Lehman Brothers International (Europe) v Lehman Brothers Finance SA

Close-out amounts under the 2002 ISDA regime must generally be determined on a clean valuation basis. The valuation assumes that contractual payments and deliveries would have continued to their natural conclusion, even if that assumption is commercially improbable. An early-termination provision which operates contrary to that continuity assumption is not ordinarily a material term for the valuation, or has nil value within it.

The contractual close-out formula is not a general damages clause. Losses falling outside its specified categories, including loss of the value of a related side agreement, cannot be recovered as additional damages. Where the agreement requires commercially reasonable procedures producing a commercially reasonable result, both standards are objective, although they permit a range of reasonable outcomes.

The joint administrators of Lehman Brothers International (Europe) sought directions concerning close-out amounts under ISDA Master Agreements with Lehman Brothers Finance SA. A side letter provided for back-to-back intercompany transactions to terminate when corresponding client transactions terminated, with settlement amounts passed through to the intercompany transactions.

Automatic early termination of the intercompany transactions occurred following the insolvency-related default of a specified entity before the corresponding client transactions terminated. The principal issue was whether the side letter, or its value, had to be taken into account in determining close-out amounts under the amended 1992 ISDA form incorporating the 2002 regime. Subsidiary issues concerned the valuation date and the standard of reasonable conduct.

1. The application was determined in favour of LBF on the principal issue. The value of the Side Letter formed no part of the Close-out Amount determinations and was not otherwise recoverable as part of LBIE’s loss.

2. The Side Letter was, in substance, an important contractual amendment to the intercompany transactions. Its separate form and English governing law did not alter that conclusion. The later Close-Out Amount Multilateral Agreement did not override it.

3. Nevertheless, the 2002 Close-out Amount definition carried forward the established value-clean principle. The required assumption that payments and deliveries would continue under section 2(a)(i), subject to satisfaction of the section 2(a)(iii) conditions, was a continuity assumption applying to the valuation as a whole. The inclusion of option rights did not displace that principle.

4. Because the Side Letter operated by bringing about early termination before the client transactions terminated, it conflicted with the continuity assumption. It was therefore not a material term for the close-out valuation. Alternatively, if it was a material term in theory, it had nil value under the clean valuation.

5. Section 6(e) supplied a contractual formula for determining close-out amounts, rather than a common-law damages clause. Its specified categories of loss excluded a separate claim for the value of the Side Letter, and section 6(e)(iv) excluded additional damages.

6. If the alternative valuation issue had arisen, the administrators could not adopt an indefinitely deferred “wait and see” approach. A date would become commercially unreasonable if chosen merely to avoid prediction. The appropriate later date would have been the date on which a higher court might finally determine that the Side Letter had to be taken into account.

7. The requirement that the Determining Party act in good faith and use commercially reasonable procedures to produce a commercially reasonable result imposed two objective standards. It allowed a range of reasonable procedures and results, but permitted the court to intervene where the contractual valuation process was not performed.

High Court (Chancery Division): the administrators’ application for directions was determined on 27 April 2012. The principal issue was decided in favour of Lehman Brothers Finance SA; the subsidiary issues were addressed conditionally.