High Court considers entitlement of investment firm to terminate Bitcoin trading account due to alleged money laundering concerns

The High Court has found in favour of a claimant investor in a dispute arising from the termination of her Bitcoin trading account with an online trading platform and concurrent cancellation of open trades (as a result of an alleged money laundering risk): Ang v Reliantco Investments Ltd [2020] EWHC 3242 (Comm). Although the claim relates to an account used to trade Bitcoin futures, the decision will be of broader interest to financial institutions, given the potential application to other types of trading accounts and accounts more generally.

The judgment is noteworthy for the court’s analysis of the defendant’s contractual termination rights in relation to the account and open trades. While the Customer Agreement provided the defendant with the right to terminate the account, the court found that the defendant remained under an obligation to return money deposited in the account (which was held under a Quistclose trust). As to the related open trades, the court found that the defendant only had a contractual right to close out the trades rather than to cancel them (or alternatively, the court said that the same result would be required under the Consumer Rights Act 2015 (the Act), as the investor was a “consumer” for the purposes of the Act).

The decision illustrates the risks for financial institutions seeking to terminate relationships with their customers, particularly in circumstances where there are money laundering or other regulatory compliance concerns. Often accounts may need to be closed without notice (as per N v The Royal Bank of Scotland plc [2019] EWHC 1770; see our banking litigation blog post). Claims against banks by customers in this type of scenario can be significant, and not limited to claims for money deposited in the account, extending to gains on outstanding trades and the loss of future investment returns but for the termination of the account. In the present case, the court found that the claimant was entitled to recover the loss on her investment returns, as it was deemed to be within the reasonable contemplation of the parties when they contracted that, if the defendant failed to repay the claimant sums which she had invested, she might lose the opportunity of investing in similar products.

In order to manage the litigation risks, it may be prudent for financial institutions to review the relevant contractual documentation associated with trading accounts to ensure that it: (i) allows for termination of the account in the relevant circumstances at the absolute discretion of the bank; and (ii) confers an appropriate contractual right to deal with any deposits and open trades. This is particularly the case where the customer is a consumer for the purposes of s.62 of the Act, as there will be a risk that any term in the contract consequently deemed unfair will not be binding on the customer.

Background

In early 2017, the claimant individual opened an account with an online trading platform (UFX), owned by the defendant investment firm. Through this account, the claimant traded in Bitcoin futures. The claimant’s husband (a specialist computer scientist and researcher with cybersecurity and blockchain expertise, and alleged inventor of Bitcoin) also opened accounts on UFX; however, these were blocked when the defendant identified though its compliance checks that he had previously been accused of fraud in 2015.

The claimant made substantial profits trading Bitcoin futures, which were then withdrawn from the UFX account. In late 2017, the defendant terminated the claimant’s UFX account and cancelled all related open transactions, apparently as a result of an alleged money laundering risk.

The claimant subsequently brought a claim alleging that the defendant did so wrongfully and seeking to recover: (i) the remaining funds in the account; (ii) the increase in the value of her open Bitcoin positions; and (iii) the sums from her proposed reinvestment of those funds.

The defendant sought to resist the claim primarily on the basis that the account had actually been operated by the claimant’s husband rather than the claimant and the claimant had provided inaccurate information to the defendant in her “Source of Wealth” documentation.

Decision

The claim succeeded and the key issues decided by the court were as follows.

Issue 1: Entitlement of defendant to terminate UFX account

The defendant argued that it was entitled to terminate the UFX account because: (i) there was a breach of certain clauses of the Customer Agreement relating to access to the UFX account – there had been misrepresentations during the course of the existence of the claimant’s account; and (ii) the claimant had made misrepresentations in her “Source of Wealth” form and documents – this constituted a breach of a warranty the claimant had given as to the accuracy of information she had given to the defendant.

The court held that the defendant was contractually entitled to terminate the UFX account on the basis that the claimant’s husband did have some access to the account, which must have involved breaches of the Customer Agreement.

However, the court found that the statements made by the claimant in the “Source of Wealth” documentation were not untrue or inaccurate. The court said that the alleged misrepresentations in relation to: (i) the “Source of Wealth” form was not pre-contractual and could not have induced the making of the Customer Agreement; and (ii) access to the UFX account failed on the facts – the UFX account did not belong to and was not solely or predominantly operated by the claimant’s husband.

Issue 2: Sums deposited in the UFX account

The defendant accepted that there was the equivalent of a Quistclose trust in respect of these amounts and that it did have an obligation to return them.

The court held that even if there was no Quistclose trust, the defendant was obliged to return the amounts in any case pursuant to the terms and conditions (incorporated into the Customer Agreement between the claimant and the defendant) and that there was no suggestion that any amount needed to be withheld from those amounts in respect of future liabilities.

Issue 3: Unrealised gains on the claimant’s open Bitcoin positions

The court highlighted that the terms of the Customer Agreement obliged the defendant to close out (rather than “cancel”) the open positions, realise the unrealised gain on the Bitcoin futures and pay the balance to the claimant.

