22 December 2010 Section 2(a)(iii) of the ISDA Master Agreement: its enforceability and effect Lomas v JFB Firth Rixon, Inc [2010] EWHC 3372 (Ch) In a judgment handed down on 21 December 2010, the High Court has considered the extent to which a party can rely on Section 2(a)(iii) of the ISDA Master Agreement where the other party is subject to an Event of Default. While generally upholding the enforceability of the provision, the court has reached certain conclusions that have implications for the market generally. Background Contents Background... 1 Reliance on Section 2(a)(iii)... 2 The suspensory effect of Section 2(a)(iii)... 3 Anti-deprivation... 4 Conclusions... 7 The case arose out of the administration of Lehman Brothers International (Europe) ( LBIE ), which was a party to about 2000 ISDA Master Agreements. The administration was an Event of Default under these Agreements, entitling each counterparty to close out its outstanding transactions by designating an Early Termination Date. Almost all counterparties did so. However, four counterparties (the Respondents ), which had entered into certain interest rate swaps with LBIE for hedging purposes, refused to close out and declined to make any further payments to LBIE, in reliance on Section 2(a)(iii) of the ISDA Master Agreement. This provision states that each obligation of each party to make the payments and deliveries specified in any Confirmation is: subject to the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing. The Respondents argued that, since the condition precedent had not been satisfied, no further payments would be due to LBIE unless it ceased to be subject to an Event of Default (of which there is little prospect). The Respondents also argued that they were free to decide whether or not to close out the swaps. Due to the collapse in interest rates that occurred towards the end of 2008, these were heavily out of the money from the Respondents perspective. It was therefore of great benefit to them to be released from their obligations. Under the ISDA Master Agreement, the Respondents would have been required to account for this gain if they had closed out and, to avoid incurring this liability, they had decided not to do so. Section 2(a)(iii) of the ISDA Master Agreement: its enforceability and effect 1
Reliance on Section 2(a)(iii) The initial question that arose was whether, as matter of construction, the ISDA Master Agreement entitled the Respondents to choose not to close out the transactions and rely on Section 2(a)(iii) indefinitely. The administrators argued that the purpose of Section 2(a)(iii) is to enable a Non-defaulting Party to avoid having to increase its exposure to a defaulting counterparty while it is deciding what action to take. However, it is not intended to enable the Nondefaulting Party to walk away from the Agreement completely. Such a construction would be at odds with the provisions of the ISDA Master Agreement that require a Non-defaulting Party to account for any gain it makes as a result of a close-out. Section 2(a)(iii) should therefore be construed so that it lasts only for as long as is reasonably necessary to make this assessment, or only until the transactions have matured. Alternatively, they argued that a Non-defaulting Party has an implied obligation to designate an Early Termination Date within a reasonable period after the occurrence of an Event of Default, unless it is prepared to waive reliance on Section 2(a)(iii) and resume the performance of its obligations. On the first of these points, it was held that the purpose of Section 2(a)(iii) is not as restrictive as the administrators claimed. The disadvantage of a closeout is that, where transactions are in-the-money from the Non-defaulting Party s perspective, so that it would have to pay a premium to enter into a replacement transaction (the opposite of the situation under consideration), the fact that the Non-defaulting Party is entitled to be reimbursed by the Defaulting Party would be of little comfort if the Defaulting Party is insolvent. Briggs J therefore considered that one of the purposes of Section 2(a)(iii) is to enable the Non-defaulting Party to suspend making further payments to the Defaulting Party without having to close out the transactions. This reasoning is rather hard to follow. A decision to close out does not oblige the Non-defaulting Party to enter into a replacement transaction. Nor does its decision make any difference to the amount the Defaulting Party is required to pay. If the Non-defaulting Party does decide to replace, it is true that this may require it to make a payment that it is unable to recover but, if the Defaulting Party is insolvent, maintaining the existing transaction can hardly be said to represent a viable alternative to entering into a replacement. If the Defaulting Party is unable to perform, the Non-defaulting Party will obtain little or no benefit from the transaction and so this is tantamount to deciding to stay out of the market. If it is unclear whether the Event of Default or Potential Event of Default will be cured, the Non-defaulting Party may prefer to keep the transaction alive rather than replacing immediately. However, in that case, it would presumably be reasonable not to close out, so that Section 2(a)(iii) would continue to operate. That said, the actual decision reached on this point is understandable. There is nothing in Section 2(a)(iii) to suggest that it is subject to any temporal limitation and (as the judge observed) the fact that the condition precedent applies if an Event of Default or Potential Event of Default has occurred and is continuing strongly suggests that it continues to operate until the Event of Section 2(a)(iii) of the ISDA Master Agreement: its enforceability and effect 2
