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Court of Appeal rules on key provisions of the ISDA Master Agreement

On 3 April 2012, the Court of Appeal handed down its judgment in four appeals,1 all of which concerned the consequences of an Event of Default under the ISDA Master Agreement, principally the 1992 version.

​Section 2(a)(iii) of the ISDA Master Agreement was relevant to each of the appeals. Section 2(a)(iii) provides, amongst other things, that the obligation of each party to make each payment or delivery specified in each Confirmation to be made by it is subject to the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing.

In a unanimous judgment, the key findings were as follows:

a) where there is an Event of Default or Potential Event of Default with respect to one party on the due date for payment or delivery, the other party's obligation to pay or deliver is suspended by Section 2(a)(iii) until either the Event of Default or Potential Event of Default is cured or an Early Termination Date occurs or is designated, but is not extinguished;

b) there is no implied term in the ISDA Master Agreement that payment and delivery obligations suspended by Section 2(a)(iii) revive after a reasonable time or on the last scheduled date for payment or delivery under the Transaction or under all Transactions;

c) payment or delivery obligations suspended by Section 2(a)(iii) do not expire on the last scheduled date for payment or delivery or otherwise by "effluxion of time";

d) when making the calculation required by Section 6 following an Early Termination Date, all outstanding Transactions (including those where the last date for performance has passed prior to the Early Termination Date) must be taken into account as part of the close-out netting mechanism;

e) the payment netting provision in Section 2(c) applies where one of the parties is subject to an Event of Default or Potential Event of Default on the payment date, and therefore operates irrespective of Section 2(a)(iii), but only in respect of amounts expressed to be payable on that date (and not amounts due and remaining unpaid in relation to any earlier payment date);

f) on the facts of the appeal in which the issue was raised, the operation of Section 2(a)(iii) does not contravene either the anti-deprivation principle of English insolvency law or the pari passu rule of distribution in an English liquidation; and;

g) a party calculating payments due on early termination in accordance with the Loss payment measure must do so assuming satisfaction of each applicable condition precedent (including Section 2(a)(iii) (1)).


Common to all four appeals was the effect of Section 2(a)(iii) of the ISDA Master Agreement. In the first two appeals, the court considered the effect of Section 2(a)(iii) where no Early Termination Date has been designated. In the third and fourth appeals, the court considered whether Section 2(a)(iii) affects the calculation of the net close-out amount due after the occurrence of an Early Termination Date. During the course of its judgment, the court referred to a number of decisions at first instance that have considered the rights and obligations of parties following an Event of Default under an ISDA Master Agreement. All four appeals primarily addressed the position in the 1992 version of the ISDA Master Agreement, however the 2002 version was also considered in relation to the first appeal and the reasoning and conclusions of the court generally apply to both versions. The 1987 version was considered (as discussed below) in relation to one point to assist interpretation.

ISDA (represented by Allen & Overy LLP, Antony Zacaroli Q.C. and Jeremy Goldring) was granted permission to intervene in the appeals, having previously been permitted to intervene in Firth Rixson at first instance.

First appeal (Lomas v Firth Rixson)

The parties had not specified Automatic Early Termination (AET) as being applicable and, following the appointment of administrators, large sums would, but for the Event of Default, have been due from each Non-defaulting Party to LBIE. Each Non-defaulting Party elected not to designate an Early Termination Date and, instead, relied on Section 2(a)(iii) as the basis for not making further payments to LBIE. Each of the relevant Transactions came to the end of its term, or would shortly do so, by the time judgment was handed down.

Second appeal (LBSF v Carlton)

The second appeal involved two linked interest rate swaps entered into between Lehman Brothers Special Financing Inc (LBSF) and Carlton Communications Limited (Carlton). Lehman Brothers Holdings Inc (LBHI) acted as Credit Support Provider for both Transactions. The entry by LBHI and LBSF into Chapter 11 bankruptcy proceedings on 15 September 2008 and 3 October 2008, respectively, constituted two Events of Default under the relevant ISDA Master Agreement. The parties had not elected for AET. But for the operation of Section 2(a)(iii), one further payment would have been due from Carlton to LBSF on 2 March 2009. Carlton, relying on Section 2(a)(iii), did not make that payment.

