ISDA Master Agreements: New guidance on when an Event of Default is ‘continuing’

Background

The Applicants, the joint administrators of LBIE, made an application for directions regarding the construction of the standard form Event of Default provisions in both the 1992 and 2002 versions of the ISDA Master Agreements (the ISDA Master Agreements). The relevant provisions considered by the Court are the same in both versions of the ISDA Master Agreement, so we have referred to the ISDA Master Agreements collectively throughout this post.

The First Respondent entered into a sterling interest rate swap transaction with LBIE, which was governed by a 1992 ISDA Master Agreement. The Second Respondent entered into a US dollar interest rate swap transaction with LBIE, which was governed by an ISDA 2002 Master Agreement. It was common ground between the parties that the First Respondent owed a principal amount of more than £8 million to LBIE under its ISDA Master Agreement and the Second Respondent owed a principal amount of more than $53 million to LBIE under its ISDA Master Agreement. 

However, when LBIE fell into administration in 2008, the Respondents relied on the provision set out in section 2(a)(iii) of the ISDA Master Agreements:

“Each obligation of each party under Section 2(a)(i) 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. (…)”

This provision suspended the Respondents’ payment obligations to LBIE where an Event of Default or Potential Event of Default had occurred and was continuing. A number of Events of Default set out in section 5(a) of the ISDA Master Agreements had been triggered upon LBIE’s entry into administration, including its failure and inability to pay its debts and the appointment of an administrator. 

The Respondents’ payment obligations were suspended until the relevant Events of Default were ‘cured’. As confirmed by previous judgments in litigation between the same parties, section 2(a)(iii) does not extinguish the payment obligation entirely but merely holds it in suspense, potentially indefinitely, where the relevant Event of Default is not cured. 

However, it ultimately transpired in the course of the long-running administration of LBIE that it was in fact solvent. Therefore, rather than the administration resulting in the dissolution of the company, as may have been expected, LBIE will exit the administration as a solvent company. As such, the administrators are taking steps to finalise the administration (the Relevant Steps), including the termination of their appointment as administrators, in order to return LBIE to its original directors. 

The Applicants asserted that once their appointment as administrators had been terminated and LBIE was returned to its directors, there would be no continuing Event of Default as it was now a solvent company. Consequently, the condition precedent set out in section 2(a)(iii) of the ISDA Master Agreements would be satisfied and the Respondents would be liable to make full payment under the respective ISDA Master Agreements immediately. 

The Decision

The judge first considered the general approach to interpretation of the ISDA Master Agreements. He emphasised their importance in the financial world to document over-the-counter derivative transactions.  In applying the normal principles of contractual construction, account should be taken of their use as standard forms in a wide variety of situations. Accordingly, there should be more than normal deference to the particular words of the contract and the background context for interpretation was not the particular situation between the parties but the anticipated use of the ISDA Master Agreements in a wide variety of situations. 

The judge held that the relevant test for whether an Event of Default is continuing is whether the identified event or state of affairs which constituted the Event of Default is continuing rather than whether or not the creditors’ rights have been permanently altered or continue to be affected by the relevant state of affairs. The overall purpose of section 2(a)(iii) of the ISDA Master Agreements, as established in Pioneer Freight Futures Co Ltd v TMT Asia Ltd [2011] 1 CLC 855, is to protect and mitigate counterparty credit risk during numerous swap transactions. The provision protects a non-defaulting party against risk from a defaulting party who is unable to meet its obligations. The provision avoids the circumstance where debit and credits accumulate in ongoing swap transactions by suspending the obligation of the non-defaulting party whilst the defaulting party is unable to pay. 

In this case, the Court held that once the Relevant Steps have been taken by the Applicants and the appointment of the administrators has been terminated, no Event of Default would be continuing and there will be no need for the protection offered by section 2(a)(iii) of the ISDA Master Agreements. The Respondents would then have an immediate payment obligation to LBIE under the ISDA Master Agreements.

Events of Default

The judge also considered the specific Events of Default relied on by the Respondents in the context of LBIE’s administration and sets out some useful guidance. 

1. Events of Default triggered by LBIE’s entry into administration

a) Failure to pay

Section 5(a)(i) of the ISDA Master Agreements provides that an Event of Default will be triggered where a party fails to make payment when due (subject to a short grace period commencing upon the delivery of a notice of failure to pay to the relevant party). 

An Event of Default arising out of a party’s failure to pay is cured and therefore no longer continuing when the relevant payment obligation is discharged in full. LBIE’s payment obligations to the First Respondent were subject to the mandatory regime for Insolvency set-off under the Insolvency Rules. At the time when the Insolvency set-off came into effect the First Respondent was a net debtor and the mandatory set-off operated to discharge cross-claims. This sufficed to ‘cure’ LBIE’s failure to pay and as such the Event of Default ceased to be continuing. 

b) Insolvency 

Section 5(a)(vii)(2) of the ISDA Master Agreements provides that an Event of Default will be triggered where a party becomes insolvent, is unable to pay its debts, or fails or admits in writing its inability generally to pay its debts as they become due. 

