“The most important standard market agreement used in the financial world” – what does it mean?

“The most important standard market agreement used

in the financial world”[1] – what does it mean?

One theme running through the mis-selling litigation in the English Commercial Court in the last 10 years is the primacy of the contract. Time and again, the investor has failed to pierce the protection afforded to the financial institution by its standard form contract. It is interesting therefore to see a case in which ISDA[2] (an entity which counts most of the major financial institutions as its members) has been on the wrong end of a debate about the proper construction of the contract, particularly when the contract in question is its own Master Agreement, so often the rock on which investor claims have foundered. The case is Lomas v JFB Firth Rixson [2010] EWHC 3372. To understand the issues in the case, some background is necessary.

Background

The case arises from the Lehman insolvency. The Joint Administrators of Lehman Brothers International Europe (LBIE) asked the Court to construe five interest swap agreements, all governed by the 1992 ISDA Master Agreement. When LBIE became insolvent, the respondent counterparties all had positions that were, or would shortly become, out the money. In other words, the respondents would be net payers and LBIE would be the net receiver of money under the swaps. Unsurprisingly, LBIE wanted the money (roughly £60m) that it would have received if it had not gone bust.

The key provision in issue was section 2(a)(iii) of the ISDA Master Agreement:

“Each obligation of each party under Section 2(a)(i) [to pay on the relevant settlement date] is subject to (1) the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing…”

Section 2(a)(iii) therefore 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. The ISDA Master has a long list of Events of Default, but it was common ground that LBIE’s insolvency on 15 September 2008 was an Event of Default.

Issues in the case

The respondents simply relied on the plain words of section 2(a)(iii): the condition precedent was not satisfied because LBIE was in default, therefore their payment obligations were not triggered. However, that begs at least one question: if the condition precedent is not satisfied, does that suspend or extinguish altogether the payment obligation?

Mr Justice Briggs plainly found this a difficult question (and the appeal of his decision will be heard in December). He came to the conclusion “on a fairly narrow balance” that the payment obligation was only suspended. His main reason was that the alternative construction (permanent destruction of the payment obligation) was pointlessly draconian if there was minor and momentary default or potential default.

That conclusion produced a further question – for how long is the payment obligation suspended? There were only two options raised in argument: the obligation was suspended until the expiry of the term of the Transaction or (as ISDA contended) indefinitely. The Judge found this a much easier question and did not hesitate to find that the suspension lasted only until the end of the term of the Transaction (at which point the obligation ceased). He said that it was wholly inconsistent with any reasonable understanding of the ISDA Master Agreement that payment obligations arising under a Transaction could give rise to indefinite contingent liabilities. Such liabilities would be indefinite because an Event of Default could be cured long after the expiry of the term of the Transaction and the obligations would then be resurrected.

Conclusion

The philosophy that underpins much of the ISDA Master Agreement and related documents is that the parties should ultimately net off the sums due under whatever transactions they have undertaken. It offends that philosophy if, as the Court found in Firth Rixson, the Non-Defaulting Party’s payment obligations are extinguished at the end of the term of the Transaction and there is no netting at all. However, it might be said that the thrust of ISDA’s argument is simply contrary to the plain words used in its Master Agreement. The parties can elect “Automatic Early Termination” such that if either party is in default, then the Transactions terminate and the calculation of the Settlement Amount is triggered. However, if no such election is made, then the default position is that the Non-Defaulting Party is not obliged to terminate. If ISDA wanted Automatic Termination to be mandatory at some point, then the Master Agreement should say so and make clear at what point this should occur.

As ever, it is important to consider whether the decision produced a fair result. Did it produce a windfall for the respondents and a corresponding shortfall for the LBIE creditors? The Master Agreement has a formula for calculating payment following an Event of Default that is designed to enable the Non-Defaulting Party to re-enter the market at the expense of the Defaulting Party. In other words, if the Non-Defaulting Party will receive money from the Defaulting Party on settlement, then that sum should be roughly equivalent to the cost of replicating the Non-Defaulting Party’s position in the market. Similarly, if the Non-Defaulting Party must pay the Defaulting Party on settlement, then the market should pay the Non-Defaulting Party a roughly equivalent sum to replicate its market position. However, that assumes that the Defaulting Party is good for the money. If the Defaulting Party cannot pay (and the Non-Defaulting Party has to prove in the insolvency of the Defaulting Party for its Termination Payment), then the Non-Defaulting Party cannot replicate its existing market position at no cost. Therefore, the Judge concluded, it is not surprising to find that the Master Agreement contains provision (section 2(a)(iii)) whereby the Non-Defaulting Party may say that, for as long as the continuing default means that he is unhedged, no further payment will be made under the swap.

This analysis seems to work satisfactorily for swap counterparties entering into genuine interest rate hedging arrangements. However, the ISDA Master Agreement now governs a whole myriad of instruments, not just swaps, some of which are used for hedging and some of which are not. It will be interesting to see the outcome of the appeal, and whether any amendment to the ISDA Master results.

14 October 2011