In a keenly anticipated judgment, the Court of Appeal today handed down its verdict in four appeals ([2012] EWCA Civ 419. In the appeal of (1) Lomas and others (together the Joint Administrators of Lehman Brothers International (Europe) (in administration)) v JFB Firth Rixson, Inc and others and ISDA as intervenor [2010] EWHC 3372 (Ch); (2) Lehman Brothers Special Financing Inc v Carlton Communications Ltd [2011] EWHC 718 (Ch); (3) Pioneer Freight Futures Company Ltd v Cosco Bulk Carrier Company Ltd [2011] EWHC 1692 (Comm.); and (4) Britannia Bulk plc v Bulk Trading SA [2011] EWHC 692 (Comm)) concerning the interpretation of various terms of the 1992 ISDA Master Agreement. In doing so, the court has unwound the tangle of conflicting first instance judgments and provided some much need clarity on a number of questions of contractual construction – in particular, a counterparty’s entitlement to rely on section 2(a)(iii) to avoid making payments to a party which has become insolvent.

Key Findings:

  • Where there is an Event of Default, payment obligations are suspended under section 2(a)(iii) until the Event of Default is cured
  • There are no implied terms in the Master Agreement which:
    • Cause Early Termination after a “reasonable period”
    • Revive payment obligations on maturity; or
    • Oblige the Non-defaulting party to designate Early Termination
  • Suspended payment obligations are not extinguished on maturity but continue indefinitely
  • The anti-deprivation principle is not offended by section 2(a)(iii)
  • Unless the contract specifies, there are no circumstances in which the Non-defaulting Party is entitled to payments on a gross basis. All close out sums must be calculated on a net basis and credit must be given for any sums due to the Defaulting Party
  • The close-out netting regime under Automatic Early Termination (“AET”) applies to all unpaid sums under all transactions under the same Master Agreement, irrespective of whether or not some of those transactions have come to a natural end prior to AET
  • The “Nil Loss” argument failed – where termination has occurred, the Non-defaulting Party cannot rely on section 2(a)(iii) to disregard amounts owed to a Defaulting Party either before or after AET


Recent legal commentary has noted that the draftsmen of the ISDA Master Agreement did not anticipate or provide for the collapse of a major market participant such as Lehman and, as a natural consequence, there was much confusion regarding the payment obligations of Lehman’s counterparties who were “out of the money” to the insolvent bank. Tensions between the supposed commercial purpose of various elements of section 2 and literal interpretations of the language of this clause led to much confusion in the market and then to conflicting High Court judgements.

The Court of Appeal approached the issues with indifference to the extraordinary complexity of the Lehman administration. Merely noting that LBIE’s bankruptcy “looks as if it will continue for some time”, the Lord Justices resolved the issue through simple adherence to the fundamental principles of established contract law.

This ebulletin picks out some of the issues which the Court of Appeal was asked to consider and how it went about resolving them.

1. Section 2(a)(iii) suspends payment obligations

The Lehman administrators’ appeal failed. In the absence of any termination clause which causes the transactions to be automatically terminated upon specified Events of Default, an innocent party is entitled to rely on section 2(a)(iii) to avoid making payments to a party which has entered insolvency proceedings.

Section 2(a)(iii) concerns payment obligations and the underlying debt obligations remain undisturbed. Accordingly the payment obligation is merely suspended (as opposed to extinguished forever) and the obligation to pay the debt can be revived if the Event of Default is cured.

2. No implied terms

The Court of Appeal dismissed the argument that, where an Event of Default was unlikely to be cured (such as insolvency), there were implied terms which required the innocent counterparty to bring the transaction to an end before natural maturity. There was no suggestion that the Parties intended such terms to be incorporated into the agreement and the Court of Appeal considered the argument to be “hopeless”. The contracts worked perfectly well without any such implied terms and to find that such implied terms existed would be to re-write the contract for the parties which the court had no business to do.

3. Payment obligations suspended indefinitely (i.e. survive maturity)

The Court of Appeal reversed the legal effect of maturity on suspended payment obligations under those transactions that have matured. A number of decisions at first instance had held that obligations suspended by section 2(a)(iii) were extinguished once the transactions had passed their final payment date (and therefore could not be revived in the event that the Default was subsequently cured). In the absence of any clear contractual terms, reliance was placed on section 9(c) (which concerns the survival of obligations under the ISDA Master Agreement of particular transactions). The Court of Appeal firmly rejected this approach. It is interesting to note that in doing so it had regard to the equivalent section of the predecessor 1987 Master Agreement as an aid to interpretation. That earlier version had not contained the words in section 9(c) said to provide for the extinction of rights. The Court determined that the intention of the draftsmen of the 1992 Master Agreement (as opposed to the parties to the transactions in dispute in the appeal) cannot have been to introduce such an important concept in a term buried under the heading “miscellaneous”.

