Literal not contextual approach prevails in interpretation of ISDA Master Agreement

Not, perhaps, what one might have expected in the wake of the recent decision of the UK Supreme Court in Rainy Sky SA v Kookmin Bank, [2011] UKSC 50, which opted for the contextual approach, as informed by business common sense. But, on the facts of Lomas v JFB Firth Rixson Inc, [2012] EWCA Civ 419, the literal approach seems to make sense.

But first, a little Derivatives 101. Under an interest rate swap, one party pays a floating rate of interest on a notional sum over a specified period; the other party pays a fixed rate on the same sum over the same period. At the end of each period one party will be ‘in the money’ and the other ‘out of the money’: the latter pays the difference in value to the other.

When Lehman Brothers became insolvent in 2008, it was in the money in relation to a number of swaps. Its administrators naturally wanted to collect but faced an obstacle in the International Swaps and Derivatives Association (ISDA) Master Agreement, the standard-form contract which governed the transactions. The ISDA Master Agreement provides that payment is conditional on there being ‘no Event of Default or Potential Event of Default’ (defined to include insolvency) that ‘has occurred and is continuing’. On its face, not good for the administrators’ case. They argued that the condition precedent ought to be read in the light of four alternative implied terms, under which the condition would no longer be operative (a) after the expiry of such time as would be required to allow the non-defaulting party to elect an early termination date, (b) after a reasonable time, (c) on the expiry or maturity of all relevant transactions or (d) on the expiry of all transactions between the parties governed by the ISDA Master. These alternatives made some commercial sense: why should the out-of-the-money party get off scot-free?  

Well, said the English Court of Appeal, because that’s what the ISDA Master Agreement provided in clear terms (that bit about ‘and is continuing’ strongly suggesting that an implied expiration date of the condition ought not to be read in). The court said it would read in terms only ‘if it is necessary to do so or if it would be obvious to any disinterested third party that the contract must have the meaning which the implied terms would give it’. Not here.

[Link available here].