Periodically the world of synthetic hedge arrangements collides with that of commercial lending in a way that provides interesting results. I was recently surveying some case law involving this very topic and came across Blue Bonnet Hotel Ventures, L.L.C. v. Wells Fargo Bank, N.A., 754 F.3d. 272 (5th Cir. Ct. App. 2014). In this case, Blue Bonnet entered into an interest rate swap agreement in anticipation of also obtaining a letter of credit, to be issued by Wells Fargo, which would support a tax exempt bond issue which, in turn, would provide the capital for Blue Bonnet’s development project.
The opinion, citing the lower court, provided a nice definition of a “swap”, describing it as “…a separate agreement whereby parties agree upon a fixed, baseline interest rate (usually including a certain spread above the market interest rate), and one party makes payment to the other based on whether the floating market interest rate (usually a specified interest rate index) moves above or below the fixed interest rate. The payments are calculated based on the difference between the fixed and floating interest rates over a given interval, multiplied by a hypothetical amount of “notional” principal agreed to in advance. Id. at 275.
Things got interesting when Blue Bonnet was not able to obtain the letter of credit and, as a result, could not complete the bond financing. Apparently there was a provision in the swap contract allowing Blue Bonnet to terminate the contract and, if it had, it would have received approximately one million dollars from the bank. For some reason, Blue Bonnet continued in the swap and allegedly ended up paying the bank over six million dollars under the swap contract. Ultimately Blue Bonnet attempted to get out of the swap contract under various state law legal theories including seeking to rescind the swap contract. The essence of its argument was that the contract was entered into to hedge interest rate risk that Blue Bonnet anticipated under its bond issue which never came to fruition.
The Court affirmed the lower court’s decision awarding summary judgment to the bank. Thus, Blue Bonnet was stuck with the swap contract despite the fact that it did not end up with the anticipated financing for which the swap was to be an interest rate hedge. The Court very strictly construed the swap contracts terms and clearly treated it as what it is: a standalone contract. The lesson here is first, the safe way to proceed is to first close the financing, then enter the swap agreement. Otherwise, make sure the swap documentation includes an “out” clause if the financing cannot be obtained.
