On May 12, 2015, the English High Court gave its judgment in Fondazione Enasarco v (1) Lehman Brothers Finance S.A. and (2) Anthracite Rated Investments (Cayman) Limited  EWHC 1307 (CH).1 The judgment is important for participants in the structured products and derivatives markets, finding that:
1. A special purpose vehicle in a structured product can calculate its Loss by reference to the cost of a replacement transaction entered into by the investor; 2. A calculation “as of” a date several months after the Early Termination Date may still be “as soon as reasonably practicable” under the definition of Loss; 3. A quotation from a leading dealer is likely to be stronger evidence of a party’s loss of bargain than a financial model, even if the terms of the replacement transaction differ from the original; and 4. A party wishing to challenge a Loss calculation must show that the non-defaulting party’s determination was irrational in the Wednesbury sense.
The case arose from Enasarco’s investment in principal-protected notes issued by Anthracite Rated Investments (Cayman) Limited (ARIC) with a maturity date in 2023 (the Notes). The proceeds of the Notes were indirectly invested in a managed pool of funds. Lehman Brothers Finance S.A. (LBF) agreed to protect the principal of the Notes under a cash-settled put option documented under the 1992 ISDA Master Agreement (the Derivative Agreement).
Following termination of the Derivative Agreement in September 2008, Enasarco took immediate steps to negotiate terms for replacement protection with dealers. Due to issues such as impairment of the Notes and market turmoil, Enasarco was only able to execute a replacement transaction, with some terms different from those of the Derivative Agreement, on May 6, 2009 (the Replacement Transaction).
The Derivative Agreement provided for calculation of a payment upon early termination using Second Method and Loss. Following termination on September 15, 2008, ARIC, as non-defaulting party, used the price for the Replacement Transaction as the basis for its calculation of Loss and determined that approximately US$61 million was due to it from LBF.
Although LBF challenged ARIC’s calculation, the court found that ARIC’s Loss had been calculated reasonably and in good faith in accordance with the terms of the Derivative Agreement. The judgment contained a number of points of wider relevance:
Criteria for reasonable determination of Loss. The judge referred to the test of rationality in Associated Provincial Picture House Ltd v Wednesbury Corporation  1 KB 223 as the standard to be used in determining whether a Loss calculation was open to challenge. This test requires only that the non-defaulting party does not take into account matters irrelevant to the calculation itself (and does take into account all matters that are relevant) and that the non-defaulting party must not arrive at a determination which no reasonable non-defaulting party could come to. The test does not require the non-defaulting party to arrive at the most reasonable result and provides relatively narrow scope for the non-defaulting party’s calculation to be challenged.
A non-defaulting party may rely on a quotation obtained and negotiated by another person. The judge observed that there was nothing in the Master Agreement that prevented ARIC from relying on the quotation obtained and negotiated by Enasarco, provided that quotation was a sufficient proxy for the Derivative Agreement. The judge made clear that, in the context of the Notes structure, it would be unrealistic to expect Enasarco not to take the lead in obtaining a replacement. Enasarco was the party with economic interest and ARIC, as an SPV, had neither the staff nor the resources to undertake such tasks.
Calculation “as soon as reasonably practicable”. ARIC’s calculation of Loss “as of” May 6, 2009 (nearly seven months following termination) was not too late to be “as soon as reasonably practicable” after the Early Termination Date, as required by the definition of Loss. “Reasonably practicable” is not the same as “possible”. All of the circumstances must be taken into account when assessing the earliest date reasonably practicable, including those that are particular to the person required to act by that date.
Quotations from the market are the best way to assess loss of bargain. The judge made clear that, given the uncertainty of the market following the collapse of Lehman Brothers, it was particularly appropriate to look to prices actually quoted for a transaction rather than to hypothetical prices. He also cast doubt on the validity of the financial models presented in the case as an alternative means of showing ARIC’s loss of bargain. He was critical, in particular, of the attempts to use mid-market prices obtained from pricing indexes as a proxy for the prices at which parties within the market were actually prepared to provide live, executable quotations.
The terms of the quotation(s) need not be identical to those of the terminated transaction. The judge determined that, although the terms of the Replacement Transaction were not identical to those of the Derivative Agreement, this did not prevent it from being a comparable replacement transaction for the purposes of calculating ARIC’s Loss. Of the differences considered by the judge, two were of particular interest.
First, where parties elect for the Market Quotation method of calculating termination payments to apply, the ISDA Master provides that the replacement transaction must preserve the economic equivalent of the terminated transaction. LBF contended that this requires the non-defaulting party to use quotations only from a counterparty with the same balance sheet and rating as the defaulting party and also that the requirement should apply equally under the Loss mechanism. The judge rejected this argument, finding that the definition of Market Quotation did not impose the requirement contended for by LBF.
Second, LBF argued that a decline in liquidity of the underlying funds between September 2008 and May 2009 increased the price of any replacement transaction. The judge found that the Loss calculation should be made by reference to the market circumstances as of the date when it was made, even if markets had moved since the termination. The definition of Loss does not require a hypothetical valuation to be made as of the termination date.