Is the Suspension of Payment Obligations under the ISDA Master Agreement Indefinite?

By Akash Amati and Shambhavi Shekhar.

Introduction: Events of Default under the ISDA Master Agreement

The International Swap Dealers Association (“ISDA”) Master Agreement is a standard form of contract used to document bilateral over-the-counter (“OTC”) derivative transactions between two parties. While there are two versions of the ISDA Master Agreement – 1992 and 2002, for the purpose of this article, we will refer to both these versions collectively as the ISDA Master Agreement. Similar to many loan agreements, ISDA Master Agreement also contains ‘Events Of Default’ (“EOD”) provisions which get triggered when either party to the agreement is unable to perform its obligations, and the non-defaulting party has the right to terminate the transactions early in order to reduce its exposure vis-à-vis the defaulting party. However, a distinctive feature of ISDA is that it allows either party to include other entities that may be related to a counterparty within the scope of some EOD via the concept of a ‘specified entity’. The objective behind this is to account for entities that have a close commercial relationship with a counterparty so that if an event of default occurs with respect to such entities, it would materially impact the counterparty too. Apart from specified entities, some events of default also include third parties providing a guarantee or security for the counterparty’s obligations, thereby strengthening the protections against counterparty risk.

While there are eight EODs under ISDA Master Agreement, the more pertinent ones from a negotiation standpoint are (i) Failure to Pay or Deliver, (ii) Default under Specified Transaction (“DUST”), (iii) Cross Default and (iv) Bankruptcy. Failure to Pay, as the name indicates, is triggered when a party fails to perform its payment or delivery obligations when due. DUST is triggered when there is a default in any agreement governing OTC derivative transactions (other than the current ISDA Master Agreement) between the two parties. Cross Default is similar to DUST in that it seeks to account for a counterparty’s default beyond the scope of the current ISDA Master Agreement. However, Cross Default focuses on defaults under third-party agreements entered by either party with respect to borrowed money. In contrast, DUST only focuses on other agreements between the same counterparties with respect to OTC derivative transactions. Hence, Cross Default is a key identifier of the deteriorating creditworthiness of a counterparty. Since ISDA Master Agreement is a globally accepted, standardised document, the bankruptcy EOD is broad enough to cover insolvency or bankruptcy proceedings in multiple jurisdictions (with a prime focus on English and New York laws). It is pertinent to note that if bankruptcy occurs, the laws of the defaulting counterparty’s jurisdiction will override the governing law of the ISDA Master Agreement.

Conditions Precedent vis-à-vis Payment and Delivery Obligations

Under Section 2(a)(iii), payment and delivery obligations under the ISDA Master Agreement (as specified under Section 2 (a)(i)) are subject to the condition precedent that an EOD or a potential EOD should not have occurred or be occurring in relation to a party to the agreement. Further, in relation to a transaction under the agreement, an ‘Early Termination Date’ ("ETD") (essentially designating a date which should not be prior to the date on which the notice under Section 6(a) becomes effective in respect of the outstanding transactions under the agreement) should have occurred or been designated to occur. Finally, the section also contains a generic condition precedent to mean all those conditions under the agreement which have been specified to be conditions precedent for the purposes of Section 2(a)(iii). The first of these conditions, which translates to suspension of the payment or delivery (other than payment) related obligations of the non-defaulting party for as long as an EOD exists, has been the bone of contention for quite a few years in the derivatives market. While an EOD should result in terminations of transactions theoretically upon an EOD notice being sent by the non-defaulting party, by virtue of Section 2(a)(iii), the non-defaulting party can avoid its payment/delivery obligations-which can have the effect of depriving the defaulting party of the amount that is otherwise due to it under the agreement for a considerable period. This is precisely what happened in the Lehman Brothers Holdings Inc. (“LBHI”) insolvency episode. In 2009, New York’s bankruptcy Court while adjudicating on a proceeding between Lehman Brothers Special Financing Inc. (“LBSFI”) and Metavante (for which LBHI was a guarantor under the 1992 ISDA Master Agreement), held that while filing of a bankruptcy petition under Chapter 11 of the United States Bankruptcy Code (“Code”) against LBSFI had given the right to Metavante to terminate the swap transaction, it chose not to do so and continued payment avoidance by relying on Section 2(a)(iii). The Court held that this action by Metavante rode was against the spirit of the Code.

