Opinion
602604/2005.
Decided December 14, 2005.
FRIEDMAN KAPLAN SEILER ADELMAN, LLP, Jeffrey Wang, Esq., New York, NY, JENNER BLOCK, David A. Handzo, Esq., Washington, DC, for Plaintiffs.
KAYE SCHOLER, LLP, Michael Braff, Esq., New York, NY, for Defendant.
This is an action for breach of contract brought by the administrators of TXU Europe Limited (TXU), a corporation organized under the laws of England and Wales and currently involved in insolvency proceedings in England. Defendant Merrill Lynch moves to dismiss the complaint, pursuant to CPLR 3211(a)(1) and (a)(7), based on documentary evidence and failure to state a cause of action.
In May of 1999, TXU guaranteed three series of bonds issued by TXU Eastern Funding Company ("Eastern Funding"), a company described as "an affiliate of TXU." Subsequently, TXU and Merrill Lynch entered into several "swap agreements" to hedge currency and interest rate risk associated with its guarantee of the bonds; specifically, the parties entered into three transactions governed by an International Swap Dealers Association, Inc. Master Agreement ("ISDA agreement" or "Agreement"), a common form contract used to hedge finance risks arising from fluctuations in currency exchange and interest rates. The ISDA Agreement commits each party to pay certain amounts to the other, based on changes in rates.
At the time of issuance, TXU was known as TXU Eastern Holdings Limited, but it does not appears that there was a relationship of succession between TXU and Eastern Funding.
The Agreement also gave each party the right to terminate upon default of the other. An event of default includes the commencement of voluntary insolvency proceedings. Upon termination, the Agreement requires the non-defaulting party to calculate the amount, if any, due the defaulting party and to pay that amount. The parties dispute under which circumstances the ISDA Agreement allows amounts, due upon termination, to be set-off by other obligations.
TXU's financial situation deteriorated during 2002 and it claims these problems were well-known in the market place and to Merrill Lynch. In October of 2002, Merrill Lynch agreed to "unwind" two of the three transactions under the Agreement, but did not agree to unwind the transaction at issue here.
Immediately after refusing to unwind the third transaction, Merrill Lynch purchased a quantity of the bonds guaranteed by TXU, a quantity having a total face value of approximately $20,400,000.00, roughly equal to the amount Merrill Lynch owed under the Agreement. Allegedly, Merrill Lynch purchased the bonds for the market value of only $3,500,000.00 because TXU's financial troubles caused the bonds to sell at a steep discount.
TXU began voluntary insolvency proceedings on November 19, 2002. The next day, Merrill Lynch exercised its right to terminate the agreement. It then provided to TXU a statement of the amount due under Agreement, a debt of over 20 million dollars. Merrill Lynch claimed that, by the terms of the Agreement, the debt due TXU could be set-off by the obligation owed to Merrill Lynch under the bonds, and that the set-off is equal to the face value of the bonds rather than the steeply discounted market value.
The amount owed under the Agreement is not disputed.
TXU brought this action, arguing breach of the ISDA agreement based on two theories of liability: First, that Merrill Lynch failed to pay the debt due under the Agreement, because, under the terms of the Agreement, the bonds could not set-off the debt, or that, if the bonds could act as a set-off, they should set-off only that amount of the debt equal to the market value of the bonds. Second, that Merrill Lynch breached the implied covenant of good faith and fair dealing by "acquiring in bad faith . . . the . . . [b]onds for the sole purpose of setting them off against the amount . . . owed . . . under the . . . Agreement. . . ." (TXU Compl., at ¶ 37). Merrill Lynch moves for dismissal based on documentary evidence and failure to state a cause of action.
Documentary Evidence
Merrill Lynch argues that documentary evidence alone justifies dismissal because the express provisions of the ISDA Agreement provide that debt owed by the non-defaulting party under the Agreement may be set-off by other obligations owed by the defaulting party to the non-defaulting party. It contends that the full face-value of the bonds may be used to set-off the debt owed to TXU under the ISDA Agreement because, in the bond indenture, TXU guaranteed payment of the bonds. Merrill Lynch submitted copies of the ISDA Agreement, a confirmatory letter written pursuant to the Agreement, and the bond indenture.
TXU opposes dismissal based on the documentary evidence offered by Merrill Lynch, arguing that the documents submitted do not conclusively establish Merrill Lynch's claimed right to a set-off nor does this evidence definitively establish that the entire debt may be set-off, if it is demonstrated that the right to a set-off exists.
