Section 2(a)(iii) ISDA® Master Agreement: Court of Appeal judgment on four appeals

Practical Law UK Legal Update Case Report 0-518-7969 (Approx. 14 pages)

Section 2(a)(iii) ISDA® Master Agreement: Court of Appeal judgment on four appeals

by PLC Finance

Background

ISDA Master Agreement

The International Swaps and Derivatives Association, Inc (ISDA®) is the dominant trade association for participants in the over-the-counter derivatives markets. It has developed a standard "document platform" for the documenting of derivative transactions, which includes ISDA Master Agreements that provide a framework agreement between two parties, under which individual derivatives transactions may be carried out.

The two versions of the ISDA Master Agreement most commonly used are:

1992 ISDA Master Agreement (Multicurrency - Cross Border).
2002 ISDA Master Agreement.

Although the 2002 ISDA Master Agreement is the most recent version of the agreement, many derivative transactions are still subject to the 1992 ISDA Master Agreement. For more information on ISDA documentation (including the ISDA Master Agreements), see Practice note, ISDA documents: overview (UK).

Provisions in both 1992 and 2002 Master Agreements

Many of the terms of the 1992 ISDA Master Agreement are similar or identical to the terms of the 2002 ISDA Master Agreement.

Both forms of ISDA Master Agreement provide for:

Single agreement. All transactions entered into under the ISDA Master Agreement and its confirmations form a single agreement (section 1(c)).
Payment subject to the condition precedent that no event of default is continuing. Each transactional payment obligation of a party is subject to the condition precedent that no event of default, with respect to the other party, has occurred and is continuing (section 2(a)(iii)).
Netting. If amounts are owed by both parties under the agreement, an automatic netting process sets off the gross amounts that "would otherwise be payable" from each party in the same currency on the same date, in respect of the same or, at the parties' election, two or more transactions under the agreement. The difference is then paid by the party out of the money to the party in the money (section 2(c)).
Early termination. If a party is in default, the other party may serve a notice on the defaulting party that will crystallise the liability of each party for all outstanding transactions under the agreement. The net financial position between the parties is then calculated and, ordinarily, the net amount of the liabilities is then paid to whichever party is in the money (section 6(a)).
Automatic Early Termination. If this is elected to apply, then an Early Termination Date arises immediately (rather than at the designation of the non-defaulting party) on the occurrence of certain Bankruptcy Events of Default (section 6(a)).
Terminated Transactions. These are defined as "all Transactions in effect immediately before the effectiveness of the notice designating the Early Termination Date (or, if Automatic Early Termination applies, immediately before that Early Termination Date)."

Provisions only in 1992 Master Agreement

Only the 1992 ISDA Master Agreement allows the parties to choose between two alternative methods of calculating close-out amounts and determining which party is entitled to receive those close-out amounts:

Calculating close-out amounts. Close-out amounts are amounts that are calculated for transactions which are terminated early as a result of an event of default. In calculating close-out amounts, parties can choose between:
- Market Quotation; or
- Loss.
Determining which party receives close-out amounts. There are two alternative methods of determining which party is entitled to receive close-out amounts:
- First Method.
- Second Method.

For an explanation of Market Quotation, Loss, First Method and Second Method, see Legal update, Automatic early termination bars reliance on section 2(a)(iii) of ISDA Master Agreement (High Court).

Anti-deprivation principle and pari passu rule of distribution

Anti-deprivation principle

The anti-deprivation principle is a common law power of the court to strike out a contractual provision, if its effect is to deprive a company's creditors of the benefit of an asset of the company in the event of the company's insolvency. For more information on the principle, see Practice note, Reviewable transactions in corporate insolvency: The anti-deprivation principle.

Pari passu rule of distribution

The pari passu rule means that all unsecured creditors in an administration or a liquidation must share equally any available assets of the company, in proportion to the debts due to each creditor. It invalidates arrangements under which a creditor receives more than its proper share of the available assets or where debts due to the company on liquidation are dealt with (other than in accordance with the statutory insolvency regime). For more information on asset distribution on insolvency, see Practice note, How are assets distributed to creditors in corporate insolvency procedures?.