However, the court added that if this construction of the Customer Agreement was wrong and the defendant did have discretion to “annul or cancel” open positions, then the relevant clauses would be unfair, as they would cause a significant imbalance in the parties’ rights and obligations to the detriment of the consumer, contrary to the requirement of good faith. In the court’s view such clauses would have the effect of permitting the defendant to deprive the claimant of what might be very significant gains for trivial breaches. The clauses therefore would not be binding on the claimant by reason of s.62 of the Act.

Issue 4: Loss of investment returns

The claimant argued that she was entitled to claim what she would have earned had the monies to which she was entitled been paid to her upon the termination of her account.

The court held that the claimant was entitled to succeed on this aspect of her claim as the defendant had breached the Customer Agreement by not closing the open positions, realising the gain and paying the balance to the claimant. In the court’s view, remoteness of damage was not an issue as it was plainly within the reasonable contemplation of the parties when they contracted that if the defendant failed to pay the claimant sums which she had invested in (and/or made from investing in) Bitcoin futures, she might lose the amount which she might gain from investing in similar products.

Ceri Morgan

Ceri Morgan
Professional Support Consultant
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Nihar Lovell

Nihar Lovell
Senior Associate
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Claire Nicholas

Claire Nicholas
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Court of Appeal confirms wide discretion afforded to a non-Defaulting Party when determining “fair market value” of securities under the GMRA (2000 version)

The recent Court of Appeal decision in LBI EHF v Raiffeisen Bank International AG [2018] EWCA Civ 719 affirms the wide discretion of the non-Defaulting Party to determine “fair market value” in accordance with the close-out mechanism under paragraph 10(e)(ii) of the standard Global Master Repurchase Agreement (2000 version) (“GMRA“). Agreeing with the first instance judgment, the Court of Appeal reiterated that (in the absence of some express or implied limitation in the contract), the only constraint to be implied on the non-Defaulting Party’s discretion to determine “fair market value” was that of rationality; the decision-maker must have “acted rationally and not arbitrarily or perversely“: Socimer International Bank Ltd v Standard Bank London Ltd [2008] EWCA Civ 116 as applied to the GMRA in Lehman Brothers International (Europe) v Exxonmobil Financial Services BV [2016] EWHC 2699 (Comm).

Interestingly, the Court of Appeal confirmed that there is no basis to imply that the determination of “fair market value” under the GMRA must be by reference to a price agreed between a willing buyer and willing seller in a market which is not suffering from illiquidity or distress. In accordance with the wording of the GMRA, the Court of Appeal found that in determining “fair market value” the non-Defaulting Party may have reference to “such pricing sources and methods” as it considers appropriate, as long as it acts rationally. It should be noted that the width of the discretion afforded to the non-Defaulting Party arises from the specific wording of the GMRA; the Court of Appeal did not, and did not seek to, provide any more general interpretation of “fair market value“.

The court thereby rejected the attempt to import into the contractual framework other uses of fair market value which would incorporate the willing buyer and seller language in accounting terms – so the non-Defaulting Party is entitled to have regard to its commercial interests in establishing Net Value. This is particularly important in circumstances where the close-out takes place in a distressed market – the non-Defaulting Party is therefore able to take into account prices which reflect the distressed conditions prevalent at the time.

Background 

The appellant, the bank formerly known as Landsbanki Islands hf. (“LBI“), entered into 11 ‘repo’ trades with Raiffeisen Bank International AG (“RBI“) on the terms of the 2000 version of the GMRA (capitalised terms not otherwise defined in this e-bulletin are to the GMRA defined terms). On 7 October 2008, LBI went into receivership. This was an Event of Default under the GMRA and RBI served Default Notices on LBI. Under the GMRA, LBI was required to pay RBI (as the non-Defaulting Party) the agreed Repurchase Price for the securities minus the Default Market Value of Equivalent Securities.

Sub-paragraph 10(e) of the GMRA sets out the methods by which the non-Defaulting Party can ascertain the Default Market Value. The framework mechanism in the 2000 version of the GMRA allows for two scenarios: (a) where a Default Valuation Notice has been served by the Default Valuation Time (defined as the close of business on the fifth dealing day after the day on which the Event of Default occurred); and (b) where a Default Valuation Notice has not been served on time.

Where a Default Valuation Notice has been served on time, sub-paragraph 10(e)(i) provides for three methods of valuation:

  1. The bonds may be sold (or bought, as the case may be) in good faith and the sale price used to determine the Default Market Value;
  2. The Default Market Value may be determined from the mean average of commercially reasonable quotations obtained from market makers for the bonds; and
  3. Where the non-Defaulting Party has endeavoured but been unable to sell the bonds or obtain commercially reasonable quotations, or determined that it would be commercially reasonable not to seek such quotations the non-Defaulting Party can determine the Net Value of Equivalent Securities and elect to treat that Net Value as the Default Market Value.

Where a Default Valuation Notice has not been served on time, sub-paragraph 10(e)(ii) provides that the non-Defaulting Party should determine the Net Value as at the Default Valuation Time. It is of note that the 2011 version of GMRA has since disposed of the 5-day window in which to serve the Default Valuation Notice; providing instead that the determination of Default Market Value (using broadly similar methodology as described above) “on or about the Early Termination Date”.

