Section 2(a)(iii) of the ISDA Master Agreement: does it suspend or extinguish obligations?

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1 Section 2(a)(iii) of the ISDA Master Agreement: does it suspend or extinguish obligations? 9 December 2009 Marine Trade SA v Pioneer Freight Futures Co Ltd BVI [2009] EWHC 2656 (Comm) The High Court has considered the scope and effect of Section 2(a)(iii) of the ISDA Master Agreement in circumstances outside formal insolvency proceedings. While the court s conclusions on the enforceability of Section 2(a)(iii) as an effective condition precedent to payment are unremarkable, the judge has made some rather surprising statements as to the effect of Section 2(a)(iii) when an Event of Default has been remedied. The facts Marine Trade SA ( Marine Trade ) and Pioneer Freight Futures Co Ltd ( Pioneer ) entered into 14 Forward Freight Agreement ( FFAs ) which were subject to an agreement on the terms of the 1992 ISDA Master Agreement (the ISDA Master Agreement ), as supplemented by Clause 9 of the 2007 Terms of the Forward Freight Agreement Brokers Association (the FFABA Terms ). The FFAs were each cash settled contracts for differences and, for each month, a Settlement Sum was calculated for each FFA by reference to the Baltic Exchange Indices. The aggregate gross Settlement Sums for the FFAs for January 2009 resulted in USD 7 million payable to Marine Trade and USD 12 million payable to Pioneer. Ordinarily, the Settlement Sums were subject to payment netting under Section 2(c) of the ISDA Master Agreement. The net payment for January 2009 after the operation of payment netting was approximately USD 5 million, payable by Marine Trade. 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 [ ]. Section 2(a)(iii) ISDA Master Agreement Marine Trade claimed that, at the end of January 2009, Pioneer was unable to pay its debts as they fell due and was consequently subject to a Bankruptcy Event of Default under Section 5(a)(vii)(2) of the ISDA Master Agreement. It relied on Section 2(a)(iii) of the ISDA Master Agreement to withhold payment of the USD 12 million, and claimed USD 7 million (the gross amount due without operation of payment netting) from Pioneer. Meanwhile Pioneer invoiced Marine Trade for the net payment of USD 5 million. Neither party made any payment on the payment date of 6 February 2009 and Pioneer served a notice on Marine Trade of a 1 Marine Trade v Pioneer 09 December 2009

2 Failure to Pay Event of Default under Section 5(a)(i) of the ISDA Master Agreement. Marine Trade sought an injunction to prevent Pioneer from serving an Early Termination Notice under Section 6 of the ISDA Master Agreement. The injunction was refused and Marine Trade then paid the net amount of USD 5 million under protest but served its own notice on Pioneer under Section 5(a)(i) for a Failure to Pay USD 7 million. In the High Court proceedings Marine Trade sought payment of USD 7 million from Pioneer and repayment of the USD 5 million which it paid under protest. Pursuant to a consent order, Pioneer undertook not to send any further notices of Event of Default or Early Termination Notices prior to the decision at first instance. Prior to the High Court hearing, in May 2009, Marine Trade became unable to pay its debts as they fell due, which constituted an Event of Default under Section 5(a)(vii)(2) of the ISDA Master Agreement. The relevant contractual provisions Section 2(a)(iii) of the ISDA Master Agreement provides as follows: Where Pioneer is affected by an Event of Default, as a consequence of Section 2(a)(iii), Marine Trade has no obligation to make payment to Pioneer at all. Marine Trade v Pioneer, per Flaux J at paragraph 22 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 [ ]. Section 2(c) of the ISDA Master Agreement provides for payment netting in the following terms: If on any date amounts would otherwise be payable: (i) in the same currency; and (ii) in respect of the same Transaction, by each party to the other, then, on such date, each party s obligation to make payment of any such amount will be automatically satisfied and discharged and, if the aggregate amount that would otherwise have been payable by one party exceeds the aggregate amount that would otherwise have been payable by the other party, replaced by an obligation upon the party by whom the larger aggregate amount would have been payable to pay to the other party the excess of the larger aggregate amount over the smaller aggregate amount. By an amendment in Clause 9 of the FFABA Terms, limb (ii) of Section 2(c) above was amended so that a net amount would be determined in respect of all amounts payable on the same date in the same currency in respect of two or more Transactions. The High Court judgment 2