Section 2(a)(iii) uncertainty in the High Court

Recent cases in the High Court (HC) have led to conflicting decisions being handed down in relation to the effect of section 2(a)(iii) of the ISDA Master Agreement.

Section 2(a)(iii) allows a non-defaulting party to withhold payments from a defaulting party, for as long as the Event of Default continues. This has the effect of frustrating a defaulting party from claiming moneys owed to it by the non-defaulting party. This can have an adverse effect on the defaulting party's creditors. Defaulting parties have therefore argued that this cannot be the intention of the ISDA Master Agreement, as it does not make commercial sense.

Uncertainty had also arisen as to how long the non-defaulting party can withhold payment and whether the obligation to pay is extinguished on the next payment date, on the expiry of the individual transaction, or whether it continues indefinitely. For example:

In Marine Trade SA v Pioneer Freight Futures Co Ltd BVI and another [2009] EWHC 2656 (Comm) (Marine Trade), Flaux J suggested, obiter, that even if the defaulting party ceased to be in default, there was nothing in the ISDA Master Agreement to suggest that the non-defaulting party's obligation to pay would be automatically revived. The court's view was that section 2(a)(iii) was a "one time" provision for the calculation of whether an amount is payable, that is, if no payment obligation existed on the relevant settlement date, the payment obligation would be extinguished (see Legal update, Winner takes all under 1992 ISDA Master Agreement. The decision was in contrast to an earlier judgment of the US Bankruptcy Court (see Legal update, Lehman Court Ruling in Metavante Expected to Complicate Withholding Payment on Derivatives Contracts), where the US court decided that the non-defaulting party must either continue to make payments under an interest rate swap or terminate the transaction and pay amounts due to the defaulting party.
In Lomas and others v JFB Firth Rixson Inc and others [2010] EWHC 3372 (Ch), contrary to the obiter statement in Marine Trade, Briggs J held that a payment obligation is suspended until the event of default is cured, but only until the expiry of the term of the transaction, at which point, if the Event of Default has not been cured, the payment obligation is extinguished (see Legal update, High Court rules on effect of section 2(a)(iii) of ISDA Master Agreement). This interpretation was also favoured in later HC judgments.
ISDA, on the other hand, which was granted leave to intervene in Lomas v JFB Firth Rixson, maintained that the effect of a continuing default on a particular payment date is only to suspend the payment obligation until the default is cured and the condition precedent is satisfied, rather than by the passage of time or termination of the transaction. The suspended payment obligation could, in theory, persist indefinitely.

Section 2(a)(iii) clarity in the Court of Appeal

The lack of clarity in the HC decisions and their conflict with the derivatives market's expectations led to the following four key judgments being appealed in December 2011:

Lomas and others v JFB Firth Rixson Inc and others [2010] EWHC 3372 (Ch).
Lehman Brothers Special Financing Inc v Carlton Communications Ltd [2011] EWHC 718 (Ch).
Pioneer Freight Futures Company Ltd v Cosco Bulk Carrier Company Ltd [2011] EWHC 1692 (Comm).
Britannia Bulk plc v Pioneer Navigation Ltd and others [2011] EWHC 692 (Comm).

The appeals were heard together and judgment was handed down on 3 April 2012.

The first two cases involved Events of Default under interest rate swaps following the collapse of Lehman Brothers. The transactions, documented under 1992 ISDA Master Agreements, had not been terminated as the counterparties had opted not to terminate, but instead withhold payments under section 2(a)(iii). The appeals in these cases addressed whether the counterparties could be forced to terminate or whether there was a limit on the amount of time they could withhold payments under section 2(a)(iii).

The second two cases involved Events of Default under forward freight agreements (FFAs), which incorporated the 1992 ISDA Master Agreement. The transactions had terminated under the Automatic Early Termination provisions, which had been selected by the parties to apply to the transactions. The appeals in these cases addressed which amounts should be included in the termination calculations and whether payments that had been withheld under section 2(a)(iii) should be included.

The Court of Appeal's (CA) decisions are explained below.

