Contractual discretions – when does “reasonable” mean more than “rational”?

The case concerned a principal-only forward currency swap that was terminated early due to the collapse of Lehman Brothers in September 2008. Once the swap was terminated, it was for the Non-defaulting Party, National Power Corporation (NPC), to determine the Close-out Amount.

The terms of the ISDA 2002 Master Agreement published by the International Swaps and Derivatives Association, Inc. (ISDA and the ISDA 2002 Master Agreement) require this determination to be made acting in good faith and using “commercially reasonable procedures in order to produce a commercially reasonable result”. Lehman Brothers contended that NPC had breached this provision.

Two varieties of reasonableness 

The provisions for calculating payments due on early termination differ in the 1992 ISDA Master Agreement (Multicurrency – Cross Border) (the 1992 ISDA Master Agreement) as compared to the ISDA 2002 Master Agreement. In the 1992 ISDA Master Agreement, where Loss is selected as the applicable payment measure on early termination, the definition of Loss refers to “an amount that party reasonably determines in good faith to be its total losses and costs”. 

In the ISDA 2002 Master Agreement, the equivalent provision requires calculation of the Close-out Amount to be determined by the Determining Party (or its agent) acting in good faith and using “commercially reasonable procedures in order to produce a commercially reasonable result”.

One of the key questions for the court was whether this change in wording altered the standard of reasonableness required.

The court described two possible standards referring to a passage from the judgment of Rix LJ in Socimer International Bank Ltd v Standard Bank London Ltd (No 2) [2008] EWCA Civ 116:

− rationality meaning not making a determination that no reasonable Non-defaulting Party could come to; or

− objective reasonableness meaning the negligence standard of reasonable behaviour.

The court’s interpretation

The judgment from Fondazione Enasarco v Lehman Brothers Finance SA  [2015] EWHC 1307 (Ch) established that the wording from the definition of “Loss” in the 1992 ISDA Master Agreement set the required standard of reasonableness at rationality. The court in the present case acknowledged this.

The 1992 ISDA Master Agreement was held to be a part of the relevant context for interpreting the  ISDA 2002 Master Agreement, along with the accompanying User’s Guide to the ISDA 2002 Master Agreement published by ISDA (the User’s Guide), and the fact that the ISDA Master Agreement is "probably the most important standard market agreement used in the financial world".

The court said that the User’s Guide made clear that the change of wording, as compared with the 1992 ISDA Master Agreement, was intended to introduce greater objectivity. Therefore, the ISDA 2002 Master Agreement definition of Close-out Amount must entail a more onerous concept of reasonableness than merely avoiding an arbitrary, capricious and irrational determination.

The court also referred to the statement in Lehman Brothers International v Lehman Brothers Finance [2012] EWHC 1072 (Ch) that the change of wording introduced a new requirement that a Close-out Amount calculation must produce a commercially reasonable result. There was no such requirement that the result of the determination be reasonable in the 1992 ISDA Master Agreement.

This additional requirement to produce a commercially reasonable result had to be an objective requirement. If the additional words had only meant that the Determining Party must use procedures that ought to produce a commercially reasonable result, this would add nothing to the requirement to use commercially reasonable procedures, and so the additional words would have been superfluous.

Reasonableness in Close-out Amount in the ISDA 2002 Master Agreement

Accordingly NPC was required to use procedures which were, objectively, commercially reasonable to produce a result which was, objectively, commercially reasonable.

On the facts it had been commercially reasonable for NPC in calculating the Close-out Amount, to obtain the quotations it had and to use the replacement swap it had. Obiter a revised calculation statement which NPC served pursuant to Section 6(d) of the ISDA 2002 Master Agreement (which it turned out it was not entitled to serve) did not use commercially reasonable procedures to produce a commercially reasonable result on the facts of this case as it used a single indicative quotation when a firm quotation and an actual transaction was to be available shortly.

Comment

The decision, in the ISDA context, is unsurprising. In commercial contracts more generally (as opposed to in the context of the ISDA 2002 Master Agreement or the 1992 ISDA Master Agreement), it shows how careful you have to be when drafting provisions where one party's decisions or actions can have an impact on both parties: do you want rationality or objective reasonableness to be the standard? Where the provision is more concerned with the process, the standard is likely to be rationality, where it is about the outcome, it is more likely to be objective reasonableness.

Further information

This case summary is part of the Allen & Overy Litigation and Dispute Resolution Review, a monthly publication.  If you wish to receive this publication, please contact Amy Edwards, amy.edwards@allenovery.com.