Lehman Brothers Special Financing Inc v Carlton Communications Ltd

A contractual condition suspending payment obligations during a counterparty’s continuing bankruptcy or insolvency does not offend the anti-deprivation principle where it operates as part of an ongoing commercial relationship and preserves party autonomy. The principle may yield where parties adjust or terminate future performance because insolvency has impaired the contractual basis of the relationship.

The penalty doctrine is ordinarily confined to provisions triggered by breach of contract. It should not be extended to a sophisticated derivatives agreement where suspension is triggered by bankruptcy or insolvency, operates mutually, and is designed to address the risk of non-performance rather than to punish breach.

Lehman Brothers Special Financing Inc claimed £2,656,649 plus interest from Carlton Communications Ltd under two interest rate swaps governed by the 1992 ISDA Multicurrency Cross Border Master Agreement.

Lehman’s payment entitlement arose after Lehman Brothers Holdings Inc and Lehman Brothers Special Financing Inc entered insolvency proceedings. Section 2(a)(iii) operated as a condition precedent to Carlton’s payment obligations while an Event of Default continued. Carlton had not elected early termination.

The claim raised substantially the same issues as those decided in Lomas v JFB Firth Rixson Inc, [2010] EWHC 3372 (Ch): construction of the payment provisions, the anti-deprivation principle, and whether the condition precedent was a penalty.

1. The claim was dismissed. On the agreed facts, Section 2(a)(iii) prevented recovery of the payment which would otherwise have fallen due on 2 March 2009.

2. The court adopted the construction reached in Lomas v JFB Firth Rixson Inc, [2010] EWHC 3372 (Ch). The effect of the condition precedent was suspensory rather than once and for all. The payment obligations remained suspended while the relevant Events of Default continued.

3. The regulatory-capital evidence did not justify implying terms requiring payment after a reasonable time or on expiry of the swaps. The objective background for construction was that the relevant class of contracting parties included non-bank customers, and the evidence did not establish that the parties’ assumed intentions concerning bank capital adequacy formed part of the admissible factual matrix.

4. The condition precedent did not infringe the anti-deprivation principle. The relevant question was whether the provision, viewed generally, was triggered by bankruptcy so as to adjust an ongoing relationship. It relieved the non-defaulting party from payment obligations while the defaulting party was unable to provide the promised hedge. That was consistent with party autonomy. The continuing Event of Default arising from the insolvency of the credit support provider supplied an additional reason why the principle did not apply.

5. The provision was not a penalty. Although a contractual withholding of money may in an appropriate case be penal, the doctrine had only been applied to breach of contract. The condition was triggered by bankruptcy or insolvency, not breach, operated mutually, and addressed the breakdown of the contractual basis and the risk of non-performance. Extending the doctrine to this sophisticated standard-form derivatives agreement would unjustifiably interfere with freedom of contract.

First-instance decision. The judgment states that Lomas v JFB Firth Rixson Inc, [2010] EWHC 3372 (Ch) , was subject to a pending appeal, but this claim was determined independently.