Energy, Trade & Commodities Alert

Energy, Trade & Commodities Alert If you have questions or would like additional information on the material covered in this Alert, please contact one of the authors: Siân C. Fellows +44 (0)20 3116 2809 sfellows@ Nicholas Horsfield Partner, Washington, D.C. +44 (0)20 3116 2989 nhorsfield@ Other contacts: Suzanne Bainbridge +44 (0)20 3116 2815 sbainbridge@ Mike Brown Partner, Chicago +1 312 207 2430 mbrown@ Andrew P. Cross Partner, Pittsburgh +1 412 288 2614 across@ Paul Dillon +44 (0)20 3116 2893 pdillon@ Kyri Evagora +44 (0)20 3116 2914 kevagora@ Diane Galloway +44 (0)20 3116 2934 dgalloway@ Amy J. Greer Partner, Philadelphia +1 215 8518211 agreer@ Robert Parson +44 (0)20 3116 3514 rparson@ Andrea J. Pincus Partner, New York +1 212 205 6075 apincus@ Wendy H. Schwartz Partner, New York +1 212 519 0272 dgalloway@ Richard Swinburn +44 (0)20 3116 3604 rswinburn@ Shai Wade +44 (0)20 3116 3620 swade@ John R. Varholy +44 (0)20 3116 2933 jvarholy@ Client Alert 10-150 June 2010 Recent ISDA Cases Overview Recent market volatility has meant that users of the 1992/2002 ISDA Master Agreements ( ISDA MA) have gone to extraordinary lengths to try and curtail their losses. In such times, market participants naturally attempt to side-step contractual obligations on increasingly technical grounds. In this context, claimants are ever more imaginative with their arguments which has in turn can led to some interesting results and legal decisions. There have been a number of cases based on the ISDA MA over the past year both in the UK and in the US. These cases have affirmed traditional ISDA MA jurisprudence but have also provided a few surprises along the way. In this Client Alert we provide an overview of the key legal principles which can be extracted from five of the recent noteworthy cases along with a tabular summary in the Appendix which outlines the facts and principles of each case for easy reference. 1. Modification of ISDA MA terms by Oral Agreement AS Klaveness Chartering v Pioneer Freight Futures Co. Ltd. [2009] EWHC 3386 Under the terms of Section 9(b) of the ISDA MA, any amendment must be in writing. However the Court in this case held that an oral agreement between the parties, constituted an oral collateral agreement the effect of which was an amendment of the ISDA MA terms. The parties were negotiating a novation agreement whereby Klaveness would take over Pioneer s position in some trades under which Pioneer was significantly in the money. The parties did this because although Klaveness owed Pioneer an amount for the December 2008 payment, from January 2009 onwards, Pioneer was significantly out of the money under various Forward Freight Agreements which incorporated the ISDA MA. During the negotiation, it was agreed that the December 2008 payment owed by Klaveness would be washed out. Even though the negotiations continued, Pioneer invoiced Klaveness for the December payment amount and issued cure notices when this was unpaid. Klaveness did not pay on the understanding that the parties had agreed the December wash out under the near finalised novation agreement. The novation agreement was still not agreed by the January 2009 payment date at which point it was Pioneer s turn to make payment, which Pioneer failed to do citing Klaveness default in December. Klaveness then issued cure notices and ultimately set an early termination date. The Court held that the oral agreement between the parties was binding even though it amended the terms of the ISDA MA (i.e. washing out the December amount). This is interesting as under the terms of the ISDA MA, any amendment must be in writing. Viewing this judgment in context, it is unlikely that any oral agreement between the parties will automatically be a valid ISDA MA amendment notwithstanding the requirement of writing. However, it seems that the Court is willing to enforce the terms of a collateral oral agreement. Furthermore the Court held that parties may agree set-off sums from different calendar months under a collateral oral agreement notwithstanding the Section 9(b) requirements. This decision seems unusual and may therefore be the product of an equitable solution to the issues of this particular case given the broader factual matrix. In any event, ISDA MA users should be careful in their oral communications with counterparties and ensure that they make it clear in any oral discussions that only a written agreement will vary the ISDA MA terms. 2. English Court Challenges Traditional View of Condition Precedent in the ISDA MA Marine Trade SA v Pioneer Freight Futures Co. Ltd. [2009] 2656 Although not a key issue in this case, the judge provided a surprising challenge to the traditional view of the operation of the condition precedent contained in Section 2(a)(iii) of the ISDA MA. The Court held that this provision does not simply suspend a party s 1