A motion to dismiss may be granted on documentary evidence so long as the documents alone "definitively dispose of plaintiff's claim." (E.g., Bronxville Knolls, Inc. v. Webster Town Center Partnership, 221 AD2d 248 [1st Dep't 1995]). The movant may not rely on affidavits or depositions to support a motion to dismiss pursuant to CPLR § 3211(a)(1). ( See Seigel, Practice Commentaries, McKinney's Cons Laws of NY, CPLR § 3211[a] [1]; see generally Juliano v. McEntee, 150 AD2d 524, 525 [2nd Dep't 1989]; Demas v. 325 West End Ave. Corp., 127 AD2d 476, 477 [1st Dep't 1987]).
A debt owed to another can be set-off by an obligation to the debtor only if both the debt and the obligation are mutual and due. ( Willett v. Lincolnshire Mgmt., 302 AD2d 271 [1st Dep't 2003]; Ferguson v. Lion Holdings, Inc., 312 F. Supp. 2d 484, 503 [S.D.NY 2004]) Here, the debt and obligation are mutual because both are contractual obligations between the same parties. ( Westinghouse Credit Corp. v. D'Urso, 278 F.3d 138, 149-150 [2nd Cir. 2002]). But, a contingent obligation cannot set-off a debt due and payable: "'there is no right to set off a possible, unliquidated liability against a liquidated claim that is due and payable.'" ( Willett v. Lincolnshire Mgmt., supra 302 AD2d at 271).
The Agreement provides for the set-off of a debt owed to a defaulting party with "any sum or obligation (whether or not arising under this Agreement and whether matured or unmatured) owed or due by [the non-defaulting party]. . . ." (Braff Affidavit, Exhibit A, at pt. 5 ¶ 3). Merrill Lynch argues that the obligation under the bonds may be asserted as a set-off because the Agreement states that an obligation used as a set-off, may be "matured or unmatured. . . ." However, that language in the Agreement is parenthetical and qualified by the words "owed or due by [the non-defaulting party]." Clearly, and unambiguously, the Agreement requires any sum or obligation to be "owed or due," regardless of its maturity, before it can set-off a mutual obligation owed to the defaulting party.
Although there is no documentary evidence showing that the bonds were due, the bonds themselves are evidence of the issuer's indebtedness to Merrill Lynch in an amount equal to the face value of the bonds — the issuer owed Merrill Lynch the face value of the bonds. That obligation, if owed by TXU, could be applied as a setoff under the language of the ISDA Agreement. However, TXU did not issue the bonds, it merely guaranteed prompt payment of the bonds. (Braff Aff. Ex. C, at § 1401). TXU's obligation to pay on the bonds then, is contingent upon the failure of Eastern Funding, the issuer, to pay the amount owed Merrill Lynch.
Since none of the documentary evidence submitted in support of this motion sufficiently refutes the contingency of TXU's obligation, Merrill Lynch's motion to dismiss based on documentary evidence is denied.
Failure to State a Cause of Action
Merrill Lynch argues that there can be no valid cause of action for breach of contract because it established a proper claim for set-off. They also claim not to have breached the implied covenant of good faith and fair dealing, because they acted in accordance with the express terms of the Agreement and such action cannot constitute breach of the implied covenant.
In opposition, TXU claims to have properly alleged a cause of action for breach of contract on two theories: First, breach of contract based on allegations of the existence of a contract, performance by TXU, breach by Merrill Lynch, and damages resulting from the breach. TXU argues that the affirmative defense of set-off is not properly alleged or, in the alternative, that their claim for breach of contract survives Merrill Lynch's set-off defense because the amount due exceeds the value of the set-off. Second, TXU argues that the complaint properly alleges breach of the implied covenant of good faith and fair dealing. They contend that the allegations in the complaint, if accepted as true, show that Merrill Lynch acted in such a way as to prevent TXU from receiving proper payment of the debt owed under the Agreement.
When deciding a motion to dismiss pursuant to CPLR 3211(a)(7), the facts as alleged in the complaint must be accepted as true. A court must accord the plaintiff "the benefit of every possible favorable inference and determine only whether the facts as alleged fit within any cognizable legal theory." (E.g, Sokoloff v. Harriman Estates Development Corp., 96 NY2d 409, 414; Leon v. Martinez, 84 NY2d 83, 87-88). "The motion must be denied, if from the pleadings' four corners, 'factual allegations are discerned which taken together manifest any cause of action cognizable at law.'" ( Richbell Information Services, Inc. v. Jupiter Partners, L.P., 309 AD2d 288, 289 [1st Dep't 2003]).
