Subprime mortgage litigation doesn’t always pit shareholders against banks which invested unwisely. Banks have been suing each other, too.  Exhibit A is Judge Scheindlin’s most recent opinion in Citibank v. Morgan Stanley, which provides a great primer on reformation and mutual mistake between “two of the most sophisticated financial institutions in the world.” The opinion analyzes Citi’s claim that Morgan Stanley failed to pay under a credit default swap covering bad mortgages. 

A company called Capmark issued a CDO, a security backed by a collateral mix of mortgages and other assets.  Under the CDO’s governing indenture, Citi, which lent $366 million to the CDO under a revolving credit agreement, had the right to liquidate the collateral if its loan was not repaid.  Thinking that it was getting belt and suspenders, Citi also purchased credit protection on its Capmark loan from Morgan Stanley via a credit default swap – essentially loan insurance.  As the real estate market tanked in 2007-08, so did the Capmark CDO, which defaulted on the Citi loan. Citi liquidated its collateral, but collected only $121 million of the $366 million it lent. Citi then turned to Morgan Stanley to collect its $245 million shortfall under the swap. 

But, Morgan Stanley claimed that the swap agreement between Citi and Morgan should be “reformed” because it did not reflect what Morgan claimed was an agreement by that only Morgan had the authority to liquidate the Capmark collateral. During the negotiations of the swap agreement, the lead Citi negotiator inserted the word “OK” in reply to an email from his counterpart at Morgan Stanley proposing that Citi’s rights under the Capmark loan agreement would pass to Morgan for the term of the swap. That transfer of rights provision was not included in the final swap agreement, and Morgan claimed that the failure to include it was a mutual mistake in the drafting of the swap. 

Judge Scheindlin’s opinion recognizes that  “In the proper circumstances, mutual mistake … may furnish the basis for reforming a written agreement. [But] [b]ecause the remedy of reformation presents the danger that a party, having agreed to a written contract that turns out to be disadvantageous, will falsely claim the existence of a different, oral contract, the New York courts have sharply limited the remedy of reformation both procedurally and substantively.”

Judge Scheindlin exhaustively examined the evidence presented by the parties on cross-motions for summary judgment, ultimately finding that the interlineated “OK” did not meet the high standard of “clear and convincing evidence” necessary to reform the swap. She also addressed the perplexing issue of who has the authority to bind a principal where there are teams of senior officers negotiating on parallel tracks.  Here’s the Judge’s useful take on that issue:

“Even assuming that [the Citi officer] was the “chief negotiator” for Citibank—and that his intent was to effect a transfer [to Morgan Stanley]—the undisputed facts establish that (1) [Morgan] knew the parties’ ultimate “intentions” would be reduced to a fully-integrated contract, (2) Costango [the Citi officer] did not have authority to override that contract by responding “OK” to a request in an informal email exchange… (3) Morgan was on notice that any executed agreement would require “Citi final internal approvals,” and (4) the parties agreed that they were “not relying upon any representations (whether written or oral) of the other party other than the representations expressly set forth” in the Capmark Swap Agreement…. ”

In other words, in a case between sophisticated parties, even the subjective intent of a lead negotiator expressed in writing won’t carry the day when it comes to meeting the daunting standard of mutual mistake.  So in the end, Citi got its belt and suspenders, but it was not an easy path, which brings us to Exhibit B – when there’s a large amount of money at stake, the gloves will come off, even between banks that usually are on the same side of the caption in subprime litigation.

And, of course, Happy Father’s Day to all.