Summary

The court determined the meaning and effect of early close-out provisions in two cash settled put options incorporating the 1992 ISDA Master Agreement which were part of larger investment structures devised and marketed by Lehman Brothers.

Facts

The court was required to determine the meaning and effect of early close-out provisions in two cash settled put options granted by the defendant (L), with a guarantee from its ultimate parent company, and which incorporated the 1992 ISDA Master Agreement with additions and amendments. The options or derivative agreements formed part of larger structures devised and marketed by Lehman Brothers. The structures involved the issue by a single purpose vehicle issuer of instruments described as bonds or notes which were Euro denominated and linked to a portfolio of underlying investments. The structures provided a degree of principal, and in one case interest, protection. That was the purpose of the derivative agreements. The subscription price for the instruments paid by the investor to the issuer was used for subscription for redeemable preference shares in another single purpose vehicle which acquired the underlying investment portfolio. The issuer entered into the derivative agreement with L, granting the issuer a put option in relation to the shares, exercisable on final maturity of the instruments if the net proceeds of redemption of the shares fell short of the original subscription price for the instruments. The issuer's obligations, both to the investor and to L under the derivative agreement were secured under a series of interrelated trust deeds. Both the trust deeds and the final terms of the instruments provided for a reversal of priority as between L and the investors, in the event of a termination of the derivative agreement by reason of L's default. L suffered an event of default under each of the derivative agreements when its ultimate parent filed for bankruptcy protection under Ch.11 of the US Bankruptcy Code. That was an event of default under the Master Agreement and caused an immediate early termination of both derivative agreements, since the parties had elected for automatic early termination. The issuers contended that they were entitled to recover a loss as non-defaulting parties based upon quotations of relevant premium rates for substitute put options for the outstanding terms of the two derivative agreements. L argued that automatic early termination of the derivative agreement triggered an early redemption of the instruments and that led to mandatory early termination of the derivative agreements triggering its entitlement to recover an early termination cash settlement amount under each agreement.

Held

(1) The automatic early termination of the derivative agreement was an early redemption event pursuant to final term 19 of the notes, which provided that an early redemption event occurred if the principal protection agreement was terminated in whole for any reason. The court rejected the submission that that term was inapplicable to any determination of the derivative agreement which arose by reason of L's default. It was not commercially absurd for the failure of the derivative agreement to lead to the automatic failure of the structure of the notes by early redemption. Where the derivative agreement terminated because of L's default its security rights were postponed to those of the investors under the security structure. That permitted the investors, the issuer and the trustee to agree together that the early termination of the derivative agreement should not lead to actual early redemption. Automatic early termination of the derivative agreement was, under both structures, an early redemption event, notwithstanding that it was triggered by L's default (paras 72-96). (2) The court rejected the submission that a mandatory early termination date under the derivative agreements had occurred by reason of the occurrence of an early redemption event under the final terms, thereby triggering a contractual entitlement of L to be paid the early termination cash settlement amount. The automatic early termination of the derivative agreement necessarily precluded a mandatory early termination at any later date. There could not be two successive terminations of the same agreement. L was not contractually entitled to receive the early termination cash settlement amount since no mandatory early termination date had occurred, or could ever occur, after automatic early termination of the derivative agreements (paras 97-111). (3) L's rights and/or liabilities arising from the automatic early termination of the derivative agreements depended on identification of the issuers' "Loss" as defined by section 14 of the Master Agreement. It was for the issuers as non-defaulting parties to identify their loss, and they had chosen to do so by a technique, replacement transaction quotation, which they were prima facie entitled to adopt. L failed to show that the use of that technique was unreasonable. That method of identifying the non-defaulting party's loss of bargain, by obtaining quotations for replacement transactions, was consistent with the case law on the interpretation of the Master Agreement and the position at common law (paras 112-129).

Judgment accordingly