Previously unincluded swaps are making their way into consideration in a lawsuit accusing banks of fraud in the variable-rate market, potentially extending the length of the case and increasing the possible damages hanging in the balance.
The development arose late last month in New York when a judge granted the wish of the accused banks — among the largest in the world — the opportunity to seek swap-related materials in discovery. A transcript of court proceedings shows the banks and the entity bringing the lawsuit, Edelweiss Fund, have differing opinions on the impact of the inclusion of swaps in the suit. Both sides appear to have opposed bringing swaps into the suits at some point during the case, but it is the defendants who asked for their inclusion now.
"The reality is, your Honor, when these issuers enter into a swap, even if that variable rate on the VRDO was inflated, it can't harm the issuer or it harms them less because they traded that obligation to make the variable-rate payment for that fixed payment that's outlined in the swap agreement," David Jorgensen, an attorney representing JPMorgan, told the court.
But Seth Greenstein, representing Edelweiss, presented a different perspective to the court.
"The type of swaps that typically were entered into in this case were index-based swaps where the issuer always had to pay to the bondholder the VRDO rate set forth in the bondholder agreement, the inflated rates we are claiming in this case," Greenstein said. "The issuer would pay a fixed synthetic rate back to the counterparty, but the counterparty would pay to the issuer a rate that was based on some other index. Typically it would be some percentage of Libor, for example."
"Which means that, in fact, discovery in this case would be exponentially expanded because now suddenly the Libor rates become very relevant to this case because you need to understand the relationship between the amounts that the issuers were getting from the counterparty vis-a-vis the inflated rates they had to pay," Greenstein said. "So, in fact, discovery would be exponentially expanded in this case, and the case would become infinitely more complex, which is one of the reasons why we wanted to know are defendants going to raise this as a defense because if not, this would basically double the effort that we were going to have to make in the case. Now, it would increase the damages substantially because not only is there this difference in the basis risk that the issuers incurred, but also many of the issuers pay termination fees to get out of the swaps."
The court decided to move ahead with discovery, while Judge Andrew Borrok seemed to have some lingering question as to how swaps tied into the larger theory of the case.
"There are lots of different ways we talked about it, but all related to the notion that the lowest possible rate which is the obligation was not met, and that there was significant movement across different unrelated VRDOs from different financial institutions that gave rise to the concern which is the focus of this action," he said, addressing Greenstein. "I think I need to see why the representations as it relates to swaps ties into your theory of the case because I am having trouble with that."
Alleged damages in the New York suit already approached $400 million.
