ISDA Master Agreements and the calculation of close-out payments
19th April 2018
A recent case in the commercial court has highlighted that the change in wording between the 1992 and 2002 ISDA Master Agreements in relation to the calculation of the amount payable on early termination is a significant one. Under the 2002 agreement, the calculation of the close-out amount has to be objectively reasonable and not simply rational.
Facts of the case
In 2007 Lehman Brothers Special Financing (LBSF) and National Power Corporation (NPC) entered into a forward currency swap under a 2002 ISDA Master Agreement. This swap was made by NPC as part of a hedging strategy it had which was broadly to help provide some protection against the risk of devaluation of the Philippine peso. Following the collapse of the Lehman Brothers group in 2008, NPC terminated the swap early in accordance with its terms. The contractual Early Termination Date was 3 November 2008.
Under Section 14 of 2002 ISDA Master Agreement, NPC had to determine the Close-out Amount using “commercially reasonable procedures in order to produce a commercially reasonable result”.
NPC obtained indicative and then firm quotations from a number of banks for a replacement swap and subsequently entered into a replacement swap with UBS.
Based on the cost of the UBS replacement swap, NPC calculated the appropriate close-out figure payable to it as $3.46 million and demanded payment by filing a proof of claim in Lehman Brothers’ bankruptcy proceedings. This calculation didn’t include any expenses that NPC might incur in replacing the swap.
NPC subsequently withdrew the bankruptcy proof and, in 2016, served revised calculations of the Close-out Amount payable to it by which time proceedings had been commenced. The amount that NPC demanded was entirely based upon the new transaction that NPC had entered into, and reflected the replacement cost of entering into the replacement swap.
1992 ISDA Master Agreement
Broadly speaking, under the 1992 ISDA Master Agreement, the early termination payment is equal to the ‘Loss’ suffered by the determining party where Loss is defined as “an amount that party reasonably determines in good faith to be its total losses and costs”. This wording has been held to require rationality. The position was summarised in Fondazione Enasarco v Lehman Brothers Finance S.A. and Anthracite Rated Investments (Cayman) Limited [2015] EWHC 1307 (Ch). In that case, the High Court held that a party wishing to challenge a Loss calculation must show that the non-defaulting party’s determination was irrational in the Wednesbury sense (that is, it was so unreasonable that no reasonable person acting reasonably could have made it).
2002 ISDA Master Agreement
Under the 2002 ISDA Master Agreement, the figure paid on early termination is comprised of the Close-out Amount adjusted to take into account any Unpaid Amounts. Section 14 of the 2002 ISDA Master Agreement specifies that the 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”.
Section 14 goes on to provide a non-exhaustive list of sources that a Determining Party may consider in determining the Close-out Amount. These include third-party quotations for replacement transactions that take into account the creditworthiness of the Determining Party and market data supplied by third parties, including rates, prices and yields.
Distinction between rationality and reasonableness
A decision is ‘Wednesbury unreasonable’ (or irrational) if it is so unreasonable that no reasonable person acting reasonably could have made it (Associated Provincial Picture Houses Ltd v Wednesbury Corporation (1948) 1 KB 223). The test is a different (and stricter) test than merely showing that the decision was unreasonable. While the concept of Wednesbury unreasonableness originally related to decisions by public authorities, an analogous concept has been used in connection with a party’s contractual discretion.
The distinction between rational and reasonable decisions was explained in Hayes v Willoughby [2013] as follows: “Rationality is not the same as reasonableness. Reasonableness is an external, objective standard applied to the outcome of a person’s thoughts or intentions. A test of rationality, by comparison, applies a minimum objective standard to the relevant person’s mental processes.”
What did the court decide?
The judge emphasised that the Close-out mechanism set out in the 2002 ISDA Master Agreement was designed to, and does, achieve a more commercially reasonable result than the loss mechanism set out in the 1992 ISDA Master Agreement.
The court held that the requirement under the 2002 ISDA Master Agreement to “act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result” when determining the Close-out Amount is a requirement for the person making the determination to use procedures that are, objectively, commercially reasonable to produce, objectively, a commercially reasonable result. This is a higher standard than rationality, which has previously been found to be required in relation to the 1992 ISDA Master Agreement.
According to the user guide to the 2002 ISDA Master Agreement, the change of wording relating to calculating the amount to be paid on early termination was specifically designed to introduce greater objectivity than existed under the 1992 ISDA Master Agreement. This was one of the factors pointing towards the conclusion that a determination of the Close-out Amount must be objectively reasonable rather than merely rational.
Applying these findings to the facts of the case, it had been commercially reasonable for NPC to obtain the quotations and to use the UBS replacement swap to make its calculations.
WM Comment
This case shows that the change in wording for calculating the amount payable on early termination between the 1992 and 2002 ISDA Master Agreements is a substantive one, with the 2002 methodology requiring greater objectivity. The change has replaced the requirement for a rational decision with a requirement for an objectively reasonable one.
Under the 2002 ISDA Master Agreement, a determining party is expected to use commercially reasonable procedures to produce a commercially reasonable result, based on an objective standard. This is the same standard that a court would apply, if it had to make the determination.
