Insurer Defeats Lehman Brothers Foreign Unit’s Attempt To Recover Alleged $485 Million Loss – Financial Services
New York state court ruled that a non-defaulting
insurer’s valuation under the 1992 ISDA Master Agreement was
commercially reasonable and in good faith and was not required to
rely on market prices that distorted the value of its loss of
bargain.
TAKEAWAYS
- The loss method under the 1992 ISDA Master Agreement permits a
non-defaulting party to select any commercially reasonable
valuation method in good faith to calculate its loss. - Theoretical market prices need not be utilized to determine
loss under the loss method when there is no market for a
replacement transaction. - A non-defaulting party’s delayed termination during
dislocated market periods did not negatively impact the use of the
loss method.
In September 2008, Lehman Brothers Holdings Inc. and its
domestic and foreign subsidiaries (Lehman) filed for bankruptcy
protection due to accelerated losses caused mainly by the subprime
mortgage crises. At the time, Lehman held a massive portfolio in
subprime residential mortgage-backed securities (RMBS) and
collateralized loan obligations (CLOs). To mitigate the risks
associated with these securities, Lehman purchased credit
protection under credit default swap agreements (CDS) governed by
agreements using the 1992 Master Agreement published by the
International Swaps and Derivatives Association (ISDA).
Each of these agreements specified the market quotation (MQ)
methodology for determining the amounts payable following the
termination of the agreement due to an event of default. As noted
in a recent client alert, the 1992 ISDA Master Agreement
requires that, if MQ is specified as applicable, the termination
payment will be based on market quotations for a replacement
transaction obtained by the non-defaulting party (NDP) from market
dealers. However, if the NDP cannot obtain more than two
quotations, the NDP must use the “loss” method to
calculate the termination payment.
In a recent case, Lehman Bros. Int’l (Europe) v. AG Fin.
Prods., Inc., No. 653284/2011, 2023 WL 2403924 (N.Y. Sup. Ct.
Mar. 8, 2023) (Assured), the New York Supreme Court
addressed how a NDP implemented these two methodologies and found
that the NDP had correctly applied each method and that its
valuation establishing loss was commercially reasonable and in good
faith.
Background
Before declaring bankruptcy in England, Lehman’s UK
subsidiary, Lehman Brothers International (Europe) (LBIE), bought
loans originated by its subsidiaries, deposited the loans into
investment vehicles, and sold 28 tranches of RMBS and CLO
securities to investors. The transactions were divided into three
categories: “ABX,” “UK RMBS” and
“CLOs.” The CLO transactions were highly rated
securities, meaning they would only suffer losses once lower-rated
CLO tranches were wiped out. Although ABX and UK RMBS transactions
bore similar risks and benefited from similar protections, the UK
RMBS transactions benefited from additional protection through
reserve funds and new loans coming in to cover losses.
LBIE purchased credit protection for these transactions by
entering into CDSs with AG Financial Products Inc. (Assured), which
were documented under the 1992 ISDA Master Agreement. Under these
CDSs, LBIE paid premiums to Assured in return for guaranteed
payments to cover principal and interest shortfalls on the
securities until the securitized mortgages and loans matured. LBIE
defaulted on the CDSs due to its bankruptcy filing, entitling
Assured to terminate each CDS transaction and determine the
termination payment due, which it did 10 months after LBIE’s
bankruptcy (i.e., July 2009).
Market Quotation and Loss Methods
The CDSs specified MQ as the termination valuation methodology.
The MQ method requires the NDP to solicit at least three market
quotations on a replacement transaction from market dealers and
choose the intermediate quote or, if the NDP is unable to obtain at
least three market quotations, to use the loss method to calculate
“an amount that [it] reasonably determines in good faith to be
its total losses and costs … including any loss of bargain.”
Using the loss method is likely to occur during times of market
dislocation.
The MQ method establishes a strict process a NDP must follow to
determine loss, whereas the loss method provides more flexibility
by giving a NDP latitude to select a valuation method to calculate
loss, so long as the methodology is reasonable and in good faith.
Under the loss method, a NDP need not determine “loss by
reference to quotations of relevant rates or prices from one or
more leading dealers in the relevant markets” because market
prices are usually divorced from the actual value of the underlying
asset in dysfunctional markets, making it commercially unreasonable
for a NDP to rely on market prices.
