HIGH COURT OF JUSTICE
Strand, London, WC2A 2LL
B e f o r e :
| (1) ANTONY VICTOR LOMAS
(2) STEVEN ANTHONY PEARSON
(3) MICHAEL JOHN ANDREW JERVIS
(4) DAN YORAM SCHWARZMANN
(5) DERECK ANTHONY HOWELL
(together the Joint Administrators of Lehman Brothers International (Europe) (in administration))
|- and -
|(1) JFB FIRTH RIXSON, INC
(2) FR ACQUISITIONS CORPORATION (EUROPE) LIM ITED
(3) BEIG MIDCO LIMITED
KP GERMANY ZWEITE GMBH
|THE INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION INC.
Mr Mark Hapgood QC and Mr Henry Forbes Smith (instructed by Macfarlanes) for the First and Second Respondents
Mr Robin Dicker QC and Ms Joanna Perkins (instructed by Clifford Chance) for the Third Respondent
Mr Richard Fisher (instructed by Freshfields Bruckhaus Deringer LLP) for the Fourth Respondent
Mr Antony Zacaroli QC and Mr Jeremy Goldring (instructed by Allen & Overy LLP) for the Intervenor
Hearing dates: 6th – 9th December 2010
Crown Copyright ©
Mr Justice Briggs :
ISDA and the Master Agreement
"(a) General Conditions
(i) Each party will make each payment or delivery specified in each Confirmation to be made by it, subject to the other provisions of this Agreement.
(ii) Payments under this Agreement will be made on the due date for value on that date in the place of the account specified in the relevant Confirmation or otherwise pursuant to this Agreement, …
(iii) 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, (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.
(c) Netting. If on any date amounts would otherwise be payable:-
(i) in the same currency; and
(ii) in respect of the same Transaction,
by each party to the other, then, on such date, each party's obligation to make payment of any such amount will be automatically satisfied and discharged and, if the aggregate amount that would otherwise have been payable by one party exceeds the aggregate amount that would otherwise have been payable by the other party, replaced by an obligation upon the party by whom the larger aggregate amount would have been payable to pay to the other party the excess of the larger aggregate amount over the smaller aggregate amount."
There follows provision for netting across multiple Transactions, where the parties so elect. No such elections were made in relation to any of the Swaps.
"Events of Default. The occurrence at any time with respect to a party or, if applicable, any Credit Support Provider of such party or any Specified Entity of such party of any of the following events constitutes an event of default (an "Event of Default") with respect to such party:—"
The eight classes include failure to pay (or to deliver), breach of the agreement, Credit Support Default (see below), misrepresentation, and, most importantly, Bankruptcy.
"Seeks or becomes subject to the appointment of an administrator, provisional liquidator, conservator, receiver, trustee, custodian or other similar official for it or for all or substantially all of its assets;"
It is common ground that going into Chapter 11 Bankruptcy in the USA is also a Bankruptcy Event of Default. By Section 14, "Credit Support Provider" is an expression which takes on meaning only from a Schedule. I shall return to its meaning when setting out the terms of the single Swap with a Schedule which included such a provision.
"Failure to Pay or Deliver. Failure by the party to make, when due, any payment under this Agreement or delivery under Section 2(a)(i) or 2(e) required to be made by it if such failure is not remedied on or before the third Local Business Day after notice of such failure is given to the party;"
Section 2(e) makes provision for payment of interest during any period between default in the performance of a payment obligation and Early Termination in respect of a particular Transaction.
Section 14 defines "Potential Event of Default" as meaning:
"any event which, with the giving of notice or the lapse of time or both, would constitute an Event of Default."
"(a) Right to Terminate Following Event of Default. If at any time an Event of Default with respect to a party (the "Defaulting Party") has occurred and is then continuing, the other party (the "Non-defaulting Party") may, by not more than 20 days notice to the Defaulting Party specifying the relevant Event of Default, designate a day not earlier than the date such notice is effective as an Early Termination Date in respect of all outstanding Transactions."
Subsection (a) then continues by providing that parties may specify what is called "Automatic Early Termination" in the Schedule so that, with respect to specified types of Event of Bankruptcy Event of Default, Early Termination follows as a matter of course, rather than by election. In none of the Swaps was Automatic Early Termination specified in a Schedule. Section 6(b) deals with the right to terminate following a Termination Event.
"(i) If notice designating an Early Termination Date is given under Section 6(a) or (b), the Early Termination Event will occur on the date so designated, whether or not the relevant Event of Default or Termination Event is then continuing.
