Lehman v. Intel: SDNY Gives Non-Defaulting Party Broad Discretion in Calculating Loss Under 1992 ISDA® Master

Practical Law Legal Update w-000-6359 (Approx. 7 pages)

Lehman v. Intel: SDNY Gives Non-Defaulting Party Broad Discretion in Calculating Loss Under 1992 ISDA® Master

by Practical Law Finance

Background

In February 2008, Lehman Brothers OTC Derivatives Inc. (LOTC) and Intel Corporation (Intel) entered into a 1992 ISDA Master, which governed all future over-the-counter (OTC) derivatives transactions between the parties.

At the beginning of August 2008, the parties entered into a forward share repurchase agreement under which LOTC would purchase Intel shares during a "quiet period" during which Intel itself was prohibited from transacting in its own shares due to securities regulations. LOTC would then later remit the shares to Intel to complete the transaction on September 29, 2008. Under the agreement, Intel gave LOTC $1 billion with which to buy the Intel shares, and LOTC was to remit to Intel on September 29, 2008 a number of shares equal to $1 billion divided by the value-weighted average price of Intel shares between September 2, 2008 and September 26, 2008 (which was ultimately determined to be 50,552,943 shares).

The transaction confirmation specified that the agreement's early termination payment measure would be the "Loss" methodology set out in the 1992 ISDA Master (see The ISDA Master Agreement: Early Termination: Early Termination Payment Methodologies Under Section 6(e) of the ISDA Master). The parties also entered into an ISDA Credit Support Annex (CSA) to govern collateralization of the transaction. Intel took possession of $1 billion worth of property from LOTC under the CSA as collateral to secure the transaction.

On September 15, 2008, LOTC affiliate and the credit support provider under the CSA, Lehman Brothers Holding Inc. (LBH), filed for Chapter 11 bankruptcy. With knowledge that it did not have access to the already-purchased shares because of circumstances related to LBH's bankruptcy filing, LOTC continued to purchase Intel shares until September 18, 2008.

While LOTC did not file its own Chapter 11 case until October 5, 2008, the related bankruptcy filings prevented LOTC from remitting the agreed-upon number of Intel shares to Intel on the transaction's settlement date of September 29, 2008. As a result, Intel declared an event of default under the ISDA Master and set the early termination date to be September 29, 2008 (see Practice Note, The ISDA Master Agreement: Early Termination for details on early termination under the ISDA Master).

Using the Loss methodology elected by the parties for the transaction in the transaction confirmation, Intel calculated that the early termination amount it was owed under the agreement was $1,001,996,256. It arrived at that number by adding the interest it had earned on the $1 billion of LOTC's posted collateral that it held to secure the transaction. Intel then set off that amount against LOTCs posted collateral to satisfy the early termination amount, as it was permitted to do under Paragraph 8(a)(iii) of the CSA.

LOTC and LBH (collectively, Lehman) commenced this adversary proceeding, which was before the court on cross-motions for summary judgment. Lehman sought repayment of a portion of the setoff amount, arguing that Intel's calculation of the early termination amount under the Loss methodology was incorrect. Lehman argued that the correct early termination amount was the fair market value of the undelivered shares on September 29, 2008, or $873 million. Lehman's valuation differed from Intel's by nearly $129 million and it sought that amount in damages. LOTC also argued that Intel breached the agreement when it setoff against LOTC’s collateral in an amount covering the $129 million it asserted was in excess.

Decision

The court rejected Lehman's arguments and held that so long as the loss calculation was reasonable and made in good faith, the non-defaulting party had broad discretion in selecting a method of calculating loss under the Loss methodology in the 1992 ISDA Master. The court examined the 1992 ISDA Master, the transaction confirmation and the CSA, and found that nothing in the definition of the Loss calculation required the use of a specific calculation method.

The court noted that, although the Market Quotation method was selected by the parties under the ISDA Master, the transaction confirmation, which controls over the ISDA Master where there is a conflict, elected the Loss methodology for calculating early termination payments under this particular transaction.

Specifically, the Loss provision provides that:

"Loss" means, with respect to this Agreement or one or more Terminated Transactions, as the case may be, and a party, the Termination Currency Equivalent of an amount that party reasonably determines in good faith to be its total losses and costs (or gain, in which case expressed as a negative number) in connection with this [ISDA Master] or that Terminated Transaction or group of Terminated Transactions… A party will determine its Loss as of the relevant Early Termination Date, or, if that is not reasonably practicable, as of the earliest date thereafter as is reasonably practicable. A party may (but need not) determine its Loss by reference to quotations of relevant rates or prices from one or more leading dealers in the relevant markets.

