Banking

Banker/client relationship - Derivative agreements

Anthracite Rated Investments (Jersey) Ltd v Lehman Brothers Finance S.A. in liquidation; Fondazione Enasarco v Lehman Brothers Finance S.A. and another: Chancery Division: 15 July 2011

Lehman Brothers Finance (LBF) granted two cash settled put options (the derivative agreements) incorporating similar additions and amendments from the 1992 ISDA Master Agreement (the 1992 master agreement). The derivative agreements were guaranteed by its ultimate parent company Lehman Brothers Holdings Inc (Holdings) and formed part of two large and complex structures devised and marketed by Lehman Brothers International Europe (LBIE).

Each structure defined and regulated the issue of instruments (described as bonds or notes) by a single purpose vehicle issuer. The function of the derivative agreements in each structure was to provide principal protection, which meant that an investor would, on maturity of the instrument, receive not less than its original purchase price, even if the value of the underlying portfolio fell below that level.

The derivative agreement constituted the contractual means whereby that principal protection was provided, by a contract with the issuer and, by a charge, to the investors, with the issuer (of the bonds or notes) promising to pay to the investor, on maturity, no less than the original subscription price for the instruments and LBF securing the issuer's rights. The only parties to the derivative agreement were the issuer and LBF.

The terms of the instruments expressly excluded third party rights. Two series of instruments were issued in 2006 and 2007 respectively, maturing in 2017 and 2023 respectively (series 38 and series 26). Both structures made detailed bespoke provision for early redemption of the instruments. One such circumstance was an event of default by the issuer.

Two invariable consequences of early redemption of the instruments were that the investors would lose their principal protection and that the derivative agreements would come to an end. Mindful that early redemption of the instruments (triggering mandatory early termination of the derivative agreements) would cut short a potentially profitable premium income stream, LBF obtained provision for it to receive compensation for the consequence of early redemption in the form of an 'Early Termination Cash Settlement Amount' (ETCSA), to be paid by the issuer.

LBF suffered an event of default under each of the derivative agreements when, on 15 September 2008, Holdings filed for bankruptcy protection under Chapter 11 of the US Bankruptcy Code in New York. Since the parties to the derivative agreements had elected in favour of automatic (rather than elective) early termination, that caused an immediate early termination of both derivative agreements. Some time thereafter, the investor of series 26, and the issuer of series 38, the claimants, in two closely related claims under CPR 8, claimed to have calculated a substantial 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.

The sums claimed from LBF were €30m (series 38) and US$61.5m odd (series 26) respectively. LBF denied the claims and claimed an entitlement to, or to an amount equivalent to, the ETCSA under each derivative agreement, amounting to €2.8m and €43.74m odd respectively. LBF's case was based, upon a contractual entitlement to the ETCSA under the mandatory early termination provisions of the derivative agreements or, alternatively, that identical amounts represented the issuers' gains under the second method and loss methodology in ss 6(e) and 14 of the 1992 master agreement.

The issues were first, whether the automatic early termination of the derivative agreement on 15 December 2008 was an early redemption event, having regard to final term 19 which provided that an early redemption event occurred if the principal protection agreement was terminated in whole for any reason; secondly whether LBF was entitled to be paid the ETCSA; and thirdly, whether the rights and/or liabilities of LBF arising from the automatic early termination of the derivative agreements depended upon the identification of the issuers' loss as defined by s 14 of the 1992 master agreement, (replacement transaction quotation).

In respect of the third issue LBF submitted that the claimants' use of quotations for replacement transactions was unreasonable. In order to resolve the third issue the court had to interpret the standard form provisions of the 1992 master agreement which have been in widespread use since 1992 and the application to the particular facts of the instant case. Consideration was given to Hadley v Baxendale [1843-60] All ER Rep 461 (Hadley)

The court ruled: (1) It was established law that generally, the court's task was to ascertain the meaning which the instrument would convey to a reasonable person having all the background knowledge which would reasonably be available to the audience to whom the instrument was addressed. In the case of a simple bilateral contract, the audience would be the parties to the contract, however that formulation was applicable to instruments generally, whether contracts, trust deeds, articles of association or even legislation.

The meaning which a document would convey to a reasonable addressee was not the same as the meaning of its words. The ascertainment of the meaning of a particular provision in a complex instrument required constant attention to the context and purposes of the overall scheme of which it formed part, and an awareness that 'even the most skilled drafters sometimes fail to see the wood for the trees'. Finally, there was an important difference between a conclusion that the ordinary or grammatical meaning of the language of a particular provision led to a conclusion that flouted business common sense, and the subjection of a complex and carefully prepared scheme to reinterpretation on the grounds of mere fairness or enhanced reasonableness. The former was legitimate but the latter was not (see [67]-[70] of the judgment).

