Lehman Brothers Special Financing Inc. v Carlton Communications Ltd

Hearing dates: 21 st March 2011

Approved Judgment

I direct that pursuant to CPR PD 39A paragraph 6.1 no official shorthand note shall be taken of this Judgment and that copies of this version as handed down may be treated as authentic.

Mr Justice Briggs:

INTRODUCTION

This judgment follows the trial, on agreed facts, of a claim by Lehman Brothers Special Financing Inc ("LBSF") for £2,656,649.00 plus interest alleged to have been owing by the defendant Carlton Communications Ltd ("Carlton") upon the maturity on 2 ^nd March 2009 of two linked interest rate swaps incorporating the terms of the 1992 ISDA Multicurrency Cross Border Master Agreement ("the Master Agreement"). The claim seeks, in addition, declarations that provisions in the Master Agreement are, at least as between these parties, unenforceable because they offend the anti-deprivation principle or, alternatively, constitute a penalty.

The issues which arise on this claim are substantially the same as those which I determined, in December 2010, in Lomas & ors v. JFB Firth Rixson Inc & ors [2010] EWHC 3372 (Ch). An application for this claim to be tried together with the Firth Rixson case was made but dismissed by me in October 2010. This was in part because LBSF wished (unlike the applicants in the Firth Rixson case) to rely upon expert evidence and in part because this claim had, as at that date, some catching up to do in terms of preparation.

In view of the almost complete overlap of issues, counsel for both parties very sensibly took my Firth Rixson judgment as the starting point for their submissions. That judgment is the subject of a pending appeal, yet to be heard. In relation to the anti-deprivation principle, the Supreme Court has now heard the appeal in Perpetual Trust Co Ltd v. BNY Corporate Trustee Services Ltd [2009] EWCA Civ 1160, but judgment is awaited. Counsel's submissions have therefore concentrated on those aspects of this case in respect of which the facts and/or expert evidence lend themselves to different submissions than those made in the Firth Rixson case. In addition, the argument that Section 2(a)(iii) of the Master Agreement operates as a penalty has been actively pursued, there being no concession, as there was in the Firth Rixson case, that it is bound to fail at first instance.

I shall in this judgment follow counsel's sensible lead by treating my judgment in the Firth Rixson case as essential pre-reading. In this judgment I shall adopt definitions and abbreviations used there, and take the in-depth analysis of the 1992 version of the Master Agreement as read.

THE FACTS

LBSF is a Delaware corporation and was, prior to the Lehman Group's collapse, the principal group company engaged in fixed income OTC derivatives business including interest rate swaps. It was an unregulated entity with no capital adequacy requirements. Its ultimate parent company was Lehman Brothers Holdings Inc. ("LBHI").

Carlton is and has at all material times been an English company carrying on business in media and broadcasting from headquarters in London. LBSF is, but Carlton is not, a member of ISDA.

LBSF and Carlton entered into an ISDA Master Agreement (1992 version) dated as of 8 ^th July 2003 for the purpose of regulating derivative transactions between them. LBHI was LBSF's Credit Support Provider. The accompanying Schedule elected against Automatic Early Termination and chose the Second Method, Loss version, under Section 6(e), for the purpose of calculating payments on Early Termination.

On or about 22 ^nd December 2004 LBSF and Carlton signed confirmations in relation to two related interest rate swap transactions, the trade date for each of which was 14 ^th December 2004. The notional amount for each was £250 million. Under the first swap LBSF paid a fixed rate of £7,031,250.00 on 2 ^nd March and 2 ^nd September in each year beginning on 2 ^nd March 2005 and ending on 2 ^nd March 2009. Carlton paid a floating rate based on sterling LIBOR, fixed in arrears, on the same dates.

Under the second swap LBSF paid sterling LIBOR based payments fixed in arrears, while Carlton paid a floating rate consisting of the greater of (i) a LIBOR based rate from the end of the relevant period or (ii) a LIBOR based rate from the last day of the preceding period. Payments were to be made on the same dates as under the first swap. The net effect of the two swaps, taken together, was that LBSF was the fixed rate payer and Carlton the floating rate payer by reference to a LIBOR based ratchet coupon.

