Two recent cases before the High Court have returned to the question first raised in Marine Trade S.A. v Pioneer Freight Futures Co Ltd as to whether or not a non-Defaulting Party to an ISDA Master Agreement is entitled to withhold payment to a Defaulting Party pursuant to Section 2(a)(iii) whilst simultaneously enforcing the Defaulting Party’s payment obligation in full. The issue is due to be heard by the Court of Appeal in the near future and Document Risk Solutions’ Michael Beaton explains how these cases provide important guidance in the interim
In 2009 in Marine Trade S.A. v Pioneer Freight Futures Co Ltd, Flaux J held that a non-Defaulting Party to an ISDA Master Agreement was entitled to withhold payment to a Defaulting Party whilst simultaneously enforcing the Defaulting Party’s payment obligation in full (the “gross” basis). In other words, the non-Defaulting Party did not have to give the Defaulting Party credit for amounts owed by the non-Defaulting Party to the Defaulting Party (the “net” basis). The rationale behind the decision was that credit only had to be given for amounts that are payable and not for amounts that are not payable due to an unfulfilled condition precedent under Section 2(a)(iii).
The same question was subsequently considered in 2010 in Lomas v JFB Firth Rixson, Inc. In this case, both parties asked Briggs J not to follow the “gross” basis precedent set in Marine Trade, primarily so as to avoid the risk that Section 2(a)(iii) be deemed to offend the “anti-deprivation” rule – the proposition that one cannot contract out of the provisions of insolvency legislation which requires pari passu treatment of creditors. In part because of the agreed “net” basis approach, the court held that Section 2(a)(iii) did not offend the anti-deprivation rule. Nonetheless, the court made clear that, if the “gross/net” question had been contentious, it would have found it difficult not to follow the precedent set by Marine Trade.
Consequently, as a matter of English law, the “gross” basis continued to apply. However, given that the court in Firth Rixson stated that had section 2(a)(iii) operated on a “gross” basis, it might well have offended the anti-deprivation rule, any party seeking to enforce this right against an insolvent party was effectively on notice that it faced an increased risk of Section 2(a)(iii) being found to be unenforceable in these circumstances.
The Issue Revisited
In 2011, the issue was considered again by Flaux J (the same judge who had presided in Marine Trade) in Pioneer Freight Futures Company Limited (in liquidation) v Cosco Bulk Carrier Company Limited. Pioneer entered into eleven forward freight agreements (“FFAs”) with Cosco. FFAs are essentially cash-settled contracts for difference which reference price movements in an index, in this case published by the Baltic Exchange. If the final level of the relevant index is higher than the value at which the contract was struck, the Seller must pay the Buyer the difference between the two. Conversely, if the final level of the index is lower than the value at which the contract is struck, the Buyer must pay the Seller the difference.
In seven of the FFAs, Pioneer was the “Seller” whereas in four it was the “Buyer”. The FFAs were documented under standard industry documentation which incorporated by reference the 1992 ISDA Master Agreement.
Seven of the eleven FFAs were due to settle in October 2008. Under four of these contracts, Cosco was the Seller and under three Pioneer was the Seller. The downturn in the freight market which occurred in the fourth quarter of 2008 meant that, on a net basis, Cosco was in the money and due to receive approximately USD 6.5 million from Pioneer. Pioneer failed to pay this amount. Exercising its rights under Section 2(a)(iii) of the ISDA Master Agreement, Cosco made no further payment to Pioneer under any of the eleven FFAs.
