The ISDA Master Agreement1 serves as the basis for the vast majority of overthe- counter derivatives transactions. Two fundamental principles of the ISDA Master Agreement are: (1) upon the default of one party to a swap, the nondefaulting counterparty may terminate the swap, calculate its loss and claim damages; and (2) the obligation of each party to a swap to make payments to the other is subject to the satisfaction of the conditions precedent that no default has occurred with respect to the other party.

The bankruptcies of Lehman Brothers entities around the globe have highlighted several novel questions in the over-the-counter derivatives market arising from the insolvency of a swap counterparty: What happens if the non-defaulting counterparty is out of the money on the swap and upon termination would owe funds to the debtor counterparty? Can the non-defaulting counterparty strategically refuse to terminate the swap (and avoid making a net close-out payment) in the hopes that the market swings in its favor to decrease (or eliminate) the amount payable to the defaulting debtor, while at the same time refusing to perform its ongoing scheduled payment obligations? Or can the estate of the in-the-money debtor compel the non-defaulting party to either terminate or perform its payment obligations?

These crucial questions have been answered — with different results — by the U.S. Bankruptcy Court and, more recently, by the English Court of Appeal. In a decision favoring U.S. bankruptcy law principles and public policy over express contract terms, the U.S. Bankruptcy Court in the Lehman Brothers case held that the non-defaulting party must continue to perform its payment obligations under the ISDA Master Agreement and must “promptly” terminate the swap transaction or else its right to terminate would be deemed waived. On the other side of the Atlantic, the English Court of Appeal gave deference to contract law principles in concluding that under the ISDA Master Agreement the non-defaulting party may suspend its payment obligations indefinitely until the default is cured or it elects for early termination of the swap transaction, while also holding that the non-defaulting party is not required to terminate a swap transaction with a debtor counterparty.

The conflicting application of the termination and payment provisions of the ISDA Master Agreement has led ISDA, in consultation with its members, to propose amendments to the ISDA Master Agreement that would provide greater certainty as to the operation of its terms in the event of an insolvency of a swap counterparty. The proposed amendments clarify the contract interpretation issues considered by the courts. However, the amendments do not address the fundamental differences between U.S. and English bankruptcy law principles and public policy, and market participants should be cognizant of the disparate results that are possible under the U.S. and English regimes.

THE ISDA MASTER AGREEMENT

Section 6 of the ISDA Master Agreement sets out the termination and close-out netting rights that are available to a non-defaulting party. In general terms, once a default (or termination event) has occurred with respect to one party to the swap, Section 6 (i) permits the non-defaulting party, by notice to the defaulting party, to terminate all transactions under the ISDA Master Agreement; (ii) specifies the effect of the termination; and (iii) prescribes the method of calculation of the net amount, if any, to be paid by either party as a result of the termination. The non-defaulting party’s right to terminate and close out swap transactions under Section 6 is predicated only on the continuation of the default and is not subject to any explicit time limit.

Most transactions under the ISDA Master Agreement require the parties to make payments or deliveries to each other during the term of the transaction.2 Section 2(a)(iii) of the ISDA Master Agreement provides that a party’s obligation to make payment or delivery is subject to, among other things, “the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing…” The purpose of Section 2(a)(iii) is to protect the non-defaulting party from increasing its credit exposure to the defaulting party who may be unlikely to perform its obligations to the non-defaulting party. Pursuant to Section 2(c) of the ISDA Master Agreement, amounts that would otherwise be payable by the parties on the same date and in the same currency will be automatically netted.

U.S. CASE LAW

In the Metavante dispute3 , Lehman Brother Special Financing Inc. (“LBSF”) and Metavante Corporation (“Metavante”) were parties to an interest rate swap under an ISDA Master Agreement, with Lehman Brothers Holding Inc. (“LBHI”) being the credit support provider for LBSF. At the time of the bankruptcy filings of LBSF and LBHI, Metavante was out of the money on the swap and elected not to terminate (presumably to avoid making payment to LBSF), while at the same time withholding performance of its scheduled payment obligations under the ISDA Master Agreement in reliance on Section 2(a)(iii). LBSF subsequently moved to compel Metavante to perform its obligation to make scheduled payments.

The U.S. Bankruptcy Court held that (i) a non-defaulting party may not rely on Section 2(a)(iii) of the ISDA Master Agreement to suspend payments to an insolvent counterparty and, at some point, must either terminate the swap transactions or perform its payment obligations and (ii) although the safe harbors for derivatives transactions under the U.S. Bankruptcy Code are intended to permit the non-defaulting party to terminate transactions and liquidate collateral under the ISDA Master Agreement, such right may be deemed to be waived by the non-defaulting party if not exercised “promptly” upon the counterparty’s bankruptcy filing.

