The ISDA master agreement has come under scrutiny during the ongoing administration of Lehman Brothers. Henry Knox dissects a recent UK judgment
On 21 December 2010 Mr Justice Briggs gave judgment in Lomas & Ors v JFB Firth Rixson Inc & Ors. Briggs J held that four out-of-the-money counterparties of Lehman Brothers International (Europe) were entitled, under the International Swaps and Derivatives Association (ISDA) master agreement, to refuse to make payments of some £60m that would otherwise have fallen due under interest rate swaps on payment dates after Lehman went into administration.
The decision has potentially wide-ranging implications for the derivatives market generally, in which the master agreement serves as the contractual foundation for more than 90 per cent of global over-the-counter derivatives transactions.
As a result of Lehman’s insolvency, its counterparties had the right under Section 6 of the master agreement to close out transactions, but many elected not to do so because it would have resulted in a sum due to Lehman.
Instead they rode the market on out-of-the-money contracts, relying on Section 2(a)(iii) of the agreement as the basis for a refusal to make payments that would otherwise have fallen due to Lehman after its insolvency.
The section provides that a party’s payment obligations are subject to the condition precedent that there is no continuing event of default with respect to the other party, such as insolvency.
In the US Lehman challenged successfully the right of counterparties to choose when to terminate and withhold payment under Section 2(a)(iii). In a 2009 ruling in Re Lehman Brothers Holdings, the Bankruptcy Court for the Southern District of New York compelled a Lehman counterparty to make payment of all past and future scheduled payments as they came due. The court ruled that Section 2(a)(iii) was unenforceable under the US Bankruptcy Code and that the right to close out transactions early must be exercised promptly or be lost.
In contrast, in JFB Firth Rixson Briggs J held that Section 2(a)(iii) was not, in the context of the swaps concerned, unenforceable under the anti-deprivation principle of English insolvency law.
One key issue was whether the effect of Section 2(a)(iii) in the 1992 version of the master agreement was to suspend payment obligations or to extinguish them once and for all. There was no dispute that, in relation to the 2002 version, the effect was merely suspensory, and the judge decided that a suspensory construction of the 1992 version was to be preferred (following Enron Australia v TXU Electricity (2003) rather than Marine Trade SA v Pioneer Freight Futures Co Ltd (2010)).
The ISDA, which intervened in the case, submitted that a suspended payment obligation remained in suspense indefinitely, but Briggs J held that payment obligations that had been suspended by Section 2(a)(iii) did not survive the expiry of a transaction at the end of its scheduled term if the condition precedent to the payment obligation continued to be unsatisfied.
The judge also decided that the counterparty’s right to close out a transaction could be exercised in the way it considered best served its own interests. He rejected arguments by Lehman’s administrators that payment obligations were only suspended for a reasonable time, revived on the expiry of the natural term of the transaction, or that the counterparty had any obligation to close out the transaction early.
Briggs J held that Section 2(a)(iii) of the master agreement, as incorporated into the interest rate swaps at issue, did not contravene the anti-deprivation rule in relation to Lehman. However, he also made two points clear.
First, a different analysis might be appropriate in a different kind of transaction, which unlike interest rate swaps, did not constitute an ongoing relationship between the parties, in which rights to receive contingent net payments accrue as the quid pro quo for the provision of a continuing service.
Second, had the parties not agreed that Section 2(a)(iii) operated on a net rather than gross basis – contrary to Mr Justice Flaux’s conclusion in Marine Trade –
Briggs J may well have concluded that it operated so as to increase Lehman’s obligation on any future payment date from a net amount to a gross amount, which might well have offended the anti-deprivation principle.
Indeed, the judge suspected that the concession made by the counterparties, that the swaps operated only on a net basis, had been made for the specific purpose of avoiding that outcome.
The result is that out-of-the-money counterparties of Lehman can use Section 2(a)(iii) to ride the market and choose when to terminate. Creditors will be significantly worse off by reason of the event of default constituted by its going into administration.
It is perhaps not surprising that, even before the case had been brought, the ISDA had started the process of preparing a form of amendment to Section 2(a)(iii) in response to concerns raised by the Treasury as to its potential effect following the failure of a major financial institution.
Henry Knox is a barrister at 3 Verulam Buildings