Appeal 1: Lomas v JFB Firth Rixson

In the first appeal, the administrators for a defaulting party (Lehman Brothers International (Europe)), appealed against the decision of Briggs J in Lomas and others v JFB Firth Rixson Inc and others (see Legal update, High Court rules on effect of section 2(a)(iii) of ISDA Master Agreement).

High Court decision

The HC found in favour of the non-defaulting counterparties under a series of interest rate swaps and held that, under section 2(a)(iii), they could withhold payments due to the defaulting party. Key findings were:

Section 2(a)(iii) has the effect of suspending (while an Event of Default is continuing), rather than extinguishing the payment obligations of the non-defaulting party. This means that a non-defaulting party can withhold payments due to a defaulting party while the default continues.
The suspension only lasts until the transaction terminates or expires at its maturity date, whereupon the payment obligation is extinguished and the non-defaulting party is permanently released from its obligation to pay the defaulting party. One reason the HC gave for reaching this conclusion was that, on its true construction, section 9(c) (survival of obligations) provided for the extinction of the payment obligation.
Terms cannot be implied into the ISDA Master Agreement that payments due to a defaulting party are suspended only for a reasonable time, or that a non-defaulting party is under an obligation to designate an "Early Termination Date" to terminate the transaction.
Section 2(a)(iii) does not fall foul of the anti-deprivation principle simply because it conveys a commercial benefit on one party if the other party becomes insolvent.

The appeal

The administrators for the defaulting party appealed against the HC decision. Arguments were put forward by:

Administrators for the defaulting party. The administrators submitted that the HC decision was a commercially unreasonable interpretation of the ISDA Master Agreement, as it gave rise to an unfair windfall for the non-defaulting parties, who were able to withhold payments they would otherwise have been obliged to pay. They also argued, as they had in the HC hearing, that terms should be implied into the ISDA Master Agreement that payment obligations under section 2(a)(iii) revive after a "reasonable" time or when the transaction terminates, or that a non-defaulting party is under an obligation to designate an Early Termination Date, at which time all amounts owed are payable.
The counterparties. These argued that if a relevant Event of Default is continuing on a scheduled payment date, the wording of section 2(a)(iii) means that either no payment obligation ever arises on the part of the non-defaulting party, or, if a payment obligation does arise, it lasts only until the transaction terminates, at which point it is extinguished.
ISDA. ISDA were granted leave to intervene both at first instance and in the appeal. ISDA submitted that the payment obligation came into existence on the due date and that the condition precedent in section 2(a)(iii) suspended the payment obligation. However, the condition precedent was not extinguished on expiry of a reasonable time or on the maturity of the relevant transaction. The obligation to pay on the non-defaulting party remained in suspension until either the Event of Default was cured or the non-defaulting party chose to terminate the transaction. If the non-defaulting party never elected for termination, the obligation to pay continued to be suspended.

CA decision: section 2(a)(iii) suspends payment obligations indefinitely

The CA dismissed the appeal and upheld the HC decision, but disagreed with the HC on the question of the extinction of the payment obligation on maturity, preferring ISDA's interpretation instead. It held that:

A non-defaulting party under an ISDA Master Agreement can, under section 2(a)(iii), refuse to make payments to a defaulting party while an event of default is continuing.
Payment obligations remain suspended (potentially indefinitely), while the condition precedent remains unfulfilled, and will revive once the default is cured or the non-defaulting party elects to terminate the transaction. Payment obligations are not extinguished by reason of maturity of the transaction (that is, the last date fixed for contractual performance), and amounts continue to accrue while the condition is unfulfilled. In deciding this point, the CA looked at the previous form of ISDA Master Agreement published in 1987, section 9(c) of which did not refer to section 2(a)(iii). The CA concluded that, as a matter of construction, it cannot have been the intention of the 1992 ISDA Master Agreement to introduce the concept that the suspended payment obligation is to be extinguished on maturity. If that had been the intention, it would have been phrased more explicitly.
Terms should not be implied into the ISDA Master Agreement requiring the non-defaulting party to terminate the transaction and pay the defaulting party.
There is a distinction between payment and debt obligations in the ISDA Master Agreement. The debt obligation arises on entry into the transaction and remains in existence at all times. It is not affected by an Event of Default. Section 2 only addresses the obligation to pay, which can be suspended by an Event of Default. This distinction was first noted by Gloster J in Pioneer Freight Futures Company Ltd v TMT Asia Ltd [2011] EWHC 778 (Comm) (PFF v TMT) (see Legal update, Nil loss argument again rejected: reliance on section 2(a)(iii) of ISDA Master Agreement is denied following automatic early termination (High Court)).

