The recent court case, Lomas v. JFB Rixson offers some clarification on various questions relating to the ‘flawed asset’ provision 2(a)(iii) of ISDA Master Agreements however, this guidance may be short lived, explains Michael Beaton, of Derivatives Risk Solutions.
Introduction
The Court of Appeal has recently passed judgment on four cases, all of which relate to Section 2(a)(iii) of the ISDA Master Agreement – the “flawed asset” provision which renders the obligations of each party to make payment or delivery conditional upon the non-occurrence of certain events, particularly an Event of Default.
Section 2(a)(iii) was originally designed to protect a Non-defaulting Party from having to make payment to a counterparty which might not be able to fulfil its own obligations, or to prematurely close out all transactions. However, in all of the cases before the Court of Appeal, an ‘out-of-the-money’ Non-defaulting Party had chosen not to designate an Early Termination Date following the occurrence of an Event of Default, but instead had chosen to rely on Section 2(a)(iii) and simply not make payment to its ‘in-the-money’ defaulting counterparty. During the ensuing litigation, the Court of Appeal provided guidance on a number of questions.
1. Is a Non-defaulting Party under any obligation at all following an Event of Default?
The Court distinguished payment obligations from debt obligations. It noted that Section 2 of the ISDA Master Agreement was concerned only with the former and not the latter, concluding that underlying debt obligations are not affected by an Event of Default and so continue to exist. In contrast, payment obligations are suspended by the occurrence of an Event of Default. The court drew further support from Section 6 of the ISDA Master Agreement which states that, in the event of an early termination, the net position of the parties is to be calculated as if all applicable conditions precedent have been satisfied. The court reasoned that, if Section 2(a)(iii) were to operate to prevent a debt obligation from existing at all, the early termination calculation contemplated by Section 6 could never take place since there would be no obligation of the Non-defaulting Party to take into account.
2. Is the payment obligation extinguished or suspended?
The High Court had previously held that, following an Event of Default, any obligation on the Non-defaulting Party to pay was extinguished rather than suspended. However, subsequent caselaw had concluded “on a fairly narrow balance” that payment obligations were merely suspended; a decision with which the Court of Appeal agreed on the basis that:
• to treat the payment obligation as extinguished was too drastic a remedy given the range and variety of actual and potential Events of Default;
• it was more natural to read the obligation to pay as being suspended while an Event of Default continues; and
• the calculations of loss in relation to Early Termination or Automatic Early Termination require it to be assumed that any condition precedent has been satisfied. Therefore, it would be counter-intuitive to find that, where an Event of Default had occurred, the condition precedent operated so as to extinguish, rather than suspend, the underlying payment obligation.
3. Given that payment obligations are only suspended, when does the suspension end?
A suspension will end if the underlying Event of Default is cured. However, absent a cure, a number of possible answers were suggested:
3.1 Suspension for a “reasonable time”?
It was argued that payment obligations are suspended for “a reasonable time”, sufficient to enable the Non-defaulting Party to decide whether to terminate or continue to perform its obligations. The Court of Appeal reject this possibility on the basis that:
• it was not necessary to make the contract work and was contrary to the words “…and is continuing…”within section 2(a)(iii), and
• the proposed term would require a Non-defaulting Party (after a reasonable time) to terminate all outstanding transactions and not just the transaction to which the Event of Default related.
3.2 Suspension until expiry of the transaction?
The Court of Appeal was also asked to imply a term into the ISDA to the effect that section 2(a)(iii) suspends the Non-defaulting Party’s payment obligations until such time as all Transactions have matured. At this point the Non-defaulting Party must either submit to a netting process which incorporates all suspended payment obligations or submit to the consequences of an Early Termination.
A court will only imply a term into a contract if it is necessary to do so or if it would be obvious to any disinterested third party that the contract must have the meaning which the implied term would give it. The Court of Appeal thought that neither of these tests were satisfied and declined to imply such a term; the ISDA worked perfectly well without such a term and to imply it would be to “re-write the contract”.
3.3 Constant Obligation to consider termination?
It had been argued before the High Court that a term should be implied into the ISDA to the effect that the Non-defaulting Party is under a constant obligation to exercise its discretion whether or not to designate an Early Termination Date in a manner which is not arbitrary, capricious or unreasonable so that, once it is clear that the other party’s default is permanent, or where the Non-defaulting Party decides to re-hedge, it must exercise its discretion in favour of Early Termination. Fortunately, this argument was not pursued before the Court of Appeal, who regarded it as “even more hopeless than the others”.
3.4 So what did the Court decide?
The Court of Appeal held that the condition precedent suspending payment continues in force until:
• the Event of Default is cured, or
• the Non-defaulting Party elects for termination.
