Calculating ISDA close out payments following early termination

A recent decision by the Commercial Court in the Lehmans insolvency highlights the importance of following the termination provisions of International Swaps and Derivatives Association (ISDA) Master Agreements.

Original news

Lehman Brothers Finance S.A. (in liquidation) v Sal. Oppenheim jr. & cir. KGaA [2014] EWHC 2627 (Comm), [2014] All ER (D) 309 (Jul)

The claimant, Lehman Brothers, brought a claim for the balance of a sum which it contended was due from the defendant arising out of early termination of four option transactions governed by an ISDA Master Agreement, together with interest. The defendant had paid the claimant €1,849,968.99. The Commercial Court held, among other things, that the defendant had breached its contractual obligation to use the agreed market quotation formula to determine the sum due. Using that formula, a payment of €2,963,081.18 should have been made.

How did the issue arise?

Four transactions governed by an ISDA Master Agreement were automatically terminated following the entry into Chapter 11 proceedings of Lehman Brothers Holdings Inc (the claimant's parent company) in 2008. Oppenheim, the defendant, as non-defaulting party, calculated the close-out payment due (along with interest) based on the 'Market Quotation' method and made a payment of this amount to the claimant in July 2009. The claimant claimed the amount was wrongly calculated and was substantially below what was due.

In the schedule to the ISDA Master Agreement between the parties, 'Market Quotation' was chosen as the applicable payment method and the dispute centred around how 'Market Quotation' should be determined. The claimant's parent company (and also the claimant's credit support provider) entered into Chapter 11 proceedings at 01:44am New York time on Monday 15 September 2008 and so this was when automatic early termination occurred. The four transactions that were closed out were put and call options referencing the Nikkei 225 Stock Average Index. Between close of business on Friday 12 September 2008 and reopening of market on Tuesday 16 September 2008 (to take account of the weekend and a public holiday in Japan on 15 September 2008), there was a substantial fall in this index meaning that the value of one of the options rose.

Oppenheim prepared a spreadsheet which contained three quotes, purportedly from ABN Amro, Credit Suisse and Société Générale. The definition clause at section 14 of the ISDA Master Agreement defines reference market makers as 'four leading dealers', but it seemed that only three dealers were asked. These three quotes were taken to provide a median result which was the amount claimed. However, when Lehmans analysed the quotes, they believed the quotations were dated as of 12 September 2008 (before the Nikkei index fell) when automatic early termination did not occur until 15 September 2008. Oppenheim could not provide evidence about the circumstances of the obtaining of the valuations from the three banks, nor could it prove that such valuations were for a 'Replacement Transaction' as is required by the Market Quotation payment measure.

What did the court decide?

The judge decided that quotations should be sought as soon as reasonably practicable after the automatic early termination occurs. These should be sought from four reference market-makers as of the same time and day, so that they are contemporaneous. It is clear the quotes should not be back-dated before the early termination date. The non-defaulting party must seek these quotations 'in good faith' but these quotations must never be received prior to the early termination date, even if the markets have moved significantly from its position on the early termination date.

What does this mean for practitioners?

This case highlights the importance of following the termination provisions of the ISDA Master Agreement to the letter and of keeping meticulous notes when seeking quotations from market makers. Section 6(d)(i) of the ISDA Master Agreement states that 'the records of the party obtaining such quotation will be conclusive evidence of the existence and accuracy of such quotation' and so it is imperative that entities closing out any transaction keep accurate and complete notes when asking for quotations and any responses it receives (even if it is to say that a market maker is unable to provide a quotation).

Further reading

If you are a LexisPSL Subscriber, click the links below for further information on ISDA Master Agreements:

Derivatives - ISDA documentation framework (Subscriber access only)

ISDA negotiation guide 5—ISDA Master Agreements Section 6 (Early Termination) (Subscriber access only)

Not a subscriber? Find out more about how LexisPSL can help you.

Anna Jeffrey, solicitor in the Lexis®PSL Restructuring & Insolvency team and Emma Millington, solicitor in the Lexis®PSL Banking and Finance team.

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