Third appeal (Pioneer v Cosco)

This case involved eleven forward freight agreements (FFAs) entered into by Pioneer Freight Futures Company Limited (Pioneer) and Cosco Bulk Carrier Company Limited (Cosco) between January 2007 and August 2008. All were subject to the 2007 terms of the Forward Freight Agreement Brokers Association (FFABA 2007 Terms) which incorporated by reference the 1992 version of the ISDA Master Agreement. AET applies by default under the FFABA 2007 Terms. Under four of the FFAs Cosco was the seller; under the remaining seven Pioneer was the seller.

Following a failure by Pioneer to make a payment due in November 2008, Cosco relied on Section 2(a)(iii) to avoid making any subsequent payments that would otherwise have fallen due. On 14 December 2009, Pioneer passed a resolution for its winding-up. This was an Event of Default under the ISDA Master Agreement, to which AET applies, resulting in the occurrence of an Early Termination Date in respect of all outstanding Transactions. Pioneer contended that all eleven FFAs were subject to AET, whereas Cosco argued that eight FFAs were not subject to AET because in each case the last date for performance had passed prior to the Early Termination Date being designated.

Fourth appeal (Bulk v Britannia Bulk)

The final appeal again involved an FFA on FFABA 2007 Terms incorporating the 1992 version of the ISDA Master Agreement pursuant to which the parties, Bulk Trading SA (Bulk) and Britannia Bulk Plc (Britannia Bulk), had specified AET as being applicable and selected Loss as the payment measure.

Administrators were appointed over Britannia Bulk on 31 October 2008 which resulted in an Early Termination Date occurring on that date by virtue of AET. The dispute related to the basis on which the Loss calculation by Bulk was required to be made.

The Court of Appeal judgment

a) Did the obligation of the Non-defaulting Party ever come into existence?

The court held that underlying any payment obligation, there is always a debt obligation. It considered that Section 2 of the ISDA Master Agreement is concerned only with the payment obligation and does not touch the underlying debt obligation. It is therefore only the payment obligation in Section 2(a)(i) that is subject to the condition precedent in Section 2(a)(iii). The court adopted observations of Mrs Justice Gloster in Pioneer Freight Co Ltd v TMT Asia Ltd [2011] 2 Lloyd's Rep 96 in which she reached the same conclusion.
The court noted that its view was supported by the operation of the ISDA Master Agreement in circumstances where early termination has taken place and calculations have to be made pursuant to Section 6(e) and, in particular, that both Market Quotation and Loss payment measures require the assumption that each applicable condition precedent has been satisfied. The court noted that if in fact no debt obligation ever arose, the calculation on early termination could never take place since there would be no obligation of the Non-defaulting Party to take into account. In other words, since the calculation on early termination clearly does take place, there must be a debt obligation that arises when each Transaction is entered into and this must be unaffected by the suspension under Section 2(a)(iii) of specific payment obligations arising from the debt obligation.

b) Extinction or suspension?

The court endorsed the view taken by Mr Justice Briggs at first instance in Firth Rixson and held that the payment obligation of a Non-defaulting Party is suspended (rather than extinguished) during the currency of an Event of Default under the ISDA Master Agreement. The payment obligation will therefore revive if the Event of Default is cured at any time before the outstanding Transactions are terminated. The court rejected the alternative view of Mr Justice Flaux expressed in obiter comments in Marine Trade SA v Pioneer Freight Futures Co Ltd BVI [2010] Lloyd's Rep 631.
In reaching that view, the court relied on, amongst other things, the following points: (i) the alternative approach could lead to payment obligations being extinguished as a result of a relatively minor Potential Event of Default (e.g. a small underpayment perhaps as a result of a bona fide dispute) which would be altogether too drastic a remedy in favour of the Non-defaulting Party; (ii) since the calculations that are made following an Early Termination Date require it to be assumed that any condition precedent has been satisfied, it would be somewhat counterintuitive to find that in other cases the existence of the condition precedent meant the underlying obligation is extinguished; and (iii) rejecting a submission made by Cosco, it made no difference that the obligation under Section 2(a)(i) applies to the delivery of chattels (e.g. financial instruments) as well as to payment obligations. While the value of these chattels could increase during the period of suspension, a Non-defaulting Party could designate an Early Termination Date if it thought that was an unsatisfactory position.

c) Revival otherwise than by curing the Event of Default?

