The matter dates back to the collapse of Lehman Brothers in 2008, when a US$100m currency-swap arrangement was terminated as a result of the bank’s insolvency. The currency swap was part of a wider hedging strategy in respect of bonds.
Following the termination, a dispute arose in respect of the 'close-out' amount payable under the contract. NPC calculated it was owed US$3,461,590.93 based on market quotations at the time.
Lehman Brothers Special Financing Inc (‘LBSF’) contended that commercial reasonable procedures were not used to arrive at this figure and that it is not a commercial reasonable result. LBSF carried out its own calculations and claimed it was owed US$12,826,887 before interest.
The case has been closely watched by both the government of the Philippines and the wider capital markets community both due to the sums at issue, and the fact that it is believed to be the first reported English case concerning the method of calculating the “Close-out Amount” payable on default under the 2002 ISDA Master Agreement.
Such close-out agreements were a significant feature of the aftermath of the collapse of Lehman Brothers.
The case also attracted attention as LBSF had argued that quotations obtained by PSALM from UBS, Deutsche Bank and Goldman Sachs in respect of the process were flawed and unreliable.
The case, however, turned on whether a change made under the 2002 ISDA Master Agreement obliged the parties to reach a rational decision with an objectively reasonable decision in determining the price.
Michael Hawthorne, the Legal Director at Pinsent Masons representing PSALM in the case, said:
"Lehman mounted a very ambitious challenge to PSALM’s determination of its Close-out Amount in which it wrongly said that the quotations that PSALM had obtained from UBS, Deutsche Bank and Goldman Sachs in a competitive bidding process were flawed and unreliable. Lehman attempted to substitute its own calculation for the prices that PSALM has taken from the market.
The judge rejected that approach completely and found that the quotations which PSALM obtained for its replacement transaction were the best available evidence of the market prices at the time. The decision strongly supports the conventional market practice of basing Close-out Amount calculations on market quotations, and should discourage defaulting parties in future from trying to challenge market quotations by reference to after the event and theoretical financial modelling. PSALM’s victory in this case will promote clarity certainty and predictability in Close-out Amount disputes and will be welcomed by market participants generally.
This is an important decision for the market because it makes clear that a non-defaulting party’s determination of a Close-out Amount under the 2002 ISDA Mater Agreement must be objectively reasonable (as opposed to merely rational as was the case under the 1992 ISDA Master Agreement). The decision establishes that a defaulting party does have the right to challenge a determination on the basis that the sum demanded is not objectively reasonable, but it also establishes that firm quotations are likely to be the best possible evidence of price. The use of firm quotations will generally be preferred to reliance on prior indicative quotations, financial modelling performed by the parties, and indeed MTM calculations produced by the defaulting party shortly before its default."