New York state court ruled that a non-defaulting insurer’s valuation under the 1992 ISDA Master Agreement was commercially reasonable and in good faith and was not required to rely on market prices that distorted the value of its loss of bargain.

TAKEAWAYS

• The loss method under the 1992 ISDA Master Agreement permits a non-defaulting party to select any commercially reasonable valuation method in good faith to calculate its loss.
• Theoretical market prices need not be utilized to determine loss under the loss method when there is no market for a replacement transaction.
• A non-defaulting party’s delayed termination during dislocated market periods did not negatively impact the use of the loss method.

In September 2008, Lehman Brothers Holdings Inc. and its domestic and foreign subsidiaries (Lehman) filed for bankruptcy protection due to accelerated losses caused mainly by the subprime mortgage crises. At the time, Lehman held a massive portfolio in subprime residential mortgage-backed securities (RMBS) and collateralized loan obligations (CLOs). To mitigate the risks associated with these securities, Lehman purchased credit protection under credit default swap agreements (CDS) governed by agreements using the 1992 Master Agreement published by the International Swaps and Derivatives Association (ISDA).

Each of these agreements specified the market quotation (MQ) methodology for determining the amounts payable following the termination of the agreement due to an event of default. As noted in a recent client alert, the 1992 ISDA Master Agreement requires that, if MQ is specified as applicable, the termination payment will be based on market quotations for a replacement transaction obtained by the non-defaulting party (NDP) from market dealers. However, if the NDP cannot obtain more than two quotations, the NDP must use the “loss” method to calculate the termination payment.

In a recent case, Lehman Bros. Int’l (Europe) v. AG Fin. Prods., Inc., No. 653284/2011, 2023 WL 2403924 (N.Y. Sup. Ct. Mar. 8, 2023) (Assured), the New York Supreme Court addressed how a NDP implemented these two methodologies and found that the NDP had correctly applied each method and that its valuation establishing loss was commercially reasonable and in good faith.

Background
Before declaring bankruptcy in England, Lehman’s UK subsidiary, Lehman Brothers International (Europe) (LBIE), bought loans originated by its subsidiaries, deposited the loans into investment vehicles, and sold 28 tranches of RMBS and CLO securities to investors. The transactions were divided into three categories: “ABX,” “UK RMBS” and “CLOs.” The CLO transactions were highly rated securities, meaning they would only suffer losses once lower-rated CLO tranches were wiped out. Although ABX and UK RMBS transactions bore similar risks and benefited from similar protections, the UK RMBS transactions benefited from additional protection through reserve funds and new loans coming in to cover losses.

LBIE purchased credit protection for these transactions by entering into CDSs with AG Financial Products Inc. (Assured), which were documented under the 1992 ISDA Master Agreement. Under these CDSs, LBIE paid premiums to Assured in return for guaranteed payments to cover principal and interest shortfalls on the securities until the securitized mortgages and loans matured. LBIE defaulted on the CDSs due to its bankruptcy filing, entitling Assured to terminate each CDS transaction and determine the termination payment due, which it did 10 months after LBIE’s bankruptcy (i.e., July 2009).

Market Quotation and Loss Methods
The CDSs specified MQ as the termination valuation methodology. The MQ method requires the NDP to solicit at least three market quotations on a replacement transaction from market dealers and choose the intermediate quote or, if the NDP is unable to obtain at least three market quotations, to use the loss method to calculate “an amount that [it] reasonably determines in good faith to be its total losses and costs ... including any loss of bargain.” Using the loss method is likely to occur during times of market dislocation.

The MQ method establishes a strict process a NDP must follow to determine loss, whereas the loss method provides more flexibility by giving a NDP latitude to select a valuation method to calculate loss, so long as the methodology is reasonable and in good faith. Under the loss method, a NDP need not determine “loss by reference to quotations of relevant rates or prices from one or more leading dealers in the relevant markets” because market prices are usually divorced from the actual value of the underlying asset in dysfunctional markets, making it commercially unreasonable for a NDP to rely on market prices.

