Interpretation Of Section 2(a)(iii) Of The ISDA Master Agreement

In Lomas and Others v JFB Firth Rixson, Inc and Others [2010] EWHC 3372 (Ch), the High Court considered the meaning and effect of Section 2(a)(iii) of the ISDA Master Agreement (1992 and 2002 versions), which provides that the payment obligations of the parties are subject to the condition precedent that no event of default is continuing with respect to the other party.

The joint administrators ("the Administrators") of Lehman Brothers International Europe ("LBIE") applied for directions as to the true construction and effect of five interest rate swap agreements pursuant to which LBIE was the floating rate payer. Each swap incorporated the terms of either the 1992 or the 2002 version of the ISDA Master Agreement.

Background

The Respondents, LBIE's fixed rate paying counterparties, relied on Section 2(a)(iii) of the Master Agreement as the basis for a refusal to make payments which would otherwise have fallen due to LBIE. Section 2(a)(iii) provides that a party's payment obligations are subject (amongst other things) to the condition precedent that there is no continuing Event of Default with respect to the other party. One such Event of Default is the "Bankruptcy" of the counterparty, which includes the appointment of an administrator. Accordingly, as at 15 September 2008, there was an Event of Default in respect of LBIE. The Respondents argued that because of this Event of Default they did not have any obligation to make any further fixed rate payments to LBIE (LBIE would otherwise have been very substantially in the money under all five swaps).

The Administrators challenged the counterparties' interpretation of the Master Agreement under four headings:

1 The Respondents' interpretation was, they said, commercially absurd and/or unreasonable and must therefore yield to implied terms to the contrary. They advanced three alternatives:

that the non-defaulting party's payment obligation was only suspended for a "reasonable period", to allow it to decide whether to designate an Early Termination Date ("ETD"); that Section 2(a)(iii) suspended the non-defaulting party's payment obligations until the end of the term of the transaction, at which point it was obliged to designate an ETD; and/or the non-defaulting party had a discretion whether or not to designate an ETD and had to do so in a manner which was not arbitrary, capricious or unreasonable. 2 The Master Agreement offended the "anti-deprivation principle", because the adverse effects on...