Summary

A letter agreement between Lehman Brothers International (Europe) and Lehman Brothers Finance SA dating from 2006 did not affect the conduct and outcome of Close-out Amount determinations under s.6 of the 1992 ISDA Master Agreement, as amended, following the Automatic Early Termination of the transactions made pursuant to it.

Facts

The administrators of Lehman Brothers International (Europe) (LBIE) asked the court to determine the consequences (if any) of a letter agreement dated July 24, 2006 (the Side Letter) on the conduct and outcome of Close-out Amount determinations under s.6 of the ISDA Master Agreement between LBIE and Lehman Brothers Finance SA (LBF) dated May 18, 1992, following the Automatic Early Termination of all the then current transactions made pursuant to it.

Automatic Early Termination had occurred on September 15, 2008, when the Lehman Group collapsed following the commencement of insolvency proceedings. The aim of the Side Letter was to reflect Lehman Group policy that LBF rather than LBIE should manage the risk arising from equity OTC derivatives traded by LBIE. The letter stated as follows: "This letter will confirm the agreement between [LBIE and LBF] concerning transactions between LBIE and LBF ("Intercompany Transactions") for which LBIE has an offsetting transaction on identical terms with a client (the "Client Transaction") leaving LBIE with no market position risk. In the event that a Client Transaction should terminate or be closed-out and a settlement amount be calculated in respect of that termination or close-out, LBIE and LBF agree that the related, offsetting Intercompany Transaction will also terminate or be closed-out contemporaneously, and a settlement amount determined as payable by LBIE under the Client Transaction will become payable by LBF to LBIE as a settlement amount under the Intercompany Transaction, and a settlement amount payable to LBIE under the Client Transaction will become payable by LBIE to LBF as a settlement amount under the Intercompany Transaction, but only to the extent LBIE actually receives that settlement amount from its client under the Client Transaction, it being the intent of LBIE and LBF that LBIE should not accept market risk or counterparty credit risk under any Client Transaction and that all risks under Client Transactions should be passed to LBF under the Intercompany Transactions". In August 2008, LBIE, LBF, other Lehman associates and a number of unconnected banking entities made a mutual agreement, entitled the Close-Out Amount Multinational Agreement, whereby they agreed common amendments to the 1992 ISDA Master Agreements; the result was that all the Intercompany Transactions relevant to this application were governed thereafter by an amalgam of the 1992 and 2002 editions of the ISDA Master Agreement. The expression "Close-out Amount" was defined in s.14 of the 1992 Master Agreement (as amended): it required the Determining Party to identify the losses or costs, or the gains, which it would incur or realise in replacing, or in providing for itself the economic equivalent of, two items, one of which was the material terms of the Terminated Transaction or group of Terminated Transactions.

The administrators argued that the value of the Side Letter fell to be taken into account in any determination of the Close-out Amounts on the grounds that (1) the contents of the Side Letter constituted material terms of each of the Intercompany Transactions, so that the valuer was to assume that the replacing, or provision for LBIE of the economic equivalent, of the material terms of each Intercompany Transaction necessarily required it to be assumed that the replacement or equivalent would include the terms of the Side Letter, or at least the value to LBIE of those terms; (2) if the terms of the Side Letter were not material terms in that sense, the omission of the terms of the Side Letter from the notional replacement transaction or economic equivalent meant that LBIE should be recognised as having suffered a consequential loss.

Held

(1) Permitting the early termination regime in the Side Letter to be taken into account in the Close-out Amount determination under the Master Agreement as amended would involve a radical departure from the "value clean" principle thus far established by the authorities in relation to the 1992 edition. That principle had been retained in the 2002 edition. InAnthracite Rated Investments (Jersey) Ltd v Lehman Brothers Finance SA (In Liquidation) [2011] EWHC 1822 (Ch), [2011] 2 Lloyd's Rep. 538, reference was made to the overriding control tests of commerciality and reasonableness as providing a measure of flexibility within the Master Agreement sufficient to enable it to be applied across a wide range of different types of transaction, in an infinitely variable combination of different circumstances. There was nothing unreasonable or uncommercial in a conclusion that LBIE and LBF should not be taken to have contracted to require the value of the Side Letter to be taken into account on a close-out following an early termination of the Intercompany Transactions caused, not by early terminating Client Transactions, but by the collapse of the Lehman Group. The commercial reasons for the Side Letter had nothing to do with achieving perfect equity as between LBIE and LBF in a mutual insolvent collapse. They were concerned with minimising LBIE's regulatory burdens while carrying on business as a going concern. Accordingly, precisely because the effect of the Side Letter was to bring about an early termination of the Intercompany Transactions, contrary to the continuity assumption underlying the 2002 determination of Close-out Amounts, the contents of the Side Letter were not material terms for that purpose. Alternatively, if they were material terms in theory, the application of the continuity assumption meant that they had to be attributed a nil value, Anthracite considered (see paras 61, 69-70 of judgment). (2) Section 6(e) of the Master Agreement, whether in the 1992 or the 2002 editions, was not a damages clause but a formula for the contractual determination of Close-out Amounts. The parties had chosen to include within that formula a list of specific items, some of which were mandatory and others permissive. Thus material terms and option rights were mandatory, whereas funding costs and associated hedging costs and losses were permissive. But the list simply did not include any other potential heads of loss which might be recoverable at common law, such as losses associated with the loss of the Side Letter rights. Section 6(e)(iv) (as amended) expressly provided that "Except as otherwise provided in this Agreement, neither party will be entitled to recover any additional damages as a consequence of the termination of the Terminated Transactions". Further, whereas the recovery as losses of funding costs and the recovery of losses in respect of associated hedges were not in any way inconsistent with the application of the continuity assumption which lay at the heart of the formula, the inclusion of an amount for the loss of the value of the Side Letter would be. It was both a loss expressly excluded by the requirement to value clean in accordance with the continuity assumption and a head of loss which was not included and which therefore fell to be left out of account. The value of the Side Letter formed no part of the process of the determination of the Close-out Amounts, nor was it otherwise to be included as part of LBIE's loss (paras 73-74).

Judgment accordingly