Lomas v Firth Rixson

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In a significant decision for the derivatives market, the Court of Appeal resolved the uncertainty surrounding the interpretation of the 1992 ISDA.

Facts

All the appeals in Lomas v JFB Firth Rixson, Inc, concerned the operation of Section 2(a)(iii) of the ISDA Master Agreement. The first two cases, arising from the collapse of Lehman Brothers, concerned transactions where the counterparties had opted to withhold payments under section 2(a)(iii). The second two cases considered Events of Default under forward freight agreements (FFAs). Although the FFAs terminated under the Automatic Early Termination provisions, the appeals considered which amounts should be included in the termination calculations and in particular whether withheld payments under section 2(a)(iii) should be taken into account.

Decision

Section 2(a)(iii): Suspension or one time only?

• The Court of Appeal held that the operation of Section 2(a)(iii) has the effect of suspending (potentially indefinitely) the non-defaulting party's payment obligations. These obligations remain suspended for as long as the Event of Default is continuing, or until the non-defaulting party elects to terminate.
• This decision ends a judicial debate that commenced with Flaux J’s decision in Pioneer v Cosco. Flaux J held that even if the Event of Default or Potential Event of Default ceases to exist, performance does not become due. The obligation is effectively extinguished. Contrastingly, in Pioneer v TMT, Gloster J argued that the payment obligation arises as soon as there ceases to be an Event of Default or Potential Event of Default.
• Although Section 2(a)(iii) makes payment conditional on the absence of an Event of Default, the underlying debt remains in existence. The Court of Appeal upheld Gloster J’s approach, concluding that payment netting must be applied to any sums that would otherwise be payable, without regard to Section 2(a)(iii). Moreover, the Court of Appeal rejected an appeal advanced by the administrators of Lehman Brothers International that Section 2(a)(iii) implicitly operates only for a reasonable length of time, or until the scheduled maturity date, with payment from the Non-defaulting party then becoming due if an Early Termination date has not been designated.

Payment Netting

• The Court of Appeal resolved the question of whether, if a non-defaulting party’s obligations are suspended under Section 2(a)(iii), it can nevertheless enforce the defaulting party’s obligations under Section 2(c) without giving credit for the suspended obligations. In Pioneeer v Cosco, Flaux J had argued that payment netting is not available in these circumstances. Conversely, in Marine Trade v Pioneer, Gloster J, held that the payment netting provisions apply to any sums that would be payable in the ordinary course of events.
• The Court upheld the approach of Gloster J, holding that it is the payment obligation alone which is suspended. The underlying debt obligation under Section 2(a)(i) remains irrespective of Section 2(a)(iii). Section 2(c), however, will only apply to payments falling due on the same date.
• Similarly, the Court of Appeal held that where there is an Early Termination Event, under the definition of Market Quotation the condition precedent in Section 2(a)(iii) is assumed to be satisfied for all transactions that remain in effect and the Defaulting Party therefore obtains the benefit of the suspended payments and deliveries in the close-out calculation. The 1992 ISDA therefore 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.

Anti-deprivation and pari passu

The Court of Appeal held that the operation of Section 2(a)(iii) does not offend the anti-deprivation or pari passu rules.

• In one appeal, Lehman Brothers v Carlton Communications, the Court held that withholding payments to a bankrupt counterparty in reliance on Section 2(a)(iii) was a proper commercial response and did not engage the anti-deprivation rule (although the Court considered that this issue must be addressed on a case specific basis).
• Similarly, the Court held that the pari passu rule is not engaged as it operates only in respect of any assets of the estate that exist on the commencement of Insolvency proceedings. Section 2(a)(iii), prevents any debt from becoming payable.

Section 2(a)(iii) litigation

There is a (generous) handful of important authorities on the effect under English law or New York law of the suspension of obligations under the most litigationey clause in the ISDA Master Agreement, Section 2(a)(iii). They consider whether flawed asset provision amounts to an “ipso facto clause” under the US Bankruptcy Code or violates the “anti-deprivation” principle under English law. Those cases are:

• Lomas v Firth Rixson
• Marine Trade v Pioneer
• Pioneer v Cosco
• Pioneer v TMT
• Enron v TXU
• Metavante v Lehman