Clayton Utz Insights
26 April 2012
By Louise McCoach, Graeme Dennis and Romany Sloan.
The Lomas decision confirms the understanding of the OTC derivatives industry and realigns the Australian and English law position on the operation of Section 2(a)(iii) of the ISDA Master Agreement.
The recent decision of the UK Court of Appeal in Lomas and others v JFB Firth Rixson, Inc and others  EWCA Civ 419 confirms that, under English law, Section 2(a)(iii) of the ISDA Master Agreement operates to protect a non-defaulting party in the case of a counterparty's default (or potential default) by suspending its payment obligations until the trigger events are cured by the defaulting counterparty. The suspension can be indefinite – it does not expire on the final payment date of the swap transaction.
The decision confirms the understanding of the over-the-counter (OTC) derivatives industry and realigns the Australian and English law position in relation to the operation of Section 2(a)(iii) of the ISDA Master Agreement.
The proposal by the International Swaps and Derivatives Association, Inc. (ISDA) in April 2011 to introduce a time limit on how long a non-defaulting party is entitled to suspend its obligations under Section 2(a)(iii) is likely to continue to be the subject of further interest, particularly in light of recent pressure from the UK Treasury and the general concern of regulators to impose a time limit to provide certainty for administrators and creditors of defaulting parties.
In Australia, the customary amendment to provide that Section 2(a)(iii)(1) ceases to apply once the defaulting party no longer has any further obligations to perform will likely still be made, to ensure that the suspension does not indefinitely deprive the defaulting party and its creditors of the benefit of an "in-the-money" position where the defaulting party has satisfied all of its obligations, notwithstanding the occurrence of an Event of Default or Potential Event of Default.
Section 2(a)(iii) of the ISDA Master Agreement is considered one of the principal pillars upon which the Master Agreement is based. Under Section 2(a)(iii)(1), where an Event of Default or Potential Event of Default occurs with respect to a party to a transaction, the other party can rely on this provision to refrain from making any further payments or deliveries under the ISDA Master Agreement, thereby protecting its position and not exposing itself to further loss.
Over the last decade and particularly in the aftermath of the GFC, the enforceability and operation of Section 2(a)(iii) has been tested in various jurisdictions, after several cases were heard involving defaulting parties (or their administrators) suing out-of-the-money non-defaulting parties for suspending payments instead of terminating and closing-out outstanding positions. The divergent approaches of UK, US and Australian courts to the interpretation of Section 2(a)(iii) and its enforceability in the context of the applicable insolvency laws had created uncertainty in the OTC derivatives market over its operation. The courts have struggled to reach a consistent view on a number of issues in relation to Section 2(a)(iii), including its suspensive effect.
Debate on the suspensive effect
The courts have considered two key issues in relation to the suspensive effect of Section 2(a)(iii):
1. Does Section 2(a)(iii) operate only to suspend the obligations of the non-defaulting party for as long as the event of default is continuing, or does it extinguish obligations entirely?
2. If the effect of Section (2)(a)(iii) is to suspend obligations, does the suspension continue for a potentially indefinite period of time (particularly in the case of an administration or insolvency)?
The recent UK Court of Appeal decision brings some welcome clarity to these issues. We have summarised below some of the leading cases affected by the decision and their differing interpretations.
The Australian decision, SIMMS and Another (in their capacity as liquidators of Enron Australia Finance Pty Ltd (in liq)) v TXU Electricity Ltd  NSWSC 1169 (Enron v TXU) is the leading authority in Australia in relation to the suspensive effect of Section 2(a)(iii).
Enron and TXU were party to a large number of electricity swaps. Upon Enron's liquidation, TXU relied on Section 2(a)(iii), to cease making payments to Enron without terminating the swaps. Enron's liquidator sought leave of the court to compel TXU to designate an early termination date.
The court refused to rewrite the agreement, essentially confirming that under the ISDA Master Agreement, a non-defaulting party has the right to choose not to designate an early termination date and rely instead on Section 2(a)(iii) to avoid having to make payments. Justice Austin went further to state in obiter that "a payment obligation [under Section 2(a)(iii)] will spring up under a pre-existing trade once the relevant condition is satisfied, and in that sense it might be said… that the payment obligation is "suspended" while the condition remains unfulfilled".
The market considered this case to confirm the non-defaulting party's right to withhold (potentially indefinitely) payments under Section 2(a)(iii) and the enforceability of that right against a liquidator.
In the US, debate has focused on the enforceability of Section 2(a)(iii) in the context of the US Bankruptcy Code.
In re Lehman Brothers Holdings, Inc., Case No. 08-13555 et seq. (JMP) (jointly administered), Metavante Corporation (Metavante) and Lehman Brothers Special Financing (LBSF), entered into interest rate swap transactions. Under the agreement, Metavante was the fixed rate payer and LBSF was the floating rate payer. LBSF filed for bankruptcy protection under Chapter 11 of the US Bankruptcy Code. Rather than designate an early termination, Metavante relied on Section 2(a)(iii) to withhold payment on the outstanding transactions, as an early termination would have required a multi-million dollar payment to LBSF.
The court held that the non-defaulting party must decide whether or not to terminate the contract, and that the decision must be made within a reasonable time, effectively limiting the section's enforceability. The court reasoned that to indefinitely suspend payment obligations under the section amounted to a modification of the parties' contractual rights, and was therefore in contravention of the US Bankruptcy Code.
