Lehman Brothers International (Europe) v Lehman Brothers Finance SA

Under the 2002 ISDA Master Agreement, Close-out Amount is determined by valuing the economic equivalent of the terminated transaction’s material terms and option rights. Material terms include terms affecting direct payment flows or pricing, including a contingent early-termination provision. The assumption that contractual conditions precedent are satisfied applies to the specified payment and delivery obligations. It does not erase other material terms or contingencies which must be valued. The 2002 wording cannot be treated as preserving the 1992 value-clean approach unchanged. Where the text permits more than one construction, the court should prefer ordinary meaning and business common sense. A side letter allocating termination, valuation and credit risks therefore had to be taken into account.

The joint administrators of Lehman Brothers International (Europe), in administration, appealed against Briggs J’s decision in the Companies Court, reported at [2012] EWHC 1072 (Ch). The dispute concerned the valuation of numerous back-to-back over-the-counter derivative transactions with Lehman Brothers Finance SA.

The transactions were governed by the 2002 ISDA Master Agreement provisions on early termination and Close-out Amount. A side letter provided for automatic termination of an inter-company transaction when the related client transaction terminated and limited payment by reference to sums recovered from the client. The central issue was whether those provisions formed part of the material terms or were excluded by the value-clean or continuity assumption.

Disposition. Arden LJ gave the leading judgment. Aikens LJ reached the same conclusion for substantially the same reasons, and Munby PFD agreed with both judgments. The appeal was allowed.

1. Construction of the 2002 Agreement. The agreement had to be interpreted according to its own words, read in the light of the relevant background. That background included the 1992 Master Agreement, prior case law and the ISDA User’s Guide. It was wrong to require substantial grounds before concluding that the value-clean principle had a different effect under the 2002 wording. The decision in Lomas v JFB Firth Rixson, [2012] EWCA Civ 419; [2012] CLC 713, did not determine the interpretation of the 2002 Agreement.
2. Effect of the amendments. The 2002 amendments expanded the valuation exercise from payment obligations to all material terms, expressly included option rights, permitted consideration of the Determining Party’s creditworthiness, and introduced flexible and commercially reasonable procedures. These changes were more significant than preserving the 1992 value-clean principle in its former context.
3. Material terms and contingencies. Material terms are terms affecting direct payment flows or pricing. The side letter affected the duration and economic value of the transactions and protected against market, valuation and credit risk. It was therefore a material term. Its possible operation during the remaining life of the transaction was a contingency capable of valuation; it did not itself bring about Early Termination in the valuation exercise.
4. Conditions precedent and option rights. The assumption in the Close-out Amount definition that conditions precedent in Section 2(a)(iii) were satisfied applied to the payment and delivery obligations to which it was attached. It did not prevent the valuation of an early-termination contingency. The unqualified reference to option rights included early-termination rights. In any conflict, the changed language of Section 14 had to be given effect rather than being cut down by the continuity assumption.
5. Commercial sense and creditworthiness. The court applied the principle in Rainy Sky SA v Kookmin Bank, [2011] 1 WLR 2900, that a commercially sensible construction should be preferred where language permits alternatives. The 2002 permission to take account of the Determining Party’s creditworthiness was a clear qualification of the former value-clean approach, contrary to the reasoning in Peregrine Fixed Income Ltd v Robinson Department Store Public Co Ltd, [2000] CLC 1328. Valuation difficulties could be reflected by appropriate discounting and did not justify excluding the side letter.

• Court of Appeal (Civil Division) allowed the administrators’ appeal and held that the side letter had to be taken into account when determining Close-out Amount.
• High Court of Justice (Chancery Division, Companies Court) Briggs J held that the side letter was not a material term for valuation purposes, alternatively that it had no value: [2012] EWHC 1072 (Ch).