The GMRA: valuation, notices and pitfalls in closing out on a default

Introduction

The High Court has partially upheld challenges brought by the administrators of Lehman Brothers International (Europe) to valuations submitted by Exxonmobil Financial Services BV under the close-out netting provisions of the TBMA/ISMA Global Master Repurchase Agreement (2000 version) (GMRA). The case turned on a number of technicalities regarding delivery of default and valuation notices, as well as the correct approach to valuation of a portfolio of securities, whether actual sale prices can be used and the approach to determining fair market value. In this briefing, we look at the main issues considered by the High Court and summarise its key findings.

Summary

The case sheds light on a number of key issues of construction under the GMRA:

• Whether a Default Notice needs to include detail of the circumstances giving rise to the Event of Default: the court held that it did not.
• Whether email is a valid form of notice under the GMRA: the court held that it was.
• Whether a notice sent to the wrong fax number was validly delivered under the GMRA: the court held it was not, but on the facts this was waived by the recipient.
• When is close of business for the purposes of delivery of a notice? The court held that this was 7.00 p.m.
• When is close of business in an Appropriate Market? The court held that this was the close of business for financial institutions generally, being 7.00 p.m., not close of dealings in the relevant market.
• What is the "Appropriate Market" for valuation purposes? The court rejected the argument that there is a single "global market" for valuation purposes, finding that there could be different Appropriate Markets for different securities in the portfolio of Purchased Securities.
• Whether the non-Defaulting Party can rely on actual sale prices to determine fair market value where it had not served a Default Valuation Notice within the required five dealing day timeframe: the court held not.
• The correct approach to determining "fair market value": the court held that the test is one of rationality and that the court would not seek to establish an "objectively reasonable" fair market value.

Facts of the case

The case¹ concerned a repurchase, or 'repo', transaction entered into between Lehman Brothers International (Europe) (LBIE), which was the main UK dealer entity for the Lehman Brothers group, and Exxonmobil Financial Services BV (EMFS) in September 2008 as part of a series of weekly rolling repo transactions documented under a GMRA. The transaction in question was documented by a Confirmation dated 5 September 2008; EMFS purchased a portfolio of securities on 9 September 2008 and the repurchase date was 16 September 2008.

On 15 September 2008, the day before LBIE was due to pay the repurchase price to EMFS, administrators were appointed in respect of LBIE. On the same day, LBIE confirmed to EMFS that it would not be able to repurchase the securities on the following day as required, and that EMFS should follow the default procedure under the GMRA. The sequence of events that followed is fairly typical of what one might expect in these circumstances and the judge's findings will be of interest to practitioners handling similar defaults in the future. The primary issues that arose are set out below.

Construction and delivery of the Default Notice

The first set of issues related to the construction and delivery of a Default Notice under the GMRA.

Under the GMRA, a Default Notice must, except in limited cases, be delivered by the non-Defaulting Party in order to trigger an Event of Default. A Default Notice is defined as follows:

"a written notice served by the non-Defaulting Party on the Defaulting Party under paragraph 10 stating that an event shall be treated as an Event of Default for the purposes of this Agreement".

What constitutes a Default Notice?

A question arose as to whether the Default Notice must specify details of the circumstances constituting the alleged Event of Default.

The facts were that on the morning of 15 September 2008, EMFS served a notice on LBIE (the First Notice) which referred to "…the occurrence of an Event of Default set out in section 10(a) of the [GMRA]…". It subsequently took legal advice and prepared, and attempted to serve (see below for more on this), a further notice (the Second Notice) containing more specific details of the Event of Default which had occurred i.e. that an Act of Insolvency had occurred by reason of the appointment of joint administrators in respect of LBIE.

In the proceedings, it was contended that EMFS's Default Valuation Notice (see below) had been served too late if the First Notice had been effective as a Default Notice. This is because the delivery of a valid Default Notice triggers a five dealing day period during which the non-Defaulting Party can notify the Defaulting Party of its valuation of the securities based on actual sale prices. In order to avoid its Default Valuation Notice being out of time, EMFS sought to argue that the First Notice was not in fact a valid Default Notice under the GMRA because it did not contain enough detail about the Event of Default being relied upon. Blair J disagreed and held that the First Notice was a valid Default Notice, commenting that:

"[…] the [default] notice has to state that an event is being treated as an Event of Default, but it does not have to identify the specific event. The notice must clearly convey to the recipient that the non-Defaulting Party is treating an event as an Event of Default for the purposes of the agreement, but no particular form of words is prescribed."