RBI had not served the Default Valuation Notice by the Default Valuation Time and therefore Default Market Value fell to be assessed under GMRA sub-paragraph 10(e)(ii). In order to provide context for the decision, the relevant paragraphs of the GMRA are set out in full, below:

10(e)(ii)…If by the Default Valuation Time the non-Defaulting Party has not given a Default Valuation Notice, the Default Market Value of the relevant Equivalent Securities or Equivalent Margin Securities shall be an amount equal to their Net Value at the Default Valuation Time; provided that, if at the Default Valuation time the non- Defaulting Party reasonably determines that, owing to circumstances affecting the market in the Equivalent Securities or Equivalent Margin Securities in question, it is not possible for the non-Defaulting Party to determine a Net Value of such Equivalent Securities or Equivalent Margin Securities which is commercially reasonable the Default Market Value of such Equivalent Securities or Equivalent Margin Securities shall be an amount equal to their Net Value as determined by the non-Defaulting Party as soon as reasonably practicable after the Default Valuation Time.” (Emphasis added)

Net Value is defined in sub-paragraph 10(d)(iv) by reference to “fair market value“:

10(d)(iv)…”Net Value” means at any time, in relation to any Deliverable Securities or Receivable Securities, the amount which, in the reasonable opinion of the non-Defaulting Party, represents their fair market value, having regard to such pricing sources and methods (which may include, without limitation, available prices for Securities with similar maturities, terms and credit characteristics as the relevant Equivalent Securities or Equivalent Margin Securities) as the non-Defaulting Party considers appropriate, less, in the case of Receivable Securities, or plus, in the case of Deliverable Securities, all Transaction Costs which would be incurred in connection with the purchase or sale of such Securities;”

The principal issue for the court to decide was the meaning of “fair market value” in this context.

High Court decision

The court at first instance held that the fair market value determined by RBI for each security was a “rational and honest determination of fair market value” as at the Default Valuation Time. These figures were a statement of RBI’s position derived from the sources available to it as at the Default Valuation Time, rather than a product of evidence from an expert or witness of fact. The sources used by RBI to determine Net Value included:

  • Bids from 10 institutional counterparties which the respondent had requested (for some securities there were no indicative bids; for other securities there were indicative bids from multiple institutions);
  • Algorithm-based prices shown on Bloomberg which RBI used for internal purposes, and which it did not consider to represent a practical and commercial realisable value; and
  • The only activity experienced by the RBI on 15 October 2008 (the Default Valuation Time) itself, namely a bid shown by Citi at 45 for ICICI (USD) bonds and a request by Citi that RBI place an order with it at 80 for RAK Bank bonds.

The figures RBI put forward did not apply prices from days other than 15 October but they did include adjustments from price information available on other days.
The sources available at that time were – in the words of the High Court – “imperfect” and included Bloomberg prices (which RBI did not consider to represent a practical and commercial realisable value). However, the court held that: “…the circumstances at that time were imperfect. Any assessment of fair market value would have been imperfect but the non-Defaulting [P]arty was nonetheless entitled to make one.”

Grounds of appeal / response

LBI appealed on the basis that the judge at first instance erred in holding that, on the true construction of the GMRA, the non-Defaulting Party’s assessment of “fair market value” of securities could be based on actual prices achieved, indicative quotes or screen prices obtained in the distressed or illiquid market prevalent at the time. RFI argued that the discretion afforded by the GMRA is wide and LBI’s approach involved a significant restriction as a matter of law on this apparently wide discretion, in particular the non-Defaulting Party’s ability to have reference to “such pricing sources and methods as it considers appropriate“. RFI argued that the restriction sought by LBI was fundamentally inconsistent with the language of the GMRA.

Court of Appeal decision

The Court of Appeal dismissed the appeal, affirming RFI’s wide interpretation of the GMRA.

The Court of Appeal found (in line with Socimer and Exxonmobil), that in the absence of some express or implied limitation in the GMRA on the exercise of the non-Defaulting Party’s discretion in determining “fair market value“, the only limitation is that the decision-maker must have “acted rationally and not arbitrarily or perversely“. Repeating the general principle set out in Barclays Bank plc v Unicredit Bank AG[2014] EWCA Civ 302, the Court of Appeal noted that what was meant by “fair market value” under the GMRA must be “determined as a matter of construction of this particular contract in its particular context“. Accordingly, the Court of Appeal resisted providing any fixed definition of “fair market value“.

Key to this decision is the specific wording of the GMRA. In particular, the entitlement of the non-Defaulting Party, as per the definition of Net Value in the GMRA, to have regard to whatever “pricing sources and methods” and to “available prices for Securities” as it considers appropriate, with no limitation as to the factual circumstances in which it may do so. The Court of Appeal therefore rejected LBI’s argument that the determination by a non-Defaulting Party of “fair market value” in the context of the GMRA should be interpreted (consistently with its use in other contexts) by reference to a price agreed between a willing buyer and a willing seller, neither being under any particular compulsion to trade, such that illiquidity or distress in the market at a particular time would not be taken into account. It held that such an implied limitation would be contrary to the express language of the GMRA.

