Commercial Division Blog

Posted: July 25, 2018 / Categories Commercial, Contracts

Questions of Fact Regarding Reasonableness of Calculations Under ISDA Master Agreement Preclude Summary Judgment

On July 2, 2018, Justice Friedman of the New York County Commercial Division issued a decision in Lehman Bros. Intl. (Europe) v. AG Financial Products, Inc., 2018 NY Slip Op. 51100(U), holding that questions of fact regarding the reasonableness of calculations under an ISDA master agreement precluded summary judgment, explaining:

In general, it is well settled under New York law that written agreements are construed in accordance with the parties' intent and the best evidence of what parties to a written agreement intend is what they say in their writing. Thus, when parties set down their agreement in a clear, complete document, their writing should as a rule be enforced according to its terms. Evidence outside the four corners of the document as to what was really intended but unstated or misstated is generally inadmissible to add to or vary the writing. Extrinsic evidence may not be considered when the intent of the parties can be gleaned from the face of the instrument. Ambiguity in a contract arises when the contract, read as a whole, fails to disclose its purpose and the parties' intent, or where its terms are subject to more than one reasonable interpretation. Extrinsic and parol evidence is not admissible to create an ambiguity in a written agreement which is complete and clear and unambiguous upon its face.

As to industry custom and usage, in particular, there is substantial federal authority that New York law permits consideration of such evidence in connection with the threshold determination of whether a contractual provision is ambiguous, at least where the contract uses specialized terms. The Second Circuit has repeatedly held that, under New York principles of contract interpretation, an ambiguity exists where the terms of the contract could suggest more than one meaning when viewed objectively by a reasonably intelligent person who has examined the context of the entire integrated agreement and who is cognizant of the customs, practices, usages and terminology as generally understood in the particular trade or business. As further explained by the Second Circuit in Law Debenture, evidence as to custom and usage is to be considered by the court where necessary to understand the context in which the parties have used terms that are specialized.

In elucidating New York law, the Second Circuit has relied on the reasoning of Fox Film Corp. v Springer (273 NY 434), a 1937 decision of the Court of Appeals, which held that where the parties to a contract have employed terms in common use in a business or art and have a definite meaning understood by those who use them, but which convey no meaning to those who are not initiated into the mysteries of the craft, the court must be informed of the meaning of the language as generally understood in that business, in the light of the customs and practices of the business. It must be made literate in a language in which it is now unschooled.

Contemporary New York cases have rarely cited Fox Film Corp. and do not appear to have cited Law Debenture. This court finds, however, that Law Debenture is in fact consistent with, and acknowledges, the general New York precept that, even in the context of a contract that uses specialized terms, the court must undertake a threshold inquiry to determine whether the agreement on its face is reasonably susceptible of only one meaning or, put another way, whether the meaning of a particular clause is unambiguous when read in the context of the entire agreement—in which event, extrinsic evidence will be unavailable in interpreting the contract.

The New York Court of Appeals has recently held that an agreement made in the context of a highly technical industry, which employs distinct terminology used by those in the business—there, a lease for the production of oil and gas—must be construed with reference to both the intention of the parties and the known practices within the industry. Some intermediate appellate courts have also held, without always making an express prior finding of ambiguity, that undefined specialized terms may be construed in light of industry custom and usage.

There is also substantial authority that an objective standard of reasonableness applies to a contractual provision requiring performance of an obligation in a reasonable manner.

It is a basic tenet, applied across a wide range of legal issues, that the question of what is reasonable may require consideration of the facts and surrounding circumstances in the case.

Consistent with this extensive body of law, the Appellate Division has held that in determining whether conduct is objectively reasonable, industry norms may be appropriately considered. In undertaking such an analysis, the court considers evidence of industry practice not for the improper purpose of interpreting or varying an agreement without ambiguity, but for the permissible purpose of providing guidelines for an unexplained term—there, unreasonably withheld.

For the reasons discussed further below, the court holds that, under these principles of contract interpretation, the ISDA Master Agreement is not ambiguous to the extent that it provides that Loss need not be calculated using market quotations in every case, but is ambiguous as to whether Loss, under the circumstances of this case, was reasonably determined.

As Assured correctly argues, there is strong textual support for reading the definition of Loss as generally permitting non-defaulting parties to select any methodology for calculating Loss, so long as such methodology is reasonable and in good faith. As explained by the Intel Court, which construed the identical ISDA Loss provision:

The first sentence of the definition of Loss makes clear that Loss will be an amount that party i.e., the Non-Defaulting Party reasonably determines in good faith to be its total losses and costs (or gain, in which case expressed as a negative number) in connection with this Agreement or that Terminated Transaction or group of Terminated Transactions. Further, there is nothing in the text of the definition of Loss that explicitly mandates any particular calculation method or otherwise modifies the plain meaning of that first sentence of the definition—that the non-defaulting party is permitted to calculate its loss reasonably and in good faith.

As is pertinent to this motion, not only is there "nothing in the text of the definition of Loss that explicitly mandates any particular calculation method" (id.), but the Loss provision unambiguously states that the Non-Defaulting Party "may (but need not) determine its Loss by reference to quotations of relevant rates or prices from one or more leading dealers in the relevant markets. Given this plain and unambiguous language, the court cannot find that the Loss provision categorically prohibits a Non-Defaulting Party, like Assured, from calculating its Loss without reference to market prices.

Put another way, the Loss provision could not be clearer in stating that a party "may (but need not)" calculate Loss using market quotations of rates or prices. The phrase "need not" is not a technical or specialized term which is, or could be, rendered ambiguous by evidence proferred by LBIE on this motion that parties to ISDA Master Agreements have consistently elected to calculate Loss using market prices. Even a reasonably intelligent person cognizant of such a custom or practice could not read the final sentence of the Loss provision as providing that a Non-Defaulting Party's failure to calculate Loss based on market prices is a per se breach of contract. Rather, the ISDA Master Agreement must be read in light of its purpose, which is to promote legal certainty and predictability or market stability when applied to termination of a diverse array of derivative transactions in global markets. The last sentence of the Loss provision should be read as an acknowledgment that there may, within this broad universe of transactions, be situations in which calculation of Loss using market prices may not be possible or would be unreasonable. The Loss provision thus by its terms affords the Non-Defaulting Party the discretion to make the determination as to whether use of market prices to calculate Loss is appropriate in a particular case.

This is not to say, however, that evidence of market practice with respect to the calculation of Loss is irrelevant to the ultimate question before the court—that is, whether the methodology Assured actually used to calculate its Loss was reasonable and applied in good faith.

To hold, as this court does, that the Loss provision affords the Non-Defaulting Party discretion to calculate Loss without reference to market prices does not mean that the Non-Defaulting Party's decision to ignore market prices can never be unreasonable or undertaken in bad faith. Discretion can, after all, be abused. Assured has not shown that the last sentence of the Loss provision must be read as effectively removing the issue of use of market prices from the analysis of a Non-Defaulting Party's reasonableness and good faith. In contrast, LBIE has submitted evidence of market practice which raises a triable issue of fact as to whether Assured has reasonably determined its Loss.

(Internal quotations and citations omitted) (emphasis added).

Under New York law, the starting point of contract interpretation is the words of the contract. As this decision shows, sometimes those words, without context, may be insufficient to establish what the parties intended--if anything. Contact Schlam Stone & Dolan partner John Lundin at if you or a client face a situation where you are unsure how to enforce rights you believe you have under a contract.