obligations whilst an event of default subsists, but goes as far as to permanently extinguish all obligations that fall due during an event of default situation. The traditional view was that the words occurred and is continuing contained in Section 2(a)(iii) meant that a party was entitled to not perform only whilst the event of default persisted. Once the event of default was cured, then the obligation would resurrect. The Court held that the ISDA MA terms did not expressly provide for such a resurrection and therefore such a presumption was unfounded. On reflection, however, it is possible that the Court was misguided as the 2002 ISDA MA does in fact provide indicative reference to the suspensive nature of Section 2(a)(iii) in the context of examining the interest accruing on deferred payments referring to interest being paid after such [withheld] amount becomes payable. Additionally the Court s new interpretation is also at odds with the early termination provisions of the ISDA MA as both versions state that amounts that were not paid by the non-defaulting party pursuant to Section 2(a)(iii) ought to be accounted for as unpaid amounts [to the defaulting party] when it comes to calculate the early termination amount. This new interpretation has some major implications: Section 2(a)(iii) mainly comes into play when an ISDA MA that is capable of being terminated early is, in fact, not terminated (as is likely when a non-defaulting party is out of the money). It is arguably less justifiable for the non-defaulting party to be rewarded by its obligations owed to the counterparty being extinguished, even if the default were eventually to be cured. This reinforces the incentive to invoke Section 2(a)(iii) even when a party knows that the other party s financial difficulties are transitory or even when a failure to pay is only due to an administrative error in the payment procedures. Another potentially harsh consequence of the Court s decision is that Section 2(a)(iii) is also triggered upon the occurrence of a Potential Event of Default. This means that the mere possibility of an event of default in respect of a party would entitle the other party to treat its obligations as extinguished. This case is now on appeal, the results of which will be very interesting to all ISDA MA users. Reed Smith published a client alert on this case available which is here. 3. ISDA Incorporated though a Confirmation Calyon v Wytwornia Sprzetu Komunikacynego PZL Swidnik SA [2009] EWHC 1914 In this case, the jurisdiction of the English Court was questioned where an unamended ISDA MA governed a number of transactions by way of reference in a long-form confirmation. This confirmation contained a deemed acceptance provision which was initiated two business days after receipt. The Court held that it had jurisdiction to hear the dispute. In reaching this conclusion the Court examined the jurisdiction requirements of Article 23(1)(b) of the Brussels Regulation (the Regulation ). Calyon satisfied the Regulation requirements because it was able to demonstrate a course of dealings with Wytwornia and Wytwornia s signature of confirmations for previous structured derivative contracts which clearly stated that the contracts were subject to English law and governed by an ISDA MA (which itself contained an English law and jurisdiction clause). Where a party is relying on the deemed execution of an ISDA MA to confer jurisdiction on English Courts, it should be clearly spelt out to the counterparty that the ISDA MA applies and that the transaction is governed by English law. The case also emphasises the importance of obtaining acknowledgment of confirmations (which proved very useful in this case), even in a case where the confirmation stipulates that if it is not acknowledged or corrected by the counterparty within a certain time frame the details of the confirmation will be considered correct. 4. ISDA MA Early Termination Provisions are not an Unenforceable Penalty BNP Parbias v Wockhardt EU Operations (Swiss) AG [2009] EWHC 3116 Client Alert 10-150 June 2010 In this case, the early termination procedures of the ISDA MA were challenged as being an unenforceable penalty because they: (1) are not true liquidated damages as the requirement to reference a market price (which will invariably fluctuate significantly) makes it impossible to accurately agree the value in advance; and (2) apply uniformly to all events of default under the ISDA MA which arguably are not all of the same gravity i.e. a technical misrepresentation vs. an insolvency event. 2

