In a recent decision that will be of interest to firms transacting in complex financial products, Justice Marcy Friedman of New York’s Commercial Division found that whether a non-defaulting party’s choice to calculate “Loss” under the standard form 1992 International Swaps and Derivatives Association (“ISDA”) Master Agreement (“ISDA Master”) without reference to market prices was reasonable and in good faith raised a genuine question of material fact. The ruling is noteworthy for its implications for contracts in areas where a widespread market practice exists and for its endorsement, under the facts of the case, of a “cross-check principle” for testing the reasonableness of a Loss calculation under the ISDA Master.


In Lehman Brothers International (Europe) v. AG Financial Products, Inc., 60 Misc. 3d 1214(A), July 2, 2018, plaintiff Lehman Brothers (“LBIE”) purchased credit protection from defendant AG Financial (“AG”) in a series of credit default swaps governed by an ISDA Master. LBIE’s 2008 bankruptcy at the onset of the financial crisis was an event of default under the ISDA Master, which gave AG the right to terminate—a right it exercised in 2009. The parties had elected “Market Quotation” as the methodology for determining the termination payment. Market Quotation required AG to seek quotes on a replacement transaction from four dealers in the market. AG attempted to do that, but it was unable to procure any quotes amidst the meltdown.

Under the ISDA Master, where fewer than three quotations are received, the non-defaulting party may fall back to “Loss” method. Under Loss, the non-defaulting party calculates the amount it reasonably determines in good faith to be its total losses and costs (or gains), as set out in greater detail in the full definition of Loss. That definition expressly 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.” AG applied the Loss method to calculate a termination payment owed to it of over $24 million. LBIE sued, alleging that AG conducted the Market Quotation process in bad faith and that it then improperly calculated Loss without reference to any market information and in a manner that was commercially unreasonable.

Market Quotation Process 

Justice Friedman first found that LBIE failed to identify any material issue of fact as to whether AG conducted the Market Quotation process in bad faith. The Court was persuaded by AG’s arguments—and the report of AG’s expert—that by hiring qualified and independent firms to design and conduct an auction consistent with market practice, it satisfied the ISDA Market Quotation process, and that there were numerous reasons, unrelated to the auction and bidding procedures, that it did not receive quotations.

Loss Computation

AG’s Loss calculation was a different story. There, AG argued that it complied fully with the ISDA Master when it calculated the termination payment based upon its “loss of bargain” (i.e., the difference between the present value of the premium payments owed by LBIE over the remaining term minus the present value of the amounts that AG estimated it would owe). AG further contended that it was not required, by the plain language of the Loss provision, to refer to market prices in calculating Loss. LBIE countered that AG’s methodology for calculating Loss was contrary to the widespread market practice of using a “replacement cost approach.” It also contended that AG’s calculation violated the cross-check principle, as discussed below. 

Although the Court sided with AG in holding that the Loss provision affords the non-defaulting party discretion to calculate Loss without reference to market prices, it rejected AG’s contention that its determination must be upheld “so long as there is any rational basis for that calculation.” The Court found, rather, that an objective standard of reasonableness applies to contractual provisions requiring performance in a reasonable manner.

Role of Market Practice

Based on its survey of New York and federal cases, the Court found that it could consider industry custom and usage as an aid to understanding an undefined, specialized contract term, as long as the custom or usage is “fixed and notorious.” But the Court ultimately relied on the more commonplace rationale that “industry norms may be appropriately considered” in determining whether AG’s methodology was objectively reasonable, as required under the Court’s interpretation of the Loss definition. The Court suggested that consideration of industry practice is particularly appropriate in the case of the ISDA Master because judicial interpretation of the agreement “in a vacuum … could lead to results that frustrate, rather than promote, ISDA’s—and the parties’—objectives of certainty and market stability.” Finally, the Court found the ISDA Master to be “ambiguous as to whether Loss, under the circumstances of this case, was ‘reasonably determine[d]’.” Accordingly, the Court held that AG’s deviation from a “uniform or highly consistent practice” raised a genuine question of fact as to its reasonableness or good faith in calculating Loss. 

The Court cautioned, however, that its decision should not be read as holding that market practice is determinative or that evidence of market practice would always be admissible. Rather, as the Court clarified, “departure … from standard industry practice is a factor, among others, to be considered in assessing reasonableness and good faith in calculating Loss.”

Cross-Check Principle 

The Court found further support for its holding in the cross-check principle, an interpretation first articulated by the English courts based on the manner in which the Loss and Market Quotation measures interrelate under the ISDA Master. Under the cross-check principle, a result under either under Market Quotation or Loss—methods regarded to be “aimed at achieving broadly the same result”—should be tested by reference to the other method. In the United States, the court in Matter of Lehman Bros. Holdings Inc. v. Intel Corp., 2015 WL 7194609 (S.D.N.Y. Sept. 16, 2015) found cross-check to be a “well-reasoned principle” but not one applicable to the facts of that case. In contrast, Justice Friedman found the principle to be appropriate here, where the parties agreed to use Loss solely as a fallback in the event that Market Quotation failed and the parties were obligated in certain circumstances to make payments following the early termination date. The Court concluded that the significant discrepancy between indicative bids received by LBIE and AG’s Loss calculation supported a finding that triable issues of fact existed as to whether the “cross-check principle is capable of application” and whether AG’s calculation of Loss satisfied that principle.

Loss of Bargain

AG argued that its “loss of bargain” methodology was consistent with New York law on contract damages, but the Court declined, on several grounds, to hold that the methodology was reasonable for that reason. After citing English authority that termination values under the ISDA Master “are not to be equated with, or interpreted rigidly in accordance with, the quantification of damages at common law for breach of contract,” the Court then identified, as a “problem” with AG’s methodology, that it “assumes that there was no possibility of a replacement transaction to mitigate the loss of value ….” (The Court did not discuss whether this assumption might be justified in light of the failure of the Market Quotation process). Alternatively, the Court held that, even assuming consistency with New York law, there was still a triable issue of fact as to whether the methodology was reasonable, particularly as to AG’s projections of the floating payments it would owe.

Concluding Thoughts

From a broader perspective, it is perhaps not surprising that the reasonableness of a Loss computation, based in part on the non-defaulting party’s projections of contingent future payments, could not be determined as a matter of law on summary judgment. Furthermore, AG’s asserted loss of bargain methodology did not require the Court to examine the full extent of the non-defaulting party’s discretion under Loss. Nonetheless, the decision is noteworthy for its reasoning on the role of industry norms, the cross-check principle and the status of the ISDA Master as an industry standard document. It remains to be seen whether the decision portends a further foothold for the cross-check principle under New York law and whether courts might find industry norms to be constraining in scenarios where the non-defaulting party is not similarly situated to “the market.” Parties to derivative transactions may wish to take note of these questions when structuring or terminating transactions, particularly if they intend to achieve commercial results that differ from an existing practice observed in the markets.