Recent judgment of the High Court in the case of Lehman Brothers International (Europe) vs. Lehman Brothers Finance S.A. has provided welcome guidance the issues of ‘close-out’ and confirmed the existence of consistency of meaning between the close-out provisions of the 1992 and 2002 editions of the ISDA Master Agreement, explains Michael Beaton, managing director, Derivatives Risk Solutions LLP.
Introduction
The recent judgment of the High Court in the case of Lehman Brothers International (Europe) vs Lehman Brothers Finance S.A. provides useful guidance on the correct interpretation of “Close-Out Amount” under the 2002 ISDA Master Agreement.
Background
Lehman Brothers International (Europe) (“LBIE”) entered into OTC derivative transactions with its clients in the normal course of its business (“Client Transactions”). The practice within the Lehman group was that the risk associated with Client Transactions was to be transferred to, and managed by, Lehman Brothers Finance S.A. (“LBF”), a Swiss company. Accordingly, all Client Transactions entered into by LBIE were matched by automatically generated back-to-back transactions between LBIE and LBF (“Intercompany Transactions”) which were governed by a 1992 ISDA Master Agreement (the “Lehman ISDA”). Under the original Lehman ISDA, the following elections had been made:
• Lehman Brothers Holdings Inc (“LBHI”) was identified as a “Specified Entity” of LBF;
• Automatic Early Termination did not apply to either party; and
• Market Quotation and Second Method did apply.
The Side Letter
The Lehman ISDA was subsequently amended by way of a side letter (the “Side Letter”) dated 24 July 2006. The Side Letter documented an agreement between LBIE and LBF that, if a Client Transaction was terminated, the corresponding back-to-back Intercompany Transaction would also terminate automatically and the settlement amount payable pursuant to the Lehman ISDA to or by LBIE would be equal to the sum payable to or by LBIE under the relevant Client Transaction.
First Subsequent Amendment
On 22 November 2007 LBIE and LBF made a further amendment to the Lehman ISDA by which Automatic Early Termination became applicable to LBF (but not to LBIE) due to a risk that Swiss insolvency law might invalidate optional early termination clauses on the insolvency of LBF.
Second Subsequent Amendment
On 29 August 2008, as part of a worldwide banking agreement called the Close-Out Amount Multinational Agreement (“CMA”), LBIE and LBF agreed to replace the provisions for close-out and settlement amounts on early termination within the Lehman ISDA (a 1992 ISDA) with the re-drafted provisions of the 2002 ISDA Master Agreement. Before the court, it was agreed that this had the effect of amending every existing Intercompany Transaction, and to constitute the basis for determining Close-out Amounts on early termination of both existing and future Intercompany Transactions between LBIE and LBF.
The Collapse of Lehman
At 06.45 BST on 15 September 2008, Chapter 11 proceedings commenced in New York with respect to LBHI. This constituted an Event of Default with respect to LBF under the Lehman ISDA (due to the fact that LBHI was LBF’s Specified Entity) and resulted in Automatic Early Termination of all Intercompany Transactions. The insolvency of LBHI may also have constituted an Event of Default with respect to LBIE with respect to the Client Transactions (as LBHI was often the “Credit Support Provider” of LBIE). However, in contrast to LBF, Automatic Early Termination did not apply to LBIE under its agreements with clients and on this basis Client Transactions were not automatically terminated as a result.
At 07.56 BST on 15 September 2008, an administration order was made with respect to LBIE.
On 29 October 2009, insolvency proceedings with respect to LBF were instituted in Switzerland.
The net result was that:
• all of the Intercompany Transactions terminated before any of the Client Transactions for which they provided back-to-back hedges;
• LBIE was the Non-defaulting Party under the Lehman ISDA and therefore entitled to calculate the Close-Out Amount – a job which fell to the administrators of LBIE after its insolvency; and
• LBIE was the Defaulting Party under any Client Transactions which were terminated, meaning that LBIE’s clients were generally entitled to determine the relevant early termination payments.
The Issues
The main issue before the court was whether LBIE was entitled or required to take into account the ‘pass-through’ settlement methodology agreed between LBIE and LBF as detailed within the Side Letter in determining Close-out Amounts under Section 6(e) of the Lehman ISDA. If the Side Letter was rightly to be taken into account, this would result in a financial benefit to LBIE and its creditors estimated at USD 1 billion. As such, the administrators of LBIE argued that it the Side Letter should be taken into account, whereas LBF took the opposite view.
The Law
Materiality
The calculation of a Close-out Amount under a 2002 ISDA Master Agreement requires the Determining Party to identify (inter alia) “…the losses or costs…or gains…that are or would be realised under then prevailing circumstances…in replacing, or in providing…the economic equivalent of…the material terms” of the Terminated Transaction(s). As such, the court was required to determine whether the terms of the Side Letter were to be regarded as “material” for the purposes of the ISDA Master Agreement.