(ii) Upon the occurrence of effective designation or an Early Termination Date, no further payments or deliveries under Section 2(a)(i) or 2(e) in respect of the Terminated Transactions will be required to be made, but without prejudice to the other conditions of this Agreement. The amount, if any, payable in respect of an Early Termination Date shall be determined pursuant to Section 6(e)."
Section 6(d) sets out a procedure for calculating the amount to be paid on Early Termination. Section 6(e) sets out a detailed set of alternative formulae for the purpose of determining (by reference to calculation and/or valuation) the amounts to be paid. There is no dispute as to the meaning of these provisions, which are supplemented in Section 14 by various lengthy definitions. In summary, Section 6(e) makes different provision as between Early Termination following Events of Default, and Early Termination following Termination Events. In relation to Events of Default, four alternative formulae are specified, one of which, namely "Second Method and Market Quotation" is applicable in default of any selection to the contrary. No alternative selection was made in the three Swaps which incorporated the 1992 Master Agreement. It is, however, material to note that two of the four formulae (being alternative versions of the First Method) cannot produce a net outcome under which the payee is the Defaulting Party. By contrast, the default formula (and the "Second Method and Loss" variation upon it) may lead to outcomes under which either the Defaulting Party or the Non-defaulting Party is the net payee.
"with respect to an Early Termination Date, the aggregate of (a) in respect of all Terminated Transactions, the amounts that became payable (or that would have become payable but for Section 2(a)(iii)) to such party under Section 2(a)(i) on or prior to such Early Termination Date and which remain unpaid as at such Early Termination Date."
Thus, that part of the formula contemplates that, where payment obligations may not have arisen because of an unsatisfied condition precedent in Section 2(a)(iii), their aggregate amount will be part of that which has to be paid on Early Termination, under the default formula.
"Survival of Obligations. Without prejudice to Sections 2(a)(iii) and 6(c)(ii), the obligations of the parties under this Agreement will survive the termination of any Transaction."
(A) A party does not pay any amount that, but for Section 2(a)(iii), would have been payable, it will, to the extent permitted by applicable law and subject to Section 6(c) and clauses (B) and (C) below, pay interest (before as well as after judgment) on that amount to the other party on demand (after such amount becomes payable) in the same currency as that amount, for the period from (and including) the date the amount would, but for Section 2(a)(iii), have been payable to (but excluding) the date the amount actually becomes payable, at the Applicable Deferral Rate;"
As will appear, it became common ground that this obscure provision resolved, for the purposes of the 2002 Master Agreement, a major issue of construction as to the nature and effect of the condition precedent in Section 2(a)(iii). In short, it clearly contemplates that a payment which, because of an Event of Default which is continuing on the date prescribed for payment in the Confirmation, fails then to become payable under Section 2(a)(i), may nonetheless become payable at a later date, when the relevant Event of Default ceases, so that the condition precedent under Section 2(a)(iii) is for the first time satisfied. No equivalent provision appears in the 1992 Master Agreement.
The Firth Rixson Transactions
The BEIG Transaction
The KPGZ Transactions
1. Whether (as the Administrators contend), either as a matter or construction or by way of an implied term, the first limb of Section 2(a)(iii) operates only for 'a reasonable period'.
2. If the answer to Issue 1 above is affirmative:
(1) Is the 'reasonable period' there referred to such period as may be reasonable to allow the Non-defaulting Party: (i) in the case of a Potential Event of Default, to establish whether the Potential Event of Default leads to an Event of Default; and (ii) in the case of an Event of Default, to consider whether its interests are best served by designating an Early Termination Date and, if so, to designate an Early Termination Date; or (iii) some other and if so what period?
(2) Has the reasonable period now elapsed in relation to the swap agreements which are the subject matter of these proceedings and, if it has elapsed, when did it elapse?
(3) At the end of the reasonable period, if an Early Termination Date has not been designated by the Non-defaulting Party, does the first limb of Section 2(a)(iii) cease to operate so that the amounts which were previously not payable by reason of the first limb of Section 2(a)(iii) become payable under Section 2(a)(i) (with or without netting)?
3. Alternatively, whether (as the Administrators contend), either as a matter of construction or by way of an implied term, the first limb of Section 2(a)(iii) only operates with respect to obligations under a particular transaction until the last date for performance in respect of, or the date of termination by effluxion of time of, the transaction (or, alternatively, all of the transactions governed by the Master Agreement), at which point the Non-defaulting Party is obliged to designate that date as the Early Termination Date or, alternatively, the obligations of the parties are netted off.
