Lehman Brothers International (Europe) v Lehman Brothers Finance S.A.
| Jurisdiction | England & Wales |
| Judge | Mr Justice Briggs |
| Judgment Date | 27 April 2012 |
| Neutral Citation | [2012] EWHC 1072 (Ch) |
| Court | Chancery Division |
| Docket Number | Case No: 7942 of 2008 |
| Date | 27 April 2012 |
In the matter of Lehman Brothers International (Europe) (in administration)
[2012] EWHC 1072 (Ch)
Mr Justice Briggs
Case No: 7942 of 2008
IN THE HIGH COURT OF JUSTICE
CHANCERY DIVISION
COMPANIES COURT
Mr Iain Milligan QC and Mr Julian Kenny (instructed by Linklaters LLP) for the Applicant
Mr David Railton QC and Mr Jonathan Russen QC (instructed by Field Fisher Waterhouse LLP) for the Respondent
Hearing date: 5,6 March 2012
Introduction
1. This application for directions by the joint administrators of Lehman Brothers International (Europe) (“LBIE”) seeks the determination by the court of issues as to the consequences (if any) of a letter agreement dated 24 July 2006 (“the Side Letter”) upon the conduct and outcome of Close-out Amount determinations under section 6 of the ISDA Master Agreement between LBIE and Lehman Brothers Finance S.A (“LBF”) dated as of 18 May 1992, following the Automatic Early Termination of all the then current transactions made pursuant to it, at 6.45 a.m. (BST) on 15 September 2008.
2. The Administrators originally sought directions not only in relation to the Master Agreement with LBF, but also in relation to similar agreements with other Lehman Group affiliates who were parties to letter agreements substantially the same as the Side Letter. In the event, there remain active and commercially relevant issues only between LBIE and (1) LBF and (2) Lehman Brothers International Inc (“LBI”). As between LBIE and LBI, those issues are to be determined (if they cannot be compromised) on a different occasion.
3. As will appear, the main issue between LBIE and LBF is whether the Side Letter is to be taken into account at all in the determination of the Close-out Amounts. As to this, (and the subsidiary issues), the Administrators are by no means neutral. They estimate that if the Side Letter is to be taken into account, this will be to the financial advantage of LBIE and its stakeholders, as against LBF, by an aggregate amount in the region of US $1 billion. This application has therefore taken the form of a straightforward adversarial contest between LBIE, acting by the Administrators, and LBF, acting by its own insolvency office holders.
The Facts
4. The relevant facts are not in dispute and, as in several previous applications by the Administrators, this application is, by consent, proceeding on the basis of assumed rather than decided facts, it being the parties' perception that the real facts are likely to prove to be sufficiently proximate to the assumed facts, for a decision on the assumed facts to be sufficient to resolve the outstanding issues.
5. At the time when the Side Letter was signed, LBIE was carrying on business with third parties (i.e. counterparties on the street, rather than Lehman Group affiliates) dealing in OTC derivatives by transactions the terms of which were governed by ISDA Master Agreements. An important class of those derivatives was equity OTC derivatives. In respect of that class it was and had been for some years prior to 2006 Lehman Group policy that LBF rather than LBIE should manage the risk arising from equity OTC derivatives traded by LBIE and that LBF should, subject to internal re-distribution of profits and losses, both enjoy the benefits and incur the risks of that trading.
6. In order to transfer those risks and benefits from LBIE to LBF, all (or almost all) OTC derivative transactions undertaken by LBIE with customers on the street were matched by automatically generated equal and opposite back-to-back transactions between LBIE and LBF. All those back-to-back transactions were governed by an ISDA Master Agreement in the 1992 form between LBF and LBIE dated 18 May 1992, with a Schedule of even date, naming LBF as Party A and identifying Lehman Brothers Holdings Inc (“LBHI”) as a Specified Entity in relation to Party A for the purposes ( inter alia) of Section 5(a)(vii) of the Master Agreement. Part 1(e) of the Schedule disapplied Automatic Early Termination under section 6(a) in relation to Parties A and B. For the purposes of Section 6(e) relating to payments on Early Termination, Part 1(f) of the Schedule specified Market Quotation and the Second Method.
7. Ordinarily, the specific terms of Transactions (as defined) under ISDA Master Agreements are identified in Confirmations so that, in relation to any particular transaction, the totality of its terms is to be ascertained from the combination of the Master Agreement, the Schedule and the relevant Confirmation. By contrast, the back-to-back transactions automatically generated for the purpose of transferring the risks and benefits of LBIE's equity OTC derivatives business to LBF were not recorded in separate Confirmations. Rather, they were recorded electronically in inter-company accounting entries. For present purposes, their details do not matter.
8. The Master Agreement was amended as between LBIE and LBF on 6 July 2000, but in a manner not material to the issues on this application. Thus, the Master Agreement in the form which I have described continued to govern LBIE's and LBF's back-to-back transactions at the time of the making of the Side Letter on 24 July 2006. It took the form of a simple letter from LBIE to LBF, signed by LBIE and then counter-signed on behalf of LBF as “Agreed and acknowledged”. For a document which is said now to have a value in the region of US$1 billion, it is in commendably concise form, sufficient to be recited in full:
“This letter will confirm the agreement between Lehman Brothers International (Europe) (“LBIE”) and Lehman Brothers Finance S.A. (“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.”
9. The terms of the Side Letter itself have given rise to no difficulty of interpretation on this application. Furthermore, apart from an immaterial minor dispute about the extent to which they were fulfilled, the purposes for which it was entered into are also reasonably clear. The back-to-back transactions (referred to in the Side Letter as “Intercompany Transactions”) were, as I have said, designed to transfer from LBIE to LBF the risks and benefits of LBIE's equity OTC derivatives transactions referred to in the Side Letter as “Client Transactions”. The use of a back-to-back ISDA governed Intercompany Transaction for transferring the risks and benefits of a relevant Client Transaction was only an imperfect tool for that purpose. Although it fully transferred the market risk in the Client Transactions from LBIE to LBF, it failed to transfer two further risks. The first, sometimes known as basis risk includes a risk, known as valuation risk, that two otherwise identical ISDA governed derivative transactions between different parties may, if closed out, lead to close-out valuations by different parties in significantly different amounts. This is because the valuation process admits a margin of differing but valid outcomes, when conducted by different persons all acting in good faith and (to the extent necessary) using commercially reasonable procedures in order to produce a commercially reasonable result (the formula imposed by the 2002 edition of the ISDA Master Agreement).
10. The second risk not catered for by the simple use of a back-to-back transaction is the credit risk associated with LBIE's street counterparty. Thus, (and ignoring valuation risk) the close-out of a client transaction which left LBIE in the money would lead to LBF being similarly in the money as against LBIE under the Intercompany Transaction, but expose LBF to no adverse consequence of LBIE's client proving to be unable to pay.
11. A third difficulty, as it seems to me, with the simple use of a back-to-back transaction is that, without further or special agreement, the close-out of a Client Transaction would not of itself trigger a close-out of the Intercompany Transaction at all.
12. All these shortcomings in the structure which, until 2006, LBIE and LBF had used for the purpose of transferring to LBF the risks and benefits of LBIE's OTC equity derivatives business were remedied, simply and save in one crucial respect effectively, by the Side Letter. Thus the basis or valuation risk was transferred to LBF by treating the settlement amount determined under the Client Transaction as the settlement amount under the Intercompany Transaction. The counterparty credit risk was dealt with by...
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