Structured Finance & Securitisation Updates
An English Court judgment in Anthracite Rated Investments (Jersey) Limited and Lehman Brothers Finance S.A. / Fondazione Enasarco and (1) Lehman Brothers Finance S.A. (2) Anthracite Rated Investments (Cayman) Limited was handed down by Justice Briggs on 15 July 2011.
The judgment is of interest to participants in the derivatives market and arrangers of, and investors in, structured finance transactions.
Briggs J’s decision rests on a detailed analysis of the specific terms of the transactions but also raises issues of broader relevance, such as:
(1) guidance as to the use of Loss as a payment measure under the 1992 ISDA Master Agreement; and
(2) the extent to which investors, the security trustee and the issuer are at liberty to agree to implement transactions without the consent of one of the secured parties.
Summary of Facts and Dispute
The cases involved two English law governed structured investments in managed pools of hedge funds and other assets. Each structure took the form of debt securities ("Notes") secured on (i) preference shares issued by a special purpose vehicle holding the hedge fund investments (a "Balco") and (ii) rights under a cash settled put option documented pursuant to a 1992 ISDA Master Agreement (a "Derivative Agreement") under which Lehman Brothers Finance S.A. ("LBF") agreed to pay a note issuer (an "Issuer") at maturity of the Notes the difference between the redemption proceeds of the preference shares and the par value of its Notes. LBF received a quarterly premium as consideration for this promise.
The Derivative Agreements terminated automatically on 15 September 2008 when LBF's parent and the guarantor of its obligations under the Derivative Agreements filed for Chapter 11 protection under the US Federal Bankruptcy Code.
Second Method and Loss applied under the Derivative Agreements. Following termination, the Issuers determined their Loss on the basis of the price of a replacement transaction as expressly permitted by the definition of Loss. The valuations were "clean" in that they assumed the term of the replacement transaction was not adversely affected by the Event of Default that brought about the Automatic Early Termination or by any event that may or may not have occurred in connection with the Notes.
The terms of the Notes specified the termination of the Derivative Agreement could be determined to be an Early Redemption Event (and it was found that such an event had occurred) following which, in the ordinary course, the Issuers would redeem their preference shares and pay the proceeds to their secured creditors primarily LBF and the noteholders.
Although LBF was subordinated to the noteholders in the payment waterfalls following its own default, the provisions relating to early redemption appeared to provide that, if it was entitled to receive a break fee (the "Early Termination Cash Settlement Amount" or "ETCSA") under the Derivative Agreement on early redemption, this amount should be deducted from the amounts ("Early Redemption Amounts") payable to the noteholders. It was ultimately found that these apparent deductions could not be interpreted so as to occur when LBF was in default and therefore subordinated.
Turning back to the Derivative Agreement it was clear that the ETCSA would only fall due if a mandatory termination occurred. The mandatory termination date was specified to be the date on which the Notes redeemed.
No such redemption occurred. The Issuers, investors and trustees agreed to implement an unwind of the investments which resulted in a payment to the noteholders on terms that would ultimately allow them to receive more than the Early Redemption Amount but which also provided for the contingency that LBF would claim the ETCSA.
LBF subsequently contacted the Issuers denying their Loss claim and claiming the ETCSA.
There were a large number of arguments advanced on both sides during the hearing. Briggs J ruled, among other things, that the Issuers were entitled to calculate Loss by reference to a clean price for a replacement transaction and that the Issuers were entitled to enter into the unwind transactions.
The case is of interest for two key reasons:
It was argued that common law principles of mitigation should apply to the calculation of Loss. If this were the case it was suggested that the gain made by the Issuers as a result of not being required to pay LBF an ETCSA should be taken into account in the calculation of Loss.
This argument was rejected for a number of reasons. Whilst the definition of Loss does have a common law flavour arising from the use of terms such as "loss of bargain" it is not correct that the limited incursion of common law principles should warrant the wholesale disapplication of the close out formula. Rather, recent cases have firmly established that it is correct to conduct a clean valuation. LBF's approach was incorrect because it sought to introduce extraneous considerations about the contractual structure of the notes sold by the Issuers to the investors which had no role to play in the determination process. It was also plainly the case that whilst the investors may have gained as a result of LBF not receiving the ETCSA, the Issuer, who was the counterparty to the Derivative Agreement and the party whose "Loss" was at issue, made no gain.
Arrangers, investors and derivative counterparties wishing to ensure that a specific close-out payment applies in all circumstances will need to bear these observations in mind when drafting documentation.
2. Investor actions
Whilst the terms of the Notes provided for a surprisingly rigid link between early termination of the Derivative Agreement and early redemption of the Notes this did not necessarily mean that the Notes would redeem following early termination of the Derivative Agreement.
The Issuers, the trustee and the investors were at liberty acting together to agree, as they did, to make alterations in their relationship which produced a different result even after the happening of an Early Redemption Event.
Briggs J noted the fact that it is precisely where the Derivative Agreement terminates because of LBF's default that its security rights are postponed to those of the investors. Whilst this postponement does not entirely remove LBF's security rights "it makes them easier for the issuer and investors to work around".
He nevertheless observed that the ability of these parties to exercise a "liberty" which was not prohibited by the structure was qualified where LBF's security rights would be infringed by the exercise. The provision of an indemnity from one investor to an Issuer to meet any future successful claim by LBF showed that the transaction in question did not cause LBF any real prejudice.
A number of investors in Lehman structured notes and other impaired products are still awaiting repayment of their investment or suffering from gridlock caused by inability to obtain a response to restructuring proposals from one or more of the secured parties. This judgment appears to indicate that an exit that does not infringe the security rights of such parties will be upheld by the English courts.
One of the investors was represented by Sidley Austin LLP.
If you have any questions regarding this update, please contact the following Sidley lawyers.
+44 (0)20 7360 3646
+44 (0)20 7360 2547
+44 (0)20 7360 2565
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