Assured’s Valuation and LBIE’s Position
In Assured, Assured initially conducted an auction to solicit market quotations under the MQ method but did not receive any bids from dealers. Following the failed auction, Assured then applied the loss method, using a discounted cash flow method to calculate its total loss of approximately $27.6 million, representing the value of LBIE’s losses of approximately $20.6 million under the ABX trades, netted against future premiums owed to Assured in the amount of approximately $48.2 million.

LBIE claimed that Assured’s valuation analysis was wrong and that LBIE was owed more than $450 million instead. According to LBIE, market prices were available because there was no market dislocation during the subprime mortgage crisis—a claim that the court found to “fl[y] in the face of the bulk of the evidence, reality, and its own expert’s opinion.” To establish a market price, LBIE tried for several months—even before the failed auction—to novate the securities transactions by searching for a replacement party to the CDS transactions but did not receive a single bid. LBIE also pointed to three indicative bids it had received, but none were binding, several were subject to significant disclaimers, and according to the court, each was obtained solely to bolster LBIE’s litigation position. LBIE also argued that Assured’s valuation methodology under the “loss” method was unreasonable because, in its view, market practice required Assured to estimate theoretical market prices to determine its loss after a failed auction.

Trial Court’s Analysis
The court found that Assured followed the 1992 ISDA Master Agreement methodology for establishing its loss. It first engaged the market, that is, it tried to use the MQ method, but it failed to attract any bids. Extreme market dislocation and illiquidity made it difficult for any NDP, including Assured, to obtain quotes from dealers. According to the court, once the MQ process failed, the “loss” methodology permitted Assured to consider any commercially reasonable valuation method, which did not require it to consider LBIE’s theoretical market prices. To determine its loss, Assured primarily used a projected default rate on the securities, then calculated a prepayment rate and loss severities to establish LBIE’s projected recoveries on the underlying loans after defaults. In doing so, Assured considered several factors, including:

• market data on delinquent borrowers and those in default;
• structural protections relating to the ABX trades that allowed LBIE to avoid losses until such lower-rated trades were wiped out;
• the UK RMBS and CLO trades, which remained investment grade through the subprime mortgage crises; and
• market conditions at the time (between 2009 and 2012), such as government programs and “burnout” and “seasoning” scenarios typical with large mortgage pools, in which some mortgages defaulted a few years after loan origination (burnout) and some avoided defaults because the borrowers managed to stay current (seasoning).

Applying these factors, Assured projected a 0% default rate on the UK RMBS and CLO trades and a 28% default rate on the ABX trades, which was an essential factor in determining LBIE’s projected losses of approximately $20.6 million. According to the court, this projected default rate was close to similar projections made by credit rating agencies, which ranged from 30% to 39%. Also, by waiting 10 months to terminate CDSs, the court noted that Assured was able to rely on improved conditions to lower its liability to LBIE, which LBIE did not dispute was in good faith.

In reaching its decision, the court compared the case to a Canadian case (Devonshire), which also addressed a large discrepancy in valuation. There, the Devonshire court accepted the loss method valuation of Devonshire’s expert (LBIE’s expert in Assured) in rejecting Barclay’s $1.2 billion valuation compared to Devonshire’s $12,000 valuation and concurred that theoretical market prices were irrelevant to determine Devonshire’s loss. As in Assured, the Devonshire court found that market dislocation during the subprime mortgage crisis made it commercially unreasonable for Devonshire to rely on market prices.

In sum, LBIE failed to rebut any of Assured’s valuation evidence because, as the court stated, LBIE “staked its position on unreasonably high numbers that bore no relation to reality.”

Conclusion
Assured confirms other decisions’ interpretation of the 1992 ISDA Master Agreement that the loss method gives a NDP the exclusive right to calculate its loss. In doing so, and in good faith, NDPs may select any commercially reasonable valuation method, including the discounted cash flow method. This flexible approach to valuation ensures that NDPs will be fully compensated for their loss when market dislocations distort market prices. Notably, the 2002 ISDA Master Agreement replaced the “loss method” with the “close-out amount” method, which may produce different damage calculations. Still, the 1992 ISDA Master Agreement continues to govern various derivatives transactions. Thus, decisions like Assured provide certainty and predictability on measuring loss following a failed auction under the MQ method.

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