Limiting the enforceability of Section 2(a)(iii) set a concerning precedent for market participants that local bankruptcy laws could simply override a commercial agreement governed by the ISDA Master Agreement.
UK approach: Marine TradeIn Marine Trade SA v Pioneer Freight Futures Co Ltd BVI  EWHC 2656 (Comm), Marine Trade and Pioneer had entered into forward freight agreements, which incorporated 1992 ISDA Master Agreements. Pioneer was subject to a Bankruptcy Event of Default. Marine Trade relied on Section 2(a)(iii) to withhold a "Settlement Sum" of USD $12 million. Pioneer initially argued that it subsequently cured the Event of Default and therefore claimed that the money became payable.
In an obiter statement, the court suggested that even if the defaulting party ceased to be in default, there was nothing in the ISDA Master Agreement to suggest that the non-defaulting party's obligation to pay would be automatically revived. The court's view was that Section 2(a)(iii) operated as a "one time" provision in assessing whether a sum is owed. That is, if the conditions precedent are not fulfilled on the due date for the relevant payment obligation, the payment obligation never becomes due.
The "once and for all test" is widely regarded as uncommercial. For instance, if mere administrative error triggers an Event of Default or Potential Event of Default, the defaulting party would lose the benefit of all payments that would otherwise have been due to it in the time it takes to rectify these problems.
UK approach: Lomas (2010)In Lomas and others (together the Joint Administrators of Lehman Brothers International (Europe) (in administration)) v JFB Firth Rixson, Inc. and others and ISDA as an intervenor (2010), four out-of-the-money counterparties declined to terminate their interest rate swap transactions with Lehman Brothers International Europe following the latter's administration, instead relying on Section 2(a)(iii) to suspend payments. Lehman's administrators sought direction from the court as to the correct interpretation of the section.
The court affirmed the reasoning in Marine Trade, that a non-defaulting party can suspend payments under the relevant transaction while there is an Event of Default.
ISDA, which was granted leave to intervene in the case, further maintained that the effect of a continuing default on a particular payment date is only to suspend the payment obligation until the default is cured and the condition precedent is satisfied. This argument departed from the "once and for all" test in Marine Trade in that the payment obligation could, in theory, remain indefinitely notwithstanding that the payment date had fallen due.
Although the court agreed with ISDA that a payment obligation is suspended until the Event of Default is cured, it found that this was only the case up until the expiry of the term of the transaction at which point, if the Event of Default has not been cured, the payment obligation is extinguished and the non-defaulting party is permanently released from its obligation to pay the defaulting party. This aspect of the decision did not align with the market's expectations, and a plain reading of the provision, that the suspension under Section 2(a)(iii) should last indefinitely.
An end to the uncertainty? – the UK Court of Appeal Lomas decision
Lomas was appealed in the UK Court of Appeal (CA) in December 2011. The appeal was joined with the appeals of three other cases that considered related issues. Judgment was handed down on 3 April 2012.
The UK CA dismissed the Lomas appeal and upheld the UK High Court's Lomas decision in relation to the suspensive effect of Section 2(a)(iii). However, it disagreed with the UK High Court on the question of the duration of the payment suspension. The UK CA held that payment suspension under Section 2(a)(iii) can be indefinite regardless of the original termination date of the related swap transaction. That is, the suspension of payment obligations continues in force until the Event of Default is cured or the non-defaulting party elects to terminate. If it is cured, the non-defaulting party's payment obligation would spring up to the extent the relevant swap transaction is not terminated. If it is never cured, there continues to be no obligation on the non-defaulting party to make payment.
The UK CA's decision realigns the English law position in relation to the suspensive effect of Section 2(a)(iii) with the position in Enron v TXU. However whether the decision effectively puts to rest the uncertainty associated with this provision is likely to be a hot topic for further debate, particularly amongst regulators in the UK and Australia.
Where to from here?
In response to concerns raised by the UK High Court cases and the UK Treasury, ISDA released a consultation paper in April 2011 which, among other things, proposed various amendments to Section 2(a)(iii) including:
- clarification that the obligations of a non-defaulting party affected by Section 2(a)(iii) are suspended rather than extinguished and that the duration of the suspension can be indefinite;
- clarification that the defaulting party's obligations under the suspension are netted against payments due by the non-defaulting party; and
- the introduction of a time period for suspension of obligations between 90 and 180 days.
It will be interesting to observe whether as a result of the UK CA's decision ISDA will be under increased pressure to further refine Section 2(a)(iii) along the lines of the proposals set out above, to provide certainty that transactions will be terminated within a reasonable period in cases where a defaulting party goes into administration or files for bankruptcy.
The position in Australia
Since the decision in Enron v TXU, OTC counterparties in Australia have traditionally included an amendment to Section 2(a)(iii)(1) providing that Section 2(a)(iii)(1) ceases to apply once the defaulting party no longer has any further obligations to perform.
Until a position is reached by the industry in relation to specifying a time limit on the operation of Section 2(a)(iii), this amendment is likely to continue to be adopted by parties to ISDA Master Agreements where the governing law is Australian law, to ensure that the suspension does not indefinitely deprive the defaulting party and its creditors of the benefit of an "in-the- money" position where the defaulting party has satisfied all of its obligations, notwithstanding the occurrence of an Event of Default or Potential Event of Default.
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