Lehman Brothers International (Europe) v Lehman Brothers Finance SA

The Court of Appeal interpreted the 2002 ISDA Master Agreement (as adopted between the parties) and held that the definition of "Close-out Amount" must be read to include the economic effect of material terms of the terminated inter-company transactions, including option rights, unless the agreement clearly excludes them. The court concluded that the Side Letter was a material contractual term affecting pricing and duration and therefore should be taken into account when valuing replacement contracts for close-out purposes. The court rejected the judge's application of the earlier "value clean" or "continuity" principle as an absolute rule that overrides the 2002 wording, holding instead that the 2002 amendments (and the User's Guide explanations) displaced the earlier, stricter application of that principle.

This is an appeal from Briggs J in the Chancery Division (Companies Court) concerning how to value inter-company derivative transactions on early termination under the 2002 version of the ISDA Master Agreement.

Background and parties: LBIE (in administration) entered into back-to-back derivative transactions with clients and transferred risk to LBF under inter-company transactions documented by an ISDA Master Agreement. LBIE and LBF also entered a side letter dated 24 July 2006 providing (inter alia) that an inter-company transaction would terminate contemporaneously with the related client transaction and that LBIE’s payment obligation under the inter-company transaction would be limited to sums actually received from the client. Following events in September 2008 LBF suffered an Event of Default and the inter-company transactions were automatically terminated; LBIE became the Determining Party for close-out purposes.

Nature of the appeal: The administrators of LBIE appealed Briggs J’s decision that the Side Letter should not be treated as a material term for the purposes of valuing replacement transactions under the 2002 Close-out Amount definition, and that, in any event, the Side Letter had no value in that valuation. The appeal thus raised a pure question of contractual interpretation of clauses 6(e) and the definition of "Close-out Amount" in clause 14 of the 2002 Master Agreement as adopted by the parties.

Issues framed:

• Whether the Side Letter is a "material term" of the inter-company transactions and therefore must be taken into account when determining the Close-out Amount;
• Whether the 2002 Master Agreement (and its User's Guide) preserved the earlier "value clean" or "continuity" assumption from the 1992 form so as to exclude contingent early-termination features from valuation; and
• How to construe the parenthetical qualification "(assuming satisfaction of the conditions precedent in section 2(a)(iii))" in the 2002 definition of Close-out Amount.

Court’s reasoning and outcome: The Court of Appeal allowed the appeal. It held that the 2002 amendments introduced important changes — notably the focus on the "material terms", the express inclusion of "option rights" and permission to have regard to the Determining Party’s creditworthiness — and that those changes were intended to, and do, modify the earlier strict operation of the "value clean" principle. The User's Guide supported an interpretation that the Close-out Amount should reflect material terms that affect pricing, including early-termination contingencies in appropriate cases. The parenthetical assumption about conditions precedent does not automatically negate the requirement to value other material terms and option rights; rather the 2002 wording must be read as a whole and in light of the surrounding commercial context. The Side Letter therefore falls to be taken into account as a material term for close-out valuation.

Appeal allowed. The court held that the 2002 Master Agreement’s definition of Close-out Amount must be interpreted in light of its text and background; the 2002 amendments (and the User’s Guide explanation) show that "material terms" and "option rights" may be taken into account in valuation and that the earlier strict form of the "value clean" principle does not automatically exclude such terms. The Side Letter was therefore a material term relevant to valuation.

Appeal from Briggs J, High Court of Justice (Chancery Division) (Companies Court), Briggs J [2012] EWHC 1072 (Ch). This Court of Appeal judgment: [2013] EWCA Civ 188.