The ISDA Master Agreements set out a number of mechanisms by which a net payment is to be determined on the early termination of derivative transactions. However, applying these mechanisms is not always without difficulty or free from uncertainty, particularly in times of severe market dislocation. This article looks at two recent areas of uncertainty addressed by the English Courts – the ambit of the determining party’s discretion and what has become known as the ‘clean valuation principle’.

The basics

Essentially, under both versions of the Master Agreement a close-out netting approach applies. That is, values are calculated for the terminated transactions and netted off to derive a single net sum. That amount may be due to either party, depending on the state of the market at the time of the calculation.

Under the 1992 Master Agreement, the parties will have chosen one of two ways of calculating that net amount – ‘Market Quotation’ or ‘Loss’. Market Quotation involves soliciting quotes from leading dealers for entering into replacement trades. If too few quotes are received, or the quotes are not commercially reasonable, Loss is used as a fall-back position. Loss is more flexible and subjective, essentially requiring the determining party to produce an estimate of the total losses and gains reasonably and in good faith.

Under the 2002 Master Agreement there is only one method – the ‘Close-out Amount’. This requires the determining party to calculate the replacement value of the trades in good faith, using commercially reasonable procedures in order to produce a commercially reasonable result. The 2002 ISDA Agreement provides guidance as to how to do that – a process which may involve the use of external or internal data.

Standard of reasonableness

The definitions of Loss and Closeout Amount both use the word ‘reasonable’. This raises the question – what standard of reasonableness applies? Is it a Wednesbury standard – that is, the party’s calculation is reasonable unless it is a calculation that no reasonable party acting reasonably could have made? Or does it mean reasonable in an objective sense? As this goes to the ambit of the discretion of the determining party, it may be thought to be a reasonably fundamental question. However, perhaps surprisingly, it is not a question to which the case law always provides a definitive answer.

There is no direct authority in relation to the 1992 Master Agreement but arguably the position is clearer under the 2002 Master Agreement. The definition of ‘Close-out Amount’ requires commercially reasonable procedures to produce a commercially reasonable result. The imposition of a reasonableness standard on both process and outcome and use of the word ‘commercially’ suggests that an objective standard applies. This was the conclusion reached in a brief obiter paragraph of Briggs J in Lehman Brothers International (Europe) v Lehman Brothers Finance [2012] EWHC 1072 (Ch), the only English judgment to expressly address this issue. Further support for this conclusion is given by Barclays v Unicredit [2012] EWHC 3655 (Comm), in which a discretion in a guarantee to be exercised in a ‘commercially reasonable’ manner was interpreted as requiring an objective standard – a conclusion which the Court found to be reinforced by the use of the word ‘commercially’.

The objective standard of reasonableness still permits a range of permissible procedures and results: in LBIE v LBF, Briggs J commented that this ‘leaves a bracket or range both of procedures and results within which the Determining Party may choose, even if the court, carrying out the exercise itself, might have come to a different conclusion’.

Life of the clean valuation principle – the 1992 ISDA Master Agreement

This principle originated in ANZ v Société Générale [2000] CLC 833 – a dispute about the calculation of Loss in relation to Dollar/Rouble foreign exchange forwards. In the Schedule to their 1992 Master Agreement the parties had provided for the occurrence of a Russian banking moratorium in two respects. First, it would be an Additional Termination Event. Second, assuming it decided not to terminate, in such circumstances SG would have the option to make its payments by alternative methods which would be less attractive to ANZ – such as payment in Roubles.

In 1998 Russia declared a banking moratorium, SG terminated and calculated the close-out payment – which ANZ disputed.

SG argued that, in determining Loss, it could take into account the alternative payment methods provision. In other words, it could determine Loss on the assumption that, had it not terminated, it would probably have made its future payments in accordance with one of those less favourable alternative methods. That would have made the transactions less valuable to ANZ, reducing the close-out payment from $17 million to less than $1 million.

To address the point, the Court of Appeal considered language within the definitions of ‘Market Quotation’ and (to a lesser extent) ‘Loss’, which requires the determining party to assume the satisfaction of ‘each applicable condition precedent’.

This language had generally been understood as dealing with a concern that would otherwise arise from the fact that, section 2(a)(iii) of the Master Agreement makes a party’s regular payment obligations conditional on certain conditions precedent being satisfied – one of which is that there is no Event of Default outstanding. As a result, following an Event of Default the non-defaulting party’s future payment obligations are suspended. Consequently, to value them, it is necessary to assume the satisfaction of any ‘conditions precedent’ which would otherwise suspend those obligations, such as the absence of an Event of Default.

However, unexpectedly the Court of Appeal interpreted ‘conditions precedent’ widely and found that not triggering the alternative payment methods was also a condition precedent which had to be assumed to be satisfied under Market Quotation and Loss. Although it was not expressly stated to be a condition precedent in the contract, the Court of Appeal found that it was captured by the reference in section 2(a)(iii) to ‘each other applicable condition precedent specified in this Agreement’. This approach, the Court of Appeal described as valuing ‘clean’, whereas to take the alternative payment methods into account would be to value ‘dirty’.

The decision was controversial because, by interpreting ‘conditions precedent’ so widely, the Court was effectively assuming important commercial terms out of the valuation process. Unfortunately, however, the principle has been upheld in a number of subsequent cases, most recently, by the Court of Appeal inBritannia Bulk v Bulk Trading [2012] EWCA Civ 419.

Death of the clean valuation principle – the 2002 ISDA Master Agreement

In LBIE v LBF the English Courts considered whether the clean valuation principle applied to the 2002 Master Agreement ‘Close-out Amount’ concept.

The background to this case was that LBIE had executed various derivative trades with clients and had then transferred certain risks associated with them to LBF via back-to-back trades under a Master Agreement which incorporated the 2002 Close-out Amount provision. LBIE and LBF also executed a side letter which changed how termination of the back-to-back transactions would work – so as to protect LBIE against certain risks if a client defaulted.

Lehman’s insolvency in 2008 constituted an Event of Default, first in respect of LBF, triggering Automatic Early Termination of the back-to-back transactions and determination of the Close-out Amount by LBIE. The question that arose was whether the terms of the side letter should be taken into account. LBIE argued that they should be. LBF argued that they should be excluded by virtue of the clean valuation principle. This was not a minor point – it was worth approximately $1 billion.

At first instance, the Court decided that the clean valuation principle applied and effectively required the fundamental economic provisions of the side letter to be assumed away.

However, the Court of Appeal recognised that the 2002 close-out provisions differed from the 1992 provisions in a number of material respects. In particular, they expressly require the valuation, not just of payment obligations, but of all material terms plus option rights and the condition precedent wording in Section 2(a)(iii) is tighter. The Court of Appeal also accepted that the clean valuation principle could lead to wholly uncommercial results.

Accordingly, in a welcome decision, it held that the 2002 Master Agreement does not preserve the value clean principle in the form that applies under the 1992 Master Agreement. The side letter should be taken into account.


On 20 March 2014, the Court of Appeal upheld the first instance decision in Barclays v Unicredit (the judgment is at [2014] EWCA Civ 302). The Court discussed ‘commercially reasonable’ but added that its comments did not apply to the interpretation of this phrase in the 2002 Master Agreement.