Upcoming Mallesons seminarsAn Australian court has ruled that the experts consulted to provide quotations for the calculation of a close-out amount under an ISDA Master Agreement should have used a valuation method radically different from the one commonly accepted. The decision has implications for the valuation of ISDA-based derivatives, says Andrew Fernbach of Mallesons Stephen Jaques.
In the second half of last year, Enron Australia Finance took Integral Energy Australia to court. The dispute was over the amount Integral had demanded to close out its electricity derivatives book.
Integral had asked Enron for A$1,584,370 ($949,000), which was the average of the quotations Integral obtained (disregarding the highest and lowest):
- Accenture: A$396,844;
- Deloitte Touche Tohmatsu: A$1,807,161;
- Ernst & Young: A$1,685,942; and
- Macquarie Risk Advisory Services: A$1,482,797.
Enron asserted that it should only have to pay an amount around the level of the Accenture quote - approximately 75% less than Integral was asking for.
How did Enron justify its claim?
Enron argued that quotations provided for the purpose of calculating the close-out amount under their ISDA Agreement with Integral should be based on the market value of Replacement Transactions.
The company said this would be best achieved by adopting a midpoint, rather than a bid-offer spread, approach.
Bid-offer spread approach: The majority of experts took a price on the opposite side of the bid-offer spread, so that where Integral was the buyer they would take the average sell price, and vice versa. Prices were taken from the Australian Financial Markets Association Electricity Forward Curve (AFMA Curve), an industry price survey.
Midpoint approach: Accenture’s approach was based on finding a midpoint between the average of the bid and offer prices, ignoring whether Integral was a buyer or seller of the contract and taking into account actual broker trades in the market.
Enron argued that adopting a bid-offer spread approach would give Integral a windfall gain because actual trades - as opposed to what a counterparty or dealer might quote to begin negotiations - in the electricity swaps market were more likely to take place around the midpoint.
Integral argued that the Defaulting Party (or one Affected Party in the case of a Termination Event) should bear the cost of the bid-offer spread.
What did the Supreme Court decide?
Enron was right. The Supreme Court of New South Wales interpreted the phrase “that would be paid” (to or by the party seeking the quote) in the definition of Market Quotation as indicating that the quotations should have been based on the price that would actually be paid in the market for a Replacement Transaction, that is, a market price.
The Court held that Enron had successfully challenged the valuation by showing that it fell outside the scope of the contract, which required the calculation of a market price.
The Court’s reasons
Common sense: An economically rational party would not pay a price that departed to a material extent from market value.
Choice of experts as opposed to dealers: The parties chose experts as opposed to dealers as the Reference Market-makers (those asked to give quotations to the party determining the Settlement Amount) in their ISDA Schedule (in accordance with industry standard wording for the Australian over-the-counter electricity derivatives market), so the calculation method common in the global markets was unsuitable.
Unfairness: A “disparity in the ultimate figure” was likely to occur in “an illiquid market” given “the grave limitations of the AFMA Curve exposed by the evidence”. There was evidence that the AFMA Curve is merely a survey, that is, it represents each participant’s view of where the future market lies, as opposed to actual trading prices and so was open to manipulation.
Do experts have to provide quotations independently and impartially?
The Supreme Court also held that it was arguable that the ISDA Agreement between the parties implied that market quotations must be given independently and impartially.
There was evidence that one of the experts had provided Integral with drafts of its quotation for discussion.
Analyzing the decision: some causes for concern
The following aspects of the ISDA documentation architecture can be used to argue that Integral was indeed correct when it came to calculating the close-out amount (leaving aside the issue of impartiality):
- the close-out mechanics in the special case where there are two Affected Parties; and
- the provisions characterizing the close-out amount as payment for the “loss of protection against future risks”.
Close-out mechanics where there are two Affected Parties: In some less common termination situations there may be two Affected Parties (as opposed to just one Defaulting Party or one Affected Party), for example, where both parties are affected by an Illegality.
Where there are two Affected Parties, the effect of the relevant provisions under the ISDA Master Agreement is that the parties will share the bid-offer spread. This is illustrated in the following example taken from the ISDA User’s Guide to the 1992 ISDA Master Agreements (1993 Edition, page 28):
Close-out where there are two Affected Parties
Settlement Amount for Y = -100
Difference between Settlement Amounts = 190
This result is roughly equivalent to mid-market quotation and makes sense because neither party is at fault and so the spread should be shared equally between them.
The fact that the ISDA documentation provides for the sharing of the bid-offer spread in this special case, indicates that the intention was for sharing not to apply in the usual case where there is only one Defaulting Party or one Affected Party (so the Defaulting Party or Affected Party would bear the spread).
Loss of protection against future risks: The ISDA Master Agreement states that the close-out amount is a payment for the “loss of bargain” and the “loss of protection against future risks” and that Replacement Transactions should “have the effect of preserving… the economic equivalent” of the Terminated Transactions. The ISDA User’s Guide provides commentary on this wording, indicating the intention that dealers are to provide market quotations for the “replacement cost” of Terminated Transactions (see page 24).
These provisions can be used to argue that the close-out amount should include the full bid-offer spread because that is what it would cost to replace the transaction (without relying on price negotiations) and to properly compensate the Non-defaulting Party (or the party that is not the Affected Party) for the loss of protection against future risks.
Were all possible issues canvassed?
There is no mention in the judgment of either party raising the wording in the Settlement Amount definition that requires the determining party to fall back to Loss (as an alternative payment measure) if Market Quotation would not produce a commercially reasonable result.
It will be interesting to see whether the Court of Appeal comments on this because it could produce a radically different result to the market value concept adopted by the trial judge. At the time of going to press, the appeal from the decision in Enron Australia Finance Pty Limited (in liquidation) v Integral Energy Australia [2002] NSWSC 753 was to begin on February 26.
Also, there was minimal comment by the Court on the issues facing a Non-defaulting Party in an illiquid market. There is a strong argument that it is unrealistic and unfair to require a party in this situation to accept a mid-market valuation when in fact there are wide spreads or where there is an imperative to re-hedge.
Introduction of the 2002 ISDA Master Agreement
The 2002 version of the ISDA Master Agreement includes a new concept of “Close-out Amount” under which “commercially reasonable procedures” are to be used to produce a “commercially reasonable result”.
As the 2002 ISDA Master Agreement becomes market standard, it will be interesting to see whether courts interpret “commercially reasonable procedures” as requiring mid-market quotes in some circumstances.
Andrew Fernbach
Solicitor
T +61 3 9643 4457
andrew.fernbach@mallesons.com
The author acknowledges the inspiration of Ania Nowakowska and the assistance of Scott Farrell, Richard Hoskins, Edward Kerr and Ian Paterson in the preparation of this article.
This article first appeared in the March 2003 issue of IFLR http://www.legalmediagroup.com/iflr/