On April 3, 2012, the English Court of Appeal handed down [1] its highly anticipated judgment in four separate matters, all of which concerned the consequences of an Event of Default and the impact of Section 2(a)(iii) under the ISDA Master Agreement. All four appeals primarily focused on the 1992 version of the ISDA Master Agreement, but the Court of Appeal's reasoning and decision applies equally to the 2002 version.

Section 2(a)(iii) of the ISDA Master Agreement

Section 2(a)(iii) of the ISDA Master Agreement is stated to be a condition precedent to any payment and delivery obligations arising out of transactions governed by the ISDA Master Agreement. If an Event of Default or Potential Event of Default has occurred and is continuing, the stated effect of Section 2(a)(iii) is that the nondefaulting party does not have to make any payments or deliveries due to the defaulting party under the agreement.

The precise legal effect of Section 2(a)(iii) has been a controversial area over the last few years. Differing judicial interpretations had emerged in earlier English litigation on key issues such as whether obligations suspended by Section 2(a)(iii) were extinguished once the transactions had passed their final payment date. In the same period, the United States Bankruptcy Court for the Southern District of New York held (in the Metavante proceedings) that a counterparty could not rely on Section 2(a)(iii) and the safe harbor provisions in the Bankruptcy Code indefinitely to excuse a failure to perform obligations under a swap agreement with an insolvent counterparty.

The Court of Appeal's unanimous decision brings significant clarity on Section 2(a)(iii) from the English law perspective. It is important to note, however, that the judgment does not address the potential impact of non-English law or procedure (particularly foreign insolvency law) on Section 2(a)(iii), notwithstanding that a relevant ISDA Master Agreement is governed by English law.

The four cases under consideration by the Court of Appeal were (1) Lomas v. Firth Rixon, which arose out of the administration of Lehman Brothers International (Europe), (2) LBSF v. Carlton, which arose out of the entry by LBSF into Chapter 11 bankruptcy proceedings in the U.S., (3) Pioneer v. Cosco, which involved 11 forward freight agreements subject to the 2007 terms of the Forward Freight Agreement Brokers Association (FFBA 2007), incorporating the 1992 version of the ISDA Master Agreement by reference; and (4) Bulk v. Britannia Bulk, again involving a forward freight agreement on FFBA 2007 terms.

Key Findings by the Court of Appeal

Section 2(a)(iii) Does Not Prevent Payment or Delivery Obligations from Coming Into Existence Under the ISDA Master Agreement. One of the first questions resolved by the Court of Appeal is whether payment or delivery obligations even come into existence at any time after an Event of Default (or Potential Event of Default) has occurred. It was suggested in earlier proceedings that they did not, based on the wording of Section 2(a)(iii).

The Court of Appeal noted when reviewing the overall structure of the ISDA Master Agreement that any payment obligation always has a corresponding debt obligation, meaning that the duty to make a payment arises from a party owing an amount to the other party. According to the court, these are two distinct obligations; the suspension of the obligation to pay under Section 2(a)(iii) does not affect the underlying amounts owed, or any other obligations that subsequently come due following suspension of payments pursuant to Section 2(a)(iii). As a result, following the nondefaulting party's election to invoke Section 2(a)(iii), any additional amounts that accrue during the suspension of payments will come due when payments are again required to be made, i.e., when the Event of Default is cured or when the underlying Transactions are terminated.

Section 2(a)(iii) Suspends Payment or Delivery Obligations, It Does Not Extinguish Them. Following logically from the previous finding, the Court of Appeal held that the payment obligations of a nondefaulting party are suspended during the period of an Event of Default under the ISDA Master Agreement. However, these obligations are not extinguished and will revive if the Event of Default is cured at any time before the underlying Transactions are terminated.

