Lomas and Others v JFB Firth Rixson Inc. and Others (International Swaps and Derivatives Association intervening)
| Jurisdiction | England & Wales |
| Judge | Mr Justice Briggs |
| Judgment Date | 21 December 2010 |
| Neutral Citation | [2010] EWHC 3372 (Ch) |
| Docket Number | Case No: 7942 of 2008 |
| Court | Chancery Division |
| Date | 21 December 2010 |
[2010] EWHC 3372 (Ch)
Before: MR JUSTICE BRIGGS
Case No: 7942 of 2008
IN THE HIGH COURT OF JUSTICE
CHANCERY DIVISION
COMPANIES COURT
Mr William Trower QC and Mr Daniel Bayfield (instructed by Linklaters LLP) for the Administrators
Mr Mark Hapgood QC and Mr Henry Forbes Smith (instructed by Macfarlanes) for the First and Second Respondents
Mr Robin Dicker QC and Ms Joanna Perkins (instructed by Clifford Chance) for the Third Respondent
Mr Richard Fisher (instructed by Freshfields Bruckhaus Deringer LLP) for the Fourth Respondent
Mr Antony Zacaroli QC and Mr Jeremy Goldring (instructed by Allen & Overy LLP) for the Intervenor
Hearing dates: 6 th– 9 th December 2010
Mr Justice Briggs:
This is an application by the Joint Administrators of Lehman Brothers International Europe (“LBIE”) for directions as to the true construction and effect of five interest rate swap agreements (“the Swaps”) pursuant to which LBIE was, when it went into administration on 15 th September 2008, the floating rate payer. Each Swap incorporated the terms of one or the other of the 1992 or 2002 versions of the ISDA Master Agreement (“the Master Agreement”), pursuant to which LBIE's entry into administration was an Event of Default as therein defined.
LBIE's fixed rate paying counterparties under each of the Swaps have since that date relied upon Section 2(a)(iii) of the Master Agreement as the basis for a refusal to make payments which would otherwise have fallen due to LBIE on subsequent payment dates. Section 2(a)(iii) provides that a party's payment obligations are subject (inter alia) to the condition precedent that there is no continuing Event of Default with respect to the other party.
As at 15 th September 2008 LBIE was “in the money” in relation to two of the five Swaps, both denominated in US dollars. In relation to the remaining three (denominated in sterling or euros), LBIE was on that date out of the money. Due to a substantial fall in the relevant floating interest rates thereafter, LBIE would have been, but for the Event of Default, very substantially in the money under all five Swaps from about the end of 2008 until now, and it appears very likely that LBIE would have continued to be substantially in the money, in relation to those Swaps which have yet to reach the end of their term, for a significant further period. By “in the money” I mean that, because on any particular payment date the floating rate payable by LBIE was less than the fixed rate payable by the counterparty, a net sum was (or but for the Event of Default would have been) payable on that date by the counterparty to LBIE, pursuant to netting provisions in Section 2(c) of the Master Agreement.
The Administrators calculate that, if their Swap counterparties are entitled to refuse to pay as they have done, then LBIE's creditors will by reason of the Event of Default constituted by LBIE's going into administration be worse off, in relation to these five Swaps alone, by the aggregate of approximately £20.6 million, US$57.3 million and €5.3 million. Noting in passing that the interpretation of the Master Agreement relied upon by its counterparties under these Swaps has not been pursued by any of LBIE's other counterparties under the thousands of other swaps open as at the onset of its administration, the Administrators challenge these counterparties’ interpretation of the Master Agreement under four broad headings. First, they submit that it is a commercially absurd or at least unreasonable interpretation which must therefore yield to implied terms to the contrary, for which they advance three alternatives. Secondly, the Administrators submit that, if the Master Agreement means what the counterparties assert, then it offends against the anti-deprivation principle, because its adverse effects upon LBIE and its creditors are triggered by the onset of LBIE's administration. Thirdly, they assert that the counterparties’ interpretation gives rise to a penalty. Finally, they assert that it constitutes a forfeiture, against which the court can and should grant relief.
In order to obtain a speedy determination of the issues raised by those alternative allegations, all of which are matters of law which arise upon substantially agreed facts, the Administrators have applied for directions under paragraph 63 of Schedule B1 of the Insolvency Act 1986, and joined each of the Swap counterparties as respondents. In addition, the International Swaps and Derivatives Association Inc. (“ISDA”) has sought and been permitted to intervene, out of an understandable concern that any decision on this application about the interpretation of the Master Agreement may have potentially wide-ranging implications for the derivatives markets generally, in which the Master Agreement is an extremely widely used standard form. ISDA claims (and it is not challenged) that the Master Agreement serves as the contractual foundation for more than 90% of over-the-counter derivatives transactions globally.
THE FACTS
Although the outcome of this application is not fact specific, and the facts are largely agreed, it is necessary to provide an outline of the factual background in order to make intelligible both the arguments and my determination of the issues.
ISDA and the Master Agreement
ISDA is a not-for-profit corporation incorporated in the state of New York, having been formed in 1985, shortly after the emergence of a recognised derivatives market. It has over 820 member institutions, including most of the world's major institutions that deal in OTC derivatives, as well as businesses, government entities and other end users that rely on derivatives to manage the risks inherent in their core economic activities. Its primary purpose is to encourage the prudent and efficient development of privately negotiated derivatives business. For that purpose it has developed standard contractual wording and transaction architecture for market participants. This first occurred, historically, in relation to swaps. Since 1992 its standard terms have been used for numerous other types of derivatives, including pure contracts for differences, caps and floors. Thus, interest rate swaps are a sub-class of an original and still very important class of derivatives for which ISDA's standard forms, and the Master Agreement in particular, are routinely used.
The 1992 version of the Master Agreement was the first to be designed in a form applicable to derivatives other than just swaps, and to accommodate both financially and physically settled transactions. The 2002 Master Agreement replicates, for the most part word for word, the provisions of the 1992 version, but with adjustments based upon lessons learnt since 1992, in particular from experience of periods of market turmoil in the late 1990s. Nonetheless, the publication of the 2002 Master Agreement did not lead to its invariable use in preference to its predecessor. For example, three of the five Swaps presently in issue incorporated the 1992 version, although all five were entered into in and after 2006. Generally speaking, it appears that the continued use of the 1992 version may have been more the result of comfortable familiarity than a specific preference based upon a detailed comparison between the two. In this judgment I shall base myself upon the 1992 version, save where different provisions in the 2002 version require specific treatment.
As expressly contemplated in its recital, the Master Agreement is designed to operate between its parties by providing contractually agreed standard terms and conditions designed to form part, but not the whole, of the terms of any particular transaction. Thus, a particular transaction is generally governed by the terms of a Confirmation, the Master Agreement and any Schedule appended to the Master Agreement. By Section 1(b) of the Master Agreement, inconsistencies are to be resolved by affording priority first to the Confirmation, secondly to the Schedule and lastly to the Master Agreement itself. In practice, parties which are content with the Master Agreement may choose not to incorporate a Schedule, but every transaction will be the subject of a Confirmation.
In relation at least to interest rate swaps, each Confirmation will identify a series of dates upon which the parties are or may be obliged to make payments to each other, and will contain the formulae necessary to identify the amounts to be paid. The fixed rate payable will simply be specified. The floating rate will generally be identified by reference to a particular market formula, such as three months sterling LIBOR.
Section 2 of the Master Agreement headed “Obligations” then provides as follows:
“(a) General Conditions
(i) 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.
(ii) 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, …
(iii) 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...
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