Default or Potential Event of Default is no longer continuing. It therefore comes as no surprise to learn that there is no implied limitation on the operation of this provision. The argument that the Non-defaulting Party has an implied obligation to close out any outstanding transactions within a reasonable period after the occurrence of an Event of Default was similarly rejected. The ISDA Master Agreement states that the Non-defaulting Party may close out the outstanding transactions following an Event of Default, which means that it has a right to decide whether to do so. The discretion is given to enable the Non-defaulting Party to protect its own interests and so there is no basis for implying a term that it may not be exercised in such a way as to deprive the Defaulting Party of the payment that would otherwise be due to it if a closeout took place. The suspensory effect of Section 2(a)(iii) The judge went on to consider what the position would be if, contrary to expectations, the Event of Default were subsequently cured. This is a topical issue because, a year earlier, Flaux J had concluded, in Marine Trade SA v Pioneer Freight Futures Ltd BVI [2009] 2 CLC 657, that, where the condition precedent is not satisfied on the date on which an obligation would otherwise fall due, performance cannot be required later if an Event of Default or Potential Event of Default subsequently ceases to exist. Although this observation was obiter, and restricted to the 1992 ISDA Master Agreement, it raised the spectre of a relatively insignificant event causing a party to lose the benefit of an expected payment or delivery permanently. In Lomas v JFB Firth Rixon Inc, Briggs J was persuaded that such a conclusion would produce an extremely uncommercial result. He therefore decided that, under both the 1992 and the 2002 ISDA Master Agreement, the effect of Section 2(a)(iii) is not to prevent an obligation from ever accruing but simply to suspend its performance until the Event of Default or Potential Event of Default ceases to exist. This conclusion is to be welcomed and, being part of the ratio, now prevails over the contrary view expressed in the Marine Trade case. Less welcome, however, is the fact that Briggs J went on to conclude that, under both versions of the Master Agreement, the suspension continues only until the expiry of the term of the relevant transaction. If, by that time, the Event of Default or Potential Event of Default has not been cured, performance of the obligation cannot subsequently be required. Such a conclusion is justified, he reasoned, because it is: wholly inconsistent with any reasonable understanding of the Master Agreement that payment obligations arising under a Transaction could give rise to indefinite contingent liabilities, because of the possibility that an Event of Default may be cured long after the expiry of a Transaction by effluxion of time. Section 2(a)(iii) of the ISDA Master Agreement: its enforceability and effect 3
The problem with this, however, is that it gives rise to precisely the same issues that caused the judge to reject the Marine Trade interpretation, albeit that the concern arises only where the Event of Default or Potential Event of Default exists on the maturity date of a transaction. For example, where a party fails to make a payment under one transaction on, or shortly before, the maturity date of another transaction with the counterparty because of a bona fide dispute, it now runs the risk that, if it is proved wrong, it could lose the benefit of any payments or deliveries that were due to it under the second transaction on that date. Indeed, the same risk arises where the non-payment occurs under a transaction between different parties, given that the Default Under Specified Transaction Event of Default covers transactions between the parties Credit Support Providers or Specified Entities. The judge s concern about a party being subject to indefinite contingent liabilities is not particularly persuasive, as it will normally be clear whether there is a realistic possibility of an Event of Default being cured fairly soon after insolvency proceedings have commenced. In any event, the Nondefaulting Party would appear to have an indefinite contingent liability anyway because, if an Event of Default or Potential Event of Default subsequently occurs with respect to that party, the other party will be able to close out the unsettled transactions, despite being subject to an earlier Event of Default. On such a close-out the obligations affected by Section 2(a)(iii) ought to be taken into account in the close-out calculation as Unpaid Amounts, although this does depend on them arising under a transaction in effect at the time of the close-out. If the condition in Section 2(a)(iii) can no longer be satisfied in relation to a transaction, the transaction might be held to have ceased to be in effect. The judge was also troubled by the concept of an Early Termination Date being designated after the maturity of a transaction, observing that it would not be early in any conceivable sense and that there would be no continuing period in relation to which to obtain a Market Quotation for a replacement swap. However, these concerns are unfounded. Although the terminology used can be criticised, there is no doubt that the methodology for calculating the close-out amount works perfectly well following the maturity of a transaction. The judge incorrectly assumed that quotations would have to be obtained for a replacement transaction in these circumstances, whereas in fact the only components of the close-out amount would be the obligations that would have accrued but for Section 2(a)(iii) (which would be treated as Unpaid Amounts ). Anti-deprivation It is a key principle of insolvency law that the assets of an insolvent company are to be distributed to its creditors on a pari passu basis. A company therefore cannot agree that, in the event of its winding up, an asset that it owns will be forfeited or transferred to a particular creditor. Nor can a company agree that a creditor s claims will be artificially inflated in the event of the company s winding up, so as to give the creditor a greater share of the available assets than is enjoyed by the company s other creditors. A similar Section 2(a)(iii) of the ISDA Master Agreement: its enforceability and effect 4
