In the latest judgment to come out of the Lehman Brothers insolvencies, the English courts have ruled on the effect of Section 2(a)(iii) of the ISDA Master Agreement and, specifically, on the ability of a Non-defaulting Party to withhold payments indefinitely when facing a UK insolvent party.
The key points from this case are:
- Section 2(a)(iii) entitles a Non-defaulting Party to withhold payments indefinitely (as long as the Event of Default continues) - the same would apply to Potential Events of Default (although those are usually not indefinite in nature);
- Section 2(a)(iii) takes effect as only a suspension of the payment obligation and does not extinguish the obligation - effectively reversing the decision in the Marine Trade case;
- the payment obligation is, however, permanently extinguished following the last date for performance under the relevant Transaction - ie, the obligations cannot be brought back from suspension after the Transaction has matured; and
- Section 2(a)(iii) does not infringe the “anti-deprivation rule” in English insolvencies.
The judgment related to an application made by the administrators of Lehman Brothers International (Europe) (“LBIE”) arising out of a number of long-dated interest rate swaps which, with the collapse of interest rates after September 2008, had become significantly in-the-money to LBIE. Rather than designate an Early Termination Date, and account to LBIE for the in-the-money amount, LBIE’s counterparties instead relied on Section 2(a)(iii) to withhold the payments that would otherwise have been due to LBIE. The administrators challenged the ability of the counterparties to rely on Section 2(a)(iii) indefinitely and claimed that an interpretation of Section 2(a)(iii) which allowed for indefinite reliance was inconsistent with the anti-deprivation rule that applies to English insolvencies.
None of the arguments raised by the administrators for an alternative interpretation of Section 2(a)(iii) was successful. The court would not imply a term that Section 2(a)(iii) can only be relied on for a “reasonable time” or a term that reliance on Section 2(a)(iii) expires after the last date for performance under all Transactions. In addition it was held that there were no grounds to argue that the Non-defaulting Party must designate an Early Termination Date after the last date for performance under all Transactions.
It is also interesting that the court did not have to consider whether the Non-defaulting Party could have proved for the gross amount of payments due from LBIE because LBIE’s counterparties conceded that the proof would only have been for the net payment. The judge indicated that he might have formed a different view on this point had it been argued and it certainly may have been different had the individual payment flows under the transactions not been due on the same day.
The ruling that suspended payment obligations are extinguished following the last date for performance under the Transaction is rather surprising to us and was not the position taken by ISDA in the proceedings. It would mean that, if an Early Termination Date was designated long after the initial occurrence of an Event of Default (and after the final payment date under some Transactions), none of the payments under those Transactions need to be included as Unpaid Amounts or in the Loss calculation when determining the net amount payable under Section 6(e).
All of the transactions in this case were interest rate swaps and the court was clearly influenced by the fact that this type of transaction involves an ongoing relationship where both parties have the right to receive contingent net payments from the other. The court has expressly left open the possibility that a different analysis could apply for other types of transaction with different characteristics - options (especially fully-paid options) or credit default swaps, particularly where the Defaulting Party is the buyer, would be good examples of these.
If indefinite reliance on Section 2(a)(iii) is considered undesirable, either on an insolvency or in other circumstances, specific amendment wording needs to be included in the ISDA Master Agreement. Our view is that this is best achieved by limiting the period of time during which Section 2(a)(iii) can be relied on, so that after this period a Non-defaulting Party has to “put up or shut up” - ie, in effect has to choose between designating an Early Termination Date and resuming payments to its counterparty. Some participants have proposed wording which would allow the Defaulting Party to designate an Early Termination Date where a Non-defaulting Party’s reliance continues beyond a defined period of time - this seems an inappropriate outcome to us, and one which sensible drafting can easily avoid.
The position under English law on Section 2(a)(iii) is now very different from that under New York law following the New York Bankruptcy Court’s judgment in the Metavante case. In that case, it was held that a Non-defaulting Party was not entitled to rely on Section 2(a)(iii) against a US bankrupt and, worse, the Non-defaulting Party also lost the right to designate an Early Termination Date after an extended (but unclear) period of time. Section 2(a)(iii) joins “flip” clauses in the increasing divergence between the New York and English court positions on certain key issues in complex financial instruments. It will be interesting to see what effect these decisions, and the potential for arbitrage between the courts’ positions, have on new structured transactions going forward.