Parties Elected Flexibility in Determining Early Termination Payment Under the ISDA Master

The court found that, contrary to Lehman's assertion, the Loss provision was intended to include flexibility in the calculation method. If the parties had intended to bind themselves to a more formal method of calculation, they were entitled to use the Market Quotation procedure, which provides a rigid method of calculating early termination amounts. However, the court found that by electing "Loss," the parties expressly chose a method that included flexibility in how the non-defaulting party would determine its loss under the transaction. This, the court noted, is supported by market understanding of the provision.

"Unpaid Amount"

Second, Lehman argued that under the ISDA Master and the confirmation, if the terminated transaction did not require deliveries after the close-out date (as this one did not), any calculation of loss using the Loss methodology must be limited to the non-defaulting party's loss incurred on the Unpaid Amount (defined in the ISDA Master as the fair market value of the undelivered property – in this case the shares) as of the settlement date.

Again, the court rejected Lehman's argument for a variety of reasons, including that, under the ISDA Master, the defined term "Unpaid Amount" only applies to the Market Quotation methodology, not the Loss methodology, and that the calculation under the Loss methodology was intentionally left more broad than Lehman's narrow interpretation (see The ISDA Master Agreement: Early Termination: Early Termination Payment Methodologies Under Section 6(e) of the ISDA Master for details on Loss vs. Market Quotation methodologies under the 1992 ISDA Master).

Other Methodologies Irrelevant

Third, Lehman argued that its Loss calculation methodology should be used because it resulted in the same early termination amount that would have been applicable under the Market Quotation methodology or under New York state law regarding contract damages.

However, the court found that the early termination amounts calculated under the Market Quotation and Loss methodologies can be (and in some circumstances should be) different, and that the parties elected to execute the transaction under the 1992 ISDA Master using the Loss methodology, not a New York contract with reference to New York contract law. Therefore, any alternate early termination amount calculation methodologies have no bearing on how Intel was required to make its early termination amount calculation.

Calculation Was Reasonable and in Good Faith

Instead, the court examined whether Intel's calculation of its loss was reasonable and made in good faith. Since Lehman did not question Intel's good faith, the court focused on whether the calculation was objectively reasonable. The court found that Intel's calculation using the initial $1 billion amount plus interest was reasonable given that:

Intel initially invested $1 billion in the repurchase of the shares.
The confirmation referred to the "Agreed Value" of the Intel shares ($1 billion) as opposed to the market value (as Lehman argued) when discussing incomplete payments.
The value to Intel was the $1 billion worth of share repurchases it intended to make, indicating that its calculation beginning with the $1 billion and adding interest was objectively reasonable.

Practical Implications

This is a very important case for interpretation of the ISDA Master close-out provisions. Derivatives market participants have long wondered how the Loss provision of the 1992 ISDA Master, in action, would be construed by US courts. We now have an important part of our answer: At least in the SDNY Bankruptcy Court – one of the courts most often tasked with interpreting the ISDA Master in the US – the court will defer to a non-defaulting party’s broad discretion in determining how to calculate the early termination payment under the Loss methodology of the 1992 ISDA Master.

The case demonstrates the Lehman Court’s unwillingness to dissect two competing valuations for their relative merit and to second-guess the early termination amount utilized by the non-defaulting party based on the availability of other, potentially "better," valuations where the parties have elected the Loss methodology under the 1992 ISDA Master.

Instead, the inquiry will focus solely on the good faith and reasonableness of the calculation made by the non-defaulting party at the time the early termination payment is determined. Thus, parties seeking to invalidate those calculations must focus on reasonableness and good faith, not on alternate means of calculating losses.

In most circumstances, it is well-settled law that simply putting one’s own business interest ahead of another’s does not constitute bad faith. As a result, defaulting parties should expect non-defaulting parties to value early termination payments in a manner that is advantageous to themselves. This case demonstrates a willingness of important courts interpreting the Loss provision of the 1992 ISDA Master to accept these valuations.

Defaulting parties face the uphill battle of arguing that the calculation is objectively unreasonable or that it was made with a nefarious purpose other than to simply maximize the non-defaulting counterparty’s recovery.

It is worth noting that, in this case, a valuation differential of almost 13% of the initial amount invested in the transaction was still found to be objectively reasonable and in good faith.

For more information on the ISDA Master Agreement, see Practice Note, Understanding the ISDA Master Agreement and Schedule and ISDA Master Agreement Toolkit.

"ISDA" is a registered trademark of the International Swaps and Derivatives Association, Inc. (ISDA). ISDA is not a sponsor of Practical Law and had no part in the development of this resource.

Lehman v. Intel: SDNY Gives Non-Defaulting Party Broad Discretion in Calculating Loss Under 1992 ISDA® Master | Practical Law