English Court Addresses Derivatives Close-outs


On July 29th, the High Court of Justice, Queen’s Bench Division, Commercial Court, issued an opinion[1] that addressed several issues regarding the calculation of early termination amounts under a standard derivatives master agreement, as well as the calculation of default interest under the master agreement.

In the case at issue, Lehman Brothers Finance S.A. (“LBF”) claimed that Sal. Oppenheim Jr. & Cie, KGAA (“Oppenheim”) had improperly calculated the early termination amount payable to LBF in connection with the termination of transactions governed by a 1992 ISDA Master Agreement under which “Market Quotation” had been selected as the payment measure. The transactions at issue were equity puts and calls that referred to the Nikkei 225 Stock Average Index (the “Index”). Pursuant to the terms of the master agreement between the parties, all transactions thereunder automatically terminated upon the bankruptcy filing of LBF’s parent, Lehman Brothers Holdings Inc. (“LBHI”), at 1:44 a.m. New York time on Monday, September 15, 2008. LBF itself went into liquidation in December 2008.

The relevant exchanges for the Index were closed for a Japanese holiday on September 15, 2008. By the time the exchanges re-opened on Tuesday, September 15, 2008, there was a substantial decline in the Index from the last close on Friday, September 12, 2008, which resulted in an increase in the value of the options in favor of LBF.

Oppenheim delivered a calculation statement to LBF on April 30, 2009 in which it informed LBF that it had determined that the amount payable to LBF in connection with the termination of transactions was some €1.85 million. In June 2009, Oppenheim provided a spreadsheet containing three dealer valuations supporting its calculations. LBF challenged the calculation on grounds including that this spreadsheet suggested that the relevant values were as of September 12, 2008, prior to the September 15 termination date. On July 14, 2009, Oppenheim paid to LBF the early termination amount it had determined, together with interest.

Based on testimony at trial and the record, the court concluded that there was no evidence that Oppenheim solicited or received market quotations from reference market-makers, and what valuations Oppenheim did receive were retrospective and as of the close of September 12, 2008, several days before the transactions automatically terminated. Based on expert testimony, the court concluded that it was more likely than not that quotations could have been obtained on September 16, 2008.[2]

Significantly, the court interpreted the language of Market Quotation to require each quotation received to be a “‘live quotation’, i.e., one capable of being taken up there and then.” In short, the court took the position that only firm quotations—and not indicative quotations—qualify for purposes of determining Market Quotation. This position is at odds with typical dealer responses to solicitations for early termination quotations, which often explicitly state that the quotations provided are for valuation purposes only and do not constitute an offer to trade at the price specified.[3]

The court also considered whether the “Loss” payment measure should have applied under the terms of the master agreement, because either a Market Quotation could not be determined or, in the reasonable opinion of Oppenheim, would not produce a commercially reasonable result. The court rejected this alternative based on its conclusion that a Market Quotation could have been determined by soliciting quotations on September 16, 2008. Based on expert testimony, the court concluded that the proper implementation of the Market Quotation formula would have led to a payment of some €2.96 million from Oppenheim to LBF.

The court finally addressed the appropriate rate of interest that should be applied to the additional early termination amount it determined to be due. It appears that the parties and court agreed that the “Non-default Rate” (essentially, the non-defaulting party’s cost of funds, as certified by it) should apply for the period between September 16, 2008 (i.e., when the early termination amount should have been calculated) to December 15, 2008, when the correct amount “should” have been paid to LBF. However, the court was left to consider the appropriate rate of interest that should apply to the underpaid amount after that date. Pursuant to the terms of the master agreement, the “Default Rate” is defined as “a rate per annum equal to the cost (without proof or evidence of any actual cost) to the relevant payee (as certified by it) if it were to fund or of funding the relevant amount plus 1% per annum.” LBF argued before the court that its only source of funding after the termination of the transactions at issue was its parent, LBHI, and that LBHI’s funding at the relevant time (based on senior credit default swaps as at September 12, 2008) was 14.427%.

The court rejected the default rate as certified to by LBF, noting that the source of funding identified by LBF could not actually be accessed by LBF (or, for that matter, LBHI) as of December 15, 2008. The court found that a source of funding that was available to LBHI (and, by extension, possibly LBF) as of such date was the Debtor-in-Possession Credit Agreement made available by Barclays as of September 17, 2008, which provided for a minimum lending rate of 11% per annum. The court therefore concluded that the Default Rate applicable from December 15, 2008 until the date of payment was 12% per annum.

This decision is of limited, if any, precedential value for cases litigated in the United States. However, the decision provides a point of reference for how one court viewed the calculation of early termination damages and calculations for default interest under derivatives master agreements.

[1] Lehman Brothers Finance S.A. (in liquidation) v. Sal. Oppenheim Jr. & Cie. KGAA, [2014] EWHC 2627 (Comm).

[2] Note that the language of the Market Quotation definition provides that the determining party is to solicit quotations from reference market-makers “to the extent reasonably practicable as of the same date and time . . . on or as reasonably practicable after the relevant Early Termination Date.”

[3] Note that the 2002 ISDA Master Agreement provides only for the “Close-out Amount” payment measure, which explicitly permits the determining party to consider “quotations (either firm of indicative)” in making its early termination calculations.