In the instant case, the phrase 'The Principal Protection Agreement is terminated in whole for any reason' meant that the collapse of the principal protection afforded by the derivative agreement was to be an occasion for the unwinding of the structure as a whole, subject to the safety valve constituted by the parities liberty to preserve.

That interpretation had accorded with the structure and purposes of the two transactions, understood as a whole (see [94], [96] of the judgment).

The automatic early termination of the derivative agreement was, under both structures, an early redemption event, notwithstanding that it was triggered by LBF's default (see [96] of the judgment).

Lomas v JFB Firth Rixson Inc [2010] All ER (D) 248 (Dec) applied; Hadley v Baxendale [1843-60] All ER Rep 461 considered; Investors' Compensation Scheme Ltd v West Bromwich Building Society, Investors' Compensation Scheme Ltd v Hopkin & Sons (a firm), Alford v West Bromwich Building Society, Armitage v West Bromwich Building Society [1998] 1 All ER 98 considered; A-G of Belize v Belize Telecom Ltd [2009] 2 All ER (Comm) 1 considered; Sigma Finance Corpn, Re [2009] All ER (D) 297 (Oct) considered.

(2) In the instant case LBF were not entitled to be paid the ETCSA on the basis, inter alia, that the parties having chosen to provide for LBF's entitlement to the ETCSA upon the happening of a particular type of termination of the derivative agreement, those provisions were, almost by definition, inapplicable in circumstances where the derivative agreement had already terminated.

There could not be two successive terminations of the same agreement (see [99] of the judgment).

LBF was not, in either case, contractually entitled to receive the ETCSA, since no mandatory early termination date had occurred, or could ever occur, after automatic early termination of the derivative agreements (see [111] of the judgment).

(3) In relation to the application both of loss and market quotation under the 1992 master agreement, the authorities established the following propositions. First, loss and market quotation were although different formulae, aimed at achieving broadly the same result, so that the outcomes derived from one might usefully be tested by way of cross-check by reference to the other. Secondly, the identification of the non-defaulting party's loss of bargain arising from the termination of the derivative transactions required a 'clean' rather than 'dirty' market valuation of the lost transaction.

Thirdly, the termination payment formulae under s 6 were not to be equated with or interpreted rigidly in accordance with, the quantification of damages at common law for breach of contract. They were methods of calculating close-out positions on the termination of a derivative transaction or series of transactions (see [116] of the judgment).

In the instant case, LBF's perspective was the wrong way to view the matter for a number of reasons. First, as between the issuers and LBF, the derivative agreements were serperate and distinct bargains between them, with their own legal consequences. Secondly, it was nothing to the point that the derivative agreements had in fact formed part of a complex structure designed to underpin the instruments as attractive marketable securities.

Thirdly, that perspective ran counter to the 'value clean' approach to the calculation of the s 6 close out payments established by the authorities. Fourthly, any attempt to rely upon principles of remoteness enshrined in Hadley floundered in the instant case on the fact that neither of the issuers had in the end received a windfall.

The rules for remoteness in Hadley were primarily designed to identify which of the innocent party's actual losses ought to fall within the confines imposed by the law upon recovery of damages from the contract breaker. Finally, the provisions of s 6 of the 1992 master agreement had not been in substance about the recovery of damages at common law. They had provided a contractual formula for the determination by the non-defaulting party of a close-out payment where the derivative agreement had come to an early end.

The limited incursion of common law principles was not a warranty for the wholesale dis-application of the close-out formula, in favour of some more general application of the common law (see[121]-[126] of the judgment).

The result of the forgoing analysis needed to be expressed in the form of answers to the issues specifically raised by each of the Pt 8 claim forms. The issues were contained in the statement of agreed facts and issues (see [130]-[134] of the judgment). Lomas v JFB Firth Rixson Inc [2010] All ER (D) 248 (Dec) considered; Scandinavian Trading Tanker Co AB v Flota Petrolera Ecuatoriana, The Scaptrade [1983] 2 All ER 763 considered; Peregrine Fixed Income Ltd v Robinson Department Store Public Co Ltd [2000] All ER (D) 1177 considered; Britannia Bulk plc (in liq) v Pioneer Navigation Ltd [2011] All ER (D) 122 (Apr) considered; Pioneer Freight Futures Co Ltd (in liq) v TMT Asia Ltd [2011] All ER (D) 23 (Apr) considered.

Mark Phillips QC and Stephen Robins (instructed by Clifford Chance LLP) for the issuer. Jonathan Russen QC and Rosanna Foskett (instructed by Field Fisher Waterhouse LLP) for LBF. Mark Hapgood QC and Jasbir Dhillon (instructed by Sidley Austin LLP) for investor. Jonathan Russen QC and Rosanna Foskett (instructed by Field Fisher Waterhouse LLP) for LBF. Jeremy Goldring (instructed by Clifford Chance LLP) for the issuer.