The next issue dealt with by the court was the arguments made by the administrators of LBIE that, even if the Event of Default was not cured but continuing, there must come a time when the obligation on the Non-defaulting Party to make payment must revive. The administrators of LBIE argued that, if this were not the case, there would be a serious mismatch between the position where there is an early termination and where there is not, and it would always be in the interests of the Non-defaulting Party to decline to terminate the Transaction and thereby receive an undeserved windfall.
The administrators therefore sought to argue, amongst other things, that either as a matter of construction or by implication of terms, Section 2(a)(iii) only suspends the Non-defaulting Party's payment obligations for a reasonable time or, alternatively, until such time as the Transaction(s) have run their course (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).
The court agreed with Mr Justice Briggs' rejection of these arguments. It noted that neither proposed term was necessary to make the contract work. The first proposed term was also contrary to the express words of Section 2(a)(iii) (i.e. "and is continuing") and was not required by the scheme of the contract.

d) Extinction of payment obligation on maturity?

At first instance in Firth Rixson, Mr Justice Briggs held that, although the payment obligation of the Non-defaulting Party was suspended during the currency of the Transaction, the suspension ended on maturity and it was then extinguished. In reaching this conclusion, he rejected submissions made on behalf of ISDA that such suspension should in theory be potentially indefinite.
The court disagreed with Mr Justice Briggs' interpretation. Accepting ISDA's submissions were correct, the court held that there is no terminus, either by extinction or revival, to the condition precedent which continues in force until the Event of Default is cured or until an Early Termination Date is designated or occurs. The court therefore concluded that "The terms of the Master Agreement recognise no concept of expiry by effluxion of time, nor is there any basis upon which it can arise by implication".
In reaching this conclusion, the court made the following key points:
i. the court rejected Mr Justice Briggs' finding that, on its true construction, Section 9(c) provided for the extinction of the payment obligation. That provision, headed "Survival of Obligations", states that "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." Having reviewed the drafting of the corresponding provisions in the 1987 version of the ISDA Master Agreement, the court concluded that the reference in Section 9(c) to Section 2(a)(iii) is a reference only to Section 2(a)(iii)(2) (i.e. the condition precedent that no Early Termination Date in respect of the relevant Transaction has occurred) and therefore had no bearing on this issue;
ii. in light of this finding, the court found that the parties had made no express provision for what is to happen to suspended obligations when a Transaction matures. Both the interpretations suggested by the administrators of LBIE (i.e. the obligation revives) and that put forward by the respondents (i.e. the obligation is extinguished) required the implication of a term, and there was no basis for such a term to be implied; and
iii. the court also rejected Mr Justice Briggs' conclusion that it was impossible to conduct the required calculation (whether by Market Quotation or Loss) after the maturity date of a Transaction. The result was simply that the first part of the necessary calculation (concerning the future value of the Transaction) results in a nil value, but the second part of the calculation (concerning Unpaid Amounts, including amounts that would have been payable but for Section 2(a)(iii)) remains relevant.

e) Are Transactions whose natural term has expired prior to the occurrence of AET subject to close-out netting?

At first instance in Pioneer v Cosco, Mr Justice Flaux found in favour of Cosco. He held that the close-out netting calculation under Section 6(e) excluded Transactions "which have already terminated at their natural expiry date".
The court held that this finding was inconsistent and unsustainable in light of its conclusions summarised above, and "was essentially dependent upon his flawed analysis that the Transaction 'expired by effluxion of time' ". The court also considered that Mr Justice Flaux's approach was inconsistent with the Single Agreement provision in Section 1(c) of the ISDA Master Agreement. It therefore followed that all eleven of the FFAs were subject to close-out netting.