Similarly, any argument that a non-Defaulting Party could not use evidence or information as to actual market value, albeit in an illiquid or distressed market, in determining “fair market value” was rejected. The Court of Appeal held that the non-Defaulting Party was not required to determine Net Value in distressed market conditions by reference to some notional or theoretical value of securities. Arguments that the non-Defaulting Party was obliged in these circumstances to mark-to-model (made by reference, inter alia, to the Frequently Answered Questions (FAQs) on Repo published by ICMA), were also rejected.

CONCLUSION

This decision is important in reiterating and reinforcing the width of the discretion of the non-Defaulting Party to determine “fair market value” under the GMRA and will therefore provide useful comfort to non-Defaulting Parties (and their legal teams) who are faced with the need to determine close-out amounts under the GMRA following their counterparty’s Event of Default. In particular, the only implied limitation on the non-Defaulting Party in formulating its “reasonable opinion” using the “pricing sources and methods” it considers appropriate, is that the decision-maker must act “rationally and not arbitrarily or perversely“. It is obviously important to appreciate that the width of this discretion arises from the specific wording of the GMRA and the framework for determining the close-out amount which that sets out.

Harry Edwards

Harry Edwards
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Simon Clarke

Simon Clarke
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Ceri Morgan

Ceri Morgan
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Emma Deas

Emma Deas
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High Court clarifies calculation of Close-out amount under 2002 ISDA Master Agreement

Lehman Brothers Special Financing Inc. v National Power Corporation & Anor [2018] EWHC 487 (Comm) is a significant case on the calculation of Close-out Amount under the 2002 ISDA Master Agreement.

Two important points of principle arise from this judgment, which will have general application to transactions governed by the 2002 ISDA Master Agreement:

  1. In calculating Close-out Amount, a manifest mathematical or numerical error should more appropriately be corrected by agreement or by court or tribunal (and only in relation to the error itself); it will not ordinarily enable a Determining Party to make a fresh determination.
  2. The standard to be applied to a Determining Party in calculating a Close-out Amount is higher under the 2002 ISDA Master Agreement compared to the 1992 ISDA Master Agreement. The 2002 ISDA Master Agreement replaced the requirement for a rational decision (the applicable standard under the 1992 ISDA Master Agreement) with the requirement for objectively reasonable procedures in order to produce an objectively reasonable result.

This result is consistent with what market participants anticipated was the impact of the wording contained in the 2002 ISDA Master Agreement, which was to introduce a higher standard through greater objectivity, although it arguably gives rise to greater scope for disputes to arise in relation to parties’ determinations pursuant to that higher standard.

Background

In 2007, the claimant (“LBSF”) entered into a US$100 million principal only US$/Philippine peso forward currency swap (the “Swap”) with the first defendant, which was later transferred to the second defendant (“NPC”, meaning the first or second defendant, or both). Both defendants were owned and controlled by the Republic of the Philippines. The parties elected to apply the 2002 ISDA Master Agreement to the Swap (terms defined in that agreement are capitalised in this e-bulletin).

Following LBSF filing for Chapter 11 bankruptcy in the United States, the terms of the 2002 ISDA Master Agreement triggered an Event of Default. NPC subsequently served a notice on LBSF for early termination of the Swap and designated 3 November 2008 as the Early Termination Date. NPC, as the non-defaulting party, had the right under the 2002 ISDA Master Agreement to determine the Close-out Amount using “commercially reasonable procedures in order to produce a commercially reasonable result”.

On 3 November 2008 (i.e. the designated Early Termination Date), NPC requested and received indicative quotations for a replacement swap from various banks and on 7 November 2008, NPC requested and received firm quotations from those banks. NPC subsequently entered into a swap with UBS based on the firm quotation received on 7 November 2008 (the “UBS Swap”). In January 2009, NPC served its determination of the Close-out Amount for the Swap on LBSF (the “2009 Determination”). NPC demanded circa US$3.5 million, which represented the cost it had incurred in entering the UBS Swap as a replacement transaction.

LBSF disputed the 2009 Determination on the basis that commercially reasonable procedures were not used to arrive at this figure and that it was not a commercially reasonable result. In 2015, LBSF commenced court proceedings asserting that LBSF itself was in the money on the Swap. LBSF claimed that NPC owed a Close-out Amount of circa US$13 million to LBSF (the “LBSF Determination”).

NPC subsequently served a revised calculation statement in 2016 which contained two alternative determinations payable by LBSF to NPC: (a) a Close-out Amount of circa US$11 million based on the indicative (not firm) quotation received from UBS on the Early Termination Date (the “Primary Determination”); or (b) a Close-out Amount of circa US$2 million based on the original 2009 Determination of circa US$3.5 million but with the deduction of an Accrued Amount which had not been taken into account in 2009 (the “Alternative Determination”).

Decision

The principal questions examined by the court were:

  • Is it open to a Determining Party to remake a determination of a Close-out Amount?
  • Was the requirement to “use commercially reasonable procedures in order to produce a commercially reasonable result” complied with?

Can a Determining Party remake a Close-out determination?

In the present case, the 2009 Determination fell for scrutiny on two counts: (a) whether the Accrued Amount should have been taken into account; and (b) whether the requirement for “commercially reasonable procedures in order to produce a commercially reasonable result” was complied with.

