Lehman Brothers Special Financing Inc. v National Power Corporation & Anor [2018] EWHC 487 (Comm) is a significant case on the calculation of Close-out Amount under the 2002 ISDA Master Agreement.  

Two important points of principle arise from this judgment, which will have general application to transactions governed by the 2002 ISDA Master Agreement:  

  1. In calculating Close-out Amount, a manifest mathematical or numerical error should more appropriately be corrected by agreement or by court or tribunal (and only in relation to the error itself); it will not ordinarily enable a Determining Party to make a fresh determination.  

  2. The standard to be applied to a Determining Party in calculating a Close-out Amount is higher under the 2002 ISDA Master Agreement compared to the 1992 ISDA Master Agreement. The 2002 ISDA Master Agreement replaced the requirement for a rational decision (the applicable standard under the 1992 ISDA Master Agreement) with the requirement for objectively reasonable procedures in order to produce an objectively reasonable result.  

This result is consistent with what market participants anticipated was the impact of the wording contained in the 2002 ISDA Master Agreement, which was to introduce a higher standard through greater objectivity, although it arguably gives rise to greater scope for disputes to arise in relation to parties’ determinations pursuant to that higher standard.

Background

In 2007, the claimant (“LBSF”) entered into a US$100 million principal only US$/Philippine peso forward currency swap (the “Swap”) with the first defendant, which was later transferred to the second defendant (“NPC”, meaning the first or second defendant, or both). Both defendants were owned and controlled by the Republic of the Philippines. The parties elected to apply the 2002 ISDA Master Agreement to the Swap (terms defined in that agreement are capitalised in this e-bulletin).

Following LBSF filing for Chapter 11 bankruptcy in the United States, the terms of the 2002 ISDA Master Agreement triggered an Event of Default. NPC subsequently served a notice on LBSF for early termination of the Swap and designated 3 November 2008 as the Early Termination Date. NPC, as the non-defaulting party, had the right under the 2002 ISDA Master Agreement to determine the Close-out Amount using “commercially reasonable procedures in order to produce a commercially reasonable result”.

On 3 November 2008 (i.e. the designated Early Termination Date), NPC requested and received indicative quotations for a replacement swap from various banks and on 7 November 2008, NPC requested and received firm quotations from those banks. NPC subsequently entered into a swap with UBS based on the firm quotation received on 7 November 2008 (the “UBS Swap”). In January 2009, NPC served its determination of the Close-out Amount for the Swap on LBSF (the “2009 Determination”). NPC demanded circa US$3.5 million, which represented the cost it had incurred in entering the UBS Swap as a replacement transaction.

LBSF disputed the 2009 Determination on the basis that commercially reasonable procedures were not used to arrive at this figure and that it was not a commercially reasonable result. In 2015, LBSF commenced court proceedings asserting that LBSF itself was in the money on the Swap. LBSF claimed that NPC owed a Close-out Amount of circa US$13 million to LBSF (the “LBSF Determination”).

NPC subsequently served a revised calculation statement in 2016 which contained two alternative determinations payable by LBSF to NPC: (a) a Close-out Amount of circa US$11 million based on the indicative (not firm) quotation received from UBS on the Early Termination Date (the “Primary Determination”); or (b) a Close-out Amount of circa US$2 million based on the original 2009 Determination of circa US$3.5 million but with the deduction of an Accrued Amount which had not been taken into account in 2009 (the “Alternative Determination”).

Decision

The principal questions examined by the court were:

  • Is it open to a Determining Party to remake a determination of a Close-out Amount?

  • Was the requirement to “use commercially reasonable procedures in order to produce a commercially reasonable result” complied with?

Can a Determining Party remake a Close-out determination?

In the present case, the 2009 Determination fell for scrutiny on two counts: (a) whether the Accrued Amount should have been taken into account; and (b) whether the requirement for “commercially reasonable procedures in order to produce a commercially reasonable result” was complied with.

As to (a), it was common ground that the Accrued Amount should have been taken into account. The question for the court was whether the failure to include the Accrued Amount was a manifest error entitling NPC to make a fresh determination, or whether it was the type of error that should simply be corrected by agreement or by the court/tribunal. This question is considered below. The following section considers whether the requirement at (b) was complied with, and the consequences if this requirement was not complied with.

On the true interpretation of the 2002 ISDA Master Agreement, the court stated that the position was as follows:

  1. With its notice of early termination of the Swap, NPC caused a debt obligation to arise and with delivery of NPC’s 2009 Determination an obligation to pay arose (Videocon Global Ltd v Goldman Sachs International [2016] EWCA Civ 130).

  2. These are significant contractual events and that once they have arisen the relationship between the parties is thereafter affected and not reversible (save by agreement, or in some cases an order of a court or tribunal).

  3. The 2009 Determination completed NPC’s obligation and right to make a determination.

  4. If there is an error in the determination then (absent agreement) the court or tribunal chosen by the parties will be left to declare that and to state what the Close-out Amount would have been absent that error.