Having dispensed with the only possible express term, the Court saw no need to imply a term where to do so was unnecessary. Nothing was inherently wrong with ISDA’s argument that the obligations should survive indefinitely. It followed that where contracting parties have opted for AET to apply in the case of certain Events of Default, all transactions entered into under the same Master Agreement will be subject to the close-out netting provisions, including transactions which have passed their final payment date.

4. No offence to the anti-deprivation principle

The anti-deprivation principle concerns the removal of assets from the estate of an insolvent person to circumvent the relevant insolvency law regime. Any contractual provision which causes this effect is prohibited.

The Court followed the Supreme Court’s 2011 decision in Belmont2 which found that the anti-deprivation principle had limited application to complex commercial transactions. There was no suggestion that section 2(a)(iii) was formulated in order to avoid the effect of any insolvency law or to give the Non-defaulting Party a greater or disproportionate return as a creditor of the bankrupt estate. It was clear that the purpose of section 2(a)(iii) is to protect the Non-defaulting Party from the additional credit risk involved in performing its own obligations whilst the Defaulting Party remains unable to meet its own.

5. The Gross / Net issue

Section 2(c) provides for netting where the amounts “otherwise payable” are due on the same day, in the same currency and in respect of the same transactions. It had been found in the first instance judgment (which was the subject of the third appeal) that, where there was a continuing Event of Default, payments should be made on a gross basis and netting was unavailable to the Defaulting Party. This finding was on the basis that the suspension of payments under section 2(a)(iii) meant that payments owed to the Defaulting Party could not be construed as “payable”. This finding was at odds with the market’s understanding of the provision and the parties to the first and second appeals did not contest the issue.

The Court of Appeal agreed and allowed the appeal. The overall scheme of the Master Agreement was to provide for netting-off of gross liability of each payment at each payment date and for a “wash-out calculation” of a final net figure on termination of all outstanding transactions. One of the Court’s key findings was that the commercial purpose of section 2(a)(iii) was to mitigate counterparty credit risk for the currency of the swap transactions. To enable the Non-defaulting Party not merely to be relieved from payment during the period of default but also to recover from the Defaulting Party its gross liabilities under the swaps as they fall due would undermine that purpose.

However, there was a limit to which unpaid sums could be netted-off against each other. The netting provisions of section 2(c) apply only in relation to contemporaneous payment obligations. Only amounts which were expressed to be payable on the same date in respect of the same two (or more) of the relevant transactions are capable of being netted. Section 2(c) cannot be utilised to net-off sums arsing on one date against sums which become due on a later date.


The Court of Appeal’s determination of the issues is consistent with the submissions made by ISDA who, as an interested party, acted as an intervener in both the first instance and the Appeal hearings. Subject to any appeals to the Supreme Court (in respect of the claims by Lehman’s administrators), some of the drafting changes to the ISDA Master Agreement proposed in the ISDA consultation would no longer be required for ISDA Master Agreements governed by English law. However, to avoid any further dispute regarding “inelegantly” drafted terms of the Master Agreement, ISDA may wish to clarify certain provisions and push ahead with the proposed amendments in any event.

The key proposed change in the ISDA consultation (which concerned the curtailment of a counterparty’s entitlement to rely on section 2(a)(iii) indefinitely) remains very much alive. In its 2009 consultation paper, HM Treasury expressed the view that payments due to insolvent counterparties should not be withheld indefinitely as this created undesirable uncertainty for administrators and the general creditors of insolvent corporates. The Court of Appeal’s decision that a Non-defaulting Party is entitled to rely on section 2(a)(iii) indefinitely means that a change to the market standard for derivatives transactions will be required to meet the concerns expressed by HM Treasury in its consultation paper. However, it remains to be seen whether ISDA and its members can agree on a new term which limits the time period for Non-defaulting counterparties to rely on the section 2(a)(iii) condition precedent, thus forcing Non-defaulting Parties to terminate open transactions unless they are prepared to resume payments to insolvent counterparties. It is understood that a number of ISDA members are uncomfortable with the prospect of being effectively forced to terminate transactions with an insolvent counterparty within a certain time period. HM Treasury has reserved its right to introduce a statutory solution in the event that a market-based solution does not emerge or is deemed unsatisfactory.

Damien Byrne-Hill
Damien Byrne-Hill
+44 20 7466 2114