Replies to post #115786 on Lehman Brothers Financial SA (LEHNQ)

[cottonisking]

The "Loss" ISDA calculation method is a flexible approach used when a derivatives contract terminates early (due to a default, for example) that allows the non-defaulting party to determine its actual losses and costs in a reasonable and good faith manner. The English High Court validated Enasarco's use of this method to calculate the amount owed by Lehman Brothers Finance S.A. (LBF) after LBF's collapse.
Explanation of the "Loss" Method
Under the 1992 ISDA Master Agreement (the standard contract used at the time), parties could choose between two main calculation methods for early termination: "Market Quotation" or "Loss".
Market Quotation involved seeking firm bids from several leading dealers in the market to determine the cost of replacing the terminated transaction. This was the preferred method in normal market conditions.
"Loss" Method is a more flexible, subjective approach that becomes particularly important during times of market stress or illiquidity (like the 2008 financial crisis) when reliable market quotations are unavailable or commercially unreasonable.
The "Loss" method allows the non-defaulting party (Enasarco in this case) to:
Calculate actual damages: Determine its total losses and costs, including the loss of the original bargain and any costs incurred in trying to re-establish a replacement position (e.g., buying a similar option elsewhere).
Use internal data: Rely on internal models or data, not just external market quotes, to value the terminated transactions, as long as the calculation is done "reasonably" and "in good faith".
Include related costs: Potentially include related costs like funding expenses or losses on hedges linked to the terminated trade.
The Enasarco Case
In the dispute, Enasarco used the "Loss" method to claim approximately $61.5 million from LBF, based on the price it paid to purchase a replacement put option after Lehman's default. LBF disputed this amount, arguing for a lower figure.
The English High Court's decision essentially:
Upheld the use of the "Loss" method: Confirmed that the parties had specified "Loss" as the applicable method in their contract's schedule.
Validated Enasarco's calculation: Ruled that Enasarco's determination of its loss was reasonable and in good faith, even without relying solely on a formal market-quotation process, given the market conditions at the time of the Lehman collapse.
Provided legal clarity: The ruling confirmed that under the "Loss" method, the non-defaulting party has broad discretion in calculating its damages, a calculation that can only be challenged if proven to be irrational.