  5. However, the Determining Party is also a party to the contract and it can make and accept proposals in its capacity as a party to the contract, including correcting an error in the determination.

  6. The Primary and Alternative Determinations might serve as evidence to inform the question of whether there was an error and the question as to what the Close-out Amount would have been on a determination without error (Socimer International Bank Ltd v Standard Bank London Ltd (No.2) [2008] EWCA Civ 116).

The court went on to consider comments on the question of remaking a determination in the practitioner text: Derivatives Law and Practice (by Simon Firth), which states as follows:

“Once a determination has been validly made of the…Close-out Amount, it will be final and binding on both parties. The determining party cannot subsequently change its mind (for example, on the basis that a mistake has been made). On the other hand, if the original determination was invalid (for example, because it was based on a misinterpretation of the Agreement), or (probably) it was founded on or infected by a manifest numerical or mathematical error [], the determining party should be able to make a fresh determination that complies with the requirements of the Agreement.”

In the court’s view (and in contrast to the suggestion in Derivatives Law and Practice), the case of manifest mathematical or numerical error would still be a case for correction of the determination (by agreement or by court or tribunal, and in the respect where there was error) rather than a fresh determination. Accordingly, the failure by NPC to take into account the Accrued Amounts in making the 2009 Determination was the type of error that simply admits a case for correction of the determination as above and NPC was not entitled to make a fresh determination.

Was the requirement to “use commercially reasonable procedures in order to produce a commercially reasonable result” complied with?

The court observed that the definition of Close-out Amount in the 2002 ISDA Master Agreement included the provision:

Any Close-Out Amount will be determined by the Determining Party (or its agent), which will act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result”.

The court considered (and rejected) NPC’s arguments that the references in the definition of Close-out Amount to “commercially reasonable procedures” and a “commercially reasonable result” required only that the Determining Party use rational procedures in order to produce a rational result. In the court’s view, the 2002 ISDA Master Agreement required the Determining Party to use procedures that are (objectively) commercially reasonable in order to produce (objectively) a commercially reasonable result. It considered that the 2002 ISDA Master Agreement had wording that showed a higher standard is intended when that standard form is chosen by the parties.

There were two principal elements to the court’s decision:

  1. The court highlighted that the change in the wording used in the 1992 ISDA Master Agreement to the form used in the 2002 ISDA Master Agreement was material. The 1992 ISDA Master Agreement states that the non-defaulting party has to “reasonably determine in good faith” the Close-out Amount payable. This was summarised in Fondazione Enasarco v Lehman Brothers Finance SA [2015] EWHC 1307 (Ch) as “essentially a test of rationality”. By contrast, under the 2002 ISDA Master Agreement: “[f]or the first time the calculation of the liabilities on closing out had to be carried out ‘in order to produce a commercially reasonable result’“: Lehman Brothers International (Europe) v Lehman Brothers Finance SA [2013] EWCA Civ 188. Further, the court said it was clear from the 2002 User’s Guide supporting the 2002 ISDA Master Agreement that the change was specifically designed to include greater objectivity.

  2. The court emphasised the difference between the tests of rationality and reasonableness (citing Lord Sumption in Hayes v Willoughby [2013] UKSC 17):

“Rationality is not the same as reasonableness. Reasonableness is an external objective standard applied to the outcome of a person’s thoughts or intentions. The question is whether a notional hypothetically reasonable person in his position would have engaged…A test of rationality, by comparison, applies a minimum objective standard to the relevant person’s mental processes”.

The court concluded that it was commercially reasonable to make the 2009 Determination as NPC did, relying on the UBS Swap. The court was not persuaded that, especially in the market circumstances at the time, it would have been commercially reasonable to determine the Close-out Amount as of 3 November 2008 (the Early Termination Date, i.e. as per the Primary Determination); at that stage only indicative quotations were available.

The court remarked that the UBS Swap replaced more than what was provided for under the original Swap because it included an option which NPC did not have at the Early Termination Date. NPC, therefore, was not entitled to pass onto LBSF the option exercise price or pre-payment premium of US$1 million attached to that option. The Close-out Amount was therefore the 2009 Determination, less the Accrued Amount, less the option premium.

The court did not proceed to consider what the position would have been if the 2009 Determination had not complied with the requirement for “commercially reasonable procedures in order to produce a commercially reasonable result”, i.e. whether NPC would have been entitled to make a fresh determination or whether the error could be corrected by agreement or by the court/tribunal.

Comment

The instant case confirms that in calculating Close-out Amount, a manifest mathematical or numerical error should more appropriately be corrected by agreement or by court or tribunal (and only in relation to the error itself); it will not ordinarily enable a Determining Party to make a fresh determination. Further, the standards imposed on a Determining Party calculating Close-out Amount are higher under the 2002 ISDA Master Agreement than the 1992 ISDA Master Agreement. The change in the relevant wording under those agreements had the effect of replacing a requirement for a rational decision with a requirement for an objectively reasonable one.