High Court hands down ruling on calculation of Loss under 1992 ISDA Master Agreement
Published 28 May 2015
On 12 May 2015 the High Court gave Judgment in the matter of Fondazione Enasarco ("Enasarco") v (1) Lehman Brothers Finance S.A. ("LBF") and (2) Anthracite Rated Investments (Cayman) Limited ("ARIC")  EWHC 1307 (CH).
Enasarco had entered into an arrangement with Lehman Brothers International Europe (LBIE) that was devised to provide Enasarco with exposure to hedge funds, but also provide protection for the initial sum invested.
- Enasarco invested €780,470,000 in notes issued by ARIC (maturity date in 2023);
- ARIC invested the proceeds of the notes in redeemable preference shares issued by a wholly owned subsidiary, Anthracite Balanced Company (R-26) Limited (Balco), also to be redeemed in 2023;
- Balco was an SPV dedicated to holding and investing the proceeds of Enasarco's investment. Balco invested the funds in a range of funds. If the value of the investments dropped to pre-determined levels, funds would be switched into "safe" assets;
- The protection for Enasarco's initial investment was provided by a put option granted by LBF to ARIC ("the Put Option") which was guaranteed by LBF's ultimate holding company, Lehman Brothers Holdings Inc. (LBHI). Under the Put Option ARIC had the right to sell its shares in Balco to LBF in 2023 at a price equal to the shortfall between €780,470,000, and the amount which would be received by ARIC on the redemption of its shares in Balco. The terms of the Put Option were contained in an ISDA Master Agreement (1992 edition) ("the Master Agreement"), a schedule and a confirmation;
- The Master Agreement stated that, in the event of Early Termination, the non-defaulting party's Loss was to be the "amount that party reasonably determines in good faith to be its total losses and costs". The party responsible for calculating the loss had to do so as soon as reasonably practicable following the occurrence of an Early Termination Date and had to provide a detailed calculation.
The collapse of the Lehman Brothers group on 15 September 2008 triggered the Automatic Early Termination of the Put Option and made the entire arrangement unworkable - various companies in the Lehman Brothers group were parties to the contractual arrangements and fulfilled vital practical functions. Following the Automatic Early Termination, ARIC was required to calculate the loss on or as soon as reasonably practicable thereafter. Enasarco took steps to negotiate terms for replacement protection. Despite being a key party in the legal structure of the transaction, ARIC played a limited role in the commercial decisions.
On 6 May 2009, Enasarco entered into a substitute arrangement with Credit Suisse International on terms that were, in some respects, significantly different because the transaction was restructured ("the Substitute Transaction"). ARIC calculated its Loss as equivalent to €46,236,114 as at 6 May 2009. That sum represents the difference in the premiums payable under the new put option as compared to those payable by ARIC to LBF under the Put Option. ARIC subsequently assigned its claim for loss to Enasarco. LBF disputed the amount of the Loss and counterclaimed for $40 million, claiming that if Enasarco had followed the procedures in the Master Agreement for the Automatic Early Termination of the Put Option, it would have been able to enter into a replacement transaction at a more beneficial rate.
The Court found that ARIC’s Loss had been calculated reasonably and in good faith in accordance with the terms of the Master Agreement. In particular, it was held that:
- In the context of the structure of this transaction, it was not necessary for the non-defaulting party, ARIC, to obtain the quotation and negotiate the Substitute Transaction itself. It would have been unrealistic to expect Enasarco not to take the lead – it was the party with economic interest. ARIC, an SPV, was not equipped to negotiate the Substitute Transaction.
- When assessing the earliest date reasonably practicable to calculate loss, all circumstances must be taken into account. ARIC’s calculation of Loss “as of” May 6, 2009 was not too late to be “as soon as reasonably practicable” after the Early Termination Date - “reasonably practicable” is not the same as “possible”. The collapse of the Lehman Brothers group had had wide-ranging effects on global financial markets - finding a replacement for the size and complexity of the investment, combined with the prevailing market conditions and the fact that it was necessary to restructure the transaction, made the replacement of the Put Option a difficult and time-consuming exercise.
- When considering the state of the funds derivatives market after 15 September 2008, the Judge was particularly critical of the evidence submitted by LBF's expert – the "evidence of prices of transactions" used were mid-market prices obtained from pricing indexes – the prices were those at which banks were marking exposures to Market, and did not provide evidence of the prices at which transactions were being quoted and concluded. The examples were also clearly different from the Put Option written by LBF. It was held that in light of the uncertainty of the market following the collapse of Lehman Brothers, it was appropriate to look to prices actually quoted for a transaction rather than to hypothetical prices. It was determined that it was not reasonably practicable, or even possible for Enasarco or ARIC to have obtained a firm quotation for and entered into a replacement transaction either by the end of October 2008, or indeed by the end of 2008.
- Whilst the terms of the Substitute Transaction were not identical to the Lehman Brothers transaction, that did not prevent it from being a comparable replacement transaction for the purposes of calculating Loss. The Judge held 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.
- In determining whether a party has "reasonably" determined its Loss, the test is one of rationality and there is relatively narrow scope for the non-defaulting party’s calculation to be challenged. The test requires only that the non-defaulting party must not arrive at a determination which no reasonable non-defaulting party could come to.
The judgment provides guidance on the interpretation of the 'Loss' provision of the 1992 ISDA Master Agreement under English law and is, therefore, an important development in this area of law. It provides useful guidance for parties when closing out transactions following Early Termination. The circumstances behind this case are exceptional, namely the collapse of Lehman Brothers, however, one of the positions of general applications here is the Judge's reference, in turbulent times, to loans being connected to real market transactions as applied to "mid-market" hypothetical prices.