As to (a), it was common ground that the Accrued Amount should have been taken into account. The question for the court was whether the failure to include the Accrued Amount was a manifest error entitling NPC to make a fresh determination, or whether it was the type of error that should simply be corrected by agreement or by the court/tribunal. This question is considered below. The following section considers whether the requirement at (b) was complied with, and the consequences if this requirement was not complied with.

On the true interpretation of the 2002 ISDA Master Agreement, the court stated that the position was as follows:

  1. With its notice of early termination of the Swap, NPC caused a debt obligation to arise and with delivery of NPC’s 2009 Determination an obligation to pay arose (Videocon Global Ltd v Goldman Sachs International [2016] EWCA Civ 130).
  2. These are significant contractual events and that once they have arisen the relationship between the parties is thereafter affected and not reversible (save by agreement, or in some cases an order of a court or tribunal).
  3. The 2009 Determination completed NPC’s obligation and right to make a determination.
  4. If there is an error in the determination then (absent agreement) the court or tribunal chosen by the parties will be left to declare that and to state what the Close-out Amount would have been absent that error.
  5. However, the Determining Party is also a party to the contract and it can make and accept proposals in its capacity as a party to the contract, including correcting an error in the determination.
  6. The Primary and Alternative Determinations might serve as evidence to inform the question of whether there was an error and the question as to what the Close-out Amount would have been on a determination without error (Socimer International Bank Ltd v Standard Bank London Ltd (No.2) [2008] EWCA Civ 116).

The court went on to consider comments on the question of remaking a determination in the practitioner text: Derivatives Law and Practice (by Simon Firth), which states as follows:

“Once a determination has been validly made of the…Close-out Amount, it will be final and binding on both parties. The determining party cannot subsequently change its mind (for example, on the basis that a mistake has been made). On the other hand, if the original determination was invalid (for example, because it was based on a misinterpretation of the Agreement), or (probably) it was founded on or infected by a manifest numerical or mathematical error [], the determining party should be able to make a fresh determination that complies with the requirements of the Agreement.”

In the court’s view (and in contrast to the suggestion in Derivatives Law and Practice), the case of manifest mathematical or numerical error would still be a case for correction of the determination (by agreement or by court or tribunal, and in the respect where there was error) rather than a fresh determination. Accordingly, the failure by NPC to take into account the Accrued Amounts in making the 2009 Determination was the type of error that simply admits a case for correction of the determination as above and NPC was not entitled to make a fresh determination.

Was the requirement to “use commercially reasonable procedures in order to produce a commercially reasonable result” complied with?

The court observed that the definition of Close-out Amount in the 2002 ISDA Master Agreement included the provision:

Any Close-Out Amount will be determined by the Determining Party (or its agent), which will act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result”.

The court considered (and rejected) NPC’s arguments that the references in the definition of Close-out Amount to “commercially reasonable procedures” and a “commercially reasonable result” required only that the Determining Party use rational procedures in order to produce a rational result. In the court’s view, the 2002 ISDA Master Agreement required the Determining Party to use procedures that are (objectively) commercially reasonable in order to produce (objectively) a commercially reasonable result. It considered that the 2002 ISDA Master Agreement had wording that showed a higher standard is intended when that standard form is chosen by the parties.

There were two principal elements to the court’s decision:

  1. The court highlighted that the change in the wording used in the 1992 ISDA Master Agreement to the form used in the 2002 ISDA Master Agreement was material. The 1992 ISDA Master Agreement states that the non-defaulting party has to “reasonably determine in good faith” the Close-out Amount payable. This was summarised in Fondazione Enasarco v Lehman Brothers Finance SA [2015] EWHC 1307 (Ch) as “essentially a test of rationality”. By contrast, under the 2002 ISDA Master Agreement: “[f]or the first time the calculation of the liabilities on closing out had to be carried out ‘in order to produce a commercially reasonable result’“: Lehman Brothers International (Europe) v Lehman Brothers Finance SA [2013] EWCA Civ 188. Further, the court said it was clear from the 2002 User’s Guide supporting the 2002 ISDA Master Agreement that the change was specifically designed to include greater objectivity.
  2. The court emphasised the difference between the tests of rationality and reasonableness (citing Lord Sumption in Hayes v Willoughby [2013] UKSC 17):

“Rationality is not the same as reasonableness. Reasonableness is an external objective standard applied to the outcome of a person’s thoughts or intentions. The question is whether a notional hypothetically reasonable person in his position would have engaged…A test of rationality, by comparison, applies a minimum objective standard to the relevant person’s mental processes”.

The court concluded that it was commercially reasonable to make the 2009 Determination as NPC did, relying on the UBS Swap. The court was not persuaded that, especially in the market circumstances at the time, it would have been commercially reasonable to determine the Close-out Amount as of 3 November 2008 (the Early Termination Date, i.e. as per the Primary Determination); at that stage only indicative quotations were available.

The court remarked that the UBS Swap replaced more than what was provided for under the original Swap because it included an option which NPC did not have at the Early Termination Date. NPC, therefore, was not entitled to pass onto LBSF the option exercise price or pre-payment premium of US$1 million attached to that option. The Close-out Amount was therefore the 2009 Determination, less the Accrued Amount, less the option premium.

