Summary
· Section 2(a)(iii) of the ISDA Master Agreement suspends indefinitely the non-defaulting party’s payment obligation but does not extinguish the debt.
· There is no requirement to interpret section 2(a)(iii) as being subject to a limitation that it may only be relied upon for a “reasonable time”.
· The maturity of a swap does not trigger an obligation to pay if an Event of Default is still continuing.
· Section 2(a)(iii) of the Master Agreement does not offend the anti-deprivation principle.
Introduction
The English Court of Appeal ruled this week on a joint appeal relating to the application of the ISDA Master Agreement in insolvency situations. The decision provides much needed clarity on the rights and obligations of “out of the money” parties whose counterparty is subject to an Event of Default. The Court ruled such parties remain potentially liable, such that they would have to pay if the Event of Default is cured, even after the transaction comes to an end.
Background
Prior to its insolvency, Lehman Brothers International (Europe) (LBIE) had entered into a number of interest rate swaps incorporating the ISDA Master Agreement.
Section 6 of the Master Agreement provides that if an event of default has occurred and is continuing, the non-defaulting party is entitled to designate an early terminate date and close out its position. Normally, the net amount of liabilities is then paid to whichever party is in the money.
LBIE’s insolvency constituted an event of default under the Master Agreement, based on which most of its swaps were closed out. Certain out of the money counterparties, however, declined to terminate their transactions with LBIE, relying instead on section 2(a)(iii) of the Master Agreement to not make payments that they would have otherwise been required to make.
Section 2(a)(iii) provides that it is a condition precedent to a counterparty's payment obligations that no Event of Default or Potential Event of Default has occurred and is continuing in respect of the other party. The provision effectively gives the non-defaulting counterparty that is out of the money the option to sit tight until it is in the money before exercising its right to termination the transaction.
Termination of these outstanding swaps would have yielded millions for the LBIE estate in favour of its general body of creditors. As a result, the administrators of LBIE sought to challenge the enforceability of section 2(a)(iii) in order to compel their counterparties to pay the out of the money amounts to the LBIE estate.
The administrators argued that the counterparties should not be able to rely on section 2(a)(iii) to withhold payments to LBIE as to do so otherwise would be a commercially absurd or unreasonable interpretation of the Master Agreement and would offend against the anti-deprivation principle of English insolvency law.
The English High Court rejected both arguments and held that the counterparties could not be forced to settle the outstanding payments under the swaps. The administrators appealed the decision.
Decision of the Court of Appeal
The following is a summary of the Court of Appeal’s conclusions.
Extinction or suspension?
The Court held that section 2(a)(iii) does not extinguish the obligation of the non-defaulting party to make payment or delivery under section 2(a)(iii), but merely suspends the obligation from coming into existence until the Event of Default is cured (if ever). In the Court’s view, to treat the payment obligation as extinguished would produce a draconian outcome in the event of a minor or momentary default, such as the presentation of a winding-up petition by a vexatious litigant.
Length of suspension
The Court had to consider whether non-defaulting parties had an implied obligation to designate an early termination date within a reasonable period of time after the occurrence of an event of default after which the right to withhold payment would be extinguished. The Court held that such an implied term would be contrary to the express terms of section 2(a)(iii), which unambiguously provides that the condition precedent is to last for as long as an Event of Default has occurred and is continuing.
The Court also rejected the argument that suspension of payment under section 2(a)(iii) should only be in place until all relations governed by the Master Agreement had run their course. The Court held that the obligation to pay is indefinite and remains in force until the Event of Default is cured. If it is not cured, there is no obligation on the non-defaulting party to make payment. In the Court’s view, the inconvenience to the non-defaulting party of an indefinite contingent liability did not justify the extinction of the suspended obligations.
Anti-Deprivation Principle
Applying Belmont Park Investments Pty Ltd v BNY Corporate Trustee Securities Ltd [2009] EWCA Civ 1160, the Court held that section 2(a)(iii) was genuine and justifiable and was not formed in order to avoid the effects of insolvency law principles and thus did not offend the anti-deprivation principle, which provides that parties cannot contract out of insolvency legislation governing the way in which assets are distributed in insolvency.
Since section 2(a)(iii) prevented a debt ever becoming payable to the defaulting party in insolvency, any such sums under the Master Agreement would never became an asset of the insolvent estate. Therefore, debts owed but for section 2(a)(iii) are not assets that must be distributed pari passu.
Netting
Following the decision in Pioneer Freight Futures v TNT Asia [2011] EWHC 1888 Com, the Court concluded that it was the net payment due to the party in default that was the sum suspended by section 2(a)(iii). The Court took into account the fact that one of the primary aims of the Master Agreement is to facilitate the netting of payments between parties conducting a series of transactions.
Decision of the US Bankruptcy Court in Metavante
The decision of the Court of Appeal is in stark contrast to the decision of the US Bankruptcy Court in case of In re Lehman Brothers Holdings, Inc at al Case No. 08-13555 (JMP) (Bankr. SDNY 15 Sept 2009), more commonly known as the Metavante case.
On virtually identical facts, the US Bankruptcy Court held that Metavante Corporation (the out of the money, non-defaulting party) could not rely on section 2(a)(iii) of the Master Agreement to suspend payments to Lehman Brothers Special Financing, Inc (LBHI). Specifically, the Court held that the safe harbour provisions in ss.560 and 561 the US Bankruptcy Code protected a non-defaulting party’s contractual rights to liquidate, terminate or accelerate swaps and to net termination values but did not provide a basis to withhold performance under a swap if it did not terminate. Accordingly, the Court ordered Metavante to perform its payment obligations under the Master Agreement and enforced the automatic stay in s.365(e)(1) of the Bankruptcy Code against Metavante to prevent it from terminating the Master Agreement.
Going beyond the issue of whether Metavante could withhold performance under s2(a)(iii), the Court found that Metavante's window to act promptly under the safe harbour provisions had passed, and although it may not have had the obligation to terminate immediately upon the filing of LBHI, its failure to do so in a timely manner constituted a waiver of that right.
Policy reasons based on the ethos of the Bankruptcy Code also factored into the decision. According to the Court, the legislative history of the safe harbours evince Congress' intention to enable the prompt closing out or liquidation of open accounts upon the commencement of a bankruptcy case for the protection of all parties in light of the potential for rapid changes in the financial markets. By riding the market for a year without taking any action whatsoever, Metavante was deemed to have acted contrary to the spirit of the Code.
It is of note that the Court of Appeal decision was consistent with the submissions of ISDA and indeed the market's view of the meaning of the Master Agreement. The decision of the US Bankruptcy Court, however, is not, and has been criticised as being an overly stringent interpretation of the bankruptcy safe harbours.
Conclusion
The Court of Appeal’s judgment is of huge significance for out of the money parties whose counterparty is subject to an Event of Default. It confirms that section 2(a)(iii) of the ISDA Master Agreement suspends the non-defaulting party’s payment obligation indefinitely until the Event of Default has been cured. Furthermore, the suspension continues even after the maturity of the transaction.
The decision also highlights the desire of the English courts to maintain the sanctity of the Master Agreement by upholding its express terms to provide clarity and certainty to the derivatives market.
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