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1992 ISDA Master Agreement: what are terminated transactions under Section 6(e)?

Allen & Overy Litigation Review: Pioneer Freight Futures Co Ltd (in liquidation) v Cosco Bulk Carrier Co Ltd [2011] EWHC 1692

In this case Flaux J held that transactions under a 1992 ISDA Master that have "reached their natural expiry date" prior to the Early Termination Date are not "outstanding" or "in effect" and cannot be "Terminated Transactions".

This is so even if accrued amounts remain owing in respect of them. Those accrued amounts are not, therefore, Unpaid Amounts for the purposes of Section 6(e) but may be set off against the amount due under Section 6(e). 

Between January 2007 and August 2008, Pioneer Freight Futures Co Ltd (Pioneer) and Cosco Bulk Carrier Co Ltd (Cosco) entered into 11 forward freight agreements (FFAs). All 11 FFAs were on the standard 2007 Terms of the Forward Freight Agreement Brokers Association (the 2007 Terms), which incorporated by reference the 1992 ISDA Master Agreement (the Master Agreement). In relation to seven of these, Pioneer was the Seller, and in relation to four it was the Buyer. By virtue of incorporation of the Master Agreement, all of the FFAs were deemed to be Transactions forming part of a single Master Agreement, which provided for Automatic Early Termination to apply in respect of each party.

In the fourth quarter of 2008, the volatility in the markets generally combined with a dramatic downturn in the freight market, meant that these FFAs were substantially "in the money" for whichever party was the Seller. Seven of the eleven FFAs had October 2008 as a Contract Month and, once the payments due had been netted, a balance was due to Cosco which Pioneer failed to pay. This failure to pay by Pioneer constituted an Event of Default under the Master Agreement, the consequence of which was that Cosco had no obligation to make any payment in respect of any of the FFAs in future Contract Months.

In December 2009, Pioneer went into liquidation, triggering Automatic Early Termination under Section 6(a) of the Master Agreement. By that time, the last Contract Month had passed in respect of eight of the FFAs, leaving only three FFAs with Contract Months left to run.

The dispute centred on whether the close-out calculations which Pioneer made under Section 6 of the Master Agreement should or should not include those FFAs under which the last Contract Month had passed prior to the triggering of the Automatic Early Termination.

The meaning of "outstanding Transactions" and "Terminated Transactions"

Section 6(a) of the Master Agreement states that on Automatic Early Termination, an Early Termination Date occurs in respect of all "outstanding Transactions". These transactions become "Terminated Transactions", the definition of which refers to all "Transactions in effect" immediately before the effectiveness of the notice designating the Early Termination Date.

Flaux J considered that it was something of a distortion of language to include within "Terminated Transactions", as Pioneer sought to do, transactions which had already come to an end. He said that "Terminated Transactions" connoted transactions that were capable of being terminated by the occurrence of Automatic Early Termination, that is, transactions where there were still future obligations to be performed. This did not apply to transactions which had already terminated 12 months previously, even where there was an accrued debt owed to one of the parties. Similarly, it was difficult to see the basis on which it could be said that a transaction that had come to an end through natural expiry could be described as "outstanding" within the meaning of Section 6(a). The word "outstanding" assumed that there was some obligation remaining to be performed in the future, which was not the case.

FFAs which had had their payment obligations suspended because of non-compliance with a condition precedent did not spring back to life after their termination on natural expiry upon a subsequent Automatic Early Termination in respect of transactions still in effect at that later date.

Flaux J, therefore, held that only the three FFAs which still had Contract Months to run as at Automatic Early Termination, and thus outstanding obligations to be performed in the future, were to be taken into account in calculating the payment due upon Early Termination under Section 6(e) of the Master Agreement. The other eight FFAs fell outside that calculation.

Comment: This is a troubling decision for several reasons. The most troubling aspect, however, is Flaux J’s view that a transaction that has not yet been fully performed is nonetheless not "outstanding" or "in effect" and, therefore, cannot fall within the definition of "Terminated Transactions". This runs counter to the normal market understanding that a transaction under a Master Agreement is "outstanding" until fully performed, and the general expectation, therefore, that any accrued but unpaid amount under such transaction will be an "Unpaid Amount" for the purposes of the Section 6(e) close out calculation.