If neither occurs, there continues to be no obligation on the Non-defaulting Party to make payment. However, if the Event of Default is cured, the obligation to pay is revived, even if the underlying transaction has matured.
4. “Gross” or “Net” Basis?
The Court of Appeal was asked to consider whether a Non-defaulting Party can rely on Section 2(a)(iii) to withhold payment whilst simultaneously enforcing its defaulting counterparty’s payment obligation in full (the “gross” basis), or whether the Non-defaulting Party must give credit for amounts due to its defaulting counterparty (the “net” basis). Overruling previous caselaw, the court concluded that the net basis applied to payment obligations, but only to obligations which were payable on the same date. The gross basis would undermine the commercial purposes of the ISDA Master Agreement which was to mitigate counterparty credit risk via an automatic payment netting mechanism.
5. Does Section 2(a)(iii) offend the Anti-Deprivation Rule?
The “anti-deprivation” rule is the proposition that one cannot contract out of the provisions of insolvency legislation which requires pari passu treatment of creditors. In applying the anti-deprivation rule it is necessary to look at the substance of the agreement rather than its form and to consider whether the provision in question amounts to an illegitimate attempt to evade the relevant bankruptcy law or has some legitimate commercial basis.
The Court of Appeal held that there was no suggestion that section 2(a)(iii) was designed to avoid the effect of any insolvency law or to give the Non-defaulting Party a greater or disproportionate return as a creditor of the bankrupt estate. Rather, the suspension of payment obligations did no more than prevent the Non-defaulting Party from having to make payment to a bankrupt counterparty. As such, Section 2(a)(iii) did not offend the anti-deprivation rule.
6. Does Section 2(a)(iii) offend the Pari Passu rule?
In contrast to the anti-deprivation rule, the rule requiring pari passu distribution on insolvency does not depend for its application on questions of commerciality and good faith. Nonetheless, the Court of Appeal held that Section 2(a)(iii) did not infringe the pari passu rule because it operates to prevent the relevant debt ever becoming payable. As such, there was no property capable of being distributed.
7. Are unperformed obligations which have arisen (or would but for Section 2(a)(iii) have arisen) under transactions which have already matured prior to the occurrence of Automatic Early Termination subject to close-out netting?
The Court of Appeal held that the close-out netting calculation under Section 6(e) of the ISDA Master Agreement included any unperformed obligations with respect to Transactions which had already matured. The rationale behind this decision flowed naturally from the previous conclusions that:
• underlying debt obligations are not affected by an Event of Default
• payment obligations are not extinguished by the occurrence of an Event of Default; and
• payment obligations are not extinguished on the maturity of a Transaction.
8. What is the relationship between “Loss” and “Market Quotation”?
The Court of Appeal held that Loss and Market Quotation, although different formulae, are aimed at achieving broadly the same result (although neither should be regarded rigidly as being synonymous with the quantification of damages at common law for breach of contract). Furthermore, the calculation of a Non-defaulting Party’s “Loss” requires a “clean” rather than “dirty” market valuation of the relevant transactions. This means that Loss must be valued on an assumption that, but for termination, the transaction would have proceeded to maturity, and that all conditions to full performance by both sides would have been satisfied, however improbable that may be in reality.
Conclusion
This judgment is of particular significance to out-of-the-money non-defaulting counterparties seeking to rely on Section 2(a)(iii) under English law governed ISDAs – they now know that they remain potentially liable to make payment if the underlying Event of Default is cured, even after the maturity of the transaction. However, this may not be the end of the story…
In December 2009, an HM Treasury consultation paper highlighted the disadvantage that a Defaulting Party and its creditors can suffer if prevented from claiming monies owed under an ISDA. A market solution, which facilitates flexible termination and safeguards Non-defaulting Parties whilst providing certainty for Defaulting Parties that termination will occur within a reasonable period, was encouraged. The government did not rule out legislating in the absence of such a solution.
In response, ISDA established a working party to re-examine the wording of Section 2(a)(iii). On 8 April 2011, the working party published a consultation document on proposed amendments to Section 2(a)(iii) and related provisions of the ISDA Master Agreement and Credit Support Documentation. One of the amendments suggested by ISDA was that payment obligations should become due on the earlier of:
• the date on which the conditions precedent in Section 2(a)(iii) are satisfied;
• the first Local Business Day occurring either 90 or 180 days after a Non-defaulting Party does not make payment or delivery to the Defaulting Party on the basis of Section 2(a)(iii); and
• the date on which all applicable conditions precedent cease to apply under any other provision of the ISDA.
As such, it seems as though the clarity provided by the Court of Appeal may be short-lived. Nonetheless, even if it ultimately proves to be only an interim statement of the law in this area, this judgment should be regarded as a welcome development for the entire market.
