No Second Bite at the ISDA Valuation Cherry

March 2018 No Second Bite at the ISDA Valuation Cherry Lehman Brothers Special Financing Inc v National Power Corporation Contents A party closing out a 2002 ISDA Master Agreement must use commercially reasonable procedures to determine the close-out amount that is due with a view to reaching a commercially reasonable result but what standard of reasonableness applies? Is it enough to show that there was no irrationality or bad faith or does the determination have to be justifiable on objective grounds? And if it turns out that an error was made, can the determining party correct it by providing a revised calculation statement? The reasonableness standard... 1 Choice of quotations... 3 Ability to revise a calculation statement... 3 Conclusion... 5 The occasion for these issues to be considered was the termination, following the collapse of the Lehman Brothers group, of a currency swap between National Power Corporation ( NPC ) and Lehman Brothers Special Financing Inc ( LBSF ). NPC was required to determine the close-out amount due under the Agreement and so, on the Early Termination Date, it sought (and received) three indicative quotations for a replacement transaction. These were followed up, four days later, by a series of firm quotations from the same dealers and, the following week, NPC entered into a replacement transaction with the dealer that had offered the most favourable terms. NPC s original calculation statement had demanded a close-out amount based on the cost of the transaction it had entered into. However, it sought to withdraw this and make a revised determination based on the indicative quotation originally offered by that dealer. This was less favourable to NPC than the price it eventually accepted and so it sought to increase the amount it claimed from LBSF. The reasonableness standard Under the 1992 version of the ISDA Master Agreement, a determination of a party s Loss must be made reasonably and in good faith. The word reasonably, in this context, has been held to be a reference to Wednesbury reasonableness, i.e. the determining party must act rationally, so that its decision can be attacked if it is one that no reasonable determining party could reach (Fondazione Enasarco v Lehman Brothers Finance SA [2015] EWHC (Ch), [53]). In Lehman Brothers Special Financing Inc v National Power Corporation [2018] EWHC 487 (Comm), however, Robin Knowles J held that, as the 2002 ISDA Master Agreement uses a different formulation, a No Second Bite at the ISDA Valuation Cherry 1

different conclusion applies. The requirement to use commercially reasonable procedures and act with a view to reaching a commercially reasonable result are both objective standards and must be judged by reference to what a reasonable person would have done in the same situation. The standard that applies is therefore not rationality but objective reasonableness. This does not mean that the court will substitute its own determination whenever it would have reached a different decision. As the judge made clear, rationality and objective reasonableness both allow for a result that falls within a range. Even if an objective standard applies, there is scope for reasonable differences of opinion. As long as the determining party s assessment falls within that range and is made in good faith (rather than, for example, taking the result that suits it best at one end of the range) it will be acting reasonably. What, then, is the practical difference between Wednesbury unreasonableness and the objective standard? The answer to this question is somewhat obscured by the way in which this aspect of the Wednesbury test has been formulated. Asking whether the decision maker has come to a conclusion so unreasonable that no reasonable [decision maker] could have come to it provides little help in distinguishing the test from objective reasonableness, which is also assessed by reference to the reasonable decision maker. There is, however, a difference of degree between the two tests. For example, in negligent valuation cases, where the objective standard applies, a professional valuer will typically be allowed a 10 per cent margin of error from the figure that the court considers a competent valuer would have arrived at (Singer & Friedlander Ltd v John D Wood & Co [1977] 2 EGLR 84, 85). In contrast, in the public law sphere, the Wednesbury test has colourfully been said to involve asking whether the decision maker has temporarily taken leave of his senses (R v Secretary of State for the Environment, ex parte Nottinghamshire County Council [1986] AC 240, 247). As Auld LJ put it in O Conner v Chief Adjudication Officer [1999] 1 FLR 1200, 1210, good old Wednesbury irrationality is about as an extreme form of irrationality as there is. Although in recent years, the courts have taken a more nuanced approach, applying a sliding scale depending on the nature of the challenge, this illustrates the difficulty of mounting a challenge on the basis that the outcome was irrational. The standard that applies to objective reasonableness is significantly less exacting. It is important to bear in mind that rationality also focuses on the decisionmaking process. For example, there is a requirement to exclude extraneous considerations and to take into account any considerations that are obviously relevant (Braganza v BP Shipping Ltd [2015] 1 WLR 1661, [29]). Indeed, it is strongly arguable that the only reason why the outcome is relevant in the context of rationality is because it shows that something must have gone wrong with the decision-making process, even if it is impossible to identify the precise error that was made. A close-out determination under the 1992 ISDA No Second Bite at the ISDA Valuation Cherry 2

