In yet another case to come out of the Lehman insolvency, the English High Court had to consider Section 6(e) of the 2002 ISDA Master Agreement: Lehman Brothers Special Financing Inc. –v- National Power Corporation. The case arose following termination of a forward currency swap that had been documented under a 2002 ISDA Master Agreement expressed to be governed by English law. The Court’s decision highlights an important distinction between the 1992 and the 2002 versions of the ISDA Master Agreement that parties should take into account when documenting a derivatives transaction.

How Should Close-out Amount Be Determined?

Under the 2002 version of the ISDA Master Agreement it fell to National Power Corporation (NPC) as the Non-defaulting Party to determine the “Close-out Amount”, and under Section 6(e) of the ISDA Master, NPC was required to act in good faith “and use commercially reasonable procedures in order to produce a commercially reasonable result”.

The case highlighted important differences with the definition of “Loss” under the 1992 version, which is defined in the 1992 version as the amount the Non-defaulting Party “reasonably determines in good faith to be its total losses and costs”.

The Court confirmed that the effect of the wording of the 1992 version was that the Non-defaulting Party must not reach “a determination which no reasonable non-defaulting party could come to”. This is essentially what has become known in a long line of English cases as the “Wednesbury” test of reasonableness, viz a test of rationality. However, the view of the Court was that the 2002 version required the party making the determination, viz the Non-defaulting Party, to act in a manner that an objective third party would consider to be commercially reasonable. Thus in this respect the 2002 version provides for a stricter test than the 1992 version.

The Court also confirmed that the requirement of the 2002 version comprised two separate obligations for the Non-defaulting Party when determining the Close-out Amount: (i) it must follow procedures that are commercially reasonable and (ii) it must reach a result that is commercially reasonable. Both obligations required objective reasonableness. This nevertheless allowed for a range of outcomes, but did not mean that NPC as the Non-defaulting Party could simply take the result that suited it best.

The Court went on to consider the application of this test to the facts and in so doing made a number of important comments, in particular as to the limited relevance of mark-to-market valuations and modelled evaluations in times of market turbulence. The Court noted that its approach to the construction of the 2002 version prevented NPC making an immediate windfall, which might well have been the outcome had the Court accepted NPC’s argument that the Court should apply the “Wednesbury” test to the 2002 version.

What Should Parties Take Away From This Case?

The case shows that more care needs to be taken by a Non-defaulting Party when making a determination of the Close-out Amount under the 2002 version, than under the 1992 version. As the judge said: “The present case may also show the value of contracting parties being clear about what they expect when they make one contracting party the decision maker in certain events, and of thinking about the consequences …….. if contracting parties want objective criteria of reasonableness to apply, they may need to do more than just use the word “reasonable”…. in my judgment sufficient was done in, and in the context of, the 2002 ISDA Master Agreement to achieve this.”