Effective termination of a repo (Lehman Brothers International (Europe) v Exxonmobil Financial Services)

A recent decision in the Lehmans insolvency discusses the construction of the termination provisions in the Global Master Repurchase Agreement (GMRA), how these provisions are effected in practice and how the securities should be valued

Original news

Lehman Brothers International (Europe) v Exxonmobil Financial Services BV [2016] EWHC 2699 (Comm)

The claimant, Lehman Brothers, contended that a default valuation notice served by Exxon was invalid and the valuations ascribed to the securities were incorrect. The Commercial Court held, among other things, that the default valuation notice had been validly exercised and that the valuation had to be rational even if it was not objectively reasonable.

What are the practical implications of this case

This case highlights the possible complications that can arise when following termination provisions under a master agreement.

In this case, the trades were governed under a GMRA. The GMRA sets out its termination provisions under section 10. In section 10(e), a 'Default Valuation Notice' (DVN) is defined. The definition does not include specific language that should be included in the DVN. It merely states that it is a written notice which:

'states that, since the occurrence of the relevant Event of Default, the non-Defaulting party has sold, in the case of Receivable Securities, or purchased, in the case of Deliverable Securities, Securities which form part of the same issue and are of an identical type and description as those Equivalent Securities or Equivalent Margin Securities'

The International Swaps and Derivatives Association (ISDA) master agreement includes its early termination provisions under Section 6 and similarly does not set out a sample notice or generic wording that should be included when terminating that notice early.

The case suggests that practitioners should be careful in ensuring that notices are delivered in a timely way and follow the procedures set out in the master agreement precisely.

What was this case about?

Background to the case

The dispute was between Lehman Brothers International (Europe) (LBIE) and ExxonMobil Financial Services BV (EMFS). When LBIE went into administration on 15 September 2008, there was an outstanding sale and repurchase (repo) transaction between the parties. Under that repo, EMFS had effectively lent $250m to LBIE and LBIE had provided EMFS with collateral in the form of a portfolio comprising of equities and bonds.

EMFS sold most of the securities on 17 and 18 September 2008, though some were not sold and were valued a few days later.

The dispute related to the balance of the account and stems from how the termination provisions of the GMRA are constructed, apply in practice and how securities are valued.

EMFS argued that it validly served a DVN under the termination provisions in the GMRA. In that DVN, EMFS has valued those securities that had been sold at the sale price and where a quotation had been obtained, at the quoted price, and a valuation was ascribed to all remaining securities for which it was not possible to obtain either a sale or quotation.

LBIE argued that EMFS did not validly serve a DVN because such DVN:

  • came after business hours
  • went to the wrong fax number, and
  • came after the 'Default Valuation Time' (DVT) in relation to the non-US securities

As a result of the DVN arriving after the DVT, LBIE argued that the 'fair market value' provisions in the GMRA applied.

There were also disputes about the valuation of securities if LBIE were correct in their dispute that EMFS had not validly exercised the DVN procedure pursuant to GMRA.

Why was there a dispute as to the validity of the DVN?

On 15 September 2008 LBIE went into administration. LBIE confirmed to EMFS that morning that LBIE would not be able to return the cash advanced by EMFS on 16 September 2008 and advised EMFS to follow the default procedure. That morning, EMFS sent a fax to LBIE notifying LBIE that:

'with immediate effect, [EMFS] hereby serves [LBIE] a default notice as per the [GMRA]'

This was sent to a fax with number ending -2044. After taking external legal advice, EMFS sent a second notice to LBIE referring to the default notice sent that morning and specifying that the notice was given following the appointment of the administrators, which gave rise to an Act of Insolvency which is defined as an event of default under GMRA, para 10(a)(iii). This second notice was sent to the same fax number, but attempts were unsuccessful, probably because a number of parties were trying to send notices to LBIE. On 16 September 2008, the second notice was sent by e-mail to LBIE by using the two e-mail addresses that were specified in the GMRA. EMFS argues that the second notice was the default notice for the purposes of the GMRA, with the effect that the procedure for serving the DVN was pushed back a day. LBIE argued that the first notice was valid and so the procedure for serving the DVN runs from that day. LBIE also submitted that serving the notice by e-mail was not valid, as e-mail is not a permitted method of service for contractual notices under the GMRA.