4. Alternatively, whether (as the Respondents variously contend), if an Event of Default or Potential Event of Default exists at a scheduled payment date, on the true construction of the first limb of Section 2(a)(iii):
(1) No payment obligation ever arises on the part of the Non-defaulting Party in respect of the amount which would otherwise have been payable on that scheduled payment date; alternatively
(2) No such payment obligation ever arises if the Event of Default or Potential Event of Default continues until the last date for performance in respect of, or the date of termination by effluxion of time of, the transaction (or, alternatively, all of the transactions governed by the Master Agreement); alternatively
(3) (As ISDA contends) obligations under Section 2(a)(i) (which have not arisen by reason of an Event of Default or Potential Event of Default at the date for performance of the relevant obligation) arise only when there is no longer continuing an Event of Default or Potential Event of Default (whether or not the last date for performance in respect of, or the date of termination by effluxion of time of, the transaction (or alternatively all of the transactions governed by the Master Agreement) has passed).
14. If the answer to Issue 4 above is affirmative, where a Non-defaulting Party proves in the administration of the Defaulting Party, is the Non-defaulting Party entitled to prove in respect of the entirety of the Defaulting Party's payment and/or delivery obligations:
(1) Where the Non-defaulting Party has not met those obligations which would have fallen due under the transaction but for the first limb of Section 2(a)(iii); and/or
(2) Without giving credit for obligations which would have arisen but for the first limb of Section 2(a)(iii)?"
"It follows that in every case in which it is said that some provision ought to be implied in an instrument, the question for the court is whether such a provision would spell out in express words what the instrument, read against the relevant background, would reasonably be understood to mean. It will be noticed from Lord Pearson's speech that this question can be reformulated in various ways which a court may find helpful in providing an answer – the implied term must "go without saying", it must "be necessary to give business efficacy to the contract" and so on – but these are not in the Board's opinion to be treated as different or additional tests. There is only one question: is that what the agreement, read as a whole against the relevant background, would reasonably be understood to mean?"
"The court does not make a contract for the parties. The court will not even improve the contract which the parties have made themselves, however desirable the improvement might be. The court's function is to interpret and apply the contract which the parties have made for themselves. If the express terms are perfectly clear and free from ambiguity, there is no choice to be made between different possible meanings: the clear terms must be applied even if the court thinks some other terms would have been more suitable. An unexpressed term can be implied if and only if the court finds that the parties must have intended that term to form part of their contract: it is not enough for the court to find that such a term would have been adopted by the parties as reasonable men if it had been suggested to them: it must have been a term that went without saying, a term necessary to give business efficacy to the contract, a term which, though tacit, formed part of the contract which the parties made for themselves."
"arises when the instrument does not expressly provide for what is to happen when some event occurs. The most usual inference in such a case is that nothing is to happen. If the parties had intended something to happen, the instrument would have said so. Otherwise the express provisions of the instrument are to continue to operate undisturbed. If the event has caused loss to one or other of the parties, the loss lies where it falls.
In some cases, however, the reasonable addressee would understand the instrument to mean something else. He would consider that the only meaning consistent with the other provisions of the instrument, read against the relevant background, is that something is to happen. The event in question is to affect the rights of the parties. The instrument may not have expressly said so, but this is what it must mean. In such a case, it is said that the court implies a term as to what will happen if the event in question occurs. But the implication of the term is not an addition to the instrument. It only spells out what the instrument means." (paragraphs 17-18)
Once and for All v Suspension
"There is nothing in the wording of the provisions of the contract to suggest that if the condition precedent is fulfilled at some later date, some obligation to pay then springs up."
"Since these two conditions are conditions precedent to the payment obligations of the counterparties, if either condition has not been met at any given time there is no payment obligation under any of the trades that have been made under the Agreement. However, a payment obligation will spring up under a pre-existing trade once the relevant condition is satisfied, and in that sense it might be said (with only approximate accuracy) that the payment obligation is "suspended" while the condition remains unfulfilled, and that amounts "accrue" notwithstanding that the condition is unfulfilled."
It does not appear that Austin J's conclusion was the result of adversarial argument on the point. Rather, it appears to have been his assumption as to the way in which Section 2(a)(iii) of the 1992 Master Agreement worked.
i) Until the expiry of the term of the Transaction;
The Constructions Alternatively Advanced by the Administrators
The alternative outcomes are as follows:
A. That Section 2(a)(iii) suspends the Non-defaulting Party's payment obligations under condition precedent (1) only for a reasonable time: that is, a time sufficient to enable that party to decide whether to elect for Early Termination, or to continue to perform its payment obligations in full.
