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16 Mar 2018

Recent judgment on ISDA close-outs



In a recent decision, the English Court has considered whether, following an Event of Default, it was open to the Determining Party under an ISDA Master Agreement to re-make a determination of the Close-Out Amount after its initial determination, and whether the changes in the wording relating to close-out between the 1992 and 2002 versions of the ISDA Master Agreement had the effect of replacing a requirement for a rational decision on the part of the Determining Party with a requirement for an objectively reasonable decision.


The transaction in question was a principal-only US Dollar/Philippine Peso forward currency swap between Lehman Brothers Special Financing Inc ("LBSF") and National Power Corporation ("NPC"). NPC had issued US$300m of bonds maturing in 2028 and the currency swap was part of its hedging strategy in connection with the bond issue. As part of the swap transaction, an option was granted by LBSF to NPC under which NPC could choose to pay US$1m on 15 May 2008 instead of paying the US Dollar equivalent of PHB 4.5 billion in 2028, although NPC did not exercise the option.

LBSF had provided mark to market (MTM) valuations on the transaction, including, on 17 September 2008, an MTM valuation of US$16.5m in LBSF's favour. NPC too, in an internal memorandum, had recorded in September 2008 that NPC was out of the money.

LBSF filed for bankruptcy on 3 October 2008, which amounted to an Event of Default under the swap. NPC served notice of early termination on 17 October 2008, designating the Early Termination Date as 3 November 2008. It was therefore for NPC to calculate the Early Termination Amount (which in turn is based on the Close-Out Amount). NPC looked to replace the gap in its hedging strategy in connection with the bond issue and therefore was looking actually to enter into a replacement transaction (rather than just getting quotations). In this connection, it initially received indicative quotations from a number of banks, including UBS. Even though the date for exercise of the option under the swap had passed without exercise, the banks were asked to provide indicative quotations for both a transaction with a pre-payment option and a transaction without. On 7 November 2008 NPC received firm quotations from three banks. In the end, on 14 November 2008, NPC entered into a replacement transaction with UBS, which included an option with an exercise date of 16 November 2009.

Based on the UBS transaction, NPC demanded, on 26 January 2009, US$3,461,590.93 from LBSF, enclosing its calculations by way of an annex. NPC then filed a proof of claim for payment of this Early Termination Amount in LBSF's bankruptcy proceedings. However, in September 2014 it withdrew the proof of claim and served a revised calculation statement in October 2016. The revised statement included both a "primary determination" and an "alternative determination". The former was of US$10.7m and the latter of US$2.1m, in each case payable by LBSF to NPC. The "primary determination" was based on the UBS indicative quotation, and the "alternative determination" was based on the actual UBS transaction (i.e. on the transaction that was entered into with an option). LBSF objected and said (based on expert evidence) that it was owed US$12.8m by NPC.

Is a party entitled to re-make a determination?

The first question for the Court was whether or not NPC was entitled to withdraw its initial statement and rely on a revised figure. NPC argued that the amount in the annex to its first statement was not an amount equal to the Close-Out Amount because it did not accord with the definition of Close-Out Amount, in particular because it failed to account for a portion of the semi-annual fixed sum payments under the swap. It was, NPC said, therefore invalid and not contractually binding. LBSF, on the other hand, argued that there was no entitlement to withdraw and replace a calculation once served under section 6(d)(i) of the 2002 ISDA Master Agreement.

On this question the Judge found that the Master Agreement should be construed as follows:

  • By delivery of its letter of 17 October 2008, NPC caused a debt obligation to arise, and the 26 January 2009 letter with the calculations caused an obligation to pay to arise;
  • Once these events had occurred, the relationship between the parties was affected, and not reversible (save by agreement of the parties or in some cases an order of a Court);
  • NPC was required to make a determination, and it determined that US$3,461,590.93 was payable. This completed its obligation and right to make a determination; and
  • If there was an error in that determination, then the Court would be left to declare that, and to state what the Close-Out Amount would have been without the error.