The Court robustly rebutted the first argument as the effect of the clause was such that both parties received the benefit (or indeed the burden) of the unperformed transactions crystallising at a time of the non-defaulting party s choice. Therefore under the clause, the defaulting party may be in the money and it is therefore not right that this same party can on the one hand use the clause for its own benefit, and on the other argue that it was a penalty. In addressing the second issue, the Court side-stepped a full analysis of this argument vis-à-vis all of the ISDA MA events of default and instead focused on the default in the case in hand i.e. failure to pay. In doing so, the Court determined that failing to pay was a contractual condition, a breach of which should trigger termination. This was reasonable and therefore not penal in nature. The Court has, however, left room for a future examination of the other ISDA MA events of default in this context. Had the Court held that the relevant provisions of the ISDA MA constituted a penalty, then this would have had serious implications for the entire industry given the wide use of the ISDA MA. Such a ruling would inevitably have reached the Supreme Court for final determination. 5. US Bankruptcy Court Limits ISDA Counterparty Rights Upon a Bankruptcy Event of Default In re Lehman Brothers Holdings, Inc., Case No. 08-13555 et seq. (JMP)(jointly administered) In this US decision, the Bankruptcy Court held that the safe harbour protections of the US Bankruptcy Code only protect a non-defaulting party s right to liquidate, terminate or accelerate a swap, to offset and to net termination values and payment amounts and to foreclose on collateral, but do not permit the withholding of performance under a swap if the swap is not terminated. In doing so, the Court forced the non-defaulting party, Metavante Corporation ( Metavante ) to make all past payments due under certain interest rate swaps governed by the ISDA MA, together with default interest, as well as future scheduled payments as they came due, despite Metavante s contractual right under Section 2(a)(iii) of the ISDA MA to withhold such payments based upon the ongoing bankruptcy events of default of counterparty LBSF and its credit support provider LBHI. Additionally the Court held that 11 months after the bankruptcy filing was too late for Metavante to invoke early termination and instead imposed a sunset on a non-defaulting counterparty s right to early termination upon a bankruptcy event of default despite no such sunset provision in either the derivatives contract or the US Bankruptcy Code itself. The implications of this ruling are that: (1) the US safe harbours are specific and limited in scope and relate to terminated transactions and settlement payments; (2) the rights to withhold periodic scheduled payments due to the debtors under Section 2(a)(iii) of the ISDA MA are improper under US bankruptcy law when triggered by a bankruptcy event of default; and (3) the right to terminate early must be exercised promptly or be lost. Metavante s appeal of the Court s decision is pending, but the Lehman debtors have proceeded to file numerous similar actions against other counterparties to compel withheld payments, in each case citing to the Metavante decision. Reed Smith published a client alert on this case available which is here. All of these cases all raise interesting issues, particularly those which are now on appeal. We will provide an update on the appeal cases once judgment has been passed. Client Alert 10-150 June 2010 3

About Reed Smith Reed Smith is one of the 15 largest law firms in the world, with more than 1,600 lawyers in 23 offices throughout the United States, Europe, Asia and the Middle East. Founded in 1877, the firm represents leading international businesses from Fortune 100 corporations to mid-market and emerging enterprises. Its attorneys provide litigation services in multi-jurisdictional matters and other high stake disputes, deliver regulatory counsel, and execute the full range of strategic domestic and cross-border transactions. Reed Smith is a preeminent advisor to industries including financial services, life sciences, health care, advertising and media, shipping, international trade and commodities, real estate, manufacturing, and education. For more information, visit US: New York, Chicago, Los Angeles, Washington, San Francisco, Philadelphia, Pittsburgh, Oakland, Princeton, Northern Virginia, Wilmington, Century City, Richmond Europe: London, Paris, Munich, Birmingham, Greece Middle East: Abu Dhabi, Dubai Asia: Hong Kong, Beijing The information contained in this Client Alert is intended to be a general guide only and not to be comprehensive, nor to provide legal advice. You should not rely on the information contained in this Alert