f) Gross vs Net

The court considered competing first instance judgments as to whether a Non-defaulting Party is entitled to payment of the gross obligations of the Defaulting Party without having to net any such obligation against any obligation of the Non-defaulting Party.
In Marine Trade v Pioneer and Pioneer v Cosco, Mr Justice Flaux held that netting under Section 2(c) was not available to the Defaulting Party where the conditions precedent contained in Section 2(a)(iii) were not satisfied as of the date for payment. A contrary view was expressed by Mrs Justice Gloster in Pioneer Freight Futures Company Limited (in Liquidation) v TMT Asia Limited [2011] EWHC 1888.
The court endorsed the approach taken by Mrs Justice Gloster. It considered that the concluding words in Section 2(a)(i), by which the parties' obligations to make each payment or delivery is "subject to the other provisions of this Agreement", are unqualified and therefore subject the primary payment obligation to both Section 2(a)(iii) and Section 2(c). The court highlighted that the netting provisions in Section 2(c), which are both automatic and mandatory, state that they are to operate in relation to amounts which "would otherwise be payable" in the same currency and in respect of the same Transaction. This wording qualifies the terms of the payment in the Confirmation so as to convert each party's contractual obligations into one to pay a net sum. The court therefore concluded that: "The words "would otherwise" can and, in our view, should be read as the draftsman’s indication that Section 2(c) operates irrespective of the terms of each payment obligation and the particular circumstances then prevailing."
The court, however, noted that the netting provisions in Section 2(c) applied only to amounts which, under the original terms of the agreement, were expressed to be payable on the same date in respect of the same or, at the parties' election, two or more Transactions. The court therefore took the view that Section 2(c) does not apply to amounts that were due on earlier dates and remain unpaid on that date.

g) Anti-deprivation principle and pari passu rule

In the second appeal, LBSF v Carlton, LBSF sought to challenge the operation of Section 2(a)(iii) on two further grounds, namely that (i) it contravenes the anti-deprivation principle of English insolvency law or (ii) it contravenes the pari passu rule of distribution between creditors in an English liquidation. The court considered that the areas of operation of these two rules are distinct. The anti-deprivation principle is concerned with contractual arrangements which have the effect of depriving the insolvent estate of property which would otherwise have formed part of it. The pari passu rule governs the distribution of assets within the estate following a liquidation. It therefore invalidates arrangements under which a creditor receives more than his proper share of the available assets or where debts due to the company on liquidation are to be dealt with otherwise than in accordance with the statutory scheme.

As regards the anti-deprivation principle, the court referred extensively to the recent Supreme Court decision in Belmont Park Investments PTY Limited (Respondent) v BNY Corporate Trustee Services Limited and Lehman Brothers Special Financing Inc (Appellant) [2011] UKSC 38 which it described as the "authoritative statement" on the anti-deprivation principle. In Belmont, it had been held that a transaction will not fall foul of the anti-deprivation principle if it was entered into in good faith and was commercially sensible. In this case, the court thought it was difficult to see how Section 2(a)(iii) could be said to offend against the principle. It considered that the purpose of Section 2(a)(iii) is to protect the Non-defaulting Party from the additional credit risk involved in performing its own obligations whilst the Defaulting Party remains unable to pay its own. The indefinite suspension of the payment obligation of the Non-defaulting Party (like any attempt to balance competing interests) might be criticised as imperfect but it could not be said to be uncommercial.

The good faith test referred to above does not prevent a transaction being challenged pursuant to the pari passu principle. Therefore, if Section 2(a)(iii) was considered to breach the pari passu principle, it would be invalid whatever the motivation behind the section. However, the court held that Section 2(a)(iii) did not breach this rule. This was for two reasons:

i. the pari passu principle is only engaged in respect of assets of the insolvent estate as at the commencement of the liquidation. In this case, there was no debt payable to LBSF when its liquidation commenced because the obligation to pay was subject to the condition precedent that there be no continuing Event of Default. There was therefore no property which was capable of being distributed. This is very much a "flawed asset" analysis and so it would appear that the court was of the view that the inclusion of a condition precedent, such as the one that appears in Section 2(a)(iii), is sufficient to prevent the pari passu principle coming into play even though a flawed asset analysis is not enough, in itself, to prevent the anti-deprivation principle from applying (the provision must also be in good faith and commercially sensible); and

ii. Carlton was not a creditor of LBSF in respect of the payment that would have fallen due, but for Section 2(a)(iii). In most cases, the pari passu rule will be relied upon by the liquidator to defeat a creditor's reliance on a contractual arrangement which was intended to give him preference in relation to the distribution of the estate.