Assured’s Valuation and LBIE’s Position
In Assured, Assured initially conducted an auction to
solicit market quotations under the MQ method but did not receive
any bids from dealers. Following the failed auction, Assured then
applied the loss method, using a discounted cash flow method to
calculate its total loss of approximately $27.6 million,
representing the value of LBIE’s losses of approximately $20.6
million under the ABX trades, netted against future premiums owed
to Assured in the amount of approximately $48.2 million.
LBIE claimed that Assured’s valuation analysis was wrong and
that LBIE was owed more than $450 million instead. According to
LBIE, market prices were available because there was no market
dislocation during the subprime mortgage crisis—a claim that
the court found to “fl[y] in the face of the bulk of the
evidence, reality, and its own expert’s opinion.” To
establish a market price, LBIE tried for several months—even
before the failed auction—to novate the securities
transactions by searching for a replacement party to the CDS
transactions but did not receive a single bid. LBIE also pointed to
three indicative bids it had received, but none were binding,
several were subject to significant disclaimers, and according to
the court, each was obtained solely to bolster LBIE’s
litigation position. LBIE also argued that Assured’s valuation
methodology under the “loss” method was unreasonable
because, in its view, market practice required Assured to estimate
theoretical market prices to determine its loss after a failed
auction.
Trial Court’s Analysis
The court found that Assured followed the 1992 ISDA Master
Agreement methodology for establishing its loss. It first engaged
the market, that is, it tried to use the MQ method, but it failed
to attract any bids. Extreme market dislocation and illiquidity
made it difficult for any NDP, including Assured, to obtain quotes
from dealers. According to the court, once the MQ process failed,
the “loss” methodology permitted Assured to consider
any commercially reasonable valuation method, which did
not require it to consider LBIE’s theoretical market prices. To
determine its loss, Assured primarily used a projected default rate
on the securities, then calculated a prepayment rate and loss
severities to establish LBIE’s projected recoveries on the
underlying loans after defaults. In doing so, Assured considered
several factors, including:
- market data on delinquent borrowers and those in default;
- structural protections relating to the ABX trades that allowed
LBIE to avoid losses until such lower-rated trades were wiped
out; - the UK RMBS and CLO trades, which remained investment grade
through the subprime mortgage crises; and - market conditions at the time (between 2009 and 2012), such as
government programs and “burnout” and
“seasoning” scenarios typical with large mortgage pools,
in which some mortgages defaulted a few years after loan
origination (burnout) and some avoided defaults because the
borrowers managed to stay current (seasoning).
Applying these factors, Assured projected a 0% default rate on
the UK RMBS and CLO trades and a 28% default rate on the ABX
trades, which was an essential factor in determining LBIE’s
projected losses of approximately $20.6 million. According to the
court, this projected default rate was close to similar projections
made by credit rating agencies, which ranged from 30% to 39%. Also,
by waiting 10 months to terminate CDSs, the court noted that
Assured was able to rely on improved conditions to lower its
liability to LBIE, which LBIE did not dispute was in good
faith.
In reaching its decision, the court compared the case to a
Canadian case (Devonshire), which also addressed a large
discrepancy in valuation. There, the Devonshire court
accepted the loss method valuation of Devonshire’s expert
(LBIE’s expert in Assured) in rejecting Barclay’s
$1.2 billion valuation compared to Devonshire’s $12,000
valuation and concurred that theoretical market prices were
irrelevant to determine Devonshire’s loss. As in
Assured, the Devonshire court found that market
dislocation during the subprime mortgage crisis made it
commercially unreasonable for Devonshire to rely on market
prices.
In sum, LBIE failed to rebut any of Assured’s valuation
evidence because, as the court stated, LBIE “staked its
position on unreasonably high numbers that bore no relation to
reality.”
Conclusion
Assured confirms other decisions’ interpretation of
the 1992 ISDA Master Agreement that the loss method gives a NDP the
exclusive right to calculate its loss. In doing so, and in good
faith, NDPs may select any commercially reasonable valuation
method, including the discounted cash flow method. This flexible
approach to valuation ensures that NDPs will be fully compensated
for their loss when market dislocations distort market prices.
Notably, the 2002 ISDA Master Agreement replaced the “loss
method” with the “close-out amount” method, which
may produce different damage calculations. Still, the 1992 ISDA
Master Agreement continues to govern various derivatives
transactions. Thus, decisions like Assured provide
certainty and predictability on measuring loss following a failed
auction under the MQ method.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
