Legal and documentation expert, Michael Beaton of Derivatives Risk Solutions, explains how a recent court case offers a summary of some of the key issues that can arise in the event of an early termination of transactions executed under an ISDA master agreement in the event of a bankruptcy.
Introduction
The recent judgment of the High Court in Deiulemar Shipping SpA and another v Transfield ER Futures Ltd highlighted several aspects of the ISDA Master Agreement which can sometimes be overlooked, including:
• the correct test for bankruptcy under Section 5(a)(vii)(2);
• whether the ‘Nil Loss’ argument constitutes good law, and
• whether a guarantor is also a Credit Support Provider under the ISDA Master Agreement.
Background
The case related to six Forward Freight Swap Agreements (“FFAs”) entered into between July and September 2008. Each of the FFAs contained the normal condition precedent found in Section 2(a)(iii) of the ISDA Master Agreement to the effect that the obligation of each party to make payment was subject to the condition precedent that no Event of Default or Potential Event of Default with respect to the other party had occurred and was continuing. In addition, the standard bankruptcy Event of Default within Section 5(a)(vii)(2) applied, allowing a party to terminate if its counterparty or the Credit Support Provider of its counterparty became “insolvent or unable to pay its debts or failed or admitted its inability generally to pay its debts as they become due”.
In order to avoid a counterclaim by Transfield ER Futures Ltd (“Transfield Futures”) totalling approximately USD 45 million, arising as a result of a failure to pay by Deiulemar Shipping SpA (“Deiulemar”), Deiulemar sought to establish the existence of a pre-existing Event of Default on the part of Transfield Futures, which would have negated Deiulemar’s liability to pay pursuant to Section 2(a)(iii). Specifically, Deiulemar alleged that at the time of its failure to pay:
• Transfield Futures was “insolvent” in a balance sheet sense on the basis that it had an excess of liabilities over assets;
• Transfield Shipping Inc (“Transfield Shipping”), another member of the Transfield group, was a “Credit Support Provider” of Transfield Futures by virtue of its position as a guarantor under a letter of guarantee; and
• Transfield Shipping was also unable to pay its debts as they became due and/or failed generally to pay its debts as they became due.
The fact that Transfield Shipping was unable to pay its debts was not disputed. As such, the main questions for the court to decide were:
• was Transfield Futures “insolvent” at the relevant time for the purposes of Section 5(a)(vii)(2), and
• was Transfield Shipping a “Credit Support Provider”?
The Test of Insolvency
In holding on the facts that Transfield Futures was not insolvent, the court provided a useful summary of the law in this area, known as the “Balance Sheet Test”.
Section 123(2) of the Insolvency Act 1986 states that a “company is…deemed unable to pay its debts if it is proved to the satisfaction of the court that the value of the company’s assets is less than the amount of its liabilities, taking into account contingent and prospective liabilities”. Following previous caselaw, the court held that this was also the appropriate text for determining whether a party is insolvent for the purposes of triggering an Event of Default under Section 5(a)(vii)(2) of the ISDA Master Agreement. The court lent its approval to the clear line of authority which confirms that, in applying the Balance Sheet Test, the court is to determine, on the basis of facts known or which could reasonably have been known to the parties at the relevant time, when the company can be said to have reached the ‘point of no return due to an incurable deficiency in its assets’. The court was at pains to note, however, that this is not simply an exercise in assessing whether the company has a balance sheet deficit, but is primarily to do with understanding when it can no longer pay its debts.
‘Nil Loss’ Argument
The ‘Nil Loss’ argument has been advanced on a number of occasions as a method by which parties to an ISDA Master Agreement have sought to reduce the amount that they would otherwise be liable to pay on a close-out. Briefly, the ‘Nil Loss’ argument states that:
• absent termination of the relevant transaction(s), if a party (“A”), to an ISDA Master is affected by an Event of Default, Section 2(a)(iii) will operate so as to mean that no further payments are owing to A from the other party (“B”);
• where “Loss” applies under the ISDA Master Agreement, B is not obliged to make any ‘assumptions regarding satisfaction of conditions precedent’ (as is the case where “Market Quotation” applies) due to the absence of this wording in the definition of “Loss”;
• therefore, in determining its “Loss”, B should look at what would have actually happened if the transaction had not come to an end;
• in these circumstances, the operation of Section 2(a)(iii) would have meant that nothing would have been payable to A by B;
• accordingly, no gain can be said to have been made by B on early termination and so there is nothing to include in the close-out calculations applicable to B.
The ‘Nil Loss’ argument suffers from the problem that it is based on several flawed assumptions, including that an Event of Default continues for the remainder of the term of the relevant transaction(s). In reality, this is not always the case. Moreover, where termination does occur, consideration of the amounts owed by, or to, parties to an ISDA Master Agreement moves from Section 2 to Section 6. Section 6 does not include any conditions precedent as are found in Section 2, but rather requires a full reconciliation and payment of all amounts due (often referred to as a “wash out”).
If true, the ‘Nil Loss’ argument would mean that, even under the Second Method, a Non-defaulting Party would only have to give credit to a Defaulting Party with respect to payments required to be made before the Early Termination Date, but which were not made (sometimes referred to as “Retrospective Losses”). Specifically, a Non-defaulting Party would not have to give credit with respect to a “gain of bargain” i.e. the fact that a Bankruptcy Event of Default may have removed the requirement for the Non-defaulting Party to make further payments to the Defaulting Party (sometimes referred to as “Prospective Losses”).
Unfortunately for its advocates, the ‘Nil Loss’ argument has been disapproved of on every occasion on which it has come before a court, and this occasion was no exception, the court finding that it “was weak and very likely to fail”.
Whether a guarantor is a Credit Support Provider
The terms of the ISDA Master Agreement which were incorporated as part of the FFAs executed by Deiulemar and Transfield Futures did not incorporate a schedule. On the facts the only election which had been made by the parties was that Credit Event Upon Merger should apply.
The court accepted that it would have made sense for the parties to have specified Transfield Shipping as a Credit Support Provider, and agreed that a guarantor would fall within the colloquial use of the words ‘credit support provider’. However, the question before the court was whether the status of a “Credit Support Provider” could be conferred on Transfield Shipping in circumstances where the FFAs did not expressly do so.
Having regard to the importance of the status of a Credit Support Provider to the operation of Section 5 of the ISDA Master Agreement, the court held that to treat Transfield Shipping as a Credit Support Provider would be to make a bargain for the parties which they could have made for themselves, but did not. On this basis, the court declined to imply this status for Transfield Shipping.
Conclusion
This judgment of the court in this case holds no surprises, merely confirming that which practitioners should already know or be able to easily guess. Nonetheless, it is a useful summary of some of the issues which can arise on the early termination of transactions executed under an ISDA Master Agreement, and a reminder of the constant need to ‘get the basics right’ in terms of specifying such things as “Credit Support Providers” and “Specified Entities”, as well as the risks inherent in relying solely on the pre-printed form of the ISDA Master Agreement.