principle probably applies in an administration, at least in certain circumstances (Perpetual Trustee Co Ltd v BNY Corporate Services Ltd [2010] Ch 347). The administrators argued that Section 2(a)(iii) contravened the antideprivation principle by removing from LBIE s estate an asset that would have been available for it but for its insolvency. They were also concerned that, since the condition precedent has no impact on the Defaulting Party s obligations, any payments that were due from LBIE would continue to accrue. There was therefore a risk of the Respondents attempting to submit a proof for the floating rate payments that were due from LBIE while declining to make any fixed rate payments themselves. In the event, each of the Respondents conceded that, as a matter of the construction of the Confirmations, it could not claim any floating rate payment due from LBIE under a transaction without giving credit for the fixed rate payment that would normally have been due under the transaction on the same date. Each Respondent also conceded that, where, but for the operation of Section 2(a)(iii), net payments would have been due to and from LBIE under a transaction on different dates, the Respondent could not claim payment from LBIE without giving credit for any payment that would otherwise have been due to LBIE on another date. It is questionable whether this construction was correct. However, as it was a valuable concession, the administrators were content to accept it. The point therefore did not have to be decided by the court. Significantly, Briggs J observed that, but for the concession: I might have concluded that if Section 2(a)(iii) operated so as to increase LBIE s obligation on any future payment date from a net amount (after giving credit for the fixed rate payment due from the counterparty) to a gross amount, namely the whole of the floating rate amount, that might well have offended the anti-deprivation principle, for the simple reason that it imposed a greater financial obligation on LBIE in favour of a particular creditor by reason of LBIE s insolvency, than would otherwise have been imposed. As this line of argument was no longer available, the application of the antideprivation rule turned on whether the operation of Section 2(a)(iii) meant that LBIE s estate was being deprived of an asset that should be distributed to creditors on a pari passu basis. The traditional view has been that, where a company s claim has, from the outset, been conditional on its remaining solvent, i.e. it is a type of flawed asset, the rule does not apply because an insolvency official must take the company s assets as he finds them. The judge noted, however, that, in Perpetual Trustee Co Ltd v BNY Corporate Services Ltd (in which the ranking of a company s interest in trust assets altered to its detriment in the event of its insolvency, pursuant to the original terms of the trust), the majority of the Court of Appeal rejected such an analysis, resting their decision on a narrower ground. Section 2(a)(iii) of the ISDA Master Agreement: its enforceability and effect 5
Briggs J concluded that a distinction must be drawn between an arrangement in which the asset of the insolvent company is the quid pro quo for something already done before the onset of insolvency and one in which the asset is the quid pro quo for something still to be supplied to the company. In the former case (where the company has already earned its claim), the court will be slow to permit the anti-deprivation rule to be circumvented by the insertion of a flaw in the asset that is triggered by the insolvency process, even if the flaw is present from the outset. On the other hand, where the company has not yet earned the claim, the insertion of a flaw into the asset is unobjectionable, as contracting parties are free to agree that what would otherwise be an ongoing relationship will be brought to an end, or otherwise adjusted, if one of them becomes subject to insolvency proceedings. In the case in hand, the judge concluded that LBIE s contingent right to payment under the swaps was the quid pro quo not for something done by it prior to insolvency but for the ongoing provision of an interest rate hedge. There was therefore no objection to the parties agreeing that the absence of an Event of Default was fundamental to their continuing relationship, so that, when such an event occurred, the Respondents were free to suspend their payments. This is an interesting rationalisation of the case law, which will have implications extending beyond the derivatives market. For example, it is well established that a lease or a licence may be forfeited on the insolvency of the lessee, subject to the court s discretion to allow relief from forfeiture (Roe v Galliers (1787) 2 Term Rep 133). On the judge s analysis, where a lessee or licensee has already earned its rights by paying an upfront premium, forfeiture would contravene the anti-deprivation rule. However, as the judge acknowledged, the location of the dividing line is far from clear. The existence of a peppercorn rent would presumably not prevent a lessee from having earned its rights by paying the premium but what if a small ground rent is payable or the rent is more substantial but still much less than a full market rent? Identifying the dividing line in the context of derivatives will be equally difficult. The judge emphasised that his conclusion was restricted to the swaps in question and that a different conclusion might be justified for other transactions. An option purchased, and paid for, by a company prior to commencing insolvency proceedings, for example, is likely to be subject to a different analysis. The judgment also raises doubts about the treatment of self-referenced credit derivatives, under which a company s right to the full repayment of a sum paid prior to its insolvency is conditional on it remaining solvent. It is doubtful whether the initial payment can be said to be the quid pro quo for something still to be supplied by the counterparty under an ongoing contract, suggesting that such a transaction would be open to attack. Where an arrangement falls within the scope of the anti-deprivation rule, however, the rule will apply only if the event affecting the company s rights is the occurrence of insolvency proceedings in relation to it. It had already been established that the rule is not infringed where the trigger is the Section 2(a)(iii) of the ISDA Master Agreement: its enforceability and effect 6
