Wachovia Defeats VCG Hedge Fund Lawsuit; Judge Says Bank Owed More Money

Wachovia Corp., the bank now owned by Wells Fargo & Co., won dismissal of a lawsuit that accused it of forcing a hedge fund to make higher margin payments than necessary on a credit-default swap.

U.S. District Judge Laura Taylor Swain in Manhattan also ruled yesterday that the hedge fund, VCG Special Opportunities Master Fund Ltd., must pay Wachovia an as-yet-unspecified further amount under the deal.

In July 2009, Swain narrowed the suit to one claim that Wachovia, as the “valuation agent” of a collateralized-debt obligation the swap covered, violated “good faith and fair dealing” by determining that VCG owed more in collateral than the swap’s $10 million value.

“Wachovia’s calculation of exposure was not ‘arbitrary or irrational’ but, to the contrary, was performed according to its contractual obligations and yielded a result that was consistent with the prevailing market perception of the value of the trade,” Swain wrote in her order.

“We’re evaluating our options, including appeal,” Steven Mintz, a lawyer for VCG at Mintz & Gold LLP, said in a phone interview.

A different federal judge in November 2008 ruled that Citigroup Inc. didn’t cheat VCG out of collateral on a similar swap, and ordered the hedge fund to pay the bank $674,252 to complete the total $10 million in coverage. That ruling was upheld by a federal appeals court in December. Citigroup’s broker-dealer unit is in arbitration over the deal.

Wachovia Counterclaim

In a counterclaim, Wachovia alleged VCG breached its contract and still owes it $1.03 million. Swain agreed the hedge fund owes the bank money. She ordered the parties to either agree on the amount or to argue the issue further.

Credit-default swaps are financial instruments used to speculate on a borrower’s creditworthiness or to hedge against losses. The contracts pay the buyer face value for the underlying securities if the company fails to adhere to its debt agreements.

VCG, an Isle of Jersey, U.K.-registered fund formerly called CDO Plus Master Fund Ltd., was required by Wachovia to deposit additional sums as collateral, eventually costing it $8.92 million on the $10 million swap, according to VCG’s amended complaint filed in 2008 in Manhattan federal court. The case was originally brought in New York state court.

Wachovia and VCG, controlled by Delray Beach, Florida-based Vanquish Capital Group, entered into the swap in May 2007. VCG sold protection against a default by a collateralized-debt obligation in exchange for an annual premium payment of 2.75 percent of the swap’s face value.

CDOs repackage bonds and other assets into new securities. Neither Wachovia nor the hedge fund owned the CDO.

Margin Calls

Wachovia told VCG it wouldn’t have to post margin beyond the initial $750,000 unless the underlying collateral defaulted, the hedge fund said in court papers. Instead, Wachovia demanded another $320,000 a few weeks after the initial payment and a total of $8.92 million over five months, according to VCG.

When VCG objected to another margin demand of $550,000, Wachovia solicited valuations of the CDO by four market makers - - Goldman Sachs Group Inc., Royal Bank of Scotland Plc, Merrill Lynch & Co. and Deutsche Bank AG -- that put Wachovia’s exposure at $9.65 million, calling for additional collateral of $1.49 million rather than the $550,000, according to Swain’s ruling.

VCG sued rather than pay, arguing the final demand would have pushed its payments to more than $10 million. Swain found that under the deal’s terms, the total amount of collateral the hedge fund could owe was the initial $750,000 plus the $10 million face value.

‘Quick Look’

Swain found VCG’s criticism of the valuations -- that the Goldman Sachs trader said he took a “quick look” at the deal and that the RBS trader was instructed to provide a “mark” -- to be “inconsistent with the plain language of the CDO contract.”

The hedge fund never offered any evidence to dispute the valuation, the judge said.

The bank had declared a $10 million writedown in the underlying assets, which the fund said didn’t occur, according to the complaint.

VCG’s expert said the notes the swap referenced had declined by less than 10 percent, the hedge fund said in court papers. It also said evidence showed Wachovia’s margin demands were “tainted by bad faith” because the bank was already over- secured and Wachovia was concerned with VCG’s creditworthiness rather than the notes’ credit risk.

Appealed Ruling

On March 29, Swain ruled that broker-dealer unit Wachovia Capital Markets must arbitrate VCG’s claims about the swap before the Financial Industry Regulatory Authority, the Washington-based watchdog known as Finra. Wachovia has appealed that ruling.

The cases are CDO Plus Master Fund Ltd. v. Wachovia Bank, 07-11078, and VCG Special Opportunities Master Fund Ltd. v. Citibank, 08-01563, U.S. District Court, Southern District of New York (Manhattan).

To contact the reporter on this story: Thom Weidlich in Brooklyn, New York, federal court at tweidlich@bloomberg.net.