h) Basis for calculations under the Loss payment measure

Bulk argued that it had made no gain in respect of the Transaction since, had early termination not occurred, no payments would have accrued due to Britannia Bulk because Britannia Bulk would have been subject to an Event of Default for the remainder of the term of the agreement. Bulk relied on the omission of the words "assuming the satisfaction of each applicable condition precedent" from the first sentence of the definition of Loss in the ISDA Master Agreement which deals with the calculation of a party's forward-looking losses, costs or gains in connection with Terminated Transactions.

The court, consistent with the findings of Mr Justice Flaux at first instance and those of Mrs Justice Gloster in Pioneer v TMT, held that the ISDA Master Agreement requires a party calculating payments due on early termination in accordance with the Loss payment measure to assume satisfaction of each applicable condition precedent. It considered that Bulk's argument was founded upon a fallacy or impossibility: it assumed an Event of Default going forward for the remainder of the contract period, but that was not possible since the Event of Default itself led to AET. In addition, if Bulk's submission were right, a Non-defaulting Party would never have to pay anything in respect of loss of bargain going forward in these circumstances, which was inconsistent with the terms of the ISDA Master Agreement.

The court also cited with approval comments made by Mr Justice Briggs in Anthracite Rated Investments (Jersey) Limited v Lehman Brothers Finance SA (in liquidation) [2011] 2 Lloyd's Rep 538 in respect of the Loss and Market Quotation payment measures. These included the following: "Loss and Market Quotation are, although different formulae, aimed at achieving broadly the same result, so that the outcomes derived from one may be usefully tested by way of cross-check by reference to the other…. The termination payment formulae under Section 6(e) are not to be equated with, or interpreted rigidly in accordance with the quantification of damages at common law for breach of contract." These findings were also inconsistent with the interpretation put forward by Bulk.


The court's rejection of the argument that payment obligations were extinguished on maturity of Transactions is of particular significance. The alternative view, adopted by Mr Justice Briggs and Mr Justice Flaux at first instance, could have encouraged a Non-defaulting Party that was out-of-the-money to withhold payments in the knowledge that its obligation to make payments would be extinguished after the last relevant scheduled date for payment had passed. That approach was contrary to market expectations.
The court's findings also endorse two fundamental aspects of the ISDA Master Agreement: the Single Agreement provision (i.e. that all Confirmations and the Master Agreement (including the Schedule) form a single agreement between the parties) and close-out netting. The effectiveness of the close-out netting mechanism has not been questioned by an English court in any of the growing number of cases that have considered the consequences of an Event of Default under the ISDA Master Agreement, although the first instance decision in Pioneer v Cosco had raised a troubling doubt about the scope of Transactions included within the close-out calculation. Fortunately, the Court of Appeal has laid that doubt to rest and confirmed what had always been the general market understanding of the proper scope. More generally, this comprehensive judgment, while considering in detail certain issues relevant to what falls within the scope of the close-out netting mechanism, takes as read that the mechanism itself works as set out in the ISDA Master Agreement. This may be read as a further robust judicial endorsement of the most important function of the ISDA Master Agreement.


(1) The four judgments subject to appeal were: Lomas v JFB Firth Rixson, Inc [2010] EWHC 3372 (Ch), Lehman Brothers Special Financing Inc v Carlton Communications [2011] EWHC 718 (Ch), Pioneer Freight Futures Co Ltd (in Liquidation) v Cosco Bulk Carrier Co Ltd [2011] EWHC 1692 (Comm), Britannia Bulk Plc (in Liquidation) v Bulk Trading SA [2011] EWHC 692 (Comm)