Pioneer was liquidated on 14 December 2009, triggering Automatic Early Termination under the ISDA Master Agreement. By this time, eight of the eleven FFAs had passed their stated maturity dates. With respect to these eight contracts, Pioneer was the Seller in four cases, and Cosco was the Seller in four cases. Pioneer’s liquidator calculated its Loss with respect to all eleven FFAs as being approximately USD 16.5 million and claimed this amount from Cosco on 24 December 2009 on the basis that all transactions formed a “Single Agreement” pursuant to section 1(c) of the ISDA Master Agreement. Cosco disputed this calculation, claiming that the eight transactions which had already expired could not be taken into account in determining any calculation of Loss under Section 6(e) of the ISDA Master Agreement, with the result that Pioneer owed Cosco approximately USD 7.5 million. Specifically, Cosco argued that:
(1) Three FFAs were outstanding and under these contracts Cosco owed Pioneer approximately USD 22.5 million;
(2) Four FFAs in relation to which Cosco had been ‘in the money’ had expired – in respect of these transactions, Cosco had a valid contractual debt claim valued at approximately USD 30 million; and
(3) Four FFAs in relation to which Cosco had been ‘out of the money’ had also expired – however, following the findings in Firth Rixson, Pioneer could not claim any amounts with respect to these FFAs due to the fact that it had not cured the non-payment Event of Default dating back to October 2008 prior to expiry.
The central question before the court was whether a transaction which had reached its natural maturity prior to an Early Termination pursuant to Section 6 of the ISDA Master Agreement could still be regarded as “outstanding” for the purposes of Section 6(a) or “in effect” for the purpose of the definition of “Terminated Transactions”. Flaux J answered this question in the negative. As such, this type of transaction cannot be taken into account when calculating a termination amount under Section 6 of the ISDA Master Agreement.
Flaux J also made clear that:
(1) The “Single Agreement” provision in Section 1(c) of the ISDA Master Agreement is to facilitate set-off and ensure that default under one transaction constitutes a default under all transactions. It says nothing about which transactions form part of that single agreement or the survival of obligations beyond the natural maturity of the transaction to which such obligations relate.
(2) Applying Firth Rixson, if a transaction terminates at its natural maturity and at that point any payment obligations due to the Defaulting Party are still suspended due to the operation of Section 2(a)(iii), that obligation ceases to exist, irrespective of any subsequent termination of a more general nature under the ISDA Master Agreement.
(3) Conversely, if a transaction terminates at its natural maturity and at that point any payment obligations due to the non-Defaulting Party are still outstanding, these obligations will constitute an accrued debt which, under ordinary contractual principles, is not extinguished by the termination of the underlying contract and which will carry default interest under the ISDA Master Agreement until the date of actual payment.
Importantly, Flaux J also confirmed the view he first expressed in Marine Trade that where the conditions precedent in Section 2(a)(iii) have not been satisfied, netting is not available to a Defaulting Party (i.e. the “gross” basis continues to apply).
But the story does not end there…
Almost immediately following the publication of the judgement in Cosco came Pioneer Freight Futures Company Limited v TMT Asia Limited, a case which also concerned the entry by Pioneer into a number of FFAs. The matter was originally heard in November 2010 where it was held that Pioneer was entitled to approximately USD 26 million from TMT on the basis that the “net” basis applies both to payments that would have to be made before an Early Termination Date (“Retrospective Loss”) or after the Early Termination Date (“Prospective Losses”).
However, in light of the findings in Firth Rixson, TMT was given permission to lodge an amended defence, the effect of which, if successful, would be to reduce Pioneer’s claim to approximately USD 16.5 million, on the basis that 9 of the 18 FFAs entered into by the parties had reached maturity in December 2008 and so were not to be taken into account in determining a termination payment under Section 6 of the ISDA Master Agreement.
“Net” Basis or “Gross” Basis?
