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The Commercial Court considered the subject of how Close-out Amount is calculated under the 2002 ISDA Master Agreement, including whether it is open to a Determining Party to remake a determination of Close-out Amount and whether the determination of the Close-out Amount only required a rational decision to be made or instead whether that decision had to be objectively reasonable.
Lehman Brothers Special Financing Inc. v National Power Corporation and another  EWHC 487 (Comm)
The judge emphasises that the Close-out mechanism set out in the 2002 ISDA Master Agreement is designed to, and does, achieve a more commercially reasonable result than the loss mechanism set out in the 1992 ISDA Master Agreement. He sets out that when making a determination of the Close-out Amount, the Determining Party must act in an objectively reasonable manner, which is a higher standard than merely acting in a rational way. It emphasises again to parties to an ISDA Master Agreement that they must ensure that the close-out process set out in the ISDA Master Agreement is followed to the letter and that the Determining Party acts in a manner that is objectively reasonable.
In 2007 Lehman Brothers Special Financing (LBSF) and National Power Corporation (NPC) entered into a forward currency swap under a 2002 ISDA Master Agreement. This swap was made by NPC as part of a hedging strategy it had, which was broadly to help provide some protection against the risk of devaluation of the Philippine peso (PHP).
In 2008, LBSF filed for bankruptcy relief under Chapter 11 which constituted an event of default under the swap. The swap was therefore terminated early by notice given by NPC with a designated early termination date of 3 November 2008. NPC then had to determine the Close-out Amount using ‘commercially reasonable procedures in order to produce a commercially reasonable result’. Suggested commercially reasonable procedures are set out in the definition of ‘Close-out Amount’ at Section 14 of the 2002 ISDA Master Agreement.
In January 2009, NPC demanded an amount from LBSF, enclosing its calculations by way of an annex. This did not include any expenses that it might incur in replacing the swap. This statement was then withdrawn in 2014 and a revised statement issued in 2016, by which time proceedings had been commenced. The amount that NPC demanded was entirely based upon a new transaction that NPC entered into, and the annex set out that the amount demanded reflected the replacement cost of entering into a replacement swap.
NPC argued that:
The judge had two issues to consider:
Paragraphs 36–40 of the judgment sets out how the ISDA Master Agreement should be interpreted, with Mr Justice Robin Knowles emphasising that the ISDA Master Agreement is one of the most important standard market agreements in the financial world.
Mr Justice Robin Knowles set out that the statement sent by NPC in January 2009 completed NPC’s obligation and right to make a determination under the 2002 ISDA Master Agreement. His view was that any error in this calculation should be declared by the relevant court or tribunal asked to determine the issue and who would set out what the Close-out Amount should be or, indeed, confirm that it had been calculated without error by the Determining Party. While the Determining Party may correct errors in its determination, certainty of contract is important. NPC should have included the accrued amounts in its original statement, but not doing so was not a ‘manifest error’ as argued by NPC, but an error capable of correction.
The definition of ‘Close-out Amount’ sets out that the Determining Party must act in good faith and use ‘commercially reasonable procedures in order to produce a commercially reasonable result’. NPC argued that this equates to using rational procedures to produce a rational result. Mr Justice Robin Knowles did not agree that reasonableness could necessarily equate to rationality. He referred to Socimer International Bank Ltd v Standard Bank London Limited (No 2)  EWCA Civ 116 where rationality is described as analogous to ‘Wednesbury unreasonableness’ to be distinguished from reasonableness, which is entirely objective. The 2002 ISDA Master Agreement included the new concept of ‘Close-out Amount’ to achieve a commercially reasonable result (contrast with how ‘loss’ is defined in the 1992 ISDA Master Agreement), and the 2002 User’s Guide clearly sets out hat the change of wording was largely to include greater objectivity. While there will always be a ’range’ of results that can fall within the category of being commercially reasonable, the fact that there is a range does not mean that the Determining Party can simply choose the result within the range that suits them best.
At paragraph 81, Mr Justice Robin Knowles states:
the 2002 ISDA Master Agreement requires the Determining Party to use procedures that are, objectively, commercially reasonable in order to produce, objectively, a commercially reasonable result. If it does not do this the court or a tribunal will.
He also emphasises that where the 2002 ISDA Master Agreement is chosen to be used by the parties, a higher standard is intended than rationality.
In making his determination, Mr Justice Robin Knowles is conscious of the fact that NPC is not a bank or financial institution and did not have regular experience of calculating Close-out Amounts. While the early termination date was 3 November 2008 and NPC received indicative quotations on this date, it did not receive firm quotations until 7 November 2008. It would not have been commercially reasonable to determine the Close-out Amount as at 3 November 2008 where only indicative quotations were available and it was commercially reasonable to use the firm quotations to make the calculation.
The judge emphasised that NPC wanted a replacement transaction because its commercial need for hedging remained. The transaction that NPC entered into with UBS included an additional option that NPC did not have with LBSF. However, apart from the option exercise price, which NPC could not pass on to LBSF, NPC properly relied on the UBS Transaction in making its determination.
Judge: Mr Justice Robin Knowles
Date of judgment: 12 March 2018
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Emma is head of the Banking and Finance team and the Finance Group at LexisNexis®UK.
Emma has wide-ranging experience in derivatives and capital markets with a particular emphasis on credit derivatives and structured products. Emma qualified as a solicitor with Allen & Overy LLP, working in the derivatives and structured finance teams in both their London and Paris offices before gaining experience with Deutsche Bank AG (advising the foreign exchange prime brokerage desk) and Crédit Agricole CIB (advising the fixed income and derivatives desk) before joining LexisNexis®.
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