Close-out and valuation under ISDA

Simmons & Simmons outlines the implications of the Peregrine Fixed Income vs Robinson Department Stores judgment.

The Peregrine swaps litigation case came to a close in May. The verdict of the High Court of England and Wales could have a significant impact on the close-out and valuation of certain derivatives trades documented by the International Swaps and Derivatives Association (ISDA).

The background

Peregrine Fixed Income and Robinson Department Store had entered into a trade under an ISDA master agreement. Peregrine defaulted (a liquidator was appointed over its assets) and an early termination date occurred. At that time, Peregrine did not have any outstanding payment obligations. But Robinson, which was itself in financial difficulties, would have been obliged to make 25 annual payments of about $6 million each to Peregrine.

The parties had selected market quotation (as opposed to loss) for termination payments. As the non-defaulting party, Robinson determined the market quotation figure (approximately $10 million) on the basis of reference market-makersÆ prices. (That was the amount that under the terms of the swap Robinson would have been required to pay to Peregrine.)

The gross total of RobinsonÆs payments, if they had been made for the full 25-year term, would have been around $170 million. Applying a discount rate agreed between the parties, the net present value of the payment stream was approximately $90 million. Clearly, there is a very significant difference between that present value figure and the $10 million market quotation, due in the main to RobinsonÆs credit status.

The dispute

There were two main strands to the dispute:

ò Could Peregrine insist on having the termination payment calculated on the basis of loss, instead of market quotation?

ò If so, was RobinsonÆs credit status relevant in calculating loss?

The ISDA master itself provides that where (as in this case) the parties have selected market quotation, the termination payment should, in fact, be determined on a loss basis if market quotation ôwould not (in the reasonable belief of the party making the determination [here, Robinson]) produce a commercially reasonable resultö.

Peregrine (through its liquidator) argued that market quotation did not produce a commercially reasonable result because it failed accurately to reflect what Robinson gained as a result of the termination of the transaction, namely avoiding payment of around $170 million over 25 years. This was clear from the discrepancy between the net present value of RobinsonÆs obligations ($90 million) and the market quotation figure ($10 million).

Robinson said Peregrine had no right to challenge the determination of market quotation because Robinson reasonably believed it to be a commercially reasonable result and, therefore, the loss alternative was not applicable.

Assuming that loss were to be used, Peregrine argued that the amount of the loss (actually a negative loss û a gain) would be equivalent to the net present value figure, $90 million. Robinson asserted that the calculation of loss should take into account both its cost of funding in respect of the settlement payment to be made to Peregrine and its credit status.

The judgment

The principal points of the judgment are as follows:

Loss instead of market quotation?

The judge decided in favour of Peregrine, that loss should be used instead of market quotation.

Key to this decision was the judgeÆs finding that market quotation and loss are intended to lead to broadly the same result. In this respect, he referred to the ANZ Bank case, in which the Court of Appeal endorsed that proposition. On that basis, loss provides a benchmark for determining market quotation. If (as here) the market quotation figure is substantially different from the loss figure, then applying the market quotation measure does not give a commercially reasonable result and loss should be used instead.

The justification for equating market quotation and loss is not clear. They are in the ISDA master as alternatives from which parties can select according to their preference. When parties are making that selection, it is open to them to vary the terms if they see fit, in order to achieve any particular result (such as equating the two measures) on termination. ISDA could have included in the master a statement that the two measures are intended to lead to a broadly similar result, but it did not. Why, as a matter of principle, should a market quotation figure be disregarded just because it differs from loss in circumstances in which the difference is wholly explicable by reference to a factor (a partyÆs credit status) expressly agreed to be relevant to market quotation but not to loss?

The ruling that loss should be used as a benchmark for market quotation creates difficulties. There is no guidance as to how significantly market quotation must differ from loss before it is considered commercially unreasonable (i.e., what is the meaning of æbroadly the sameÆ?). There is also a practical problem in that this essentially requires that the termination payment be calculated twice in all circumstances to check that a commercially reasonable result is being achieved.

The judgment may effectively mean that whenever a non-defaulting party is out-of-the-money and has deteriorating credit, market quotation will lead to a commercially unreasonable result.

Challenging reasonable belief

The judge found for Peregrine, that Robinson could not have reasonably believed that market quotation was a commercially reasonable result (because of the substantial difference between market quotation and loss).

Calculation of loss

What was the correct basis for determining loss?

The judge found, in PeregrineÆs favour, that RobinsonÆs (negative) loss was the value to Robinson of being relieved of the obligation to perform the contract. It was æsavingÆ approximately $170 million over 25 years. The net present value of that æsavingÆ was $90 million. That was the loss, payable by Robinson to Peregrine.

The judge rejected RobinsonÆs argument that the loss calculation should take into account that Robinson would need to fund that payment and that (given its financial position) its cost of funds would be high û in other words, that its gain would actually be considerably less than $90 million.

The judgment acknowledges that the wide discrepancy between the market quotation measure and the loss measure was as a result of the financial weakness of Robinson. The crucial question was whether the credit status of Robinson should be taken into consideration in assessing Loss. The judge ruled, in favour of Peregrine, that credit status was irrelevant. This was on the basis that damages for loss of bargain are not normally discounted for the chance that the obligor will fail to perform û and there is nothing in the ISDA terms to suggest that anything other than this general principle should apply when calculating loss.

On the other hand, the judge confirmed that the financial status of the non-defaulting party is relevant when determining market quotation (although regardless of the partiesÆ selection, the effect of the ruling appears to be that if this status would produce a significantly different figure than loss then market quotation is not the appropriate method of calculation).

The impact

The dispute has been described in the press as a test case on the ISDA master. In fact, these were rather unusual circumstances: the transaction looked more like a long-term loan than a straightforward swap; the event of default was triggered by the party that was in-the-money and that had already performed all its obligations; and the non-defaulting party itself was in financial difficulties. ISDA contends that the decision applies only on its particular facts and does not set a generally applicable precedent.

It is correct to say that this is not a binding legal precedent for all future cases. It is a first instance judgment only, not carrying the weight of an appeal court decision. However, on the issue of equating market quotation and loss, it is supported by the Court of Appeal in the ANZ case. In addition, there is very little case law on interpretation of the ISDA documentation, so this decision will be important.

If parties wish to try to avoid the result that was reached in the case, it may be advisable to draft into their documents a provision expressly acknowledging that market quotation could lead to a result significantly different from loss and confirming that the non-defaulting partyÆs determination as to whether market quotation produces a commercially reasonable result is final.

By Simmons & Simmons International Finance Group in Hong Kong.