as if it were legal or other professional advice. Reed Smith is a trade name of Reed Smith Richards Butler LLP. Reed Smith Richards Butler LLP is a limited liability partnership registered in England and Wales with registered number OC303620 and its registered office at Beaufort House, Tenth Floor, 15 St Botolph Street, London EC3A 7EE. Reed Smith Richards Butler LLP is regulated by the Solicitors Regulation Authority. This Client Alert was compiled up to and including June 2010. All rights reserved. Reed Smith LLP is a Limited Liability Partnership organised under the laws of Delaware, USA. The firm is comprised of German Attorneys-at-Law, UK Solicitors and U.S. Attorneys-at-Law. A list of all Partners and employed attorneys as well as their court admissions can be inspected at the website www. All rights reserved. Reed Smith Beaufort House, Tenth Floor, 15 St Botolph Street, London EC3A 7EE Tel: 0207 247 6555 Fax: 0207 247 5091 Client Alert 10-150 June 2010 4

Appendix 1: Factual Summary of the ISDA Cases Factual Summary AS Klaveness Chartering v Pioneer Freight Futures Co. Ltd. [2009] EWHC 3386 Klaveness claimed against Pioneer under a various forward freight agreements ( FFAs ) all of which where subject to the 1992 ISDA MA. The freight market deteriorated significantly in 2008, resulting in Pioneer owing Klaveness a significant sum for the January 2009 payment date. The parties then discussed novating one of Pioneer s trades with a third party to Klaveness to cover Pioneer s liabilities. During the negotiations the parties agreed that the December 2008 payment owed by Klaveness would be washed out. However, Pioneer did in fact invoice Klaveness for the December 2008 settlement sum (even though at the time of the invoice, the negotiations were continuing and Klaveness had relied on the washout aspect of the proposed deal). Klaveness did not pay and Pioneer then issued cure notices. The novation agreement was never finalised. Klaveness then invoiced Pioneer for the January 2009 settlement sum, off-setting the December 2008 amount. Pioneer then failed to pay after which Klaveness designated an early termination date and sought $30 million as an early termination amount from Pioneer. Marine Trade SA v Pioneer Freight Futures Co. Ltd. [2009] 2656 In this case the Court disagreed with traditional views on the effect of Section 2(a)(iii) of the 1992 & 2002 ISDA MA. Under this Section a party s obligation to pay or deliver 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. Marine Trade S.A. ( MT ) and Pioneer Freight Futures Co Ltd ( Pioneer ) entered into 14 forward freight agreements ( FFAs ), governed by an ISDA MA. In January 2009, the aggregate settlement sums in favour of MT and Pioneer were approximately $7 million and $12 million respectively. By the end of January 2009, MT believed that Pioneer was affected by a bankruptcy event of default under the ISDA MA. MT therefore considered that Pioneer was not entitled to set-off the $7 million it owed to MT against the $12 million owed by MT, rather that MT was able to withhold its payment altogether by virtue of Section 2(a)(iii). Accordingly MT invoiced Pioneer for the gross amount of $7 million on 30 January 2009. On 1 February 2009, Pioneer invoiced MT for the net balance of $5 million. Neither party paid and then Pioneer served a notice of failure to pay on MT. The difficulty MT faced was that if Pioneer was not, in fact, subject to an event of default, MT s failure to settle the $5 million invoice would have resulted in an event of default on MT s part resulting in global close-out of all of the trades Summary of Judgment Under the terms of Section 9(b) of the ISDA MA, any amendment must be in writing. However the Court in this case held that in the course of the negotiations the parties had reached an oral agreement whereby the December amount would be washed out, therefore Pioneer could not then rely on the non-payment of this amount by Klaveness to call an event of default and therefore validly withhold payment for the January 2009 payment amount. This oral agreement was not an amendment for the purposes of the ISDA MA which therefore bypassed the need for it to have been executed in writing. The traditional view was that the words occurred and is continuing contained in Section 2(a)(iii) meant that a party was entitled to not perform whilst the only event of default persisted. Once the event of default was cured, then the obligation would then resurrect. The Court held that the ISDA MA terms did not expressly provide for such a resurrection and therefore such a presumption was unfounded. On reflection, however, it is possible that the Court was misguided as the 2002 ISDA MA does in fact provide indicative reference to the suspensive nature of Section 2(a)(iii) in the context of examining the interest accruing on deferred payments referring to interest being paid after such [withheld] amount becomes payable. Additionally the Courts new interpretation is also at odds with the early termination provisions of the ISDA MA as both EME_ACTIVE-551890151.1-NHORSFIE 24/6/10 4:15 PM