To state a valid cause of action for breach of contract, a plaintiff must allege the terms and existence of a contract between the parties, performance by plaintiff, breach by Merrill Lynch, and damages incurred by plaintiff. ( E.g. Pernet v. Peabody Engineering Corp., 20 AD2d 781, 781-82 [1st Dep't 1964]) ( See Kraft v. Sheridan, 134 AD2d 217 [1st Dep't 1987]). With regard to the terms of the contract, the pleader should "plead its legal effect, as he [or she] understands it and purposes to maintain it. . . ." ( United States Printing Lithograph Co. v. Powers, 183 A.D. 513 [1st Dep't 1918]) ( See The Promenade v. Schindler Elevator Corp., 1 AD3d 240, 241 [1st Dep't 2003]).
The complaint alleges all the elements of a breach of contract action: (1) the parties entered into an ISDA Agreement; (2) TXU performed their obligations under the agreement; (3) Merrill Lynch breached by failing to pay the amount due upon termination; and (4) that breach by Merrill Lynch caused damage to TXU.
Merrill Lynch asserts that no breach or damage exists because they set-off their debt under the Agreement with the obligation under the bonds they purchased before termination. As discussed above, TXU's obligation to pay is contingent upon the failure of Eastern Funding, the issuer, to promptly pay amounts due under the bonds. In addition, TXU argues that the right to a set-off should not be allowed in this case.
However, even if the bonds could be used to set-off the debt, TXU argues that, as a matter of equity, only the market value of the bonds should be allowed as a set-off. The ISDA Agreement, by its own terms, is "subject . . . to equitable principles of general application. . . ." (Braff Aff., Ex. A, at § 3 [a] [v]), and TXU argues that it would be inequitable to allow Merrill Lynch to extinguish its debt of over 20 million dollars with bonds it purchased for approximately 3.5 million dollars.
Relying on the Second Circuit decision in Finance One Public Co. Ltd. v. Lehman Brothers Special Financing, Inc., 414 F.3d 325, 344 (2nd Cir. 2005), Merrill Lynch argues that principles of equity do not apply to this case with respect to the question of the value of the asserted set-off. However, Finance One decided against the application of equity based on Thai public policy and Thai law regarding the right of set-off.
Courts, when exercising their powers of equity, may deny an asserted set-off of a debt with an obligation where the asserting party purchased the obligation for nominal or no value with knowledge of the obligor's impending insolvency. ( See Modern Settings, Inc. v. Prudential-Bach Securities, Inc., 936 F.2d 640, 647-48 [2nd Cir. 1991]; Resiman v. Independence Realty Corp., 195 Misc. 260, 264 [NY Sup. Ct. 1949]; Pond v. Harwood, 139 NY 111, 119-20). Thus it would appear that a set-off may be reduced to an amount equal to the value paid for the obligation forming the basis of the set-off, if the claimant paid more than nominal but less than full value for the obligation. ( See generally Beecher v. Vogt Manufacturing Co., 227 NY 468, 473).
Here, it may be reasonably inferred from the allegations of the complaint that, in early October of 2002, Merrill Lynch knew or had reason to know that TXU was or soon would be insolvent. Merrill Lynch voluntarily unwound two of the three swap transactions governed by the Agreement but refused to unwind the third. It purchased bonds of equal value to the debt under the Agreement. It knew that the bonds traded for only a fraction of their face value and that offering the bonds as a set-off would be "the least expensive way" to extinguish the debt. (Defendant's Reply Memorandum, at 7). Inferring that Merrill Lynch knew or should have known of TXU's impending insolvency, its actions in purchasing the discounted bonds and offering them as a set-off of the third and final swap transaction may be determined to be inequitable, justifying a reduction of the set-off to the value paid for the bonds, should a claim for set-off alternatively be allowed. ( See Modern Settings, Inc., supra, 936 F.2d at 647-58; Pond, supra, 139 NY at 119-20; Reisman, supra, 195 Misc. at 264).
