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Focus: Enforceability of the flawed asset – more to consider?

1 March 2011

In brief: A recent English High Court decision introduces conditions on relying on flawed asset clauses, particularly with respect to the ISDA Master Agreement. Partner Tom Highnam (view CV) and Summer Clerk Elise Ho report.

How does it affect you?

  • If you are a non-defaulting party under an International Swaps and Derivatives Association Inc. (ISDA) Master Agreement and purport to avoid making payments to your defaulting counterparty rather than terminate your relationship, you will need to consider this case.
  • The case indicates that a divergence may be developing between English law and Australian law on the interpretation of the flawed asset under the ISDA Master Agreement.

Background

The facts of the case1 are as follows. Four named respondents were swap counterparties of Lehman Brothers International (Europe) (LBIE) under five interest rate swap agreements governed by one or other of the 1992 or 2002 versions of the ISDA Master Agreement. In each case, LBIE was the floating rate payer. The four counterparties chose not to terminate their ISDA Master Agreements with LBIE upon LBIE's entry into administration on 15 September 2008 (an event of default).

Since then, the four respondents had relied on section 2(a)(iii) of the ISDA Master Agreement to stop making payments to LBIE that otherwise would have fallen due on subsequent payment dates. Section 2(a)(iii) provides that a party's payment obligations are subject to the condition precedent that there is no continuing event of default – the 'flawed asset'.

From the triggering of the event of default, LBIE would have been owed (on a net basis) an aggregate of approximately £20.6 million, US$57.3 million and €5.3 million by its counterparties under these five swaps.

LBIE's joint administrators applied to the England and Wales High Court (Chancery Division) for directions as to the true construction and effect of the five swap agreements; in particular, the interpretation of s2(a)(iii) and whether it offends the anti-deprivation principle of English insolvency law.

ISDA was granted permission to intervene in the case.

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What the court was asked to decide

The court was asked to decide the limitations around a non-defaulting party purporting to rely on s2(a)(iii) of the ISDA Master Agreement to stop making payments to a defaulting party. In particular:

  1. whether s2(a)(iii) only suspends payments while the default continues, or if it is a once-and-for-all test;
  2. whether a non-defaulting party can only rely on s2(a)(iii) for a reasonable period;
  3. alternatively, can a non-defaulting party only rely on s2(a)(iii) until the end of the ordinary term of a particular transaction under an ISDA Master Agreement? If so, what happens at that point:
    1. are the suspended payments then calculated, and netted with the relevant party obliged to pay the net sum; or
    2. if the event of default at that time still subsists, does the ISDA Master Agreement assume that no payments were ever due?;
  4. alternatively (as ISDA argued), does s2(a)(iii) suspend payments indefinitely until the relevant event of default no longer continues?

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The court's decision

Justice Briggs determined that, as a matter of construction, the parties' intention was that 'where any obligation is suspended by Section 2(a)(iii) because of the non-fulfilment of a condition precedent, then that obligation does not survive the termination of a Transaction at the end of its natural term, if by then the condition precedent is still unsatisfied'. In short, (c)(ii) above was the correct determination. Importantly, this decision reversed the non-binding comments in the Marine Trade2 case suggesting s2(a)(iii) was a once-and-for-all test.

Justice Briggs then had to determine whether this formulation offended the anti-deprivation rule. The anti-deprivation rule essentially says that parties cannot contract out of insolvency rules governing the way in which assets are distributed in insolvency. Generally, this is seeking to protect the principle of pari passu distribution: that all the property of an insolvent estate should, subject to the prior payment of preferential liabilities and expenses, be applied in satisfaction of its liabilities in proportion to the size of those liabilities. The administrators relied on the British Eagle3 case to argue that the operation of s2(a)(iii) means that, on LBIE going into administration, it was (in all probability, permanently) deprived of the asset constituted by the contingent obligation to make net payments.

Justice Briggs rejected this argument as being too broad an application of the principle to the current case. There was nothing contrary to insolvency law in permitting a party either to terminate or adjust what would otherwise be an ongoing relationship with an insolvent company at the point when it goes into an insolvency process.

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Two important conditions

Justice Briggs admitted that there was a difficult dividing line to determine whether provisions in an agreement, such as the ISDA Master Agreement, which allow parties, ab initio to include an insolvency-based flawed asset, infringe the anti-deprivation rule or not.

