The English Court of Appeal has recently handed down a decision in Lomas and others v JFB Firth Rixson, Inc. and others, [2012] EWCA Civ 419 that, among other things, has provided an interpretation of Section 2(a)(iii) of the 1992 form of ISDA Master Agreement that mirrors the predominant market view of the correct interpretation of this Section. Section 2(a) in the ISDA 2002 Master Agreement is substantially the same as in the 1992 form of ISDA Master Agreement, so this interpretation is equally applicable to both Agreements.

Section 2(a) in the 1992 form of ISDA Master Agreement provides, in part, as follows:

“GENERAL CONDITIONS.

  1. 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.
  2. 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 . . .
  3. 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.”

The context for the relevant aspect of the appeal was that four corporate counterparties had each entered into a 1992 form of ISDA Master Agreement (each, an “Agreement”) with Lehman Brothers International (Europe) (“LBIE”). Each Agreement was used for interest rate swaps for hedging purposes. LBIE went into administration in September 2008, which constituted an “Event of Default” under each of the Agreements. At the time, each counterparty was “out of the money” under its Agreement with LBIE, in that it had to pay a net sum to LBIE at that time. None of the counterparties made payment on the scheduled payment date. At issue was the interpretation of Section 2(a)(iii) of the ISDA Master Agreement; specifically, whether, when there is an Event of Default by or with respect to the party due to receive a payment, there is any obligation on the counterparty to make a payment and, if so, whether such obligation is initially suspended but then disappears or revives or remains in suspense indefinitely. Given the potential impact of the Court’s decision on the derivatives industry, the International Swaps and Derivatives Association, Inc. (“ISDA”) was granted permission to intervene in the case.

The Court treated this as a case of contractual construction. The Court agreed with the conclusion of the lower court that an Event of Default would only suspend, rather than extinguish, the non-defaulting party’s obligation to make a payment, with one reason being that to treat the payment obligation as extinguished would be “too drastic a remedy in favour of the non-defaulting party.” In so concluding, the Court considered whether the payment obligation revives at any other times while the Agreement continues to exist and whether the obligation is extinguished when the Agreement reaches its maturity date. Based on the express phrasing of Section 2(a)(iii), “…. and is continuing”, the Court held that so long as the Event of Default was present, there was no obligation on the non-defaulting party to make payments to the defaulting party. On the issue of whether the payment obligation is extinguished when the Agreement reaches its maturity date, the Court concluded that such obligation is not extinguished. While Section 9(c) of the Agreement provides that the obligations of the parties will survive the termination of any Transaction “without prejudice to Sections 2(a)(iii) and 6(c)(ii)”, the Court held that the reference to Section 2(a)(iii) in Section 9(c) is a reference only to Section 2(a)(iii)(2). The Court noted that the reference to Section 2(a)(iii) in Section 9(c) is an addition compared to the 1987 form of ISDA Master Agreement. However, in the Court’s view, if it had been the intention of the framers of the 1992 form of ISDA Agreement to introduce the concept of extinction of the payment obligation in Section 2(a)(iii)(1), they would have made that intention “much more explicit than by hiding it in a clause headed ‘Miscellaneous’ . . . ”

The conclusion reached by the Court in Lomas on the interpretation of Section 2(a)(iii) is consistent with ISDA’s position, which, according to ISDA, reflects the market’s understanding of the construction of the Agreement. Accordingly, many of the changes that ISDA had proposed to make to the form of Master Agreement are now unnecessary. However, given the English lower court’s comment that the wording in Section 9(c) is “non-ideal” and “inelegant” and in order to provide greater clarity on the intention of Section 9(c), we are of the view that ISDA may propose drafting amendments to the ISDA Master Agreement to address these issues. Furthermore, while the Court’s conclusion on the interpretation of Section 2(a)(iii) (a conclusion that was reached by taking a straightforward approach) will be welcomed particularly by non-defaulting parties, ISDA and the industry as a whole need to consider the impact of such interpretation on defaulting parties. This will include, to the extent that a long-term suspended payment result is not desirable in certain circumstances, what tools exist or need to be included under the ISDA Master Agreement in order to afford to such parties the opportunity to properly manage their interests and affairs. This may lead to further amendments and refinement of the ISDA Master Agreement, including possible time limits on the ability to rely on the suspended payment right under Section 2(a)(iii).  

In our view, Lomas is helpful for Canadian counterparties and is instructive even for ISDA Master Agreements that are not governed by English law. As Lomas confirms ISDA’s views on the intended application of Section 2(a)(iii), and given the cross-border nature of many over-the-counter derivatives transactions, we anticipate that a Canadian court would give much weight to Lomas in its interpretation of Section 2(a)(iii).