The source of Flaux J’s conclusion appears to be the view that a transaction "expires" on the last date scheduled for performance under the transaction; or, in other words, it terminates "by effluxion of time" on that date. Briggs J expressed the same view in Lomas v JFB Firth Rixson, Inc [2010] EWHC 3372 (Ch), leading to the most troubling aspect of that decision, namely, that obligations that would have been required to be performed, but for the conditions precedent in Section 2(a)(iii), expire on the last date scheduled for performance of the relevant transaction. There is, however, no basis in the Master Agreement for this view.

A transaction under a Master Agreement has, of course, a defined commencement date and one or more agreed dates for performance by payment or, if physical settlement is required or permitted, delivery of an asset. The transaction, however, lasts until neither party has any actual or contingent obligations under it.

The one common type of derivative transaction that provides for "expiration" is, of course, an option transaction, and it may be that this somehow, perhaps unconsciously, informed the view of Briggs J and Flaux J that each transaction under a Master Agreement "expires" or terminates "by effluxion of time". However, in the case of an option transaction, expiration is expressly provided for. If the rights of the option buyer have not been exercised by the agreed expiration date, they may not be exercised subsequently. The very fact that expiration is provided for expressly in an option transaction confirms the general expectation that obligations due and not yet performed under other types of transaction, for example, a swap transaction or a forward transaction (a FFA being a type of forward transaction), do not expire, but remain in effect until performed or discharged in some other way. Under a Master Agreement, that means performance must occur as provided by Section 2(a)(i), unless discharged by Section 6(c)(ii), in which case a separate obligation arises under Section 6(e).

Flaux J was clear that his finding did not depend on whether the view he had expressed in Marine Trade v Pioneer Freight Futures [2009] 1 Lloyd's Reports 631 (December 2009 Litigation Review), that obligations expire on their due date if the conditions precedent of Section 2(a)(iii) are not fulfilled on that date, is to be preferred to the view of Briggs J in Lomas that the obligations expire on the last scheduled date for performance if the conditions precedent of Section 2(a)(iii) remain unfulfilled on that date. His "once-and-for-all" interpretation versus Briggs J’s "suspension until extinction" interpretation were also mentioned, if not considered, in other recent cases, including Pioneer Freight Futures Company Ltd v TMT Asia Ltd [2011] EWHC 778 (Comm) (See the June 2011 Litigation Review) and Britannia Bulk Plc v Pioneer Navigation Ltd [2011] EWHC 692 (Comm). Although Flaux J considered the interpretation of Section 2(a)(iii) in some detail in his judgment, he decided that, in circumstances where the issue was likely to come before the Court of Appeal later this year on appeal from one of the above-mentioned cases, it was not desirable for him to express any conclusive view on the question, and that this was, in any event, not a necessary part of his reasoning.

Although this case concerns the 1992 version of the ISDA Master Agreement, Flaux J’s reasoning would apply to transactions under the 2002 version. In relation to the 1992 version, if the parties have included a broad contractual set off provision, such as the one recommended by ISDA in the User’s Guide to the 1992 version, then the practical effect of this decision will be limited, provided that the contractual set-off provision would be enforceable against either party as the defaulting party in the event of its insolvency. If the parties have not included such a provision, but the defaulting party is an English company subject to winding up or administration under the Insolvency Act 1986, then insolvency set-off will be available to mitigate the effects of the decision. However, the timing of the insolvency set-off will not necessarily match the timing that would apply in relation to a contractual set-off provision, and in some cases the difference in value could be significant. The 2002 version of the ISDA Master Agreement includes a contractual set-off provision in Section 6(f), but it will be necessary for each party to ensure that the contractual set-off is enforceable against the other party as defaulting party in the event of its insolvency.

The Court of Appeal may have the opportunity to consider this ruling, which is currently being appealed. It is possible that the appeal will be heard together with the appeal in Lomas. In the meantime, parties will wish to consider amending their ISDA Master Agreements to clarify that transactions under which amounts remain outstanding, whether on an actual or a contingent basis, are "outstanding" or "in effect" for purposes of the definition of "Terminated Transactions" and the outstanding amounts will, therefore, be Unpaid Amounts in the event of a close-out under Section 6(e).

Further information

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