under the ISDA MA and resulting in a significant payment liability for MT. MT then paid a net balance of $5 million under protest and then served a notice on Pioneer to pay the $7 million and then became insolvent itself. Calyon v Wytwornia Sprzetu Komunikacynego PZL Swidnik SA [2009] EWHC 1914 In this case, Wytwornia entered into a number of derivative trades with Calyon through the use of a long form confirmation. The confirmation stated that until the ISDA MA is agreed between the parties, the confirmation will be deemed to include an unamended form of the ISDA MA subject to English law. Additionally the confirmation stated that should Calyon not receive an acknowledgement or correction of the confirmation within two business days of receipt, the confirmation is deemed accepted. The transaction in dispute was orally agreed on 13 August 2008 with the standard confirmation was sent shortly thereafter. Wytwornia did not sign the confirmation but permitted a number of payments to be made to discharge payments due under the trade. Subsequently Wytwornia stopped the remaining payments stating that it had not agreed to the terms in the confirmation and that the trade was not subject to the ISDA MA terms. Litigation was then commenced at which Wytwornia challenged the jurisdiction of the English Courts to hear the dispute. BNP Parbias v Wockhardt EU Operations (Swiss) AG [2009] EWHC 3116 BNP Paribas ( BNP ) and Wockhardt EU Operations (Swiss) AG ( Wockhardt ) entered into a number of transactions under a 2002 ISDA MA. Wockhardt failed to pay BNP under the transactions on a total of three occasions, after which BNP served cure notices and subsequently designated an early termination date following the terms of the ISDA MA. BNP then applied to the Court for summary judgment against Wockhardt at which Wockhardt contended that the early termination provisions of the ISDA MA are unenforceable as they constitute a penalty. This versions state that amounts that were not paid by the non-defaulting party pursuant to Section 2(a)(iii) ought to be accounted for as unpaid amounts [to the defaulting party] when it comes to calculate the early termination amount. This case is now on appeal. The Court held that it had jurisdiction to hear the dispute. In reaching this conclusion the Court examined the jurisdiction requirements of Article 23(1)(b) of the Brussels Regulation (the Regulation ). Calyon satisfied the Regulation requirements because it was able to demonstrate a course of dealings with Wytwornia and Wytwornia s signature of confirmations for previous structured derivative contracts which clearly stated that the contracts were subject to English law and governed by an ISDA MA (which itself contained an English law and jurisdiction clause). Where a party is relying on the deemed execution of an ISDA MA to confer jurisdiction on English Courts, it should be clearly spelt out to the counterparty that the ISDA MA applies and that the transaction is governed by English law. The case also emphasises the importance of obtaining acknowledgment of confirmations (which proved very useful in this case), even in a case where the confirmation stipulates that if it is not acknowledged or corrected by the counterparty within a certain time frame the details of the confirmation will be considered correct. The Court robustly rebutted the first argument as the effect of the clause was such that both parties received the benefit (or indeed the burden) of the unperformed transactions crystallising at a time of the non-defaulting party's choice. Therefore under the clause, the defaulting party may be in the money and it is therefore not right that this same party can on the one hand use the clause 2