3 The effect of Section 2(a)(iii) on payments falling due from the Non-Defaulting Party after an Event of Default Pioneer conceded that in January 2009 it was unable to pay its debts as they fell due and that an Event of Default had therefore occurred under Section 5(a)(vii)(2). Consequently, as a result of Section 2(a)(iii), Marine Trade had no obligation to pay Pioneer on February 6. This conclusion was not disputed by Pioneer and was accepted by the judge without any lengthy consideration. The effect of remedying the Event of Default on the suspended payment Although Pioneer conceded this point, it initially argued that it subsequently became able to pay its debts. It therefore claimed that Marine Trade s obligation to pay the USD 12 million that would otherwise have been due on 6 February was no longer suspended and so became payable at that time. Pioneer later conceded that it had been affected by the Event of Default at all material times and so the issue strictly did not arise. However, as the point had been argued in full, the judge expressed his views on it. Flaux J stated that, in his opinion, Section 2(a)(iii) is a one time provision for the assessment of whether a sum is owed. If the party due to receive an amount has not satisfied the condition precedent then no obligation to pay comes into existence. Even if the Event of Default is remedied at a later date, no amount will ever become payable. Section 2(a)(iii) therefore operates to extinguish rather than suspend the obligations if the condition precedent is not satisfied on the due date. This view is contrary to commentators on the ISDA Master Agreement (see Firth, Derivatives: Law and Practice, paragraphs to and Henderson on Derivatives, paragraph 18.3). Flaux J found that there was no provision in the ISDA Master Agreement to suggest that if the condition precedent is fulfilled at some time later then the obligation to pay springs up. While it is true that there is no such express provision, the difficultly with his interpretation is that it leads to an extremely uncommercial result. If the party seeking payment cannot comply with the conditions precedent, then it is clear from the terms of the contract that no obligation to pay comes into existence. There is nothing in the wording of the provisions of the contract to suggest that if the condition precedent is fulfilled at some later date, some obligation to pay then springs up. Marine Trade v Pioneer, per Flaux J at paragraph 61 For example, if an administrative error causes there to be a de minimis underpayment, the party would lose the benefit of all payments and deliveries that would otherwise be due to it before the error has been corrected. Similarly, if a bankruptcy petition is filed against a party by a vexatious litigant that party will lose the benefit of all payments and deliveries it should have received in the time it takes to dismiss the petition. Flaux J s conclusion would also lead to the paradoxical situation that if A is owed an amount by B but A is, on the due date, subject to an Event of Default which is subsequently cured, the amount due to A would never become payable while the ISDA Master Agreement subsists, but on an early termination of the Agreement it would be an Unpaid Amount (since this term includes the amounts that became payable (or that would have become 3