This is a useful clarification and suggests that courts will be inclined not to strike down Default Notices for lack of information about the Event of Default being relied upon. However, given the factual context of this decision, this may not be a universal rule, and it would still be best practice, in our view, to include reasonable details of the Event of Default in the Default Notice.

Is email a valid method of service under the GMRA?

The Second Notice was ultimately delivered on 16 September 2008 by email, because LBIE's fax number specified in the GMRA was (unsurprisingly) busy. The judge considered, obiter, whether email is a valid method of serving a contractual notice under paragraph 14 of the GMRA and held that there is no reason why the phrase "electronic messaging system", as used in paragraph 14(b)(v) of the GMRA, should not include email, particularly where, as was the case here, Annex I of the GMRA specified email addresses for such delivery. He also went on to note that the 2011 version of the GMRA expressly permits the delivery of notices by email .

This decision can be contrasted with the 2014 decision in Greenclose Ltd v National Westminster Bank PLC ³, which concerned a 1992 ISDA Master Agreement. In Greenclose, it was held that email was not a valid method of service, email being extremely uncommon in 1992 and it therefore being unlikely that the reference to "electronic messaging system" was intended to include it as a method of service. Blair J also noted that, in this case, email addresses were included in Annex I of the GMRA, whereas in Greenclose, email addresses were not included in the Master Agreement. He held that there would be no reason for including email addresses in Annex I of the GMRA if notices thereunder could not be validly sent by email.²

The decision highlights the importance of including correct notice details for the intended method of delivery in Annex I of the GMRA.

The Default Valuation Notice

The next set of issues covered in the judgment relate to EMFS's Default Valuation Notice (DVN) which, in order to be effective under the GMRA, was required to be given to LBIE between the occurrence of the Event of Default and the Default Valuation Time. The Default Valuation Time is defined as:

"in relation to an Event of Default, the close of business in the Appropriate Market on the fifth dealing after the day on which the Event of Default ocurs…".

As the court found that the Event of Default had been triggered on 15 September 2008 by the delivery of the First Notice, the deadline for service of the DVN was the close of business on the fifth dealing day in the Appropriate Market after that date. The main questions in dispute were, first, when the DVN had actually been delivered to LBIE, second, which was the "Appropriate Market" for the purpose of determining the fifth dealing day and, third, when was "close of business" in that market. These issues arose because the DVN was sent by fax at 6.02 p.m. London time on 22 September, which LBIE argued was after the close of business in the place of receipt (London) and that therefore under paragraph 14 of the GMRA receipt was not effective until the following day. The fax was also sent to the wrong fax number (i.e. not the fax number specified for notices in Annex I of the GMRA). LBIE also argued that the Appropriate Market for some of the securities in the portfolio had already closed (e.g. Asian markets) at that time, therefore the notice was too late even if it was delivered before the close of business in the place of receipt.

Problems with fax machines

EMFS originally tried to send its DVN to the fax number specified by LBIE in the GMRA, but this was unsuccessful because the fax machine was still busy. The DVN was, however, successfully sent to a fax machine in the same office but with a different number from that specified in the GMRA.

Blair J agreed with LBIE that the successful transmission and actual receipt of the DVN was irrelevant and that the DVN had not been effectively delivered because it had not been received by the specified fax number, referencing Lord Hoffman's quote from Mannai Investment Co Ltd v Eagle Star Life Assurance Co Ltd ⁴  that (in respect of a tenant's notice of termination of a lease), "if the clause had said that the notice had to be on blue paper, it would have been no good serving a notice on pink paper…".

Notwithstanding the above, on the facts of the case it was found that the requirement to deliver to a particular fax machine had been waived by LBIE's subsequent conduct. It had waited too long to dispute the validity of the notice, or alternatively it had subsequently acted on the basis that the notice was valid. Although in this case on the facts the notice provision was waived, the decision highlights the importance of following contractual notice provisions precisely, as the courts may otherwise find the notice to be invalid.

What does "close of business" mean?

The court was also asked to consider the meaning of the phrase "close of business" for the purposes of paragraph 14(b) of the GMRA. Paragraph 14(b) regulates when notices under the GMRA are deemed to be effective, and provides that:

"any notice or communication which is received, or delivery of which is attempted, after close of business on the date of receipt or attempted delivery or on a day which is not a day on which commercial banks are open for business in the place where that notice or other communication is to be given shall be treated as given at the opening of business on the next following day which is such a day."

