UK: Calculations On ISDA Close-Out

Last Updated: 20 August 2014
Article by Richard Caird, Sam Coulthard and Alexandra Doucas

This case provides further guidance in relation to how payment on early termination of a 1992 ISDA Master Agreement should be calculated where Automatic Early Termination applies, in particular as to the meaning of the provisions dealing with market quotations and whether they require parties to obtain live quotations or historic valuations.

Background to the disputed calculation

The claimant (Lehman) and the defendant (Sal Oppenheim) entered into four option agreements under the umbrella of a 1992 ISDA Master Agreement, pursuant to which the sums payable between the parties were calculated by reference to the Nikkei 225 Stock Average Index. The parties elected for the Automatic Early Termination provisions of the ISDA Master Agreement to apply, and consequently the ISDA Master Agreement terminated at 01:54 New York time on Monday, 15 September 2008, when Lehman's credit support provider (Lehman Brothers Holdings Inc.) filed for bankruptcy.

That was mid-afternoon in Japan, but, by coincidence, the Japanese exchanges were closed for a public holiday until 16 September 2008. Once they reopened, it was clear that there had been a substantial fall in the Nikkei from its closing position on the previous business day, Friday, 12 September 2008. The effect of the fall on these specific transactions was that the value of the options in the hands of Sal Oppenheim had risen.

In this context, Sal Oppenheim had to calculate the Payment on Early Termination as contemplated by ISDA. 

Relevant provisions of the 1992 ISDA Master Agreement

The parties had elected to use Market Quotation (as opposed to Loss) as the means of quantifying that payment. The provisions of the Master Agreement (contained at clause 6 and in the definitions at clause 14) in relation to Market Quotation are extensive and are not replicated here. The judgment referred extensively to the obligation on the party making the determination (here Sal Oppenheim) to request that quotations be provided by four reference market makers "to the extent reasonably practicable as of the same day and time ... on or as soon as reasonably practicable after the Early Termination Date. The day and time as of which those quotations are to be obtained will be selected in good faith by the party obliged to make a determination". 

The Master Agreement specifies that the purpose of Market Quotation is to calculate the cost to the party making the determination of entering into a Replacement Transaction (as the ISDA Master Agreement defines it), in other words a transaction which "would have the effect of preserving for such party the economic equivalent" of any payment or delivery which would have been required after the early termination date, but for that termination occurring.

Sal Oppenheim's actions

On 18 June 2009, Sal Oppenheim emailed Lehman a calculation of the Payment on Early Termination it proposed to make (and which it went on to make approximately one month later). Appended to the email was a schedule which purported to contain three quotes. Sal Oppenheim apparently provided very limited disclosure in relation to these quotes, but it was apparent that the spot rate they used was the closing level of the Nikkei on 12 September 2008, the business day prior to Early Termination.

On being challenged with this (in February 2011), Sal Oppenheim initially denied that it had used quotes from 12 September, but was forced to resile from this. No witness was able to explain how the valuations were obtained. There was, however, some evidence that Sal Oppenheim had taken steps to hedge its risk on 15 September 2008 and shortly thereafter.

The judge's findings of fact were that Sal Oppenheim had not approached four dealers in the market. It had approached three banks and obtained retrospective valuations for the relevant transactions as at close of business on 12 September 2008, before those transactions terminated. It had not obtained quotations for a Replacement Transaction, and there was no evidence that it had attempted (or been unable) to do so. 

The parties' experts agreed that it was more likely than not that quotations for a Replacement Transaction could have been obtained on 16 September 2008, the business day after Early Termination, and the judge reached that conclusion as a finding of fact. 

Sal Oppenheim defended its calculation on arguments which raise fundamental questions as to the construction of clause 6 of the 1992 ISDA Master Agreement.

"Live" quotation or retrospective valuation?

The judge held that the provisions of the ISDA Master Agreement did not permit Sal Oppenheim to choose a date and time as of which valuations were to be given which predated termination of the transactions. This conclusion is unsurprising given the Agreement's specific reference to a date "on or as soon as reasonably practicable after" termination. The reasons for which Sal Oppenheim argued a contrary position are considered below.

However, while the judgment does not elaborate on the context, Sal Oppenheim also suggested that it was open to it to calculate the amount of the payment it needed to make "as of the date and time of Automatic Early Termination, even although (ex hypothesi) this calculation would only in fact be made at a later time and therefore retrospectively". While the judgment focuses on the narrower question of whether the date in respect of which quotes are sought can predate termination, it answers the more general question of whether that date can predate the request actually being made to reference market-makers at all. If a party does not learn of an Automatic Early Termination until the following day, can it approach market-makers for their valuations of the terminated transaction as they would have been given on the day and at the time of termination, and still comply with the Market Quotation method?