No Suspension of Payments

LBSF asserted, and the U.S. Bankruptcy Court agreed, that the ISDA Master Agreement (together with the transactions thereunder) constitute a “garden variety” executory contract under U.S. bankruptcy law, which a debtor has the right to assume or reject. Under relevant case law, an executory contract is enforceable by the debtor against the counterparty while the debtor contemplates whether to assume or reject the contract.

LBSF also argued that the safe harbor provisions of the U.S. Bankruptcy Code do not provide a basis for Metavante to withhold payments. The U.S. Bankruptcy Court held that the safe harbors are available only to the extent that a non-defaulting counterparty seeks to liquidate, terminate or accelerate a swap transaction because of a bankruptcy filing or to net out its positions under the ISDA Master Agreement. All other ipso facto provisions4 are unenforceable. Accordingly, the court concluded that the safe harbor provisions of the U.S. Bankruptcy Code do not excuse Metavante’s failure to perform. Moreover, the court noted that federal bankruptcy law trumped any state contract law excuse for nonperformance.

Prompt Termination

The U.S Bankruptcy Court went beyond the relief sought by LBSF, and held that while Metavante was not obligated to immediately terminate the swap upon the debtors’ bankruptcy filings, the failure to do so after one year constituted a waiver of such right. In reaching its decision, the court cited legislative history as evidencing Congress’s intent to allow the prompt termination and netting of open swap positions upon the commencement of bankruptcy proceedings, for the purpose of protecting parties from the potential of rapid changes in the financial markets. The court concluded that Metavante’s “conduct of riding the market for the period of one year, while taking no action whatsoever, is simply unacceptable and contrary to the spirit of [the safe harbor provisions] of the Bankruptcy Code.” The court, however, did not give definitive guidance on how long the non-defaulting party has to terminate a swap transaction before the right to do so is deemed waived under the safe harbor provisions.

The Metavante ruling was a surprise to the market and has been widely criticized. It is, however, important to note that the decision is premised on the application of U.S. bankruptcy law and underlying public policy and not contract law principles. In contrast, contract interpretation was central to the English Court of Appeal decision.

ENGLISH CASE LAW

On March 4, 2012, in a result that is directly opposite of Metavante, the English Court of Appeal ruled on four related appeals5 that an out-of-the-money counterparty may both elect not to terminate a swap and also withhold scheduled payments to an insolvent English counterparty.

The Court of Appeal decision considered a number of issues arising under English contract law and insolvency law principles, and held that (i) upon a default with respect to one party to a swap, Section 2(a)(iii) operates to suspend, and not terminate, the payment obligations of the non-defaulting party; (ii) the suspension will end only upon the defaulting party’s cure of its default or the non-defaulting party’s termination of the transactions under the ISDA Master Agreement; (iii) the nondefaulting party may not claim a gross payment from the defaulting counterparty, and must net any suspended obligations in accordance with Section 2(c); and (iv) the suspension of obligations under Section 2(a)(iii) does not violate or contravene English insolvency law principles.

Indefinite Suspension of Payment Obligations

One of the key issues considered by the Court of Appeal is whether the obligation of the non-defaulting party to make payments pursuant to the ISDA Master Agreement continues to exist after a default has occurred with respect to the other party and, if so, for how long.

The Court of Appeal held that the “natural reading” of Section 2(a)(iii) is that the payment obligation of a nondefaulting party is indefinitely suspended (and not extinguished) so long as the relevant default is continuing and shall “revive” and become due if the default is subsequently cured before the termination of the transactions.

The administrators of Lehman Brothers International (Europe) argued that payment obligations of the nondefaulting party cannot be suspended indefinitely, and there must come a time when the suspended payment obligations revive. Lehman proposed a number of implied terms that would prevent a non-defaulting party, who is out-of-the-money, from walking away from its payment obligations to an in-the-money debtor counterparty.

The Court of Appeal firmly rejected all of the administrator’s arguments, and held that payment obligations suspended pursuant to Section 2(a)(iii) will continue indefinitely until the suspension comes to an end either by the cure of the relevant default or the election of the non-defaulting party for early termination. The court reasoned that the parties could have contracted differently but did not, and refused to “re-write” the contract to include implied terms.

Net Payments

A related issue considered on appeal was whether, if a non-defaulting party’s payment obligations are suspended under Section 2(a)(iii), the non-defaulting party is able to enforce the defaulting party’s payment obligations on a gross basis without netting out its own suspended obligations pursuant to Section 2(c). The Court of Appeal looked to the construction of Section 2(c), which provides that netting operates in relation to amounts that “would otherwise be payable,” and concluded that the language means that the netting contemplated by Section 2(c) operates irrespective of the conditions precedent set out in Section 2(a)(iii) (i.e., a non-defaulting party’s suspended payment obligations will be netted against the amount payable by the debtor counterparty).

English Insolvency Law Principles

Lastly, the Court of Appeal examined the application of the English insolvency principles of the anti-deprivation rule and the pari passu rule.