Gloster J reconfirmed her view that the “net” basis applied rather than the “gross” basis and expressed the belief that the conclusions reached by Flaux J in both Marine Trade and Cosco were incorrect. She held that “the broad commercial scheme…under section 6(e)(i)(4)) is that aggregate or gross amounts in respect of all Transactions between the parties subject to the Master Agreement are to be netted off against each other…I cannot see that there is any sensible commercial justification or rationale for a construction of section 2 of ISDA 92 which enables a Non-defaulting Party to claim against a Defaulting Party on a gross basis. It appears to be wholly contrary to the ethos of ISDA 92…and the clear commercial purpose of the parties that all amounts outstanding under all Transactions subject to one ISDA 92 Master Agreement should be subject to automatic payment netting in respect of payments due on the same date. It emasculates the netting provisions of section 2(c) in the very circumstances where they may be most needed: namely where a Defaulting Party in the money may have to wait a long time for payment of what is owing to it (for example, until cure of its own Event of Default, or potential Event of Default, or Early Termination), and where it may well itself be subject to cash flow constraints, or other financial pressures. On the contrary, it confers a wholly unmerited (in commercial terms) benefit on the Non-defaulting Party. Such a construction would, in my mind, fundamentally change the financial structure of the relationship”
Due to the fact that both TMT and Cosco are to be heard by the Court of Appeal and because the “net” basis” versus “gross” basis question was determinative in the case before her, Gloster J declined to express any view on the issues of whether:
(1) Automatic Early Termination can apply to a Transaction after its natural expiry, or
(2) A suspended debt obligation owed to a Defaulting Party is extinguished once and for all at the natural maturity of a transaction if the condition precedent in Section 2(a)(iii) has not been satisfied by that point.
It is still unclear as to whether the “net” basis or the “gross” basis applies as a matter of English law. However, given the comments of both Briggs J in Firth Rixson and Gloster J in TMT regarding the conclusions reached by Flaux J in both Marine Trade and Cosco, it would seem sensible to regard the “net” basis as more accurately capturing the current state of English law in this area. Nonetheless, as leave to appeal has been granted in relation to both TMT and Cosco, clarity should be provided by the Court of Appeal in the near future on both this question, the nature of what constitute an “outstanding Transaction” and the circumstances in which debt obligations which have been suspended by the operation of Section 2(a)(iii) are extinguished.
And Elsewhere… “Loss” Under the ISDA Master Agreement
In July 2011, Anthracite Rated Investments (Jersey) Limited v Lehman Brothers Finance S.A. came before the High Court. This case concerns the proper calculation of “Loss” following termination of a derivative contract documented under a 1992 ISDA Master Agreement.
Although it may provide some useful guidance to practitioners in the fund- and equity- linked derivatives areas regarding the drafting of early close-out provisions, the facts of Anthracite are not particularly relevant. The litigation flowed from the issuance of certain ‘off-balance sheet’ notes by Anthracite (an SPV) in relation to which Lehman Brothers Finance S.A. (“LBF”) provided principal protection by way of an option sold to Anthracite. LBF became subject to an Event of Default following the bankruptcy of its Credit Support Provider, Lehman Brothers Holdings Ltd, on 15 September 2008.
‘Automatic Early Termination’, ‘Second Method’ and ‘Loss’ all applied to the transaction. This resulted in a claim being lodged by Anthracite in its capacity as the non-Defaulting Party with respect to its Loss. LBF disputed the claim, counter-claiming that it was entitled to an ‘early close-out fee’ under the terms of the transaction documentation.
On the facts of the case, the court held that LBF was not contractually entitled to receive the early close-out fee. However, in doing so, it provided a neat summary of the current state of the law with respect to various aspects of the ISDA Master Agreement, as set out below:
(1) Loss and Market Quotation are, although different formulae, aimed at achieving broadly the same result;
(2) A non-Defaulting Party’s ‘loss of bargain’ arising from the termination of a derivative transaction should be valued on a ‘clean’ basis and not a ‘dirty’ basis. In other words, it should be valued on the assumption that, but for the termination, the transaction would have proceeded until maturity and all conditions to its full performance would have been satisfied by both parties, “however improbable that assumption may be in the real world”; and
(3) The termination payment methodologies described under section 6(e) of the 1992 ISDA Master Agreement are not to be equated with the common law measure of damages for breach of contract. Rather, they provide a contractual formula for the determination by a non-Defaulting Party of a close-out payment on early termination of a derivative transaction.