The phrase "close of business" is commonly used and in many ways its vagueness is helpful and gives, as Blair J commented, a "useful flexibility". However, where (as here) the date of delivery of a notice is determined by whether it was delivered before or after close of business, just when does business "close"? In this case, the fax containing the DVN was received at 6.02 p.m. LBIE said that "close of business" means 5.00 p.m.; EMSF said 7.00 p.m. If LBIE had been correct, the DVN would have been deemed to be delivered only on the following business day, after the Default Valuation Time, and would therefore have been of no effect.

Blair J agreed with EMSF. He said that if LBIE had wanted to specify a particular cut-off time for delivery, this should have been incorporated into the contract. He also agreed with EMSF that the onus was on LBIE, as the party alleging that the DVN arrived after close of business, to establish when close of business occurred, and that LBIE had not adduced any admissible evidence on this point. The only evidence given was given by EMFS's expert and this was accepted by the judge: "though this is a necessarily rough approximation, in the modern world commercial banks close at about 7pm".

Blair J made it clear that this finding was fact-specific, saying that "[i]n the context of financial business of the kind at issue in this case, repo financing extended by an oil major to an international investment bank, a reasonable person might be surprised to hear that business closes at 5pm. In fact, it does not…".
These comments mean that we should be cautious in applying a hard and fast rule as to when "close of business" occurs, as the answer may differ depending on the context and the parties involved. Best practice, of course, is to deliver the notice earlier in the day in order to avoid difficult questions as to when precisely close of business occurs in a particular location.

Can the "global market" be an Appropriate Market?

The concept of "close of business" is used in two different ways in the GMRA. As discussed above, it is relevant under paragraph 14 to determine when a notice is deemed to be effectively received. It is also used in the definition of Default Valuation Time, which requires that the DVN must be delivered to the Defaulting Party by close of business in the Appropriate Market on the fifth dealing day after the Event of Default occurred. The Appropriate Market in respect of securities is defined as "…the market which is the most appropriate market for [s]ecurities of that description, as determine by the non-Defaulting Party".

Even if the DVN was effectively delivered at 6.02 p.m. London time, LBIE argued that this was still later than the close of business in the Appropriate Market for some of the securities in the portfolio. The question considered by the court was whether, given that the securities in question were located in multiple time zones, it was open to EMFS to determine that the Appropriate Market was "the global market" (or, alternatively, "the US market"), or whether multiple Appropriate Markets should have been specified for the various different securities in the portfolio. LBIE argued that there were multiple "Appropriate Markets" for different categories of securities in the portfolio, and that the multiple DVNs could be served, each with a different Default Valuation Time depending on the timing of market close for the relevant market. Blair J held that, while it is meaningful to speak of a "global market" in securities in a general sense, the "global market" cannot be a "market" for the purposes of paragraph 10(d)(i) of the GMRA – and therefore could not have been the Appropriate Market. He also said that, had the "global market" been a valid Appropriate Market, EMFS had not specified it as such in its DVN.

As a result, it was held that there could be multiple Appropriate Markets and that the DVN was served too late for certain securities in the portfolio (in particular, Asian securities), due to the earlier closing time of the relevant Appropriate Market for those securities.

This ruling does somewhat complicate the close-out process for portfolios of securities as it means that multiple DVNs may be required, each with a different Default Valuation Time.

Close of business in the Appropriate Market

The court also considered whether, for the purposes of determining the Default Valuation Time, close of business in the Appropriate Market should mean close of business for financial institutions generally or close of business for dealing in the relevant Appropriate Market. Clearly, the close of business for financial institutions in a market generally can be significantly later than the closing time for dealings on stock exchanges. Blair J agreed with EMSF that the former interpretation (close of business for financial institutions generally) is correct and said that "there is no reason to construe "close of business in the Appropriate Market" as meaning "close of business for dealing in the Appropriate Market"". He applied the same close of business test as described above, concluding that 7.00 p.m. was the relevant cut-off time rather than any earlier time at which relevant exchanges might close.

Valuation of the securities

The remainder of the judgment is largely concerned with the valuation of the securities in question, which comprised a combination of debt and equity securities from a variety of issuers situated in a range of geographical locations. Due to timing issues, the court was only asked to consider certain high-level points of principle, the most important of which are summarised below.

