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Despite Losses from Investment with Madoff, Investor May Not Rescind Swap Agreement with HSBC

Friday, January 6, 2012

Fanni Koszeg | Bloomberg LawWailea Partners, LP v. HSBC Bank USA, N.A., No. 11-CV-03544, 2011 BL 318810 (N.D. Cal. Dec. 15, 2011)

  • In the ISDA agreement, Wailea, a sophisticated business party, expressly disclaimed reliance on statements by HSBC regarding the investment.
  • Under New York contract law and applicable precedent, the written agreement governs the relationship between the parties.
The U.S. District Court for the Northern District of California dismissed with prejudice all claims by Wailea Partners, LP (Wailea), a California investment firm, against HSBC Bank, USA, N.A. (HSBC) for rescission of a total return swap agreement (Agreement) and return of approximately $15 million of collateral Wailea posted to HSBC. HSBC synthetically invested Wailea's money in a fund that used Bernard Madoff as the exclusive asset manager on the basis that the fund would use a specific investment strategy. Once Madoff's Ponzi scheme was uncovered and the investment failed, Wailea sued HSBC asserting five claims for rescission, including mutual and unilateral mistake, innocent misrepresentation, and failure of condition precedent. Wailea contended that HSBC had been aware of a risk of fraud at Madoff's firm and that Madoff was not using the investment strategy Wailea intended to get exposure to. The Court agreed with HSBC's motion to dismiss and found that the clear language of the Agreement prevented Wailea's claims from succeeding.

Background–the Disputed Swap Agreement

In May 2007 Wailea and HSBC began negotiating the Agreement through which Wailea would gain exposure to hedge funds that utilize the so-called "split-strike conversion" (SSC) trading strategy. Under the terms of the total return swap, Wailea would receive a return based on the performance of the reference asset, in this case a fund called Senator Equity Segregated Portfolio One (Senator Fund). The parties selected the Senator Fund because most of its capital was deposited with Bernard L. Madoff Investment Securities LLC (BLMIS), which purported to use the SSC trading strategy. Between October 2007 and December 2008 the parties amended the Agreement several times to increase the maximum notional amount and Wailea periodically adjusted the amount of collateral it provided to HSBC, which had the effect of adjusting the amount of Wailea’s synthetic investment in the Senator Fund. In total, Wailea transferred $15,970,000 in collateral to HSBC. Wailea alleged that HSBC suspected Madoff's involvement in fraud since 2005 because it had hired the auditing firm KPMG to review BLMIS’s business for "fraud and related operational risk." KPMG did indeed find several risks of fraud, including a failure to segregate client funds and deviation from the SSC trading strategy, both in a 2006 report submitted to HSBC and a subsequent report issued in March 2008. In the second report, KPMG pointed HSBC to risks of "falsification of client mandates, embezzlement of client funds, and diversion of client funds for Madoff's personal gain." Following this report, HSBC affiliates began a mass liquidation of their assets in BLMIS hedge fund clients, including the Senator Fund in which HSBC liquidated substantially all of its assets. When Wailea asked about the HSBC affiliates' liquidation efforts, HSBC told Wailea "that there was no reason for concern and that the redemptions were made for 'market reasons.'" HSBC did not disclose the contents of the KPMG reports to Wailea.

Choice of Law–the ISDA Agreement Prevails

Wailea argued that since it was disputing the very formation of the contract, the contractual choice of law provision of the Agreement should be inapplicable and California law should apply. HSBC contended that pursuant to the choice of law clause in the Agreement, New York law should apply to Wailea's first four claims. The Court agreed and determined that California choice of law rules strongly favor the application of contractual choice of law clauses and New York law was thus applicable to the first four claims.

Rejected Claims

The Court dismissed all of Wailea's claims against HSBC with prejudice. — Claims for Mutual or Unilateral Mistake Under New York law, a mistake of material fact is not grounds for rescission if the party seeking rescission bears the risk of mistake. HSBC argued that the first two claims failed as a matter of law because Wailea expressly assumed the risk of the alleged mistake that the Senator Fund would not perform as expected. Wailea contended that while it assumed certain specified risks in the Agreement, it did not assume the risk that the Senator Fund’s capital would not be invested pursuant to the SSC trading strategy. The Court explained that under section 12 of the Agreement, Wailea affirmed that it understood and assumed the financial risks of the "Transaction," defined as "the share swap transaction entered into by the parties." Moreover, as would be the case in most swap agreements between sophisticated business parties, Wailea expressly agreed that "it was solely responsible for making an independent appraisal" of the Senator Fund and that Wailea was not relying on any representations or warranties made by HSBC regarding the Senator Fund. Accordingly, dismissing the first two claims, the Court stated that the Agreement "consistently and unambiguously allocates to Wailea the risk of mistake as to the Senator Fund’s performance," including the risk that the funds would not be invested in accordance with the SSC strategy. — Innocent Misrepresentation Claim In order to make a successful claim for rescission due to innocent misrepresentation, the plaintiff must "set forth the circumstances in detail showing that a false material representation was made and that it relied on this representation to its detriment." Wailea argued that it relied on two sets of representations: (1) oral and written representations made by HSBC that the Senator Fund would follow the SSC strategy; and (2) representations in each month-end valuation report sent by HSBC that misstated the value of Wailea's investment. The Court found that due to the above detailed disclaimers in the Agreement, which Wailea reaffirmed each time it agreed to amend and restate the Agreement, Wailea cannot, as a matter of law, establish that it relied on the alleged misrepresentations. To support its position, the Court cited a recent relevant case from the Southern District of New York, which found that "[the] disclaimer does not have to identify precisely the alleged misrepresentation, but the disclaimer must track the substance of the misrepresentation." — Claim for Failure of Condition Precedent To obtain rescission based on a failure of condition precedent, Wailea would have to point to express language in the Agreement that "establishes the parties' unambiguous intent to condition the Agreement's formation on the Senator Fund's capital being invested pursuant to the SSC strategy." Wailea acknowledged that the Agreement does not contain such language, but alleged that the parties had an oral agreement regarding the use of SSC strategy qualifying as a condition for entry into the Agreement. In response, the Court stated that "New York's highest court has held that allegations of an oral condition precedent cannot be reconciled with an express disclaimer covering the same subject matter." — Claim of California Corporations Code Violation In its last claim, Wailea alleged that HSBC violated Section 25401 of the California Corporations Code, which provides that it is unlawful for any person to sell a security by means of a communication involving an "untrue statement of material fact or [omissions of] a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading." Wailea argued that it was entitled to rescind the Agreement under Section 25501 of the same, which provides a purchaser of a security sold in violation of Section 25401 the right to sue the seller. The Court agreed with HSBC that the alleged oral and written misrepresentations or omissions are either expressly disclaimed by the above discussed provisions in the Agreement of the swap agreement or are not cognizable under Section 25401. DisclaimerThis document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.

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