Since the plaintiff has sufficiently set forth the elements of a breach of contract and since further factual development concerning the alleged set-off is necessary, the motion to dismiss this theory of liability for breach of contract must be denied.
With respect to the second theory of liability under the breach of contract cause of action, the theory is based on breach of the implied covenant of good faith and fair dealing, Merrill Lynch argues that the Agreement expressly provided for a set-off and, therefore, there could be no violation of the implied covenant of good faith and fair dealing because they acted in accordance with an express provision of the Agreement.
TXU opposes, arguing that there can be a breach of the implied covenant without the breach of an express provision of the Agreement, that even if the express terms of the Agreement allow for a set-off, Merrill Lynch acted in bad faith to deprive TXU of the benefits of the Agreement by attempting to set-off the debt with obligations owed under distressed securities worth only a fraction of the amount owed TXU and purchased by Merrill Lynch only a short time before termination of the Agreement.
An implied covenant of good faith and fair dealing exists in every contract. (E.g., Wood v. Lucy, Lady Duff-Gordon, 222 NY 88, 90-91). Breach of the implied covenant constitutes a breach of the contract. ( See generally Jaffe v. Paramount Communications, Inc., 222 AD2d 17, 22-23 [1st Dep't 1996]; AIM Int'l Trading, LLC v. Valucine S.P.A., No. 02 Civ. 1363, 2003 WL 21203503, at *7-9 [S.D.NY May 22, 2003]; Boscorale Operating, LLC v. Nautica Apparel, Inc., 298 AD2d 330, 331 [1st Dep't 2002]). Under the implied covenant, parties to a contract are precluded from taking action "which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract." ( Kirke La Shelle Co. v. Paul Armstrong Co., 263 NY 79, 87). A determination of bad faith or "willful or negligent disregard of the rights of the other party . . . is generally a question of fact. . . ." ( Pernet v. Peabody Engineering Corp., 20 AD2d 781 [1st Dep't 1974]).
In support of this theory of liability, Plaintiff alleges that, because of Merrill Lynch's knowledge that TXU would likely file for insolvency, Merrill Lynch acquired, for the purpose of set-off, bonds with a face value equivalent to the debt they owed to TXU, that Merrill Lynch acquired those bonds at a deep discount, and that, upon termination of the Agreement, it claimed a set-off in an amount equal to the face value of the bonds. TXU alleges that Merrill Lynch took such action in bad faith to avoid payment of the full value of its debt under the Agreement.
These allegations, if accepted as true, support a valid theory of liability based on breach of the implied covenant of good faith and fair dealing. Whether Merrill Lynch acted with an intent sufficient to justify liability for breach of the implied covenant is a question of fact that cannot be resolved on a motion to dismiss. Furthermore, the viability of TXU's allegations based on breach of the implied covenant does not depend on the existence of any breach of an express provision of the Agreement. ( See Chase Manhattan Bank N.A. v. Keystone Distributors, Inc., 873 F. Supp. 808, 815 [S.D.NY 1994]). If it is accepted as true that Merrill Lynch acted in bad faith when they sought to set-off its debt to plaintiff with deeply discounted bonds, then it caused injury to one of TXU's rights under the Agreement the right to payment of the full value of the debt due upon termination. By purchasing the discounted bonds shortly before offering them as a set-off, and with knowledge of TXU's impending insolvency, Merrill Lynch leveraged TXU's financial problems to pay less than the full value due TXU under the Agreement.
It is true that, as Merrill Lynch seems to argue, there can be no breach of the implied covenant where such breach would be inconsistent with the other terms of the contract. ( Murphy v. American Home Products Corp., 58 NY2d 293, 304-05; Holder v. General Motors Corp., 189 Misc 2d 297 [Sup. Ct. 2001]). However, TXU's argument for breach of the implied covenant is based, at least in part, on Merrill Lynch's attempt to set-off a debt of over $20,100,000 with bonds having a market value of $3,500,000. Even if Merrill Lynch had a right to set-off their debt with an obligation of equal value, it presents a question of fact as to whether attempting to set-off the debt with distressed securities was either in bad faith or a "willful or negligent disregard of the rights of" TXU under the Agreement, a question of fact that should not be decided on a motion to dismiss. ( See generally Pernet v. Peabody Engineering Corp., supra, 20 AD2d 781).
Merrill Lynch's motion to dismiss is denied in all respects.
Accordingly, it is ORDERED that the motion to dismiss is denied.