Appeal 2: LBSF v Carlton

In the second appeal, a defaulting party (Lehman Brothers Special Financing Inc), under two interest rate swaps, appealed against the decision of Briggs J in Lehman Brothers Special Financing Inc v Carlton Communications Ltd (see Legal update, Section 2(a)(iii) of ISDA Master Agreement considered again (High Court)).

High Court decision

The facts of the case and arguments submitted were similar to those in Lomas v JFB Firth Rixson. The HC followed its earlier decision in Lomas and again found in favour of the non-defaulting counterparties and held that:

Section 2(a)(iii) has the effect of suspending (while an Event of Default is continuing), rather than extinguishing the payment obligations of the non-defaulting party. This means that a non-defaulting party can withhold payments due to a defaulting party while the default continues.
However, this suspension only lasts until the transaction terminates or expires at its maturity date, whereupon the payment obligation is extinguished and the non-defaulting party is permanently released from its obligation to pay the defaulting party.
Terms cannot be implied into the ISDA Master Agreement that payments due to a defaulting party are suspended only for a reasonable time, or that a non-defaulting party is under an obligation to designate an "Early Termination Date" to terminate the transaction.
Section 2(a)(iii) does not contravene the anti-deprivation principle simply because it conveys a commercial benefit on one party if the other party becomes insolvent.

The appeal

The defaulting party appealed against the HC decision, submitting the same arguments as in the first appeal above (see The appeal). However, it also relied on an argument that the operation of section 2(a)(iii) falls foul of the anti-deprivation principle, which was recently considered by the Supreme Court in Belmont Park Investments PTY Ltd v BNY Corporate Trustee Securities Ltd and another [2011] UKSC 38 (see Legal update, Supreme Court guidance on the anti-deprivation rule: flipping great) and the pari passu rule of distribution of assets.

The defaulting party submitted that:

A deprivation occurred on the final payment date for the swaps when payment was due from the non-defaulting party, but was withheld under section 2(a)(iii).
Section 2(a)(iii) breaches the pari passu rule because it suspends the recoverability (and therefore the distribution) of an asset of the estate of an insolvent entity.

CA decision: section 2(a)(iii) does not contravene anti-deprivation or pari passu rule

The CA dismissed the appeal and held that the suspensory effect of section 2(a)(iii) does not contravene:

The anti-deprivation principle, as its purpose is not to deprive creditors of the property of the insolvent company. The Supreme Court in Belmont held that the anti-deprivation rule will only apply if there is a deliberate intention to evade insolvency laws. The rule does not apply to bona fide commercial transactions which do not have, as their main purpose, the deprivation of the property of the insolvent party. The indefinite suspension of the payment obligation of the non-defaulting party may be "imperfect" but it is not "uncommercial".
The pari passu rule of distribution of assets, as there is no asset at the time of liquidation. Section 2(a)(iii) operates to prevent the relevant debt ever becoming payable. There is therefore no property which is capable of being distributed.

Appeal 3: PFF v Cosco

In the third appeal, a defaulting party under 11 FFAs appealed against the decision of Flaux J in Pioneer Freight Futures Company Ltd v Cosco Bulk Carrier Company Ltd [2011] EWHC 1692 (Comm) (see Legal update, Section 2(a)(iii): expired transactions not included in ISDA Early Termination calculations (High Court)).

High Court decision

The HC found in favour of the non-defaulting party and held that transactions, whose final contract month for payment had passed (between an Event of Default and Automatic Early Termination being triggered), were not to be taken into account in calculating the net payment due on Automatic Early Termination, because:

Payment obligations suspended by section 2(a)(iii) do not survive the natural expiry date of a transaction. Therefore, the non-defaulting party's obligations to pay were extinguished on the last date for payment.
Those transactions are therefore not "outstanding transactions" within the meaning of section 6(a), or transactions "in effect" within the definition of "Terminated Transactions" in the 1992 ISDA Master Agreement. Therefore, they cannot be included in the close-out amount calculations to arrive at the net sum payable under section 6(e), following Automatic Early Termination.