On 16 September 2008, EMFS signed a transition management agreement with JP Morgan (JPM) (who was the collateral agent). Under that agreement, JPM agreed to act on a best execution basis as EMFS' transition agent to liquidate the portfolio. It was agreed that JPM would be paid commission of 0.08% of the sale proceeds. JPM provided a 'pre-trade estimate' and on 17 September 2008 started trading the portfolio. The sales proceeds turned out to be significantly lower than the pre-trade estimates and there was little interest in the bonds. On 22 September 2008, EMFS discussed obtaining bids for the remaining bonds, and in the alternate valuing them. It was understood that the DVN had to be served by close of business.

EMFS then prepared the DVN and attached three appendices which classified the securities by reference to the sub-paragraphs of the GMRA, para 10(e)(i). The net shortfall claimed by EMFS was around $9.6mi.

The DVN was sent by fax at 5:54pm and the transmission time said it was received in full by LBIE at 6:02pm. Attempts to send to the fax number ending 2044 were unsuccessful. EMFS sent a further copy of the DVN by email, which was sent at 7:30pm.

LBIE say that the notice should have been sent by 5pm and that it was sent to the wrong fax number and in respect of the non-US securities, the notice came after the 'Default Valuation Time'. Therefore the notice was invalid and the 'fair market value' provisions of the GMRA should apply. If the notice was valid, LBIE contended that it was not valid until the following morning, 23 September 2008.

What should a default notice include?

Default notice is defined in paragraph 2(1) of the GMRA as:

a written notice served by the non-Defaulting Party on the Defaulting Party under paragraph 10 stating that an event shall be treated as an Event of Default for the purposes of this Agreement

In reading the definition it seems that such notice:

  • should be in writing
  • served by the non-defaulting party, and
  • should state that a particular event should be treated as an event of default

In sending a second notice on 15 September 2008, it seems that EMFS doubted that the first notice was a valid notice. The first notice was headed 'Default Notice' but did not specify what the event was that constituted an event of default.

The court held that the definition in the GMRA does not state that the notice should detail the facts of the event that are being relied upon and that the first notice that EMFS sent was valid pursuant to the provisions set out in the GMRA.

Can notices be sent by email?

The recent case of Greenclose Ltd v National Westminster Bank discussed whether notices could be sent by email under an ISDA master agreement. In that case, the court determined that notices could not be sent by email under the 1992 ISDA master agreement, having relied on the ISDA user guides and provisions in the 2002 ISDA master agreement to determine that 'electronic communications' was not intended to include 'email'.

The judge came to a different conclusion in relation to the GMRA. para 14(b)(v) states that notices are effective if sent by 'electronic messaging system' and the judge held that this should include email. Note that the 2011 GMRA expressly contemplates the delivery of notices by email. Greenclose was distinguished largely because Annex 1 of the GMRA included email addresses as a contact detail, whereas the Schedule to the ISDA Master Agreement in Greenclose did not include such addresses.

When is 'close of business'?

The termination provisions specify that such notice should be received before close of business. LBIE and EMFS contested when that would be for commercial banks in London. Interestingly, the judge did not accept LBIE's argument that it would be 5:00pm. The judge said that in the context of financial business of the kind at issue, 5:00pm would be too early and the term 'close of business' has different meanings depending on the context. The judge thought that actually 'close of business' offered a useful flexibility and it should deter arguments that were based on pedantics which make little commercial sense. One of the experts offered a close of business time of 7:00pm being a more reasonable for a commercial bank.

