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Is the tide turning in the $245 million credit default swap dispute between Citigroup and Morgan Stanley? In a ruling in May, Manhattan federal district court judge Shira Scheindlin granted judgment on the basis of the pleadings to Citi in its breach of contract suit against Morgan Stanley. She also dismissed two Morgan Stanley counterclaims. But the May ruling didn’t address two additional counterclaims asserted by Morgan Stanley’s lawyers at Quinn Emanuel Urquhart & Sullivan. And in an opinion issued Friday, Scheindlin offered a ray of hope to Morgan Stanley: She granted one of its counterclaims, citing e-mails between the Citi and Morgan Stanley employees who negotiated the credit default swap at issue in the litigation. The dispute stems from the collapse of a collateralized debt obligation issued in 2006 by Capmark VI Ltd. Citi, which agreed to provide up to $366 million in revolving credit to the CDO, paid $750,000 to Morgan Stanley as part of a three-year credit default swap deal. In exchange for the payment, Morgan Stanley agreed to assume the risk that the CDO would fail. After the CDO collapsed in 2008, Citi recouped $121 million from the CDO’s liquidation and sought the rest it was owed — $245 million — from Morgan Stanley. After Citigroup filed suit last year, Morgan Stanley responded with counterclaims asserting that Citi breached the terms of the swap when it ordered the liquidation of the CDO without Morgan Stanley’s consent. In May, Scheindlin ruled in favor of Citi, citing the unambiguous terms of the swap contract. But she didn’t address a counterclaim for reformation of the contract, which Quinn Emanuel added prior to the May ruling. In support of the counterclaim, Morgan Stanley provided e-mails between contract negotiators that, Quinn Emanuel argued, showed negotiators erroneously omitted from the swap contract a clause stating that Citi would obtain Morgan Stanley’s consent prior to exercising its rights under the Capmark indenture. Scheindlin, citing the e-mails, said Morgan Stanley’s argument was plausible. “While Citibank may very well succeed on summary judgment or at trial, [Morgan Stanley] has sufficiently pleaded a claim for reformation based on mutual mistake,” wrote Scheindlin. In the same ruling, the judge dismissed with prejudice Morgan Stanley’s counterclaim for equitable estoppel. “We look forward to presenting all of our evidence, which shows that Morgan Stanley obtained the rights at issue,” Michael Carlinsky of Quinn Emanuel wrote us in an e-mail. Gregory Joseph of the Gregory P. Joseph Law Offices, who represents Citi, did not return a call for comment.

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