On July 2, 2018, Justice Marcy Friedman of the New York State Supreme Court, Commercial Division, denied a motion for summary judgment filed by defendant, AG Financial Products, Inc. (“AG”), against plaintiff Lehman Brothers International Europe (in administration) (“LBIE”), which is represented by Davis Polk. Justice Friedman’s opinion is only the second U.S. court opinion to analyze in detail the Loss provision of the 1992 ISDA Master Agreement (“ISDA Master”), and the first to closely analyze and hold that Loss calculations must be assessed using an objective standard of commercial reasonableness.

Between 2005 and 2008, LBIE, the European-based subsidiary of Lehman Brothers, entered into 28 credit default swap contracts with AG, a monoline insurance company, documented pursuant an ISDA Master (the “Transactions”). LBIE, as protection buyer, agreed to make fixed payments to AG, which as protection seller would make payments to LBIE upon the occurrence of credit events related to the underlying securities. Under the ISDA Master, Lehman’s bankruptcy and LBIE’s entrance into administration in September 2008 provided AG with the right to terminate the Transactions, which it did in July 2009.  

The ISDA Master authorized AG, as the non-defaulting party, to calculate a termination payment based on its “Loss,” defined to be the “amount that [a] party reasonably determines in good faith to be its total losses.” In fall 2009, notwithstanding that the collapse in credit markets should have made the Transactions “in the money” for LBIE, AG calculated that LBIE should make a termination payment to it of $24.8 million. AG’s novel methodology ignored standard market practice to calculate Loss on a market, replacement-cost basis, which would have demonstrated that AG owed LBIE several hundred million dollars, as the cost of obtaining LBIE’s credit protection from AG would have been significantly more expensive in 2009 than it was when the Transactions were entered into years earlier. 

Davis Polk filed a complaint on behalf of LBIE in November 2011, asserting that AG breached the contract by improperly calculating Loss without reference to market information and in a commercially unreasonable manner. After several years of extensive fact and expert discovery, AG moved for summary judgment in 2016, arguing that as the non-defaulting party, its determination of Loss is subject to deference and must be judged based on a subjective standard, not an objective standard.

In her opinion, Justice Friedman denied AG’s motion as to its calculation of Loss, rejecting AG’s argument that the Loss provision gave it broad discretion to calculate Loss using an approach that failed to reference market prices. The court also rejected AG’s argument that the Loss provision was unambiguous and that extrinsic evidence could not be used to assist in interpreting the provision. Specifically, Justice Friedman ruled that New York law permits evidence of industry custom to determine the meaning of specialized terms in a contract—here, the term “Loss.” Similarly, Justice Friedman concluded that evidence of industry custom was permitted in determining whether AG’s conduct was “objectively reasonable.” On these points, Justice Friedman explained that the substantial and uncontroverted fact and expert evidence adduced by LBIE that there was a uniform practice of calculating Loss by reference to market prices raised material questions of fact as to whether AG “reasonably determine[d]” Loss by using an unprecedented methodology. 

Justice Friedman’s decision is particularly significant given that the only other U.S. case to analyze the Loss provision, Lehman Bros. Holdings Inc. v. Intel Corp., No. 08-13555 (SCC), 2015 WL 7194609 (S.D.N.Y. Sept. 16, 2015), largely held that the Loss provision gave the non-defaulting party significant discretion to calculate its Loss.

The Davis Polk team includes partner James H.R. Windels (who argued the motion), counsel Michael Scheinkman and associate R. Brendan Mooney. All members of the Davis Polk team are based in the in New York office.