This confirmed Flaux J's view in Marine Trade, in which he had held that, where one party is in default under the ISDA Master Agreement, amounts owed by a counterparty are not capable of being netted to reduce the liability of the defaulting party under section 2(c). Flaux J had relied on his interpretation of the word "payable" in section 2(a) of the ISDA Master Agreement to mean an immediately enforceable obligation to pay.

The appeal

The defaulting party appealed against the HC decision, arguing that transactions whose natural term has expired prior to the occurrence of Automatic Early Termination are subject to close-out netting.

The defaulting party argued that all transactions should be included in the close-out calculation under section 6, including those whose final date for payment had passed. Alternatively, the netting provisions of section 2(c) should apply to net off amounts owed by the defaulting party against amounts owed to it.

The non-defaulting party, however, argued that only those transactions with contract months left to run should be included in the close-out calculations, as the other transactions, whose final contract month for payment had passed, had expired before Automatic Early Termination was triggered.

In coming to its decision, the CA considered another recent HC case. Contrary to the decisions of Flaux J in Marine Trade and the first instance decision in PFF v Cosco, Gloster J had held, in Pioneer Freight Futures Company Ltd v TMT Asia Ltd [2011] EWHC 1888 (Comm) (PFF v TMT 2), that:

An approach that concentrated exclusively on the meaning of the word "payable" was far too narrow. There is nothing in the 1992 ISDA Master Agreement that requires the word "payable" in section 2(c) to be limited to amounts that are payable provided that the condition precedent of section 2(a)(iii) has been satisfied.
The "landscape" of the 1992 ISDA Master Agreement (particularly where Second Method is chosen) is that it strongly demonstrates an intention to provide for netting off of payments, both throughout the life of the transactions and on Early Termination or Automatic Early Termination:
- during the life of a transaction, section 2(c) of the 1992 ISDA Master Agreement, operates to ensure that there is a monthly netting off of all gross amounts payable in the same currency on the same day, for all transactions between the parties;
- on Early Termination or Automatic Early Termination, Second Method, section 6 and the relevant definitions in section 14 require a closing or wash-out calculation that produces one final net figure that one party is obliged to pay the other.
There is no commercial justification or linguistic requirement that amounts referred to in section 2(c) should be construed as amounts that would only be payable provided that the conditions precedent of section 2(a)(iii) are satisfied. Payments should be made without regard to whether one party has complied with the conditions precedent specified in section 2(a)(iii).
Any construction that would entitle a non-defaulting party to insist on payment from a defaulting party on a gross basis would undermine the commercial purpose of section 2, and would be "wholly contrary to the ethos" of the 1992 ISDA Master Agreement.

CA decision: expired transactions included in close-out netting

The CA allowed the appeal and overturned the HC decision. It held that:

All transactions, including those that have final payment dates falling before the Early Termination Date, where payments have been suspended under section 2(a)(iii), should be included in close-out amount calculations for the reasons given in the first appeal, namely that the maturity date of a transaction does not extinguish the payment obligation, so it continues to be in existence.
It is possible for the non-defaulting party to terminate "early" after the maturity date of the transaction, just as Automatic Early Termination can take place after the maturity date of the transaction.
Under section 2(c), a non-defaulting party who wishes to enforce the payment obligations of the defaulting party must give credit for what is due under its part of the agreement. This extends to any sums which would have been payable to the defaulting party on an earlier date, had they not been suspended by section 2(a)(iii).
Section 2(c) applies only to amounts which are payable on the same date in respect of the same transactions. In this case, the defaulting party would not, therefore, have been able to set off sums it owed in one month against sums owed to it in a later month.
Gloster J's analysis in PFF v TMT 2 is correct. The 1992 ISDA Master Agreement provides for netting off of payments, both throughout the life of transactions under section 2(c) and on Early Termination or Automatic Early Termination under section 6.

