Lehman Brothers International (Europe) (in administration) v Assured Guaranty Financial Products Inc. (2023), Index No. 653285/2011
This case now holds the record as the longest-running case to come out of the 2008 Lehman Brothers collapse, having entered the legal system in 2011. It was heard in the Commercial Division of the Supreme Court of New York State by Justice Melissa Crane, with a judgment released in March 2023. The claimant was Lehman Brothers’ European division, and the defendant was Assured Guaranty, a bond insurer registered in Bermuda. A number of parallel claims did not make it to trial, with one dispute receiving judgment.
The two parties were at odds over the correct method of calculating Loss as defined in the 1992 ISDA Master Agreement, which governed the original trades.
The 28 transactions between the parties were Credit Default Swaps (CDS) governed by 1992 ISDA Master Agreements. 11 of these CDSs referenced collateralized loan obligations (CLOs), mostly based on subprime mortgage and business loan payments in the US and the UK. Some of the tranches referenced by the trades were considered ‘super senior AAA’ – theoretically, these would be insulated in a crunch by the lower tranches acting as a buffer. In the ensuing events, any certainty conferred by stellar credit ratings proved to be illusory, as these bonds and their lesser-rated brethren were wiped out in the crisis that engulfed Lehman Brothers.
These 28 transactions were terminated on the 23rd July 2009. The counterparties’ calculated Loss valuations were separated by a wide gulf – LBIE initiated the litigation with a claim that Assured owed it $485m, whereas Assured claimed that it was owed a figure of $20m by LBIE. This variance was created by the use of different calculation methods by the two parties. Assured used the ‘ordinary business’ method and LBIE used the ‘market prices’ method.
Section 6(e)i(3) 1992 ISDA MA provides that the amount payable on Early Termination is determined by the Non-Defaulting Party (Assured in this case) in respect of the terminated transactions, regardless of direction of loss.
The basis of Assured’s loss calculation was formed by netting LBIE’s premium payments over the transaction lifetime against payments. Assured estimated it would need to pay to cover ‘expected shortfalls in interest and principal’. Assured ran four scenario models to establish likely default rates, payment rates, and loss severities. The Court noted that as an insurer ‘in a highly regulated industry, accurate modelling was essential to its risk management’. For instance, their models took into account more nuanced phenomena such as ‘seasoning’ and ‘burnout’ that could affect mortgage-backed securities. The difference in calculated losses between Assured and LBIE’s methods comes with Assured’s prediction (as it happens, a correct one) that the default rate on mortgage payments would drop to historically average levels after a couple of years, whereas LBIE reckoned that a drop in housing prices would lead to a further spike in mortgage defaults, and thus a continuing erosion of the underlying securities.
A secondary difference comes from the use of two different loss prediction profiles – Assured used forecasts for 2009 provided by the ratings agencies, all between 30-40%, whereas LBIE used loss projections from banks. Barclays Bank projected a loss of 67%, but the Court considered this ‘quite dubious’, and even suspected that Barclays’ acquisition of Lehman Brothers’ US arm may have led it to project a loss figure favourable to LBIE’s problematic position against Assured. The Court also notes that LBIE’s request to take into account bank projections does not note Goldman Sachs’ projection at the same time, which featured a loss figure even lower than those provided by the ratings agencies. The ratings agencies, already under fire after failing to notice the 2008 crisis, were at pains to disclose their methodology and provide accurate projections, so the Court holds that Assured’s use of their loss calculation was more than reasonable.
LBIE argued that Assured should not have used this method, and instead should have calculated Loss based on the state of the market at the time, and the price at which the underlying securities were valued. The Court pointed out that it was impossible for Assured to have used market prices to calculate Loss – at the time of valuation date, ‘the markets were so disrupted that accurate market prices were non-existent’. The minute-by-minute volatility of all relevant trackers meant that no specific price could be used to complete the calculation. The Court noted, with a certain irony, that LBIE’s expert witness had previously described the market dislocation of the relevant time as ‘severe’, featuring risk premiums unrepresentative of the actual credit losses that occurred.
Furthermore, Assured’s calculation ‘was commercially reasonable and in good faith’ in the eyes of the Court – good faith itself being a requirement of the Loss calculation as per the ISDA Master Agreement. As a result, Justice Crane found for Assured, stating that they were entitled to the $20m figure that they had calculated.
The SCNY is a trial-level court, with two levels of appellate court above it. It remains to be seen whether Lehman’s administrators will take the case further by way of appeal.
The case’s background in Lehman Brothers’ collapse, and the specific dispute over calculating prices in a period of extreme volatility amounting to total market paralysis, naturally limit its application to ordinary business. However, the court’s approval of Assured’s conduct in rigorously vetting its own modelling, and acting in conspicuous good faith, should be noted. Assured’s commercially reasonable calculation was favoured over LBIE’s somewhat panicked valuations.Contact Us