How to calculate "fair market value"

As discussed above, the DVN was delivered late in respect of certain of the securities and was therefore not valid in respect of these. Under paragraph 10(e)(ii) of the GMRA, since a valid DVN had not been given by the Default Valuation Time, EMFS should have gone on to calculate the Net Value of the affected securities at the Default Valuation Time (the Net Value being the amount which, in the reasonable opinion of EMFS, represented their fair market value). EMFS did not do this so the court was asked to consider "the counterfactual" and decide how, for the purposes of determining the Net Value, the "fair market value" would have been calculated by EMFS at the time, had it done so, given that it had not been calculated at the Default Valuation Time.

LBIE asserted that, in these circumstances, the fair market value should be determined by the court and should refer to the objectively reasonably fair market value of the securities. However, the judge agreed instead with EMFS that the securities should be ascribed a fair market value in accordance with the opinion which EMFS as the non-Defaulting Party (acting rationally) would have formed had it conducted the valuation at the Default Valuation Time. He held that the court should not substitute its own objective determination of a reasonable valuation but should apply a "rationality" test, in other words the valuation should be that which EMFS would have determined subject to requirements of honesty, good faith, genuineness, absence of arbitrariness, capriciousness, perversity and irrationality ⁵.

Could EMFS rely on the sale prices of the sold equities?

Certain of the equities in the portfolio had been sold by prior to the Default Valuation Time and had been valued in EMFS's (invalid) DVN at their actual sale prices. EMFS maintained that, had it carried out the Net Value calculation as of the Default Valuation Time, it would still have valued these securities at their actual sale prices.

Blair J held that, while the actual sale price is an "unimpeachable" valuation method if the DVN is delivered within the specified timeframe, where this is not the case (as here), valuation must take place at the Default Valuation Time and the securities' value cannot be ascertained by reference to earlier sale prices. Consequently, it was not permissible for EMFS to use the actual sale price for the valuation of the sold securities.

The court was then asked to consider how the equities should have been valued, with each party proposing a method. Both assumed a notional liquidation to value the securities, but LBIE assumed liquidation of all securities in a closing auction on the fifth dealing day while EMFS assumed liquidation over a period of days. LBIE asserted that its method was the only reasonable valuation method.

The court held, applying the rationality test:

• with regard to LBIE's assertion that its valuation method was the only reasonable method, Blair J pointed out that the GMRA allows for a variety of methods and sources to be used when valuing securities and that there was no reason to assume that LBIE's approach would have, or should have, been used by EMFS;
• EMFS was entitled to value the securities based on a notional disposal over several days rather than an immediate sale of all of the securities at the Default Valuation Time. There was nothing inherently unreasonable in assuming a disposal over a period of days; and
• accordingly, EMFS's valuation was found to satisfy the rationality test and was upheld.

How should the bonds have been valued?

A number of the securities were bonds which EMFS had been unable to sell or obtain bids for. EMFS ultimately valued these bonds by taking the applicable screen price and reducing this by 40%. At the time of the default, it had attempted to sell the bonds, but had not been prepared to accept a discount greater than 5%.

However, Blair J was of the view that, given the quality of some of the issuers (such as Statoil and Converium Holdings, part of the Berkshire Hathaway Group), the bonds may have been sold had they been offered at a more reasonable discount, and that EMFS should have tested the market at greater discounts in an attempt to find buyers. A fact which the court placed great weight on was an internal presentation made by EMFS on 26 September 2008, the Friday of the week in which the DVN was given. This presentation showed EMFS valuing the securities at a 20% discount, not a 40% discount. The court held that "this is an internal, effectively contemporaneous valuation of the bonds, and I am satisfied that it shows the value that EMFS in fact ascribed to the bonds at the time." The 40% discount was therefore found to be "irrational" and, as a consequence, the DVN was invalidated in respect of these bonds.

Conclusion

The decision provides very useful guidance as to the interpretation of key provisions in the GMRA; however, it also highlights significant pitfalls for unsuspecting non-Defaulting Parties in valuing a portfolio of securities. It is critical to be aware of the correct manner and timing for delivering notices, and the correct approach for valuing securities.

^{1 Lehman Brothers International (Europe) v Exxonmobil Financial Services BV [2016] EWHC 2699 (Comm).}

^{2 Through the incorporation of a definition of "Electronic Messaging System", which includes email.}

 ^{3 Greenclose Ltd v National Westminster Bank PLC [2014] EWHC 1156 (Ch).}

^{4 Mannai Investment Co Ltd v Eagle Star Life Assurance Co Ltd [1997] UKHL 19.}

^{5 Applying Abu Dhabi National Tanker Co v Product Star Shipping Ltd [1993] 1 Lloyd's Rep 397.}