Focus: Flawed asset provision in English law ISDA Master Agreement clarified
18 April 2012
In brief: The English Court of Appeal has provided clarity on the operation under English law of some clauses in the ISDA Master Agreement, including a key protection for Non-defaulting Parties – the flawed asset provision under Section 2(a)(iii). Partners Diccon Loxton (view CV) and Tom Highnam (view CV) and Senior Associate Caleb Chua report.
- Section 2(a)(iii) of the ISDA Master Agreement
- The English High Court decision
- The English Court of Appeal decision
- Other issues determined in the English Court of Appeal decision
- ISDA approves
How does it affect you?
- The English Court of Appeal heard together four appeals from High Court judgments concerning the ISDA Master Agreement, particularly Section 2(a)(iii). That section makes each party's payment obligations conditional on the absence of a default involving the other party, so Non-defaulting Parties have the option of not having to make payment.
- This is a key part of the protection of Non-defaulting Parties, but can create problems for lenders to Defaulting Parties and others who are relying on the cash flow or protection provided by the hedge. Australian courts have given full effect to this provision.
- English first instance cases have been slightly less robust. This brings the English position closer to the Australian one.
Section 2(a)(iii) of the ISDA Master Agreement states that a party's payment or delivery obligation 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. Hence a Non-defaulting Party can rely on Section 2(a)(iii) to withhold payments under the ISDA agreement that are due from it to the Defaulting Party.
At first instance the English High Court in Lomas1 decided that:
- Section 2(a)(iii) operates to suspend the obligations of a non-defaulting party while an Event of Default continues and does not extinguish such obligations;
- the suspension is not limited to a reasonable time;
- where any obligation is suspended, that obligation does not survive the maturity of the relevant Transaction at the end of its natural term.
The decision and its relevance to the Australia derivatives market were considered in our March 2011 Focus: Enforceability of the flawed asset – more to consider?
The English Court of Appeal dealt with the following issues in relation to Section 2(a)(iii):
Whether any obligation of a Non-defaulting Party will ever come into existence once an Event of Default has occurred and if so, is such obligation extinguished or merely suspended while the Event of Default continues?
The English Court of Appeal distinguished between the underlying debt obligation and the payment obligation. It held that Section 2(a)(iii) affects the payment obligation but not the debt. Therefore the underlying debt obligation of a Non-defaulting Party does arise on the relevant due date notwithstanding the occurrence of an Event of Default. However, while the Event of Default is continuing, the payment obligations of a Non-defaulting Party are suspended (rather than extinguished). Such payment obligations will be revived if the Event of Default is cured before the outstanding transactions are terminated.
Whether the suspension of the payment obligation will come to end on the expiry of a reasonable time or at the maturity of the relevant transaction or all outstanding Transactions.
The English Court of Appeal also agreed with the first instance decision that the suspension of the payment obligation of a Non-defaulting Party does not expire after a reasonable time or at the maturity of the relevant Transaction or all outstanding Transactions.
Whether the payment obligation is extinguished at the maturity of the relevant transaction if the Event of Default is not cured at that time.
The English Court of Appeal reached a different conclusion from the English High Court. It held that a payment obligation that is suspended under Section 2(a)(iii) is not extinguished on maturity of the relevant Transaction, hence such suspension can continue indefinitely until the Event of Default is cured or the Non-defaulting Party elects for termination. The court determined that, as a matter of construction, the provisions of the ISDA Master Agreement do not expressly provide for the extinguishment of suspended payment obligations upon the maturity of the relevant Transaction. In the absence of an express provision to that effect, the court refused to imply such a term in the relevant derivatives contracts in question.
The court also examined the following issues:
- Netting of same date payments – It found that, under Section 2(c) of the ISDA Master Agreement, only amounts payable on the same date and in the same currency in respect of the same Transaction (or such other types of Transactions as elected by the parties) are netted and only the balance is payable by the relevant party.
- Close-out netting – It endorsed the approach that Section 6(e) of the ISDA Master Agreement will still operate on close-out and termination to net off the gross liabilities of a Defaulting Party and a Non-defaulting Party including on previously terminated transactions. As a result, a Non-defaulting Party who is in-the-money with respect to the netted payment obligations can only recover the net sum owed to it. It overruled the contrary view expressed by Justice Flaux in Marine Trade SA v Pioneer Freight Futures Co Ltd BVI2. Therefore a Non-defaulting Party cannot seek to recover from a Defaulting Party its gross liabilities under the hedges while relying on Section 2(a)(iii) to withhold its gross payments due on the same date under such hedges to the Defaulting Party.
- Anti-deprivation principle doesn't apply – It confirmed that Section 2(a)(iii) does not offend the anti-deprivation principle formulated in Belmont Park Investments Pty Ltd v BNY Corporate Trustee Securities Ltd 3 (a public policy rule overturning arrangements which deprive insolvents of assets). It said there is no suggestion that Section 2(a)(iii) was formulated to evade insolvency law or to give the Non-defaulting Party a greater or disproportionate return as a creditor. Note this public policy principle does not apply in Australia4.
- Interpretation of Loss to be net of amounts withheld – In the 1992 version of the ISDA Master Agreement, the parties can elect for a Market Quotation or a Loss method of calculating the early termination amounts. The Loss calculation method is essentially a good faith determination of a Non-defaulting Party's total loss or gain in connection with the terminated transactions. The English Court of Appeal took the view that the gain to a Non-defaulting Party as referred to in the definition of Loss is to be assessed by the amounts which the Non-defaulting Party would have paid to the Defaulting Party but for the occurrence of an Event of Default. Hence, the determination of the early termination amount based on the Loss calculation method has to take into account amounts withheld by a Non-defaulting Party under Section 2(a)(iii).
The decision of the English Court of Appeal in Lomas was welcomed by the International Swaps and Derivatives Association, Inc. (ISDA) as providing 'clarity and certainty to the derivatives market'. ISDA was granted leave to intervene in the English Court of Appeal case of Lomas and ISDA's submissions on the operation of Section 2(a)(iii) were endorsed by the English Court of Appeal.
ISDA has proposed in a memorandum to its members certain amendments to Section 2(a)(iii), which include imposing a time limit on its application and clarifying that Section 2(a)(iii) applies after the relevant amounts are netted under Section 2(c).
- Lomas v JFB Firth Inc & Ors  EWHC 3372 (Ch).
-  Lloyds Rep 631.
-  UKSC 38;  Bus LR 1266.
- See IATA v Ansett  HCA 3.
- Diccon LoxtonPartner,
Ph: +61 2 9230 4791
- Tom HighnamPartner,
Ph: +61 2 9230 4009
- James DarcyPartner,
Ph: +61 3 9613 8516
- Karla FraserPartner,
Ph: +61 7 3334 3251
- Tim LesterPartner,
Ph: +61 8 9488 3841