was based on the fact that the early termination amount is payable regardless of whether: (1) the defaulting party has one open transaction or many open transactions; (2) the default occurs early in the life of a transaction or towards the end of its life; or (3) the default is a small default on one transaction, a large default on one transaction or a large default on many or all transactions. Wockhardt argued that this amount should not be construed as liquidated damages for two reasons. The first was because such damages cannot be predicted at the time of entering into the transactions as the amount invariably depends upon market fluctuations. The second was because the defaulting party is required to pay the same amount on the occurrence of any one of a number of possible breaches which may give rise to widely different consequences. In re Lehman Brothers Holdings, Inc., Case No. 08-13555 et seq. (JMP)(jointly administered) In 2007, Metavante Corporation ( Metavante ) and Lehman Brothers Special Financing, Inc. ( LBSF ) entered into an interest rate swap transaction pursuant to a 1992 ISDA MA with LBSF. LBSF's obligations were guaranteed by Lehman Brothers Holdings Inc ( LBHI ). Pursuant to the terms of the swap, the floating and fixed payments were netted, and the party with a net payment obligation was required to pay the difference to the other party on each scheduled payment date. The ISDA MA was governed by NY law and both counterparties were US entities. LBHI & LBSF filed for bankruptcy protection under Chapter 11 of the US Bankruptcy Code within three weeks of each other. Each filing was a separate event of default under the ISDA MA giving rise to (a) Metavante's right to designate an early termination date; and (b) the trigger of the right to withhold performance under Section 2(a)(iii), as long as an event of default was continuing. Early termination by Metavante would have yielded a substantial payment in favour of LBSF and therefore Metavante did not designate an early termination date instead withheld payments that became. In May 2009, the debtors moved to compel Metavante's performance (payment of all amounts due plus default interest for past due amounts) arguing that the underlying swaps were simply executory contracts that ordinarily could not be terminated or modified under applicable law other than by the debtors. Generally, bankruptcy-based contract terminations are unenforceable; non-debtor swap counterparties, however, may enforce bankruptcy termination as a contractual right pursuant to the specific "safe harbour" provisions of the US Bankruptcy Code. While conceding that these special provisions of the US Bankruptcy Code expressly allow the non-defaulting swap counterparties their contractual rights upon a bankruptcy filing to terminate, accelerate or liquidate their positions in such executory contracts and to net payments, Lehman argued that such rights only adhere upon termination. for its own benefit, and on the other argue that it was a penalty. In addressing the second issue the Court side-stepped a full analysis of this argument vis-à-vis all of the ISDA MA events of default and rather focused on the default in the case in hand i.e. failure to pay. In doing so, the Court determined that failing to pay was a contractual condition a breach of which should trigger termination. This was reasonable and therefore not penal. The Court has, however, left room for a future examination of the other ISDA MA events of default in this context. In this US decision, the Bankruptcy Court held that the "safe harbour" protections of the US Bankruptcy Code only protect a non-defaulting party's right to liquidate, terminate or accelerate a swap, to offset and to net termination values and payment amounts and to foreclose on collateral, but do not permit the withholding of performance under a swap if the swap is not terminated. This case is now on appeal. 3

Lehman further argued Metavante's reliance on ISDA MA Section 2(a)(iii) as an alternative to prompt termination of the contract was contrary to legislative intent to permit markets to continue functioning in the direct aftermath of a major player's collapse. Finally, Lehman challenged Metavante's reliance upon Section 2(a)(iii), decrying it an unenforceable ipso facto clause in violation of US Bankruptcy Code Section 365(e) (in essence an impermissible bankruptcy penalty). Lehman essentially argued that by invoking Section 2(a)(iii), Metavante effectively modified the parties' contract rights by permitting indefinite suspension of performance obligations only because of the financial conditions of the debtors and commencement of the bankruptcy cases. Metavante countered by citing that (1) the ISDA MA which clearly provided that the non-defaulting party had the right, but not the obligation, to terminate all outstanding transactions, and that such right had no time limit or market-related conditions; (2) Section 2(a)(iii) which expressly permitted the non-defaulting party to suspend its performance while an event of default was continuing, again with no contractual time limit and no exception for a bankruptcy event of default; and (3) the US Bankruptcy Code itself which expressly excepts from the ipso facto clause prohibition a derivative counterparty's broad exercise of its contractual right to terminate, set-off and net its positions under a swap or master netting agreement, and does so without imposing any statutory time limit. 4