In concluding that s2(a)(iii) did not infringe the anti-deprivation rule, he made two warnings:

  • The decision was based on the fact that each of the relevant transactions was an interest rate swap with ongoing payment obligations between the parties. Much was made of the fact that the right to receive contingent payments on each payment date was the quid pro quo for the provision of an ongoing service. The decision may have been different if the defaulting party had no further payment obligations owing to the non-defaulting party at the time of the event of default.
  • The decision was also based on the fact that only a net amount was ever due to, or owing by, the non-defaulting party on each payment date. Justice Briggs indicated that, if the analysis had been that s2(a)(iii) applied to increase LBIE's obligations on each future payment date from a net amount to a gross amount (ie it was obliged to pay the floating leg payment, whereas the non-defaulting party could rely on the flawed asset not to pay its fixed leg payment), then that might well have offended the anti-deprivation principle.

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Relevance for Australia

Enron Australia v TXU Electricity4 remains the Australian precedent on the application and interpretation of s2(a)(iii) of the ISDA Master Agreement. However, Lomas v Firth Rixson provides some useful insight if equivalent issues were to be argued in court here, albeit that two of these issues may not be relevant if Australian law is the applicable law. The three significant differences are worth considering further:

  • Section 2(a)(iii) applies only until the original termination date of the transaction. If the event of default continues at that time, the suspended payments are deemed never due.

    This is in direct opposition to Justice Austin's assumption in Enron v TXU5 that 'a payment obligation will spring up under a pre-existing trade once the relevant condition is satisfied.'

    In one sense, the approach in Lomas provides more certainty for the parties, rather than the threat of a potentially endless suspended payment. Justice Briggs reached this conclusion on the construction of the contract based on the parties' intention. However, this approach could be seen to be unfair in the context of a three-year interest rate swap with only one or two payment dates remaining. Rather than crystallise a loss, a non-defaulting party may take the view that it is worth holding on for three to six months to see if it is able to avoid making any payments at all.
  • Section 2(a)(iii) can only be relied on by a non-defaulting party if it is assumed that only a net amount was ever due to, or owing by, the non-defaulting party on each payment date. This was not considered in Enron v TXU.

    Justice Briggs suggests that a non-defaulting party may not be able to rely on s2(a)(iii) to avoid making payments while at the same time seeking to enforce the defaulting party's obligations in full. The general effect of this conclusion would be as to how to account for the non-defaulting party's potential claim in the insolvency of the defaulting party. However, this analysis would also go to the calculation of default interest. Is interest calculated on gross payments that remain due from the defaulting party or only net payments? Presumably, on Justice Briggs's assumption, it would only be calculated on the net sum. This appears contrary to the express wording in s9(h)(i)(1) of the ISDA Master Agreement and is contrary to the analysis in Yallourn v Enron6 , which determined that unpaid amounts would include interest on the gross unpaid s2(a)(i) payments owed by a defaulting party.
  • Section 2(a)(iii) can only be relied on by a non-defaulting party in relation to transactions for which each party has ongoing obligations.

    This is the most interesting point of distinction between Lomas and Enron and, again, was not considered in Enron. Effectively, it means that s2(a)(iii) could not be relied on by the non-defaulting party who is the protection seller on a standard credit default swap, or by any option seller of fully funded options. However, the result is probably fair. The market has already determined that this is probably a fair result, through the standard form additional termination event that allows a defaulting party to exercise an additional termination event where the non-defaulting party is purporting to rely on s2(a)(iii) in precisely these circumstances.

In Australia, the case of IATA v Ansett7 made it clear that there was no general anti-deprivation rule outside of statute. The High Court held that in that case8:

The asserted rule of public policy finds no footing in the relevant provisions of the Corporations Act. Those provisions take effect according to their terms and are not to be supplemented or varied by the superimposition of a rule of the kind alleged.

Accordingly, the second and third differences highlighted above may not be relevant in Australia if their application is limited to an interpretation of the anti-deprivation rule as it applies in England and Wales. For now, Enron and IATA are the settled law in Australia and a diference may exist in interpreting s2(a)(iii) under English law and Australian law.

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Conclusion

Lomas v Firth Rixson raises some interesting issues that non-defaulting parties will need to consider if purporting to rely on s2(a)(iii) of the ISDA Master Agreement. For a start, parties will need to consider the applicable law. ISDA has already started the process of preparing a form of amendment to s2(a)(iii) in response to concerns raised by regulators as to its impact following the failure of a major financial institution.

Footnotes
  1. Lomas v JFB Firth Rixson Inc & Ors [2010] EWHC 3372 (Ch).
  2. Marine Trade SA v Pioneer Freight Futures Co Ltd BVI [2009] EWHC 2656 (Comm) [2010] 1 Lloyd's Rep 631.
  3. British Eagle International Airlines Ltd v Cie Nationale Air France [1975] 1 WLR 758.
  4. [2003] NSW SC 1169.
  5. At paragraph 12.
  6. Yallourn Electricity Ltd v Enron Australia Finance Pty Ltd (in Liq) [2005] NSWCA 326.
  7. [2008] HCA 3.
  8. At paragraph 93.

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