In early April, the English Court of Appeal considered the meaning of section 2(a)(iii) of the ISDA Master Agreement in the case of Lomas v JFB Firth Rixson. ISDA Master Agreements are widely used around the world (including in New Zealand) and, at any given time, there are literally trillions of dollars worth of current derivatives contracts documented under them. Consequently, any case that considers the meaning of any section of the ISDA Master Agreement is very significant.

A little bit about derivatives for context

Derivatives come in a vast array of shapes and sizes, but one thing many of them have in common is that they are put in place to hedge against a particular risk. For example, say Company A is a New Zealand company that exports wine and borrows from a New Zealand bank. Company A might receive US$ for its wine and pay interest in NZ$. In this situation Company A faces an exchange rate risk. If the US$ falls significantly against the NZ$ it may find that the income it receives in US$ converts into less NZ$ than it needs to meet its interest payments and other expenses in New Zealand. To hedge against this risk, it could enter into a derivative contract under which it paid, say, US$750,000 to a third party in return for NZ$1,000,000 every six months. Thus it would effectively be fixing its exchange rate for a portion of its income to reduce its exchange rate risk.  

A little bit about the ISDA Master Agreement for context

A derivative contract like that in the above example would typically be entered into between the third party and Company A using an ISDA Master Agreement.

An important feature of the ISDA Master Agreement is that the value of a derivative is not lost if the agreement is terminated early, even to a defaulting party. The way this feature works is that when the agreement is terminated, the derivatives contracts under it are valued, and the value of them is paid by one party to the other. The valuation is typically conducted in a way that favours the non-defaulting party, but the defaulting party still, more or less, realises the value of the contract.  

Take the example above. Say that after a year US$750,000 could only buy NZ$900,000. The derivative contract Company A entered into would then have great value because Company A would be getting NZ$100,000 more every six months than it would otherwise be getting. Consequently, if that contract was terminated, even because of a default by Company A, the third party would have to pay Company A to compensate it for the value of the contract. From a hedging point of view, this means that before the contract was terminated, Company A would have a significant payment stream to compensate it for the lower NZ$ value of its wine sales, and on termination it would receive a large lump-sum payment to compensate it for the lower NZ$ value of its wine sales.

Section 2(a)(iii) of the ISDA Master Agreement and the Lomas case

Section 2(a)(iii) of the ISDA Master Agreement says (among other things) that one party only has to make payments if no Event of Default has occurred and is continuing in relation to the other party. This is so that, in examples like that above, Company A could not cease making its US$ payments and still demand NZ$ payments from the third party. It is also so that if Company A became insolvent (which would be an Event of Default), the third party would not be required to pay when it had no realistic expectation of payment in return.

When this section was drafted, the general expectation was probably that if one party defaulted, the other would cease payments, and then terminate the agreement, thus crystallising the position for both parties. However, in the Lomas case, when faced with this situation, the non-defaulting party did not terminate. The agreement was valuable to the defaulting party, so the non-defaulting party would have had to pay money if it terminated – so instead it chose to leave the agreement in limbo, with all payments effectively suspended.

The Court of Appeal had to decide what happened to the non-defaulting party's payment obligations under section 2(a)(iii) if the agreement was never terminated. Did the non-defaulting party's obligations terminate at any time? Was there a point at which the non-defaulting party had to start making payments again (eg after it had had a reasonable opportunity to terminate the agreement)?

The Court of Appeal held that the effect of the section is to suspend the payment obligations of the defaulting party until the relevant transaction is terminated or the Event of Default is cured. At no point before that time did the non-defaulting party's obligations terminate, but at no point before that time does it have to perform them either. The agreement can, in effect, remain in a state of limbo indefinitely.  

Consequences of judgment

The result was not unexpected, but it did confirm a reasonably serious issue with section 2(a)(iii) of the ISDA Master Agreement. The possibility for the position under a hedge to be indefinitely suspended, and thus never crystallised, seriously undermines the value of such contracts as hedges.

Funnily enough, for a defaulting party, it may have limited relevance. By the time it matters, the defaulting party is likely to be insolvent, and indifferent to how its assets are divided up. However, from a creditor point of view, it could have serious ramifications. For example, a bank might lend to a company like Company A on the basis that its exchange rate risk is fully hedged. However, if that company then becomes insolvent, the bank might find that the hedges can never be crystallised, and are therefore ineffective. The amount available to the bank will then effectively be reduced by losses from exchange rate movements, despite the hedge being in place.  

Although the law has been relatively unsettled in this area until now, the potential issue has been recognised for some time. Consequently, in New Zealand, many ISDA Master Agreements have an additional clause that addresses the issue. (There are two widely used clauses. One allows a crystallisation of the position by the defaulting party and the other overrides the condition precedent, in each case so long as all of the defaulting party's payment and delivery obligations have been met.) This case confirms the desirability of such clauses.