This approach reflects, he said, the certainty that the parties must have intended. It is also broadly in line with the view expressed by Simon Firth in “Derivatives: Law and Practice”, in which he states that the Determining Party cannot subsequently change its mind, unless it failed to comply with the instructions set out in the ISDA Master Agreement.

In this case, although the “Accrued Amount” was not taken into account, that was an error that only permitted the determined figure to be corrected, by agreement or by the Court, but only in the respect in which there was an error – in other words, a determination had been made and the determination as a whole was not liable to be reopened and recalculated all over again.

Commercially reasonable procedures and the commercially reasonable result

The definition of Close-Out Amount in the 2002 Master Agreement provides "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".

In a previous Lehman case, the Court had said that this provision imposes two objective standards – the first is that the procedures used should be commercially reasonable, and the second is that the result produced should also be commercially reasonable. NPC had argued that the definition of Close-Out Amount required only that the Determining Party use rational procedures in order to produce a rational result. The Court disagreed. The Judge pointed out that the wording in the 2002 Master Agreement had changed from the 1992 version, which defines "Loss" by including the words "an amount that a party reasonably determines in good faith to be its total losses and costs". Previous case law had found this required the calculating party to act rationally, but not necessarily objectively reasonably. The Court found that the change to the wording from the 1992 form to the 2002 form was material. The 2002 User’s Guide also made clear that the change in the wording was specifically designed to include the notion of "objectivity". Although NPC had argued that the requirement for a "wholly objective approach" would deprive the Determining Party of the benefit of the discretion, the Judge disagreed, saying that he was not convinced that a "discretion" was given at all, but that in any event there was a benefit in terms of the control of the decision-making process. Taking all this into account, the Court concluded that the Determining Party was required to use procedures that were, objectively, commercially reasonable in order to produce, objectively, a commercially reasonable result. If it does not do this, then the Court will.

The findings in this case

The Judge concluded that it was commercially reasonable for NPC to rely on the UBS transaction (and NPC was effectively stuck with it). The MTM valuations did not assist as they were not the same as the price at which a replacement transaction could be achieved, and all the banks who provided a quotation did so at a price that was very different from the MTMs and always at a cost to LBSF rather than NPC. Where a firm quotation existed from UBS it was appropriate to regard that as having superseded the indicative quotations, and the firm quotations from the other banks were in line with UBS's quotation. As for the fact that the UBS replacement transaction replaced more than the LBSF transaction, because it included an option that NPC did not have as at the Early Termination Date, the Judge found that this made no material difference, save that NPC was not entitled to pass on to LBSF the option exercise price of US$1 million.


The Judge concluded the case by pointing out that the dispute demonstrated the range of possible outcomes when parties are calculating Close-Out Amounts, and the wisdom of ISDA making the changes that it did in the 2002 Agreement – NPC illustrated the type of outcome that a party given the role of decision maker and limited only by a requirement of rationality might press for, regardless of the fact of an actual replacement transaction.

Given the commentary in the User's Guide and the changes made in the 2002 Master Agreement, the decision is perhaps not surprising. However, it does again confirm that the non-defaulting party, calculating the Close-Out Amount following an Event of Default under the 2002 version, is required to act objectively reasonably, and produce an objectively commercially reasonable result – rather than just being required to act "rationally". Practically, this means that although there might still be a range of possible valuations, it is not open to the non-defaulting party just to choose the valuation which best suits it. Moreover, if a replacement transaction is actually entered into, then it appears from this judgment that it is going to be difficult for either party to challenge a Close-Out Amount which is based on that replacement transaction.

The decision also clarifies that once the Early Termination Amount has been calculated and notified, absent a substantive mistake or a failure to follow the provisions of the Master Agreement, it is not going to be possible for the non-defaulting party later to change its mind and seek to rely on a different Early Termination Amount.

It is therefore important that care is taken, when serving a calculation notice under section 6(d)(i) of the 2002 ISDA Master Agreement, to ensure that it is “objectively reasonable”.



Edward  Davis

Edward Davis

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