regard KS as duly authorised to execute all the relevant transactions, falling as they did within the intended scope of the Letter of Authority and the FXPBA. Claims that there existed further limitations on KS’s authority, beyond that which had been prescribed by the Letter of Authority and the FXPBA, were said to have no effect on SHI’s liability. All such transactions, therefore, were treated as binding on SHI.
Noteworthy/ Novel points
Deutsche Bank’s booking and reporting obligations to SHI on individual transactions was limited only to an implied term requiring the provision of certain information and did not extend to the provision of detailed advice or more complicated data as alleged by SHI. This obligation was also limited by the terms and conditions of Deutsche Bank’s online reporting system and, even in the event that gross negligence was found, by waiver on account of the defendant’s knowledge of the bank’s limitations in this respect.
The Court was highly critical of SHI’s conduct and testimony during proceedings, which was reflected in the award of 85% of DB’s costs on an indemnity basis.