Further, since Metavante did not exercise its right to terminate promptly, the Court stated that it had waived off that right in toto, i.e., it was a deemed waiver. More importantly, the Court noted that a non-defaulting party under the ISDA may not rely on Section 2(a)(iii) to suspend payments owing to the bankruptcy filings of the defaulting party. However, the Court did not throw light on when exactly that deemed waiver would kick in, i.e., how long the non-defaulting party could suspend the payment obligations.

Suspension of obligations is not the same as an extinguishment

On the back of the LBHI insolvency, considerable litigation was triggered before the English Courts regarding the interpretation of Section 2(a)(iii), particularly with respect to the duration of suspended payments. Lomas vs JFB Firth Rixson Inc. (“Lomas”) was the culmination of these various conflicting judgements regarding the interpretation of Section 2(a)(iii). Previous judgements such as Pioneer vs Cosco, held that the performance of obligations under Section 2(a)(i) does not revive even after the event of default ceases to exist. The payment obligations initially suspended become effectively extinguished eventually. The prime issue in Lomas was whether, during the continuance of EOD, while there is an initial suspension of obligations, could the payment obligation revive later or would there be an indefinite suspension. The court of appeals in Lomas found no contractual basis for the appellant's argument that payment obligations should revive after a reasonable period of time. The Court held that “the indefinite suspension of the payment obligation of the non-defaulting party (like any attempt to balance competing interests) may on one view be criticised as imperfect, but it cannot be said to be uncommercial.” (¶ 92).

However, more recently, in Grant vs FR Acquisitions Corporation (Europe) Ltd. & JFB Firth Rixson Inc. [2022] WLR(D) 407, the England and Wales High Court (Chancery Division) interpreted the terms of the two ISDA Master Agreements to which Lehman Brothers International (Europe) (“LBIE”) was a party. Vide the 2008 Court order, pursuant to which LBIE moved into administration, Rixson (Respondent No. 2 herein) suspended its payment obligations by virtue of Section 2(a)(iii). While Rixson expected the dissolution of LBIE, it actually emerged as a solvent entity. Joint administrators of LBIE (who are the applicants in this case) contend that upon the termination of their duties as administrators and relegating LBIE back to its directors, the EOD would stand cured,the Respondents vehemently opposed this and Rixson would be liable for the amounts it owed to LBIE under the agreement. While this was vehemently opposed by the Respondents, by submitting that whether or not an EOD continued depended upon whether its “effects” continued to be in existence, thereby making a case that an EOD was, in effect, incurable. However, the Court held that “...the proper enquiry is not as to the effect of the relevant Event of Default, but as to whether the event or state of affairs which triggered that Event of Default still subsists” (¶ 147). The exit of LBIE from the administration procedure was reflective of the EOD ceasing to exist and in fact, becoming “cured”. Ultimately, it was held that Rixson had the contractual obligation to pay the amounts due under the agreement to LBIE, thereby establishing that suspension of obligations cannot continue indefinitely.

Takeaways

The ISDA Master Agreement is silent on the duration the obligations of the non-defaulting party can stay suspended. As the ISDA Master Agreement has been widely recognised as the standard document in the global derivatives market, subjective interpretation of the agreement has been, to a large extent, discouraged in the derivatives jurisprudence. Interpreting the implied terms into the agreement can have larger implications on the broader market and defeat the very purpose behind introducing standard documentation. Particularly, as parties to the ISDA Master Agreements increasingly expand to include non-expert users, the temptation to contrive convenient interpretations should be resisted. As Justice Briggs had laid emphasis in Lomas “it is axiomatic that the ISDA Master Agreement should, as far as possible, be interpreted in a way that serves the objectives of clarity, certainty and predictability, so that the very large number of parties using it should know where they stand.” (¶ 92)

Disclaimer

The views expressed in this article are solely those of the author(s). This article is intended for educational/information purposes only. The source of this article is publicly available information and under no circumstances should the contents of the article be construed to be professional advice by the authors.