4 payable but for Section 2(a)(iii)) [ ] prior to such Early Termination Date ). It would, therefore, be taken into account in the Early Termination Amount. Flaux J s view also seems to be contrary to the interpretation of the Supreme Court of New South Wales in Enron Australia v TXU Electricity [2003] NSWSC 1169 (affirmed (2005) N.S.W.C.A.). In this case, it was suggested that a payment obligation will spring up once the relevant condition (in Section 2(a)(iii)) is satisfied and in that sense it might be said that the payment obligation is suspended while the condition remains unfulfilled, and that amounts accrue notwithstanding that the condition is unfulfilled (at paragraph 12). Interpreting Section 2(a)(iii) Flaux J has taken a literal approach to interpreting Section 2(a)(iii) as a one time test. However, the condition precedent that no Event of Default or Potential Event of Default has occurred and is continuing could be construed as meaning that an obligation does not fall due for performance while an Event of Default or Potential Event of Default is continuing. As Lord Diplock stated in The Antaios 1, if detailed semantic and syntactical analysis of words in a commercial contract is going to lead to a conclusion that flouts business commonsense, it must be made to yield to business commonsense. The adverse consequences that result from a literal interpretation of Section 2(a)(iii) would suggest that the obligation should be regarded as only suspended while the Event of Default or Potential Event of Default is continuing and not destroyed by it. The 2002 ISDA Master Agreement, which contains the same condition precedent, is clearer as to the effect of Section 2(a)(iii). This provides, in Section 9(h)(i)(3)(A), that interest will accrue on amounts withheld under Section 2(a)(iii) and that such interest will be paid after such [withheld] amount becomes payable. This clearly contemplates that the suspended amounts may become payable at a later date. Although the 2002 ISDA Master Agreement strictly cannot be used as a guide to interpreting the 1992 Agreement, it would be odd if the identical provisions in Section 2(a)(iii) of each agreement resulted in different conclusions. Is payment netting under Section 2(c) available after an Event of Default? The judgment also considers whether payment netting under Section 2(c) is available where a payment has been affected by Section 2(a)(iii). The judge held that, since nothing was due from Marine Trade on 6 February due to Section 2(a)(iii), Section 2(c) could not operate as it requires amounts to be payable, which as a matter of ordinary language means now due and owing for immediate payment. If detailed semantic and syntactical analysis of words in a commercial contract is going to lead to a conclusion that flouts business commonsense, it must be made to yield to business commonsense. Per Lord Diplock, Antaios Sompania Naviera SA v Salen Rederierna AB (The Antaios) Quite apart from the ordinary meaning of language, when the agreement is considered as a whole, the word payable in Section 2(c) clearly means that there is a current enforceable obligation to pay. Marine Trade v Pioneer, per Flaux J at paragraph 22 1 Antaios Sompania Naviera SA v Salen Rederierna AB (The Antaios) [1984] A.C

5 Can Section 2(a)(iii) apply to a late payment? At the date of the hearing, Pioneer had not paid the USD 7 million claimed by Marine Trade. It argued that, to the extent that this gross amount had been due on 6 February 2009 rather than the net amount, as Marine Trade itself was subject to a Bankruptcy Event of Default in May 2009, Pioneer could rely on Section 2(a)(iii) to withhold this payment. The judge did not agree. Section 2(a)(iii) is tested when the obligation falls due; if at this date there is no Event of Default then the obligation falls due for performance at that time and is not subsequently destroyed or suspended by an Event of Default by the payee. To entertain Pioneer s construction would allow the party with the obligation to take advantage of its own failure to perform in the interim. Conclusion On one hand this ruling is helpful in confirming that: 1. Section 2(a)(iii) results in no payments being due from a nondefaulting party where the counterparty is subject to an Event of Default; 2. such withheld payments will not be subject to payment netting under Section 2(c); and 3. the condition precedent in Section 2(a)(iii) is tested at the time the payment obligation falls due, so that a subsequent Event of Default by the payee does not excuse payment. On the other hand, the judge s conclusion that Section 2(a)(iii) is a one time test and therefore prevents the obligation from ever arising rather than simply suspending it is unhelpful and, if followed, leads to an extremely uncommercial result. Finally, it is worth noting, that although Pioneer and Marine Trade were both subject to a Bankruptcy Event of Default, neither party was subject to formal insolvency proceedings and so there was no question of Section 2(a)(iii) falling foul of the anti-deprivation rule as most recently considered in Perpetual Trustee & Belmont Park Investments v BNY Corporate Trustee Services [2009] EWCA Civ On this point, Section 2(a)(iii) remains untested in the English courts. 5

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