English Court Rules on 2002 ISDA Master Close Out Provisions

Factual Background

The case concerned a forward currency swap between Lehman and a Philippines company, National Power Corporation (NPC), whereby Lehman agreed to pay US$100 million to NPC in 2028 and NPC agreed to pay the U.S. dollar equivalent of PHP4.4788 billion on the same date (PHP4.4788 billion being the PHP equivalent of US$100 million when the transaction was entered into). NPC was also to pay semi-annual coupons to Lehman at a fixed rate.

NPC terminated the transaction following the collapse of Lehman and designated an Early Termination Date of November 3, 2008. On November 3, 2008, NPC obtained indicative quotations from three leading market dealers, including UBS. NPC proceeded to firm quotations from each of the leading market dealers on November 7, 2008 and entered a replacement transaction with UBS on November 14, 2008.

On January 26, 2009, NPC submitted a calculation notice demanding payment from Lehman of around US$3.5 million, based on the transaction actually entered into with UBS. Lehman challenged that calculation, stating that NPC had neither used “commercially reasonable procedures” nor reached a “commercially reasonable result” as required by the 2002 ISDA Master. Lehman subsequently commenced legal proceedings seeking payment from NPC in the sum of around US$13 million. In 2016, after the commencement of legal proceedings, NPC purported to withdraw its calculation statement and serve a revised statement.

The Judgment

Standard of reasonableness to be applied

The judge confirmed that it is now quite clearly established before the English courts that, in the context of the Loss payment measure under the 1992 ISDA Master, the phrase “reasonably determines in good faith” requires only that the determining party must not reach “a determination which no reasonable non-defaulting party could come to” (the “1992 Standard”). This has been described in the English cases as a standard of “rationality” or analogous to “Wednesbury Reasonableness.”

Significant changes were made in the 2002 ISDA Master to the provisions applicable upon termination. In particular, the 2002 ISDA Master required that “[a]ny Close-out Amount will be determined by the Determining Party (or its agent), which will act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result.”

NPC argued that despite the change in wording from “reasonable” to “commercially reasonable,” the 1992 Standard should still apply because a party to the contract was tasked with the Close-out calculation. NPC’s argument was rejected by the judge. Even where the parties had agreed that one of them, rather than an external third party, would be tasked with the calculation, the “commercial reasonableness” language in the 2002 ISDA Master required the determining party to act in a manner that an objective third party would consider to be commercially reasonable. This is a stricter test than the 1992 Standard.

The judge also confirmed earlier case law that stated the requirement in the 2002 ISDA Master “to produce a commercially reasonable result” was not simply describing the aim of commercially reasonable procedures but, instead, created a separate obligation. The determining party must ensure that it follows procedures that are commercially reasonable and also ensure that it reaches a result that is commercially reasonable.

It was unreasonable under the circumstances to rely on indicative quotes

When NPC sought quotations on the Early Termination Date, it made clear that these were indicative and “in preparation for the actual bidding.” Given this fact and the market circumstances at the time, the judge found it would not have been commercially reasonable for NPC to calculate the Close-out Amount based on the indicative quotations rather than the transaction it had actually entered into.

This finding has significant relevance for both the 2002 ISDA Master and also the 1992 ISDA Master as both state that the calculation must take place as of the Early Termination Date or, if that is not reasonable, as soon as practicable thereafter. A number of parties have argued that this language prevents the determining party from calculating as of a date after the Early Termination Date unless it has proven impossible to calculate as of the Early Termination Date itself (e.g., because the markets were closed and no alternative source of pricing was available). The finding in NPC adds further weight against this argument and suggests that the English courts will, notwithstanding the express wording in the 2002 ISDA Master permitting indicative quotations to be considered, allow a party to calculate as of a later date where doing so would allow it to reflect more accurately the price for a replacement transaction that was actually available in the market.

The determining party is not entitled to withdraw its calculation

The judge made clear that, once a party has served its calculation statement, it is not entitled to withdraw it and serve an amended statement, even where the counterparty has made no payment in reliance on the original. The bases for this finding included that, by serving a calculation statement, the determining party causes a debt obligation from one party to the other, a significant contractual event that cannot be reversed.

The judge added that if there is an error in the determination, it is for the court or tribunal chosen by the parties to declare that an error has been made and to state what the close-out amount would have been on a determination that was without error.

The judge did make clear that, as a party to the contract, the determining party could serve a revised calculation statement as evidence to inform the question of whether there had been an error, although the language the judge used left open whether a determining party could apply to the relevant tribunal of its own volition to correct a mistake in its determination or whether it would have to hope for a challenge from its counterparty.

The use of mark-to-market and modelled evaluations

Lehman relied on mark-to-market valuations from the Early Termination Date to argue that the price NPC relied on was unreasonable. Those mark-to-market valuations suggested that the transaction was in the money to Lehman as of the Early Termination Date. The judge, however, made clear that the mark-to-market valuations did not necessarily reflect the price at which a replacement transaction could actually have been obtained in the market. He noted, in addition, that he accepted NPC’s evidence that it considered the mark-to-market valuations to be of limited value as they were theoretical and based on simulations. Similarly, the judge was unwilling to accept modeled evaluations in circumstances where actual quotations had been obtained which, by their very nature, reflected the price available in the market at the relevant time. This decision is a further indication that, particularly in difficult markets, the English courts will require significant persuasion to accept a mark-to-market or modeled evaluation as the basis to challenge a calculation under either the 1992 or the 2002 ISDA Master that has been based on quotations obtained properly from the market.

Practical Considerations

The case is the first English judgment to focus on the interpretation of the close-out provisions under the 2002 ISDA Master Agreement and provides valuable guidance in this regard. When choosing whether to contract on the basis of the 1992 or the 2002 ISDA Master, parties should consider carefully whether they would like the determining party following termination of the transaction to be bound by an objective standard of commercial reasonableness (under the 2002 ISDA Master) or the less onerous standard applicable to Loss calculations under the 1992 ISDA Master.