It was common ground that LBIE was no longer insolvent or unable to pay its debts. However, the Respondents argued that as LBIE had issued a notice which referenced its inability to pay its debts, it had admitted in writing its inability to pay its debts. Therefore, in order for this Event of Default to be ‘cured’, it would be necessary to withdraw or correct this admission in order for the Event of Default no longer to be continuing.  

The Court held that a clarificatory notice should be published for good order but that, given the publicity around the case, the general perception amongst the creditors would be that the previous notice had been superseded and that LBIE was now solvent.

c) Administration

Sections 5(a)(iii)(4) and (6) of the ISDA Master Agreements provide that an Event of Default will be triggered where a party is subject to proceedings seeking a judgment of insolvency, bankruptcy or any other relief or where a party becomes subject to the appointment of an administrator.

The Applicants argued that when their appointment has been terminated the Event of Default will cease to be continuing. However, the Respondents argued that because the administration was a ‘distributing administration’, the distribution of funds by the administrators had substantially altered the creditor’s rights. Therefore, the effect of the Event of Default would not cease on the termination of the administrator’s appointment because LBIE was now ‘unrecognisable’, in the Respondents’ view, from the entity that entered into administration in 2008. The Respondents further asserted that a decade of continuing default could not be cured by procedural steps taken at the close of an administration.

The Court agreed with the Applicants and held that the state of affairs that triggered the Event of Default would cease to exist on the termination of the administrators’ appointment. At that point, the Court held, there will be no justification for the prolonged suspension of the Respondents’ payment obligations.

2. Freestanding Events of Default separate from (and additional to) the original Event of Default triggered by LBIE’s entry into administration

a) The Scheme of Arrangement

Section 5(a)(vii)(3) of the ISDA Master Agreements provides than an Event of Default will be triggered where a party “makes a general assignment, arrangement or composition with or for the benefit of its creditors”.

The Respondents argued that the existence of the scheme satisfied this provision and constitutes a separate Event of Default. The Court found that this provision relates to processes set up in circumstances of financial distress. Therefore, this would not apply to the scheme in LBIE’s case, which was set up to manage and maximise a surplus. The scheme of arrangement set up for LBIE did not affect the credit risk to which the Respondents were exposed and as such it would not constitute an Event of Default.

However, the judge commented obiter that if he had erred on this point and the establishment of the scheme of arrangement was in fact an Event of Default, it would not automatically cease to be continuing on the termination of the administrators’ appointment. In this case, the state of affairs that triggered the relevant Event of Default would continue to exist after the termination of their appointment.

b) Recognition and enforcement of the Scheme of Arrangement 

Sections 5(a)(vii)(4) and (8) of the ISDA Master Agreements provide that an Event of Default will be triggered where a party has proceedings seeking a judgment of insolvency, bankruptcy and/or other relief under bankruptcy or insolvency law or any other similar law instituted against it under the applicable laws of any jurisdiction. 

The Respondents relied on this provision to establish that an Order made for the recognition of the scheme of arrangement in the USA under Chapter 15 of the US Bankruptcy Code constituted an Event of Default. The Court held that the order for the recognition of a scheme that was solvent and proposed to deal with a surplus would not constitute an Event of Default. The mere fact that the relevant applicable law had the term ‘bankruptcy’ in the title was insufficient for the Order to suffice as an Event of Default because the Order related to a company that was not in financial distress. 

Similarly, the Court held that French and Spanish exequaturs, which recognised the appointment of the administrators of LBIE, would also not establish a free-standing Event of Default and would not constitute a continuing Event of Default following the termination of the appointment of the administrators. 

Key Takeaways

In helpfully deciding on the correct construction of the relevant sections of the ISDA Master Agreements, the Court had regard to considerations of commerciality, fairness and the overarching purpose of the provisions in question.

If the Event of Default provisions in the ISDA Master Agreements could be deemed ‘continuing’ for the duration of the purported effect of the relevant state of affairs, the agreements themselves would become commercially unworkable as they would lack practicality and predictability. As the judge emphasised, the ISDA Master Agreement is the most commonly used standard agreement for OTC derivative transactions. The purpose of using a standard agreement such as an ISDA Master Agreement is to provide commercial certainty for all parties and therefore the provisions should be construed in such a way that is reasonably predictable. Consideration of the presence of the state of affairs which triggered the Event of Default when deciding whether or not an Event of Default is continuing achieves this objective of commercial certainty and accords with the plain, intelligible language of the relevant provision.

In the context of an administration, it is apparent from this judgment that where a party exits an administration as a solvent entity, the mere fact that it had previously been in the process of administration will not suffice to suspend indefinitely the payment obligations of counterparties under an ISDA Master Agreement.  Instead, the early termination provisions allow the non-defaulting party to terminate the outstanding transactions and calculate any net sum payable in accordance with such early termination provisions.  The indefinite suspension of section 2(a)(iii) is therefore vulnerable to the – perhaps unusual – circumstance that the counterparty survives the administration as a solvent entity.

Although in 2014 ISDA published a form of amendment to section 2(a)(iii) which includes a time limit on its operation where an Event of Default has occurred in relation to one of the parties (to address exactly this issue), this amendment is still not routinely included in new ISDA Master Agreements entered into.