The underlying commercial purpose of the swaps for Carlton was to hedge its fixed interest exposure. While this may sound a little less easy to understand than a hedge against a floating rate exposure, Carlton's objective was to match its fixed interest rate liabilities against income which it expected to fluctuate broadly in accordance with floating interest rates.

Carlton's only use of derivative financial instruments was for the purpose of hedging its exposure to interest rates. It was not a speculator in derivatives, and had no knowledge of the regulatory capital requirements affecting some financial institutions.

All but the last of the payment dates under the two swaps had come and gone by the time the Lehman Group collapsed in late 2008. LBHI was placed in Chapter 11 bankruptcy on 15 ^th September, and LBSF followed on 3 ^rd October. There were therefore two Events of Default continuing by 2 ^nd March 2009, the default constituted by LBHI's bankruptcy having occurred first.

LBSF was in the money on 2 ^nd March 2009 and, but for those Events of Default, was entitled to be paid £2,656,649.31 by Carlton. During the period between the two Events of Default and the expiry of the two swaps by effluxion of time on 2 ^nd March 2009 Carlton did not re-hedge.

CONSTRUCTION

Gross Net

In paragraphs 60 to 65 of my Firth Rixson judgment, I described a convention between the parties to that case, to the effect that, notwithstanding Marine Trade SA v. Pioneer Futures Co Ltd BVI [2009] EWHC 2656 (Comm) [2010] 1 Lloyd's Rep 631, the non-defaulting party did have to give credit on any payment date for an amount which, but for the other party's default, it would have been obliged to pay, when claiming any amount from the defaulting party. In the present case, both LBSF and Carlton adopted the same convention, both in relation to payment obligations arising on the same date, and in relation to netting of payment obligations arising on different dates during a period of continuing default. For LBSF Mr Jonathan Nash QC emphasised that this convention should be understood to be limited strictly to the swaps the subject matter of this litigation, and to have no wider purport or effect.

Once and for All v Suspension

Carlton was broadly content to adopt the construction of the 1992 Master Agreement set out in my Firth Rixson judgment, albeit that Ms Felicity Toube reserved Carlton's right to argue on any appeal (like ISDA in the Firth Rixson case) that there was an indefinite survival of contingent obligations suspended by Section 2(a)(iii) of the Master Agreement. It was therefore common ground that the effect of non-satisfaction of the condition precedent in Section 2(a)(iii)(1) was suspensory rather than once and for all.

The Constructions Alternatively Advanced by LBSF

For LBSF Mr Jonathan Nash QC advanced two of the three alternative submissions which had been made by the Administrators in the Firth Rixson case. They are identified under subheadings A and B in paragraph 81 of my Firth Rixson judgment. In the context of a case in which the Events of Default occurred only before the very last of the payment dates provided for in the two swaps, Mr Nash submitted that Carlton had the necessary reasonable time between the occurrence of the defaults (in September and early October 2008) and the payment date (2 ^nd March 2009) in which to decide whether to elect Early Termination. Carlton was therefore obliged to pay the full aggregate amount of £2.6 million odd, not having elected for Early Termination in the meantime, despite the fact that both Events of Default were, in ordinary language, still continuing at the time of the final payment date.

Mr Nash made a number of additional submissions in support of LBSF's case on construction, beyond those which I addressed in my Firth Rixson judgment. The first was that I should approach the interpretation of the Master Agreement upon the basis of a matrix of fact which included an awareness that the capital adequacy requirements of most bank participants in ISDA agreements were such as to prohibit the inclusion of what are known as "walk-away clauses". He submitted that any construction of Section 2(a)(iii) which could permanently discharge the non-defaulting party from what would otherwise have been a payment obligation (whether immediately, or upon expiry of the agreement by effluxion of time) meant that Section (2)(a)(iii) would be classified as a walk-away clause, contrary to the parties' assumed intention. By contrast, a construction of Section 2(a)(iii) which merely suspended the payment obligation for a reasonable time, or until termination by effluxion of time, pending an election for Early Termination, would not have that effect.

The legal basis for this submission...