The court did not proceed to consider what the position would have been if the 2009 Determination had not complied with the requirement for “commercially reasonable procedures in order to produce a commercially reasonable result”, i.e. whether NPC would have been entitled to make a fresh determination or whether the error could be corrected by agreement or by the court/tribunal.

Comment

The instant case confirms that in calculating Close-out Amount, a manifest mathematical or numerical error should more appropriately be corrected by agreement or by court or tribunal (and only in relation to the error itself); it will not ordinarily enable a Determining Party to make a fresh determination. Further, the standards imposed on a Determining Party calculating Close-out Amount are higher under the 2002 ISDA Master Agreement than the 1992 ISDA Master Agreement. The change in the relevant wording under those agreements had the effect of replacing a requirement for a rational decision with a requirement for an objectively reasonable one.

 

Harry Edwards

Harry Edwards
Partner
+44 20 7466 2221

Ceri Morgan

Ceri Morgan
Professional Support Lawyer
+44 20 7466 2948

Nihar Lovell

Nihar Lovell
Senior Associate
+44 20 7374 8000

Clearing brokers’ duties when exercising close out powers

In the current economic climate, brokers will find the decision of the High Court (UK) in Euroption of considerable interest, since it considers the duties of a broker which is conducting a close-out and liquidating the position of a client who is in a state of default.

Euroption Strategic Fund Limited v Skandinaviska Enskilda Banken AB [2012] EWHC 584 (Comm).

The facts

The claimant (Euroption) was a BVI-domiciled investment fund which primarily conducted options trading on the London International Financial Futures Exchange (LIFFE). As a non-member of LIFFE, it could only do so through engaging one of the clearing members of the exchange and accordingly entered into a contract with Skandinaviska Enskilda Banken (SEB).

Pursuant to that contract, Euroption was obliged to meet margin calls when requested by SEB in order to provide SEB with protection against adverse market movements on the fund’s positions, failing which SEB was entitled to close out Euroption’s open contracts “at any time without reference to” the fund and to do so having made reasonable efforts to contact Euroption if “at any time SEB deems it necessary for its own protection.”

Basis of Euroption’s claim

It was common ground that SEB had a contractual right to close out Euroption’s open positions and could choose the moment in which it did so. However, the claim involved allegations regarding SEB’s conduct of the forced close out of the portfolio in the extraordinary market conditions which prevailed in early October 2008. Euroption claimed for loss that was suffered as a result of the use of a trading strategy which involved the purchase of additional option positions together with their sale (so-called combination trades), as well as the delay in the close out of certain positions (during which the extent of losses increased). Euroption said that SEB’s conduct was in breach of:

  • a duty not to conduct the close out in an capricious, arbitrary or irrational manner;
  • an implied contractual duty of care to perform the close out with reasonable care and skill; and/or
  • a tortious duty of care brought about by an assumption of responsibility to act with reasonable, care and skill.

Basis of SEB’s defence

SEB countered that the mandate between SEB and Euroption provided a broad and unfettered discretion in relation to the conduct of any close out process and that, having taken the decision to liquidate the portfolio, SEB could effect that liquidation in a number of ways which were not limited by the express terms of the contract. Accordingly, the only limitation on what it could do to bring about the liquidation of the portfolio was that it must not act capriciously, arbitrarily or irrationally.

Regarding the specific trading strategies adopted during the close-out, SEB pointed to the fact that Euroption’s own expert had accepted that the ‘combination’ trades which were entered into by SEB were a legitimate means of closing out an options portfolio (and were in any event authorised by Euroption’s primary trader responsible for management of the portfolio) and that the delay in the sale of the short call positions was reasonable in the circumstances (even if not, with hindsight, the optimal strategy).

The Court’s findings

In relation to the argument that a contractual duty to take reasonable care was owed by SEB in exercising its close out rights, the Court held that no such duty could be implied into the broking agreement, either by the terms of section 13 of the Supply of Goods and Services Act 1982 or otherwise. The Court held that the implied term imposed by section 13 (requiring services to be carried out with reasonable care and skill) applies only to services which it is agreed will be provided under a contract; it does not extend the obligations under the contract. Certain advisory services and the settlement and exchange services were the services which the Broker had contracted to provide, not the close out of the portfolio which was a consequence of the client’s breach. Accordingly, absent express provisions in the contract, there was no basis on which to imply a requirement of reasonable care and skill into how the close-out was conducted.

Equally, there was no assumption of responsibility by the broker to the client to take reasonable care in exercising its right of close-out, in view of the nature of the role which a clearing broker undertakes and the modest commission which it receives for that role.

Moreover, the Court determined that, following a default, the broker was entitled to put its own interests first in order to protect itself against the exposure which had been brought about by its client’s breach (the failure to post margin). It was therefore the broker’s decision, which can be made in its own interests, how the close out should be conducted, subject only to the requirement that it did not step outside the bounds of a duty to act in good faith, honestly and not arbitrarily or irrationally.

On the experts’ evidence, SEB’s method of closing out the options positions was found to have been reasonable, both in entering new ‘combination’ trades as part of the close out and the delay in closing out some of the short call positions. In those circumstances, SEB was found not to have acted arbitrarily or irrationally.