Master Agreement can therefore be attacked if there is a fundamental flaw in the methodology used (as, for example, where it is based on prices that are obviously out of date), even if the outcome is not so extreme as to justify a challenge in isolation. However, this requires evidence about how the determining party reached its decision, which may not be readily available. Choice of quotations The 2002 ISDA Master Agreement requires the determining party to make its determination as of the Early Termination Date or, if that would not be commercially reasonable, as soon thereafter as would be commercially reasonable. Under its original calculation statement, NPC had not made its determination as of the Early Termination Date, despite having obtained indicative quotations on that date, as it had used the firm quotations obtained four days later. Whether this was permissible therefore turned on whether it would have been commercially reasonable to use the indicative quotations. Robin Knowles J held that, in the circumstances of the case, it would not have been commercially reasonable to have made the determination as of the Early Termination Date. That would have involved using indicative quotations even though, by the time the determination was made, firm quotations had become available. It was not only legitimate to use the firm quotations in preference to the indicative quotations, it would have been unreasonable to do otherwise. This illustrates the fact that, even though the 2002 ISDA Master Agreement expressly allows the determining party to take indicative quotations into consideration, they should not be used where a firm quotation, or an actual trading price, is available. The same is true of the use of financial modelling, except perhaps on the rare occasions on which it would be unreasonable to enter into a replacement transaction on the basis of any firm quotation that has been obtained. It also indicates that the fact that firm quotations are not available on the Early Termination Date is not necessarily an obstacle, at least if they can be obtained within a reasonable period thereafter. Ability to revise a calculation statement In light of this conclusion, there was no prospect of NPC being allowed to revise its calculation statement in the way it wished, as that would have involved it substituting an unreasonable determination for a reasonable one. Even if the original determination had been invalid, however, the judge held that a fresh calculation statement could not have been provided as there is no provision in the Agreement for a second attempt. Where a determination is invalid, it will be for the court to state what the close-out amount would have been on a determination that was without error. A revised calculation statement may, however, be used as evidence of what that determination would have been, as well as whether there was an error in the first place. That conclusion would seem to be equally applicable to the 1992 ISDA Master Agreement. No Second Bite at the ISDA Valuation Cherry 3

In many cases, little is likely to turn on this point. Where a discretion is invalidly exercised, the court is required to determine what decision would have been made in the absence of an error by putting itself into the shoes of the decision maker (Socimer International Bank Ltd v Standard Bank London Ltd [2008] 1 Lloyd s Rep 558, [65]). Where the determining party purports to correct a mistake in a calculation statement by providing a revised statement that has been drawn up reasonably and in good faith, that will often constitute good evidence of the approach it would have taken if it had performed the task correctly in the first place. However, there are situations in which the point could be material. If the determining party were able to revise the original determination, it could take account of any facts that had come to light in the intervening period. On the other hand, a determination by the court of the result that would have been reached if the discretion had been properly exercised must be made on the basis of the facts that were in existence at the time that such exercise would have taken place. A more fundamental point is whether, under the 2002 ISDA Master Agreement, a discretion is given at all. Robin Knowles J said that he was not convinced that it is. There is no doubt that the determining party has control over the timing of the decision-making process and scope for deciding how to go about the task, but it is required to come up with a result that, looking at the matter objectively, is commercially reasonable. Arguably, therefore, there is a single, objectively justifiable, result that the determining party is supposed to target. As we have seen, the fact that there is room for reasonable disagreement about what that result should be means that, as long as it falls within the appropriate range and uses a commercially reasonable methodology, it will be upheld. Provided that the determining party performs the task correctly, it makes very little difference whether or not this is characterised as the exercise of a discretion. On either basis, that party s choice of methodology will prevail. However, it raises the question of what approach the court should take in the event of an error. Should it then make its own assessment of the position, on the basis of the methodology it considers to be appropriate, or should it ascertain what the determining party would have done if it had not made a mistake? As noted above, where there is an allegation of negligence in a professional valuation, the court will determine, on the basis of all the evidence, what the result should have been and then ask whether the defendant s valuation fell within the permitted range either side of that valuation. If it did not, the damages will be based on the court s assessment of the true value (South Australia Asset Management Corp v York Montague Ltd [1997] AC 191, 221). This is different from asking what result the defendant would have come up with if it had performed the task correctly, as it may still not have hit the objectively justifiable target. Although the task to be carried out under the ISDA Master Agreement is different from the valuation of a business or a property, a similar approach is probably required. Hence, in the Lehman Brothers case, Robin Knowles J said that, where a decision maker has made No Second Bite at the ISDA Valuation Cherry 4

a decision not open to it, the court will decide what a decision on entirely objective criteria would be. Conclusion The case illustrates the much more exacting standard that applies to a closeout determination under the 2002 ISDA Master Agreement, when compared to the 1992 version of that Agreement, and the care that needs to be taken by a determining party. As long as it can justify its approach, it will have a degree of latitude over the preferred methodology, as well as the timing of the valuation. However, if it falls into error, this flexibility will be lost. It will not get a second chance. Simon Firth No Second Bite at the ISDA Valuation Cherry 5

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