In a judgment delivered on 21 December 2010 which has important implications for the derivatives markets, Briggs J dismissed the claims of Lehman Brothers International (Europe) (in administration) (‘LBIE') to recover substantial sums under ISDA interest rate swap agreements. The three counterparties sued by LBIE were each ‘out of the money' solvent counterparties who had invoked the condition precedent in Section 2(a)(iii) of the 1992 and 2002 ISDA Master Agreements to refuse payment to LBIE of fixed interest amounts on the ground of LBIE's Bankruptcy Event of Default.
Section 2(a)(iii) provides that each obligation of each party under Section 2(a)(i) is subject to the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing. Six possible approaches to the operation of Section 2(a)(iii) were variously advanced by LBIE, the First to Fourth Respondents (‘R1-R4') and ISDA (who successfully applied to intervene in the proceedings):
(1) By an implied term, Section 2(a)(iii) operates for only a reasonable period (LBIE's primary case).
(2) By an implied term, the ‘in the money' party is required to designate an Early Termination Date when the swap reaches its natural end (LBIE's first alternative case).
(3) Section 2(a)(iii) ceases to operate when the agreement reaches its natural end, at which point all outstanding payment obligations are automatically netted off (LBIE's second alternative case).
(4) Section 2(a)(iii) is a ‘one time' provision such that, once a payment date passes without the Non-defaulting Party being obliged to pay, the payment obligation falls away (the primary case for R1, R2 and R4). (This was the obiter view of Flaux J in Marine Trade.)
(5) Section 2(a)(iii) suspends the obligation to pay until the natural end of the swap, at which point the payment obligation falls away (the primary case for R3 and the alternative case for R1, R2 and R4).
(6) Section 2(a)(iii) operates indefinitely to await the possible cure of the Event of Default, although in the case of an insolvent counterparty, there will be a practical end date of six years after the company's dissolution, this being the end of the period during which a dissolved company can be restored to the register (ISDA's case).
Briggs J concluded that the correct answer is in terms of (5) above. He concluded that answer (4) produces too draconian a result where one party is subject to a short-term, remedial Event of Default.
LBIE also argued that any approach to Section 2(a)(iii) other than its own would result in the provision being void on the basis of the anti-deprivation rule. The basis of this argument was that answers (4), (5) and (6) above would deprive LBIE of valuable assets simply because it has become insolvent. This led to a secondary issue as to whether Section 2(a)(iii) permits a solvent counterparty to claim payment at payment dates when it is in the money while at the same time refusing payment at payment dates when it is out of the money (‘claiming gross'). In Marine Trade, Flaux J held, in the context of separate swap agreements which were in the nature of contracts for differences, that this is indeed the effect of Section 2(a)(iii). However, none of R1-R4 intends to prove in LBIE's administration. Each of them took the position that claiming gross is not permitted in the context of a single interest rate swap which imposes mutual payment obligations on agreed dates. Accordingly, Briggs J was content to proceed on the basis that the Respondents would now be estopped from claiming gross. From this starting point, he held that the anti-deprivation rule was not applicable.
The judgment is here.
Mark Hapgood QC appeared for R1 and R2 and made the lead submissions for the Respondents on the construction/implied term issues.