Hot on the heels of the Metavante decision, the English High Court has recently considered Section 2(a)(iii) of the ISDA Master Agreement in the case of Marine Trade SA v Pioneer Freight Futures Co Ltd. The case concerned freight derivatives, a relatively niche market which effectively collapsed at the end of 2008 bringing down with it a number of participants. Freight derivatives are typically traded, as in this case, on the basis of forms of confirmation published by the Forward Freight Agreement Brokers Association (FFABA) but which are subject a form of the 1992 ISDA Master Agreement (or an actual signed ISDA Master Agreement between the parties if there is one). The decision is effectively a decision on the ISDA Master Agreement itself and would be no different had it concerned a 2002 ISDA Master Agreement instead of a 1992 ISDA Master Agreement.
There were two issues decided in relation to Section 2(a)(iii) in the Marine Trade case.
The first issue was whether the settlement netting in Section 2(c) applied to a payment which was not required to be made on a day because one of the conditions to payments in Section 2(a)(iii) had not been satisfied on the date that payment was due to be made. On this issue the court held that the conditional payment obligation was not taken into account under Section 2(c). This was the expected outcome and, we would suggest, the correct one.
The second issue was not one which, it seems, the court had to decide but it nevertheless chose to do so. The issue was whether a payment, which was due to be made on a day but did not have to be made because the conditions to payments in Section 2(a)(iii) were not satisfied on that date, would be required to be made if the conditions to payment in Section 2(a)(iii) were satisfied subsequently. On this issue the judge concluded that the conditions to payment were "once and for all" conditions so that, if the conditions to payment were not satisfied on the day on which the payment was due, then the party due to make that payment never had to make that payment - i.e. it was effectively extinguished. This is patently not how participants anticipate that Section 2(a)(iii) will operate. This is clearly evidenced by the fact that, if an Early Termination Date does subsequently occur, any payments not made by virtue of Section 2(a)(iii) are taken into account (with interest) in determining the net termination payment under Section 6(e). If the decision in Marine Trade were correct, this would even further discourage a Non-defaulting Party from ever designating an Early Termination Date.
As mentioned in our update on Metavante, we advocate the use of a waiting period for the purpose of Section 2(a)(iii). Whether or not you subscribe to that view it is perhaps prudent, in the meantime, at least to add some wording to avoid any doubt over the interpretation of Section 2(a)(iii) itself post the Marine Trade case.
Despite the Marine Trade case, there is still no decision on enforceability under English law of Section 2(a)(iii), either in bankruptcy or as a matter of general law. As was the case in Enron v TXU (read our commentary on that case) the enforceability of Section 2(a)(iii) seems to have been accepted by the parties in the Marine Trade case.
We understand that the decision in the Marine Trade case may be appealed.
It is worth noting that there are anticipated to be a number of other legal proceedings arising out of the collapse of the freight derivatives market in the near future and these could shape the legal position on some fundamental issues of English law derivatives documentation which could have serious implications for the wider financial markets. We can only hope that the decisions in those cases will be cognisant of the way that the derivatives market and documentation operates.
Section 2(a)(iii) of the ISDA Master Agreement states that: "Each obligation of each party under Section 2(a)(i) [i.e. each payment and delivery obligation under any Transaction] is subject to (1) the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing, (2) the condition precedent that no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated and (3) each other applicable condition precedent specified in this Agreement." It allows a party whose counterparty has suffered or is likely to suffer an Event of Default to withhold payments which, in the context of a likely or possible imminent early termination, is commercially sensible. More controversially, following an Event of Default affecting their counterparty, some parties (when they are net "out-of-the-money") seek to rely indefinitely on their right to withhold under Section 2(a)(iii) rather than terminate and crystallise the payment by them of a Section 6(e) amount. As discussed in our commentary on Enron v TXU, in these circumstances there is little practical difference between this approach and a "walk-away" clause.