English Court Of Appeal Interprets The ISDA Master Agreement

Last week the Court of Appeal of England and Wales handed down its decision in four appeals which raise a number of questions of construction in relation to derivatives in the form of interest rate swaps and forward freight agreements documented under the International Swaps and Derivatives Association Inc. Master Agreement (the "ISDA Master Agreement").1 In particular, the decision focuses on the interpretation of section 2(a)(iii) of the ISDA Master Agreement.

Key Points

Under section 2(a)(iii), the underlying debt obligation between the parties to the ISDA Master Agreement is undisturbed by an Event of Default – the section deals with the payment obligation alone. Under section 2(a)(iii), a Non-defaulting Party's payment obligation is not extinguished because of an Event of Default – it is merely suspended. Nor is the payment obligation extinguished on the maturity of the transaction. The suspension of the payment obligation may be indefinite – the condition precedent under section 2(a)(iii) continues in force until the Event of Default is cured. There is no implied term that the payment obligation revives at any other time. The suspensory effect of section 2(a)(iii) cannot be said to engage the English law antideprivation principle. Nor does section 2(a)(iii) breach the English law pari passu rule of distribution. A Non-defaulting Party who wishes to enforce the payment obligation of the Defaulting Party must give credit for what is due by the Non-defaulting Party under its part of the swap. Individual transactions whose natural term has expired prior to the occurrence of Automatic Early Termination are subject to close-out netting. This is consistent with the "single agreement" provision in section 1(c). In determining "Loss", the parties are required to assume that the conditions precedent specified in section 2(a)(iii) to any payment obligations have been satisfied. The Metavante decision by the United States Bankruptcy Court concluded that the United States Bankruptcy Code prohibited the enforcement of section 2(a)(iii). However, the Court of Appeal decision and Metavante can be reconciled. Commentary

The decision of the Court of Appeal will be studied closely by all market participants.

Non-defaulting Parties that are "out of the money" will note that their obligation to pay is not extinguished after the scheduled maturity date of the underlying transaction. Market participants who have been concerned that they may be forced to designate an Early Termination Date will welcome the decision that there is no implied terms in the ISDA Master Agreement which require termination after a reasonable period. The derivatives industry may have to consider whether the ISDA Master Agreement will need amending to address concerns that its provisions may be used to withhold payments from insolvent entities. In its 2009 consultation paper,2 HM Treasury expressed the view that payments due to insolvent counterparties should not be withheld indefinitely as this creates undesirable uncertainty for administrators and the general creditors of insolvent counterparties. It remains to be seen whether HM Treasury will introduce a statutory solution to the effect of section 2(a)(iii) as confirmed by the decision of the Court of Appeal. The First Appeal

The First Appeal is from the decision of Briggs J in the High Court3 and relates to a series of interest rate swap transactions entered into between Lehman Brothers International (Europe) ("LBIE") and a number of counterparties including JFB Firth Rixon. The entry into of administration by LBIE on 15 September 2008 constituted an Event of Default under each of the transactions entitling each of the non-defaulting counterparties to designate an Early Termination Date. The non-defaulting counterparties never designated an Early Termination Date – the transactions were "in the money" to LBIE – and instead relied on section 2(a)(iii) of the ISDA Master Agreement to argue that no further amounts were due to LBIE as any payment obligation is subject to the condition precedent that "no Event of Default has occurred and is continuing".

The issue raised by the First Appeal is whether obligations to make payments pursuant to the ISDA Master Agreement subsist after the party to whom payment is due has committed an Event of Default and, if so, for how long.

Did the occurrence of an Event of Default have the effect that no amounts ever became due and payable from the Non-defaulting Party?

In analysing section 2 of the ISDA Master Agreement, the court drew a distinction between payment obligations and underlying debt obligations and concluded that the underlying debt obligation is undisturbed by the Event of Default – it is merely the payment...