The policy behind the anti-deprivation rule is that parties cannot deprive an insolvent estate of property that would otherwise be available for creditors. In considering this point, the Court of Appeal followed the recent English Supreme Court case of Belmont,6 which held that the anti-deprivation rule does not apply to bona fide commercial transactions so long as depriving the bankruptcy estate of property is not the predominate purpose, or one of the main purposes, of the transaction.

In this context, the Court of Appeal held that Section 2(a)(iii) does not contravene the anti-deprivation principle, as its purpose is to protect the interests of a non-defaulting party from the credit risk associated with performing its own obligations when the defaulting counterparty may be unable to perform its own, not to evade insolvency laws.

While the anti-deprivation principle is concerned with contractual arrangements which have the effect of depriving the bankrupt estate of property which would otherwise have formed part of it, the pari passu rule governs the distribution of assets within the estate following an event of bankruptcy. It is based on the principle that one cannot receive more than his or her proper share of the available assets other than in accordance with the statutory regime. The court held Section 2(a)(iii) does not infringe the pari passu rule because it operates to prevent the relevant debt becoming payable, and therefore does not form part of the property which is to be distributed.

The Court of Appeal decision highlights the desire of the English courts to preserve the integrity of written contracts between the parties by upholding the express terms of the ISDA Master Agreement and rejecting unnecessary, implied terms. This policy contrasts starkly with that of the U.S. Bankruptcy Court, which, as a court of equity, appears to have overridden the express terms of the contract in order to achieve an outcome that some may characterize as pro-debtor. Regardless of one’s sympathy, a disparity of outcomes under the two legal regimes by which most ISDA Master Agreements are governed is not a good outcome for the derivatives market. While the insolvency laws and public policies cannot be changed by anyone other than the legislature and judiciaries of the relevant jurisdiction, contract interpretation can be aided by fine-tuning the contractual provisions.

PROPOSED AMENDMENTS TO ISDA MASTER AGREEMENT

For its part, ISDA has proposed several amendments to Section 2(a)(iii) and related provisions of the ISDA Master Agreement, to provide greater clarity and certainty to the market. Most notably, the proposed amendments would impose a time limit to the suspension of payments pursuant to Section 2(a)(iii). The current proposal is for a time limit of 90 or 180 days.

It is important to note that ISDA’s proposal does not completely address the issues raised by the Metavante ruling. Since the Metavante court held that the suspension of a non-defaulting party’s payment obligations upon the bankruptcy of its counterparty was an ipso facto clause and unenforceable, there is some uncertainty as to whether Section 2(a)(iii), as modified, will be respected by the U.S. Bankruptcy Court.

In addition, the proposed amendments do not explicitly impose a time limit for the non-defaulting party to terminate under Section 6. The time limitation proposed for suspension of payments under Section 2(a)(iii) may provide an impetus (but not a requirement) for the non-defaulting party to terminate within the specified timeframe, rather than be obligated to make payments to the debtor counterparty for the remaining term of the swap.

ISDA continues to consult with its members regarding the proposed amendments, and it remains to be seen what effect the Court of Appeal decision has on the final draft. Once the amendments are finalized and consistent with past practices, ISDA is likely to publish a Protocol to permit members to efficiently incorporate the amendments into their existing ISDA Master Agreements.

CONCLUSION

When confronted with the question whether an out-ofthe- money non-defaulting party to a swap may refuse to terminate the transaction without prejudicing its right to do so, while at the same time withholding payment to the debtor counterparty in reliance on Section 2(a)(iii) of the ISDA Master Agreement, the U.S. Bankruptcy Court and English Court of Appeal have reached opposing answers in decisions that reflect fundamental differences in insolvency laws and related public policies. The U.S. Bankruptcy Court’s decision reveals a bias toward protecting the debtor’s estate, whereas the English Court of Appeal’s decision shows a deference to contract law principles.

ISDA has proposed amendments to the ISDA Master Agreement to clarify its terms and provide greater certainty in its application. In particular, ISDA has proposed a time limit to the period that a nondefaulting party may suspend its payment obligations under Section 2(a)(iii) in light of a default with respect to the counterparty, to promote greater certainty in the interpretation of the conditionality provisions in Section 2(a)(iii) and to prevent a non-defaulting party from reaping an unjust benefit at the expense of its defaulting counterparty. These amendments, however, have their own limitations and, since the amended Section 2(a)(iii) would continue to be a conditionality provision (with a more limited effect), there may still be uncertainty with respect to its enforceability under the principles espoused by the Metavante ruling.

When structuring swap transactions, market participants should bear in mind the differences in the U.S. and English regimes and the disparate results that are possible in the event of the insolvency of the swap counterparty. Market participants must also continue to monitor developments in the proposed amendments to the ISDA Master Agreement and consider the enforceability of those amendments in light of Metavante.