Practitioners should consider specifying the time of cut-off in their contract to avoid disputes of this nature. Either amending the definition of 'close of business' so that it states that it is, 5:00pm in London, or adding in a proviso stating this would avoid confusion about what time notices need to be received by.

How can default market value be calculated?

There are two methods of calculating the DMV under the 2000 GMRA :

  • the fair market value ascribed to the securities in accordance with EMFS's rational opinion, and
  • the securities' objective fair market value

The first method is time limited as the notice has to be given within a specified period, and is the route that EMFS sought to rely on. The DVN must be given between the occurrence of the event of default and the default valuation time (DVT). The DVT is defined in paragraph 10(d)(ii) as

the close of business in the Appropriate Market on the fifth dealing day on which the Event of Default occurs

LBIE argued that because the DVN was not valid, EMFS should have used the second method to calculate the valuation of the securities. EMFS argued that even if it relied on the second method, the valuation would have been the same. The judge distinguished between what is rational and reasonable. Rational equates to acting in good faith, whereas reasonableness has a more objective focus.

Why did LBIE contest EMFS's valuation of the securities?

LBIE argued that EMFS should have issued a number of DVNs, for the different securities that it set out in the appendices. The reason for this was that the securities all traded in different markets and so the DVT couldn't be the same for all of them. LBIE said that EMFS could not select one single global market as the 'Appropriate Market' for all the equities and bonds.

Appropriate Market is defined in GMRA, para 10(d)(i) as being:

the market which is the most appropriate market for Securities of that description, as determined by the non-Defaulting Party

If appropriate markets is ascertained on a security by security basis, the deadline for giving the DVN would depend on the time zone of that appropriate market coupled with the time zone of the place where the notice was given (London). This would mean working out the deadlines would get complicated and EMFS argued that such construction would become unworkable. LBIE argued that multiple DVNs should be provided for the different securities.

The issue with this for practitioners is that typically if issuing DVNs, the non-defaulting party is likely to be in a stressful commercial situation and issuing multiple DVNs and managing different deadlines for different securities increases complications attached to the situation. There is also an issue of how to categorise what the appropriate market is for that security—they may be issued, listed and traded in different countries on different time zones. However, the way that the GMRA is structured, it does assume that securities are classified individually. It is difficult to categorise a whole range of securities in one sweep and the judge therefore decided that different securities should have different DVTs ascribed to them.

What should practitioners consider in light of this case?

Practitioners are always aware that when working in a stressful situation, such as a counterparty's insolvency, it is imperative to ensure that procedures are followed very carefully. This case highlights that even provisions set out in an international master agreement can still be open to interpretation which may be concerning.

The judge took a practical approach in much of his decision. In stating that close of business may not be 5:00pm and a notice could be valid even when sent after this time, this may reflect commercial reality but also opens up uncertainty to parties as to when a deadline may be. Practitioners should therefore ensure that where a specific time is not specified in their agreement, a time should be added to avoid doubt in the future.

The question of whether an email can be an effective notice was also raised in Greenclose in relation to an ISDA master agreement as discussed above. The judge's findings in this case should be welcomed: the modern world uses email more than fax and the fact that the email addresses were included in the Annex and EMFS could not send a fax because LBIE's machine was too busy means that it made practical sense for EMFS to send an email notice. If parties do not want emails to be used as notices, this again should be specified in the agreement so that there is no doubt.

Perhaps more interestingly in terms of the GMRA specifically was the question of what an appropriate market is. The 'global market' presented by EMFS was rejected by the judge and he thought that securities should be considered on a security by security basis. This means that practitioners should seriously consider serving more than one DVN on counterparties where the securities have different characteristics. While administratively more difficult, this will avoid issues in the future as to whether a DVN has been served in the correct timeframe for specific securities.

Case details

  • Court: Queen's Bench Division, Commercial Court
  • Judge: Blair J
  • Date of judgment: 28 October 2016

First published on LexisPSL Banking & Finance. Click here for a free trial.

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