In Lomas and Others v JFB Firth Rixson, Inc and Others [2010] EWHC 3372 (Ch), the High Court considered the meaning and effect of Section 2(a)(iii) of the ISDA Master Agreement (1992 and 2002 versions), which provides that the payment obligations of the parties are subject to the condition precedent that no event of default is continuing with respect to the other party.
The joint administrators ("the Administrators") of Lehman Brothers International Europe ("LBIE") applied for directions as to the true construction and effect of five interest rate swap agreements pursuant to which LBIE was the floating rate payer. Each swap incorporated the terms of either the 1992 or the 2002 version of the ISDA Master Agreement.
Background
The Respondents, LBIE's fixed rate paying counterparties, relied on Section 2(a)(iii) of the Master Agreement as the basis for a refusal to make payments which would otherwise have fallen due to LBIE. Section 2(a)(iii) provides that a party's payment obligations are subject (amongst other things) to the condition precedent that there is no continuing Event of Default with respect to the other party. One such Event of Default is the "Bankruptcy" of the counterparty, which includes the appointment of an administrator. Accordingly, as at 15 September 2008, there was an Event of Default in respect of LBIE. The Respondents argued that because of this Event of Default they did not have any obligation to make any further fixed rate payments to LBIE (LBIE would otherwise have been very substantially in the money under all five swaps).
The Administrators challenged the counterparties' interpretation of the Master Agreement under four headings:
1 The Respondents' interpretation was, they said, commercially absurd and/or unreasonable and must therefore yield to implied terms to the contrary. They advanced three alternatives:
- that the non-defaulting party's payment obligation was only suspended for a "reasonable period", to allow it to decide whether to designate an Early Termination Date ("ETD");
- that Section 2(a)(iii) suspended the non-defaulting party's payment obligations until the end of the term of the transaction, at which point it was obliged to designate an ETD; and/or
- the non-defaulting party had a discretion whether or not to designate an ETD and had to do so in a manner which was not arbitrary, capricious or unreasonable.
2 The Master Agreement offended the "anti-deprivation principle", because the adverse effects on LBIE and its creditors were triggered by the onset of LBIE's administration.
3 The counterparties' interpretation gave rise to a penalty.
4 Their interpretation constituted a forfeiture, against which the Court should grant relief.
The Court rejected the arguments on penalty and forfeiture very swiftly, and so most of the judgment, and hence this article, focuses on the Administrators' arguments as to implied terms and the anti-deprivation principle.
Once and for all or suspension?
The Judge dealt first with an issue about whether or not Section 2(a)(iii) had a "once and for all" effect (i.e. that if an Event of Default was continuing on a particular date for payment by the non-defaulting party, then that payment obligation never arose); or whether the effect of Section 2(a)(iii) was only to suspend the coming into effect of the payment obligation until the default was cured. It was accepted that in relation to the 2002 Master Agreement the "once and for all" submission could not be maintained because Section 9(h)(i)(3)(A) of that agreement expressly contemplated that an amount might become payable to the satisfaction of the Section 2(a)(iii) condition precedent after a payment date. Nonetheless, some of the Respondents submitted that, under both the 1992 and 2002 versions, an amount could not become payable by reason of the satisfaction of a condition precedent after the swap had run its term. The Judge found that although the once and for all approach had the undoubted merit of simplicity and certainty because the payer did not need to make a provision against the risk of the obligation falling due in the future, he came to the conclusion on balance that the suspensory construction was to be preferred. The main reason for this was that the "once and for all" construction would produce a pointlessly draconian outcome (the permanent extinction of a right to a payment), in the event of a minor and momentary default, or even a Potential Event of Default.
The question then arose of how long a suspended payment obligation remains in suspense (i.e. until the expiry of the term of the transaction, or indefinitely?). The Court concluded that the payment obligation remained in suspense only until the expiry of the term of the transaction, essentially because it was wholly inconsistent with any reasonable understanding of the Master Agreement to argue that payment obligations arising under a transaction could give rise to indefinite contingent liabilities, in the event that an Event of Default may be cured long after the expiry of the transaction.
Implied terms
The Court then considered the three alternative constructions advanced by the Administrators, as outlined above. The essence of the Administrators' complaint was that, in the events that had happened, the construction proposed by the Respondents gave them a windfall rather than protection from, or compensation for, the consequences of LBIE's default. The Court was not persuaded by any of the Administrators' submissions on construction:
- The argument that the suspension of the non-defaulting parties' payment obligation was only for a reasonable time could not be implied into the terms of the Master Agreement. In the event of a Bankruptcy Event of Default the non-defaulting party would have to buy a replacement hedge in the market and then prove for the Settlement Amount against the defaulting party in its liquidation or administration, from which it may receive a modest, or no, dividend. Accordingly, it was not possible to treat the early termination election as always being a sufficient remedy for the non-defaulting party. It was not therefore surprising to find that the Master Agreement contains provision whereby the non-defaulting party may say that, for as long as the default means that the secure hedge for which it had contracted is absent, no further payment will be made under the swap.
- The alleged implied term that the condition precedent in Section 2(a)(iii) falls away at the end of the term of the transaction, at which point the non-defaulting party had to designate an ETD, was also found to be at variance with the plain language with the Master Agreement.
- Finally, in relation to the Administrators' arguments about the unreasonable exercise of a discretion, the Court said that it did "not begin to understand how the Respondents' choice not to elect for Early Termination in relation to the swaps . . . can possibly be categorised as dishonest, in bad faith or exercised otherwise than for the purpose for which it was conferred".
Anti-deprivation
The Court found that Section 2(a)(iii) did not contravene the anti-deprivation rule because the nature of LBIE's rights did not change on 15 September 2008 when it went into administration. Where the asset of an insolvent company is a chose in action representing the quid pro quo for something already done, sold or delivered before insolvency, then the Court will be slow to permit the insertion of a flaw in that asset triggered by the insolvency process. On the other hand, where the right in question consists of the quid pro quo for services yet to be rendered, or something still to be supplied by the insolvent company in an ongoing contract, then the Court will readily permit the insertion of such a flaw. The contingent rights to future net payments, as at 15 September 2008, enjoyed by LBIE were the quid pro quo not merely for services previously rendered to the swap counterparties, but also for the ongoing provision of an interest rate hedge. LBIE's insolvency was sufficient to undermine the basis of that ongoing relationship with its counterparties.
Practical implications
ISDA has stated that it is in the process of preparing a form of amendment to Section 2(a)(iii) in response to some of the issues raised by this case. In particular, ISDA has said that the finding by the Court that payments that had been suspended under Section 2(a)(iii) may be extinguished after the last day for payment under the transaction is surprising and at odds with the market's expectations. The decision may well be subject to appeal.
Although the Court found that Section 2(a)(iii) did not contravene the anti-deprivation principle, it made it clear that this decision was based on the fact that the swaps in question were interest rate swaps which constituted an ongoing relationship between the parties in which their rights to receive contingent net payments accrued from time to time as the quid pro quo for the provision of a continuing service. It is perfectly possible that a different analysis might be appropriate for other transactions under an ISDA Master Agreement. Moreover, it was conceded in this case that Section 2(a)(iii) operated on a net rather than a gross basis (i.e. the non-defaulting party must take into account its own payments when enforcing the defaulting party's payment obligation). If it had been concluded that Section 2(a)(iii) operated so as to increase LBIE's obligation on any future payment date from a net amount to a gross amount, that might well have offended the anti-deprivation principle because it would have imposed a greater financial obligation on LBIE by reason of its insolvency than would otherwise have been imposed.
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