commencement of insolvency proceedings with respect to an affiliate (Perpetual Trustee Co Ltd v BNY Corporate Services Ltd). Briggs J held that this remains the case even if such proceedings are accompanied by contemporaneous insolvency proceedings with respect to the company itself and are the result of a common financial problem. Indeed, even if the trigger is the occurrence of insolvency proceedings with respect to the company, where its rights would have been affected in the same way anyway, as a result of some later proceedings affecting an affiliate, this would still provide a defence. In such a scenario, the only asset of which the company would be deprived is a right that was always contingent on the non-occurrence of those other proceedings. Since such a contingency would not be open to attack on anti-deprivation grounds, the asset would have proved valueless anyway and so there would be no conflict with the anti-deprivation rule. Where one company in a group becomes insolvent, this tends to be accompanied by the insolvency of other members of the group. By including the commencement of insolvency proceedings with respect to an affiliate in the list of Events of Default, therefore, it seems that it will often be possible to avoid the application of the anti-deprivation rule in practice. Indeed, it may not even be necessary to take this step. In common with many other financing agreements, the ISDA Master Agreement includes an extensive list of Events of Default, many of which have nothing to do with insolvency. Where a party goes into winding up or administration, it is very likely that one of these other Events of Default will occur sooner or later. Briggs J s approach means that, at least where the insolvency official is unable to cure the Event of Default, arguing that the party was deprived of an asset when it commenced winding up or administration is likely to be futile, as the asset will be one that would have been of little benefit to the estate anyway. Conclusions Although the decision that a Non-defaulting Party may rely on Section 2(a)(iii) for as long as an Event of Default or Potential Event of Default continues is unsurprising, and consistent with the expectations of most practitioners, it underlines the fact that the ISDA Master Agreement can operate in a very one-sided way. The same is true of many agreements. Indeed, the common law starting point is that a party to an unprofitable contract faced with a repudiatory breach by the other party may terminate the contract with impunity, regardless of the impact this has on that other party. Contractual termination provisions are equally enforceable, at least in the circumstances discussed above. One of the unusual features of the ISDA Master Agreement, however, is that it recognises that these rules can operate somewhat harshly and so allows the parties to agree that the Non-defaulting Party must account for any gain it makes as a result of a termination. Such a result is also attractive to the regulators of banks and investment firms, who do not want the assets of a regulated entity to be depleted if it becomes insolvent. Briggs J s judgment confirms that this objective is capable of being undermined by the operation Section 2(a)(iii) of the ISDA Master Agreement: its enforceability and effect 7
Contacts of Section 2(a)(iii) and that, in contrast to the position in many other jurisdictions, there is little in English insolvency law to prevent it It has been clear for some time that this issue will have to be addressed and, indeed, ISDA has already recognised the need to amend Section 2(a)(iii) to prevent it being used in the manner considered in the judgment. The form of the amendment remains under discussion. However, in addition to addressing this point, it will need to reverse the judge s decision that obligations suspended by Section 2(a)(iii) are extinguished if an Event of Default or Potential Event of Default exists on the maturity date of a transaction. On previous occasions, ISDA has drawn up the form of a multilateral protocol to which parties can adhere to amend any Agreements they have entered into with other adhering parties and it is likely that a similar approach will be adopted in the present case. For further information please contact: Simon Firth Partner (+44) 207 456 3764 simon.firth@linklaters.com The administrators have been given leave to appeal, although whether they will do so is not yet known. Whatever their decision, the case underlines the fact that the law in this area is far from settled. It is to be expected that the antideprivation rule will come under further scrutiny in future cases. Simon Firth This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters LLP. All Rights reserved 2010 Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC326345. The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP together with a list of those non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ or on www.linklaters.com and such persons are either solicitors, registered foreign lawyers or European lawyers. Please refer to www.linklaters.com/regulation for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by emailing us at marketing.database@linklaters.com. One Silk Street London EC2Y 8HQ Telephone (+44) 20 7456 2000 Facsimile (+44) 20 7456 2222 Linklaters.com Contacts For further information Section 2(a)(iii) of the ISDA Master Agreement: its enforceability and effect 8