The “Continuity Assumption”
The calculation of a Close-out Amount under the 2002 ISDA Master Agreement also requires the Determining Party to assume satisfaction of every condition precedent specified within the ISDA Master Agreement – this is more commonly known as the requirement to value on a ‘clean’ basis.
The court noted the existing authority on the 1992 ISDA Master Agreement which had established that early termination payments were to be valued on a ‘clean’ rather than ‘dirty’ basis (i.e. to value on the assumption that, but for termination, the relevant transaction would have proceeded to maturity, and that all conditions to full performance by both parties would have been satisfied, however improbable that assumption may be in reality). The court referred to this as the “continuity assumption”. It noted further that there was no reported authority on the meaning of the analogous provisions in the 2002 ISDA Master Agreement (as inserted in the Lehman ISDA by the CMA amendment), but that the provisions of both the 1992 ISDA and the 2002 ISDA should be interpreted in a consistent manner as there was no reason to suppose that, in drafting the 2002 ISDA Master Agreement, a decision had been taken to ‘substantially abandon’ the continuity assumption.
The Judgment
The court held that the terms of the Side Letter were not “material”. It also concluded that to permit the provisions of the Side Letter to be taken into account in the Close-out Amount determination under the Lehman ISDA would involve a radical departure from the “clean” valuation principle and thus run counter to the “continuity assumption”. As such, the terms of the Side Letter were not to be included in any valuation of the “Close-out Amount” under the Lehman ISDA. Furthermore, even if that conclusion was incorrect and the terms of the Side Letter were correctly to be regarded as “material”, the court concluded that the “continuity assumption” demanded that those terms be ignored or attributed a nil value for the purposes of calculating a “Close-out Amount”.
Analysis
Materiality
Ostensibly, it may not be easy to follow all of the logical steps on the road to this judgment. The court readily accepted that the ‘pass-through’ provisions of the Side Letter were “important” terms, the purpose and intent of which was to “…wholly…displace the early termination payment regime in the Intercompany Transaction in the event of an early termination of the associated Client Transaction”. Moreover, it held that a term was to be regarded as “material” if “…its inclusion in the replacement transaction (or the economic equivalent of its value) would be relevant to the pricing of that hypothetical transaction…” – a criteria that would seem to apply to the provisions of the Side Letter. Nonetheless, the court still reached the conclusion that the terms of the Side Letter were not “material” for the purposes of valuing the losses and gains which formed part of the “Close-out Amount”.
This apparent contradiction can be explained by the finding that the “commercial reasons for the Side Letter had nothing to do with achieving perfect equity as between LBIE and LBF in a mutual insolvent collapse”. Rather, the Side Letter was concerned with “minimising LBIE’s regulatory burdens while carrying on business as a going concern”. The effect of the Side Letter was to bring about an early termination of the Intercompany Transactions in circumstances where the Client Transactions had already been terminated, but it does not logically follow that this had any effect on the value of Intercompany Transactions in circumstances where the Client Transactions continued in force. On the facts, the court held that the Side Letter did not provide for anything other than the “standard form consequences of early termination” in circumstances where the Intercompany Transactions terminated before the Client Transactions. As the court noted, if the parties had wished to make arrangements to deal with this specific eventuality they could have done so – but did not. In these circumstances, the conclusion of the court that the terms of the Side Letter were not material in this context no longer appears surprising.
Conditions Precedent and ‘Clean’ Valuations
Section 2(a)(iii) of the ISDA Master Agreement states that “Each obligation of each party under Section 2(a)(i) is subject to…the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing.” Put another way, if Party B has committed an Event of Default then Party A is under no obligation to make payment or delivery under the ISDA Master Agreement. However, in calculating the “Close-out Amount”, the ‘continuity assumption’ requires the parties to assume that no Event of Default has occurred.
The terms of the Side Letter can also be viewed as a condition precedent, in that the obligations of LBIE and LBF to make payment under Section 2(a)(i) were conditional upon there being no early termination of the relevant Intercompany Transaction by reason of the terms of the Side Letter. Put another way, if a Client Transaction had been terminated then the amount payable under the relevant Intercompany Transaction would be determined in accordance with the ‘pass-through’ terms of the Side Letter. However, in calculating the “Close-Out Amount”, the ‘continuity assumption’ again applied and the parties were to assume that no termination of the Client Transactions has occurred. This left the valuation of Intercompany Transactions to be determined on the standard terms of the ISDA Master Agreement, thus explaining the rationale of the court in reaching its verdict.
Conclusion
The judgment in this is case is not always easy to follow in all respects. Moreover, the conclusions reached are likely to be no more than was already generally assumed to be the case by the market. However, the fact remains that this represents the first official ruling on this issue. To that extent, this case constitutes welcome and important guidance on the issue of close-out under the 2002 ISDA Master Agreement as it confirms the existence of consistency of meaning between the close-out provisions of the 1992 and 2002 editions of the ISDA Master Agreement.