The Payment Obligations Cannot Be Revived Other Than by Curing the Event of Default. The Court of Appeal considered a number of implied terms that would have the effect of reviving the suspended payment obligations without the Event of Default having been cured. For example, one suggested implied term would have disapplied Section 2(a)(iii) after a "reasonable time" had elapsed following the occurrence of an Event of Default, on the basis of a similar reasoning to Judge Peck's decision in Metavante. Other suggestions included disapplying Section 2(a)(iii) upon the maturity of all relevant transactions, or after such time as required to elect for early termination and effect closeout netting under the ISDA Master Agreement.

None of the implied terms was accepted by the Court of Appeal. The test under English law for reading implied terms into a contract requires that the implication is "necessary" or "obvious" to any disinterested third party such that the contract must have the meaning that the implied terms would give it. The court concluded that none of the suggested terms was necessary or required to this standard. As a result, Section 2(a)(iii) under English law can suspend payment obligations under the ISDA Master Agreement potentially indefinitely.

Suspended Payment Obligations Are Also Not Extinguished On Maturity. Various earlier English decisions had held that payment obligations suspended by Section 2(a)(iii) would be entirely extinguished once the transactions had passed their final payment date (and therefore could not be revived in the event that the Event of Default was subsequently cured).

In line with ISDA's submissions as intervenor on these issues, the Court of Appeal rejected this analysis, on the basis that it was simply not supported by the express terms of the ISDA Master Agreement and there was no need to read an implied term into the contract to give this effect. The court concluded that any suspended payment obligation is not extinguished on the maturity of the underlying transaction and noted that it would still be possible for the nondefaulting party to terminate "early" after maturity, if they wished to do so. If the nondefaulting party does not wish to do so, it must accept the consequence of the contractual obligations continuing to exist (i.e., the possibility that the Event of Default will be cured and the suspended payment obligations will revive).

Gross vs. Net Claims. The Court of Appeal considered two conflicting, earlier English decisions on the question of whether a nondefaulting party is entitled to payment of the gross obligations of the defaulting party, without being required to net against any outstanding obligations of the nondefaulting party. Previous decisions had suggested that netting under Section 2(c) would be available only where Section 2(a)(iii) is not in play, i.e., where the nondefaulting party is not entitled to suspend payments.

The Court of Appeal rejected this view and determined that Section 2(c) remains applicable in circumstances where the nondefaulting party relies on Section 2(a)(iii).

However, the court also noted that the netting provisions in Section 2(c) apply only to amounts that, under the terms of the original agreement, are expressed to be payable on the same date and with respect to the same transaction.

Section 2(a)(iii) Does Not Offend the Anti-Deprivation Principle. The anti-deprivation principle is a fundamental tenet of English insolvency law. It is based on the principle that a party cannot contract out of the statutory requirement that assets owed at the date of liquidation should be available to the liquidator to meet the claims of the estate's creditors.

The Court of Appeal concluded that the suspensory nature of Section 2(a)(iii) did not offend this principle and that the anti-deprivation rule was directed toward intentional or inevitable evasion of the principle that a debtor's property is part of the insolvent estate. The suspension of the payment obligations of the nondefaulting party for the duration of the insolvency appeared to the Court of Appeal only to prevent the nondefaulting party from having to make payments under a swap agreement with a bankrupt counterparty. Given the history of Section 2(a)(iii) as a standard ISDA clause, the court concluded it did not meet the requirement of having been formulated in order to avoid the effect of any insolvency law or to give the nondefaulting party a greater or disproportionate return as a creditor of the bankrupt estate.


The Court of Appeal's decision has clarified a number of key issues relating to Section 2(a)(iii), and the decision that suspended obligations are not extinguished on maturity has been welcomed by market participants. The decision will also be relevant to the current ISDA consultation on changes to the ISDA Master Agreement (and particularly the proposed curtailment of a counterparty's entitlement to rely on Section 2(a)(iii) indefinitely). In the United Kingdom, H.M. Treasury ("HMT") has taken the view that payments due to insolvent counterparties should not be withheld indefinitely due to the level of uncertainty and adverse impact on unsecured creditors of bankrupt entities. HMT has suggested it may look to effect a statutory solution to this issue if a market-based solution does not emerge in the near future.