The implication of the judgment is that it cannot. The judge found that: "It seems to me entirely plain that this is intended to be what was described in the course of argument as a 'live quotation', i.e. one capable of being taken up there and then. It is not a question of a historic valuation".

The judge's view, supported by the ISDA User's Guide and (more explicitly) by Firth's Derivatives Law and Practice, appears to have been based predominantly on the stated purpose of the Market Quotation method. If the objective is to get a price for a Replacement Transaction, then (in crude terms) it is irrelevant what you could have paid (or been paid) for it a day or more ago. 

This confirms what Henderson on Derivatives describes as the prevailing market view. Henderson sets out a detailed discussion of the rights and wrongs of that view, and the history of the debate, at 19.22, although this does not feature among the various commentaries referred to in the judgment. If Henderson's summary of past market practice is correct, then this decision confirms a departure from the views which prevailed 15 or 20 years ago.

The commentary on this judgment by Simon Firth also raises interesting questions. He refers to the judge's statement that a "live quotation" for these purposes is one "capable of being taken up there and then" and draws from it the conclusion (implicit in the following paragraph of the judgment) that this means that only "firm" quotations are valid for the purposes of the Market Quotation method. The significance of this is, he says, that the market-maker providing the quotation must be providing a firm price at which it would be willing to deal and that any requests for quotations or responses which are expressed to be "for valuation purposes only" would not be valid for Market Quotation purposes. The judgment does not expressly consider this point, and deals only with the timing rather than the content of quotations. If Firth's analysis of the judgment is correct, it will (as he says) give rise to further issues. 

Extent of the "value clean" principle

Sal Oppenheim's submission that it could, consistently with the Market Quotation method, use the price which it would have obtained had it gone to the market at close of business on 12 September 2008, was connected with its position on the "value clean" principle, which applies to close-outs under the 1992 ISDA Master Agreement. The value clean principle required that Sal Oppenheim's loss of bargain had to be calculated on the basis that the transactions would have proceeded to a conclusion, and that all conditions precedent (including the absence of any Event of Default) were satisfied. 

Sal Oppenheim argued that this meant that the transaction must be valued assuming not only that the default had not occurred, but also that any consequences of the default had not taken place. In this case, the circumstances were unusual: the event giving rise to the default had simultaneously caused substantial market disruption. In Sal Oppenheim's view, Lehman would (in the context of this transaction) be profiting from its own default and Sal Oppenheim could therefore legitimately value the transactions at the last "clean" point in the market, i.e. close of business on 12 September 2008.

The judge did not consider this proposition to be arguable on a construction of the Master Agreement or bearing in mind the normative intentions of ISDA documentation, nor did he consider that it was possible to quantify precisely the effect of Lehman Brothers' collapse on market prices.

When is Loss available instead?

Where Market Quotation has been selected, there are nonetheless two circumstances in which the party calculating the payment can instead use the Loss method: (a) where a Market Quotation cannot be determined (referred to by the judge as the "First Gateway"); and (b) where Market Quotation would not, in the reasonable belief of the party making the determination, produce a commercially reasonable result (referred to by the judge as the "Second Gateway"). 

As stated above, the judge found that Sal Oppenheim could (and should) have obtained quotations as of 16 September 2008. This meant that the First Gateway was closed to it. 

In order for the Second Gateway to have been available, the judge applied existing case law stating that the party making the determination needed to turn its mind to the question of whether Market Quotation would produce a commercially reasonable result. In this case, there was no evidence that Sal Oppenheim had done so, let alone that it held a reasonable belief that Market Quotation would produce an unreasonable result, and the Second Gateway was therefore also unavailable.

Conclusions: what could Sal Oppenheim have done differently?

The judgment is primarily interesting for its consideration of the requirement that parties use live quotations in order to comply with the Market Quotation method.

The question of what Sal Oppenheim could legitimately have done in order to avoid the eventual outcome (which included a 12 per cent rate of interest on the shortfall in its payment) has a number of answers, and those answers are of general application.

  1. The most obvious point is that, where parties have agreed to Market Quotation, they are obliged actually to follow that route unless it would be unreasonable to do so.
  2. Sal Oppenheim suffered for its lack of evidence as to the process it followed, including as to when and how it sought valuations. It would be prudent for parties in that position to document the requests for quotations that they make, and the responses they receive.
  3. In the event of serious market disruption, it would be advisable for parties in the position of Sal Oppenheim to consider specifically whether Market Quotation would produce an unreasonable result and to document those considerations.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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