The English High Court has today handed down judgment on what is believed to be the first case on the 2002 ISDA Master Agreement close-out formulation.
The case was brought by Lehman Brothers International (Europe) ("LBIE") against Lehman Brothers Finance SA ("LBF") (the Swiss equity derivatives vehicle). See: In the matter of Lehman Brothers International (Europe) (in administration) (2012) EWHC 1072 (Ch)
The principles which were decided were that:
1. Like the 1992 Market Quotation and Loss measures before it, the Close-out Amount formulation required "clean" valuations of terminated transactions. That meant that LBIE was not entitled to take into account the effect of a letter that provided for the termination of transactions between LBIE and LBF if corresponding "back-to-back" transactions between LBIE and its street clients terminated. Valuing "clean" means that termination rights cannot be taken into account when determining early termination payments; they are incompatible with the so-called "continuity assumption" that the transactions should be assumed to continue to maturity.
2. This was the case even though, under the Close-out Amount formula (unlike the Market Quotation and Loss measures), it is specifically stated that the determining party's creditworthiness may be taken into account in quotations provided as a basis for establishing the Close-out Amount; the judge did not consider this change was sufficient to introduce such a radical departure from the now well established "continuity assumption" which applies to the 1992 Master Agreement.
3. Close-out Amount is not the same as a damages claim; it does not include all types of loss that might be recoverable at common law. Accordingly LBIE could not claim the loss it claimed it suffered through loss of its rights under the side letter in question.
The case concerned a side letter between LBIE and LBF which affected those OTC derivatives transactions between them where LBIE had entered into "back-to-back" transactions with its street clients. The transactions between LBIE and LBF meant that the market risk of the LBIE transactions with the street was passed on to LBF but there remained certain risks with LBIE. The purpose of the side letter was to provide for:
a. an inter-company transaction to terminate automatically and at the same time as the corresponding LBIE street trade;
b. the termination payment under the inter-company transaction to follow the termination payment under the LBIE street trade;
c. any termination payment which might be due to be paid by LBIE to LBF only to be payable if the client paid LBIE the corresponding amount in respect of the LBIE street trade.
The court determined that the side letter should not be taken into account for the purposes of determining the early termination payment, whether or not the side letter constituted a 'material term' of the ISDA trade, and rejected LBIE's claim.
Nor could LBIE take into account the value to it from the loss of the benefit of the side letter as an additional head of loss under the Close-out Amount formulation.
If market participants do have back-to-back trades containing termination rights, they should carefully consider the implications of this case but they should generally be cognisant of the continuity assumption and make specific provision for termination rights to be taken into account in determining close-out payments if that is the commercial intention of the parties. Absent such a specific provision, they cannot be taken into account under any of the ISDA formulations.
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Field Fisher Waterhouse LLP represented LBF in the proceedings. Linklaters represented LBIE. It remains to be seen if LBIE will appeal.