Furthermore, the judge found that, even if she was wrong in rejecting the existence of a duty to take reasonable care in conducting the close out, SEB did not breach any such a duty. It was emphasised that looking back critically at each trading decision with the benefit of hindsight, as Euroption (and its expert) had sought to do, was not a permissible way to assess the trading strategy adopted by SEB:

The issue for the court is not the relative strengths and weaknesses of another strategy compared with the strategy in fact adopted but whether the decisions actually taken were within the bounds of reasonableness.”

Accordingly, Euroption’s claim was rejected in full.

Damien Byrne-Hill

Damien Byrne-Hill
Partner
+44 20 7466 2114

Simon Clarke

Simon Clarke
Partner
+44 20 7466 2508

Rupert Lewis

Rupert Lewis
Partner
+44 20 7466 2517

Harry Edwards

Harry Edwards
Partner
+44 20 7466 2221

Jan O'Neill

Jan O'Neill
Professional Support Lawyer
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Court of Appeal provides clarity on payment obligations owed to insolvent counterparties

In a keenly anticipated judgment, the Court of Appeal today handed down its verdict in four appeals ([2012] EWCA Civ 419. In the appeal of (1) Lomas and others (together the Joint Administrators of Lehman Brothers International (Europe) (in administration)) v JFB Firth Rixson, Inc and others and ISDA as intervenor [2010] EWHC 3372 (Ch); (2) Lehman Brothers Special Financing Inc v Carlton Communications Ltd [2011] EWHC 718 (Ch); (3) Pioneer Freight Futures Company Ltd v Cosco Bulk Carrier Company Ltd [2011] EWHC 1692 (Comm.); and (4) Britannia Bulk plc v Bulk Trading SA [2011] EWHC 692 (Comm)) concerning the interpretation of various terms of the 1992 ISDA Master Agreement. In doing so, the court has unwound the tangle of conflicting first instance judgments and provided some much need clarity on a number of questions of contractual construction – in particular, a counterparty’s entitlement to rely on section 2(a)(iii) to avoid making payments to a party which has become insolvent.

Key Findings:

  • Where there is an Event of Default, payment obligations are suspended under section 2(a)(iii) until the Event of Default is cured
  • There are no implied terms in the Master Agreement which:
    • Cause Early Termination after a “reasonable period”
    • Revive payment obligations on maturity; or
    • Oblige the Non-defaulting party to designate Early Termination
  • Suspended payment obligations are not extinguished on maturity but continue indefinitely
  • The anti-deprivation principle is not offended by section 2(a)(iii)
  • Unless the contract specifies, there are no circumstances in which the Non-defaulting Party is entitled to payments on a gross basis. All close out sums must be calculated on a net basis and credit must be given for any sums due to the Defaulting Party
  • The close-out netting regime under Automatic Early Termination (“AET”) applies to all unpaid sums under all transactions under the same Master Agreement, irrespective of whether or not some of those transactions have come to a natural end prior to AET
  • The “Nil Loss” argument failed – where termination has occurred, the Non-defaulting Party cannot rely on section 2(a)(iii) to disregard amounts owed to a Defaulting Party either before or after AET

Introduction

Recent legal commentary has noted that the draftsmen of the ISDA Master Agreement did not anticipate or provide for the collapse of a major market participant such as Lehman and, as a natural consequence, there was much confusion regarding the payment obligations of Lehman’s counterparties who were “out of the money” to the insolvent bank. Tensions between the supposed commercial purpose of various elements of section 2 and literal interpretations of the language of this clause led to much confusion in the market and then to conflicting High Court judgements.

The Court of Appeal approached the issues with indifference to the extraordinary complexity of the Lehman administration. Merely noting that LBIE’s bankruptcy “looks as if it will continue for some time”, the Lord Justices resolved the issue through simple adherence to the fundamental principles of established contract law.

This ebulletin picks out some of the issues which the Court of Appeal was asked to consider and how it went about resolving them.

1. Section 2(a)(iii) suspends payment obligations

The Lehman administrators’ appeal failed. In the absence of any termination clause which causes the transactions to be automatically terminated upon specified Events of Default, an innocent party is entitled to rely on section 2(a)(iii) to avoid making payments to a party which has entered insolvency proceedings.

Section 2(a)(iii) concerns payment obligations and the underlying debt obligations remain undisturbed. Accordingly the payment obligation is merely suspended (as opposed to extinguished forever) and the obligation to pay the debt can be revived if the Event of Default is cured.

2. No implied terms

The Court of Appeal dismissed the argument that, where an Event of Default was unlikely to be cured (such as insolvency), there were implied terms which required the innocent counterparty to bring the transaction to an end before natural maturity. There was no suggestion that the Parties intended such terms to be incorporated into the agreement and the Court of Appeal considered the argument to be “hopeless”. The contracts worked perfectly well without any such implied terms and to find that such implied terms existed would be to re-write the contract for the parties which the court had no business to do.