Appeal 4: Britannia Bulk

In the fourth appeal, a non-defaulting party under a series of FFAs appealed against the decision of Flaux J in Britannia Bulk plc v Pioneer Navigation Ltd and others [2011] EWHC 692 (Comm), (see Legal update, Automatic early termination bars reliance on section 2(a)(iii) of ISDA Master Agreement (High Court)).

High Court decision

The HC found in favour of the defaulting party and held that:

Once an Early Termination Date is automatically designated as a result of an Automatic Early Termination event, a party cannot rely on section 2(a)(iii) to withhold payments it owes under the ISDA Master Agreement. The "nil loss" argument is therefore impossible.
The Loss and Second Method provisions are not designed to mirror common law principles of calculating damages for breach of contract.
In determining its loss or gain, a non-defaulting party should make a "clean" valuation and not factor in the occurrence of the Event of Default.
Loss and Market Quotation are intended to achieve broadly the same outcome.

The appeal

The non-defaulting party appealed.

It was accepted by both parties that, had the Event of Default not occurred and the agreement had been performed to its maturity, the non-defaulting party would have been liable to pay the defaulting party substantial amounts over the life of the transaction.

The defaulting party therefore claimed that, because early termination relieved the non-defaulting party of that liability, the non-defaulting party had made a gain, which it should pay to the defaulting party.

The non-defaulting party, by contrast, maintained that it had not made a gain since, had the early termination not occurred, no payments to the defaulting party would have accrued, as the condition precedent to payment in section 2(a)(iii) would not have been satisfied. Since nothing would have been payable had the contract continued, there was no gain ("nil loss" argument).

CA decision: all section 2(a)(iii) withheld payments included in close-out netting

The CA dismissed the appeal and upheld the HC decision. It held that:

Once an Early Termination Date is automatically designated as a result of an Automatic Early Termination event, a party cannot rely on section 2(a)(iii) to withhold payments it owes under the ISDA Master Agreement. The "nil loss" argument is therefore impossible. By agreeing to incorporate Automatic Early Termination in the ISDA Master Agreement, the parties contract out of the ability to designate a termination date of their choosing. In doing so, they lose the option to delay termination, and therefore withhold payments under section 2(a)(iii).
Following Automatic Early Termination, the definition of Loss requires a non-defaulting party to calculate its losses or gains arising from the terminated agreements, including amounts that would have been owed by the non-defaulting party had they not been suspended by section 2(a)(iii).
In determining its loss or gain under the definition of Loss, a non-defaulting party must not factor in the occurrence of the Event of Default but should instead make a "clean" valuation of the transaction. This means that the loss of bargain must be valued on an assumption that, but for termination, the transaction would have proceeded to a conclusion, and that all conditions would have been satisfied, even if that is unlikely in reality.
Second Method operates to oblige a non-defaulting party that is out of the money under the ISDA Master Agreement to pay a defaulting party following early termination of the agreement. The Loss and Second Method provisions represent a deliberate departure from (and should not be equated with) common law principles of calculating damages for breach of contract. If parties want their agreements to replicate common law principles, by only providing for one-way payments from an out of the money defaulting party, they could elect First Method to apply instead.
The Loss and Market Quotation measures for valuing outstanding obligations are intended to achieve broadly the same outcome.

The CA confirmed that these principles are established case law and referred to the decision in PFF v TMT in which Gloster J agreed with the HC reasoning and came to the same conclusion (see Legal update, Nil loss argument again rejected: reliance on section 2(a)(iii) of ISDA Master Agreement is denied following automatic early termination (High Court)).

The CA also referred to Briggs J's judgment in Anthracite Rated Investments (Jersey) Ltd v Lehman Brothers Finance SA [2011] EWHC 1822 (Ch) in which the court cited other previous authority on these points. For more on the Anthracite case, see Legal update, Court considers transaction parties' ability to bypass derivative counterparty's right to early termination payment (High Court).

Comment

The CA's judgment provides welcome clarity on the interpretation of section 2(a)(iii) of the 1992 ISDA Master Agreement, particularly after the uncertainty created by recent HC decisions.