B. That Section 2(a)(iii) suspends the Non-defaulting Party's obligations under Section 2(a)(i) until such time as the Transaction, or alternatively all of the Transactions between the parties governed by the Master Agreement, have run their course (assuming no Early Termination) such that, at the expiry of the natural term of the last Transaction the Non-defaulting Party must either submit to a netting process which calls for payment of all suspended payment obligations or submit to the consequences of an Early Termination as at that date.
C. That the Non-defaulting Party is, under Section 6(a) under a constant obligation to exercise its discretion whether or not to designate an Early Termination Date in a manner which is not arbitrary, capricious or unreasonable so that, once it is clear that the other party's default is permanent, or where the Non-defaulting Party decides to re-hedge, it must exercise its discretion in favour of Early Termination.
(i) I am not persuaded that the purpose behind Section 2(a)(iii) is as narrow as the Administrators suggest.
(ii) Both of their alternatives A and B require substantial implication of terms in circumstances where the well-settled requirements for doing so are not met.
(iii) Alternative C is based on a misreading of Section 6(a) of the Master Agreement, which confers a right on the Non-defaulting Party to elect or to decline to elect for Early Termination as it thinks best suits its own interests.
(iv) By contrast the respondents' construction reflects the clear meaning of the express terms of the Master Agreement. It is neither un-commercial in its outcome, nor does it necessarily confer an unjustified windfall benefit on the Non-defaulting Party.
I will expand on each of those conclusions in turn.
Unreasonable Exercise of Discretion
"is essentially based on the proposition that one cannot contract out of the provisions of the insolvency legislation which govern the way in which assets are dealt with in a liquidation."
(per Lord Neuberger MR in Perpetual Trustee Co Ltd v. BNY Corporate Trustee Services Ltd  EWCA Civ 1160  3 WLR 87, at paragraph 50). As the modern cases including Perpetual show, it is a principle which is easy to state, but difficult to apply, in particular in relation to sophisticated dealings between modern financial and commercial entities. This difficulty of application is best illustrated by the fact that, in British Eagle International Airlines Ltd v. Cie Nationale Air France  1 WLR 758, all their Lordships were in substantial agreement about the nature of the principle, but split 3/2 over its application, the minority agreeing with all the judges in the courts below.
(i) At the moment when LBIE went into administration on 15th September 2008 it was the owner, under each of the Swaps, of an asset consisting of a contingent liability owed by each of its counterparties, the contingencies being:
(a) that floating interest rates should be such, on each of the outstanding payment dates in the relevant Confirmation, that a net sum was due from the counterparty to LBIE (i.e. that LBIE should be in the money); and
(b) that no Event of Default or Potential Event of Default had occurred and was continuing.
(ii) The operation of the condition precedent constituted by the requirement that there by no Bankruptcy Event of Default meant that, upon LBIE going into administration, it was (in all probability permanently) deprived of that asset, either for distribution to creditors pari passu, or for beneficial utilisation in the course of its administration.
(iii) It was no answer for the respondents to say that the condition precedent had existed from the moment when the asset (in the form of a contingent liability) was created. That was equally true of the royalties in ex parte Mackay (1873) 8 Ch App 643, approved in British Eagle and followed in Perpetual, in particular by Lord Neuberger MR at paragraph 67, with whom Longmore LJ agreed, at paragraph 99.
2) Not applicable.
4) (1) No
(2) Yes, on a transaction by transaction basis.
6) (1) Not necessary to decide.
(2) Yes, but regardless whether it provides a benefit to the Non-defaulting Party.
(4) Does not arise.
Penalty/relief from forfeiture
8) Not applicable.
10) (1) No.
(2) Not applicable.
12) See the analysis in the judgment.
13) Not applicable.
14) The respondent Non-defaulting Parties in the present case all acknowledge that, as at present, the netting of the payment obligations which have arisen since 15th September 2008 mean that they have no present right of proof against LBIE in respect of the Swap agreements. LBIE is, on a net basis, heavily in the money under each of them. Further, in relation to such Swap agreements as have yet to reach their termination by effluxion of time, no rights of proof will arise unless changes in interest rates hereafter are so large that, even after giving LBIE credit for all the payments which would have been payable when LBIE was in the money, a net sum were still to be due to the respondent counterparty. Mr Fisher submitted that, even then, it would be necessary for the counterparty to waive the condition precedent constituted by LBIE's continuing default. I make no decision about that. For the avoidance of doubt, it has not been argued or decided whether that condition precedent is capable of unilateral waiver by the Non-defaulting Party.