3. Payment obligations suspended indefinitely (i.e. survive maturity)

The Court of Appeal reversed the legal effect of maturity on suspended payment obligations under those transactions that have matured. A number of decisions at first instance had held that obligations suspended by section 2(a)(iii) were extinguished once the transactions had passed their final payment date (and therefore could not be revived in the event that the Default was subsequently cured). In the absence of any clear contractual terms, reliance was placed on section 9(c) (which concerns the survival of obligations under the ISDA Master Agreement of particular transactions). The Court of Appeal firmly rejected this approach. It is interesting to note that in doing so it had regard to the equivalent section of the predecessor 1987 Master Agreement as an aid to interpretation. That earlier version had not contained the words in section 9(c) said to provide for the extinction of rights. The Court determined that the intention of the draftsmen of the 1992 Master Agreement (as opposed to the parties to the transactions in dispute in the appeal) cannot have been to introduce such an important concept in a term buried under the heading “miscellaneous”.

Having dispensed with the only possible express term, the Court saw no need to imply a term where to do so was unnecessary. Nothing was inherently wrong with ISDA’s argument that the obligations should survive indefinitely. It followed that where contracting parties have opted for AET to apply in the case of certain Events of Default, all transactions entered into under the same Master Agreement will be subject to the close-out netting provisions, including transactions which have passed their final payment date.

4. No offence to the anti-deprivation principle

The anti-deprivation principle concerns the removal of assets from the estate of an insolvent person to circumvent the relevant insolvency law regime. Any contractual provision which causes this effect is prohibited.

The Court followed the Supreme Court’s 2011 decision in Belmont2 which found that the anti-deprivation principle had limited application to complex commercial transactions. There was no suggestion that section 2(a)(iii) was formulated in order to avoid the effect of any insolvency law or to give the Non-defaulting Party a greater or disproportionate return as a creditor of the bankrupt estate. It was clear that the purpose of section 2(a)(iii) is to protect the Non-defaulting Party from the additional credit risk involved in performing its own obligations whilst the Defaulting Party remains unable to meet its own.

5. The Gross / Net issue

Section 2(c) provides for netting where the amounts “otherwise payable” are due on the same day, in the same currency and in respect of the same transactions. It had been found in the first instance judgment (which was the subject of the third appeal) that, where there was a continuing Event of Default, payments should be made on a gross basis and netting was unavailable to the Defaulting Party. This finding was on the basis that the suspension of payments under section 2(a)(iii) meant that payments owed to the Defaulting Party could not be construed as “payable”. This finding was at odds with the market’s understanding of the provision and the parties to the first and second appeals did not contest the issue.

The Court of Appeal agreed and allowed the appeal. The overall scheme of the Master Agreement was to provide for netting-off of gross liability of each payment at each payment date and for a “wash-out calculation” of a final net figure on termination of all outstanding transactions. One of the Court’s key findings was that the commercial purpose of section 2(a)(iii) was to mitigate counterparty credit risk for the currency of the swap transactions. To enable the Non-defaulting Party not merely to be relieved from payment during the period of default but also to recover from the Defaulting Party its gross liabilities under the swaps as they fall due would undermine that purpose.

However, there was a limit to which unpaid sums could be netted-off against each other. The netting provisions of section 2(c) apply only in relation to contemporaneous payment obligations. Only amounts which were expressed to be payable on the same date in respect of the same two (or more) of the relevant transactions are capable of being netted. Section 2(c) cannot be utilised to net-off sums arsing on one date against sums which become due on a later date.

Comment

The Court of Appeal’s determination of the issues is consistent with the submissions made by ISDA who, as an interested party, acted as an intervener in both the first instance and the Appeal hearings. Subject to any appeals to the Supreme Court (in respect of the claims by Lehman’s administrators), some of the drafting changes to the ISDA Master Agreement proposed in the ISDA consultation would no longer be required for ISDA Master Agreements governed by English law. However, to avoid any further dispute regarding “inelegantly” drafted terms of the Master Agreement, ISDA may wish to clarify certain provisions and push ahead with the proposed amendments in any event.

The key proposed change in the ISDA consultation (which concerned the curtailment of a counterparty’s entitlement to rely on section 2(a)(iii) indefinitely) remains very much alive. In its 2009 consultation paper, HM Treasury expressed the view that payments due to insolvent counterparties should not be withheld indefinitely as this created undesirable uncertainty for administrators and the general creditors of insolvent corporates. The Court of Appeal’s decision that a Non-defaulting Party is entitled to rely on section 2(a)(iii) indefinitely means that a change to the market standard for derivatives transactions will be required to meet the concerns expressed by HM Treasury in its consultation paper. However, it remains to be seen whether ISDA and its members can agree on a new term which limits the time period for Non-defaulting counterparties to rely on the section 2(a)(iii) condition precedent, thus forcing Non-defaulting Parties to terminate open transactions unless they are prepared to resume payments to insolvent counterparties. It is understood that a number of ISDA members are uncomfortable with the prospect of being effectively forced to terminate transactions with an insolvent counterparty within a certain time period. HM Treasury has reserved its right to introduce a statutory solution in the event that a market-based solution does not emerge or is deemed unsatisfactory.

Damien Byrne-Hill

Damien Byrne-Hill
Partner
+44 20 7466 2114