Although the judgment reflects ISDA's submissions in the hearing, ISDA has consulted with its members, and is currently considering amendments to section 2(a)(iii). This follows pressure from regulators and HM Treasury for ISDA to provide certainty to administrators that transactions will be terminated within a reasonable period (see Legal update, ISDA close out: government calls for change).

It is, therefore, likely that amendments will be made to section 2(a)(iii) in the near future.

PLC Finance is grateful to Edmund Parker of Mayer Brown International LLP and James Warbey of Milbank, Tweed, Hadley & McCloy LLP for providing their comments below on the decision.

Edmund Parker, Mayer Brown International LLP

"The judgment was a victory for certainty of contract, affirming that the terms of an ISDA Master Agreement should be construed only according to its wording, and that terms such as limiting the operation of section 2(a)(iii) only for a reasonable time should not be implied. As OTC derivatives have developed, each updated set of definitions, new protocol and template has moved towards greater objectivity, less subjectivity and more certainty. Derivatives require the confidence of their users: "certainty" and objective interpretation of the plain words of the contract and market understanding are at the core of this. A negative judgment would have done the UK’s position as the world’s largest derivatives market no good at all.

Even though the judgment favoured the industry position, the ISDA Master Agreement will change. Amendments are in the pipeline to force a non-defaulting party to close out within a reasonable time. What that reasonable time will be, is still up for debate, but we can expect to see changes soon."

Edmund Parker is a member of PLC Finance's consultation board.

James Warbey, Milbank, Tweed, Hadley & McCloy LLP

"The Court of Appeal's decisions represent a welcome clarification of the proper legal interpretation of ISDA's standard forms of agreement and, in the main, market participants will not have been surprised by the court's observations, particularly in relation to section 6 of the Master Agreement and the determinations of "Loss" and "Market Quotation".

It is clear, however, that the process that arguably began with the discussion of section 2(a)(iii) in section 7 of HM Treasury's consultation of December 2009 entitled "Establishing resolution arrangements for investment banks" (see Legal update, ISDA close out: government calls for change) and to which ISDA initially responded in March 2010 (see Legal update, ISDA responds to HM Treasury consultation on establishing resolution arrangements for investment banks) now has some way yet to run. Regulated firms and investment banks that form the mainstay of the derivatives market (who are no doubt mindful of the favourable regulatory capital treatment allowed to exposures under the Master Agreement) have largely closed-out their derivatives exposures promptly upon the insolvency of defaulting counterparties. However, there are a small minority of, mainly corporate, entities that, as the Court of Appeal has ruled they are entitled, have chosen to treat section 2(a)(iii) as a walk-away clause. Absent a successful appeal to the Supreme Court and in light of the Court of Appeal's decision, it would be unfair to categorise the behaviour of these entities as abusive, but it does nonetheless highlight a systemic risk for which the most efficient and immediate solution is a market-wide amendment to ISDA's standard forms.

The successful defendants to the Court of Appeal and others relying on section 2(a)(iii) as a walk-away clause, should also recognise that the Court of Appeal judgment is materially less favourable than the High Court decisions that preceded it. Since suspended obligations are no longer subject to extinguishment at maturity, there is the possibility of their revival months or years hence. The Court of Appeal recognised that this revival could be triggered by the defaulting party's emergence from insolvency proceedings as one possibility. Although not presented as an option to the Court, it is axiomatic that should a non-defaulting party itself become subject to an Event of Default under the ISDA Master Agreement (e.g. a Bankruptcy or Credit Event upon Merger), then the original defaulting party will also be entitled to designate an Early Termination Date and so crystallise the payment long denied to it."

Milbank is counsel for the Official Committee of Unsecured Creditors of Lehman Brothers Holdings Inc.

Case

Lomas and others v JFB Firth Rixson Inc and others [2012] EWCA Civ 419 (3 April 2012).

"ISDA" and "ISDA SIMM" are registered trademarks of the International Swaps and Derivatives Association, Inc. (ISDA). ISDA is not a sponsor of Practical Law and had no part in the development of this resource.

Section 2(a)(iii) ISDA® Master Agreement: Court of Appeal judgment on four appeals | Practical Law