Lomas v JFB Firth Rixson Inc

The Court of Appeal construed the 1992 ISDA Master Agreement and held that section 2(a)(iii) operates as a condition precedent affecting the payment obligation only: the underlying debt remains intact but the obligation to make payment is suspended while an Event of Default or Potential Event of Default is continuing. The suspension is not limited by implication to a "reasonable time" or to the natural maturity of the transaction; it endures until the Event of Default is either cured or brought to an end by the non-defaulting party's election to terminate. The court rejected a series of implied terms sought by the administrators (using the test in Belize Telecom) and concluded the contract works without those implications.

In addition the court held that (i) the automatic and mandatory netting provision in section 2(c) applies to amounts that "would otherwise be payable" (i.e. the netting re-formulates contractual payment obligations on the relevant payment dates), and (ii) early/close-out netting under section 6(e) extends to Transactions whose natural performance date passed before Automatic Early Termination, because the Master Agreement treats Confirmations and the Master Agreement as a single agreement.

The administrators' anti-deprivation and pari passu challenges to section 2(a)(iii) failed: the Court applied Belmont and held the suspensory mechanism is a bona fide commercial allocation of insolvency risk and does not offend the anti-deprivation principle or the statutory pari passu rule.

Background and parties: These consolidated appeals concern construction of the 1992 ISDA Master Agreement in the context of derivative transactions (interest rate swaps and forward freight agreements) involving Lehman entities and various counterparties. The principal appellant in the leading appeal was the joint administrators of Lehman Brothers International (Europe) ("LBIE"); respondents included JFB Firth Rixson, FR Acquisitions, BEIG Midco and KP Germany Zweite. The court also heard linked appeals involving Lehman Brothers Special Financing, Pioneer Freight/Freight counterparties and Britannia Bulk.

Procedural posture: These appeals came from decisions of Briggs J and Flaux J in the High Court: see [2010] EWHC 3372 (Ch), [2011] EWHC 718 (Ch), [2011] EWHC 1692 (Comm) and [2011] EWHC 692 (Comm). The Court of Appeal heard argument on construction, implied terms and insolvency challenges.

Nature of the applications and issues:

• The administrators sought directions and contended that where the counterparty to an ISDA transaction became subject to an Event of Default, obligations to make payments nevertheless came into existence and should either revive when the default was cured or, failing that, revive at a reasonable time or on maturity (so as to avoid an indefinite deprivation).
• Issues framed included (i) whether section 2(a)(iii) prevents any obligation from arising after an Event of Default or merely suspends payment obligations; (ii) whether suspension is extinguished at maturity or revives on cure or by implication at some other point; (iii) whether close-out netting under section 6(e) can take into account Transactions whose natural performance date passed before Automatic Early Termination; and (iv) whether section 2(a)(iii) offends the anti-deprivation principle or the pari passu rule.

Court’s reasoning (concise):

• The court distinguished the underlying debt from the contractual payment obligation and held the debt survives the Event of Default while the payment obligation is suspended (adopting the suspensory approach exemplified in Enron Australia and earlier authorities and reasoning of Gloster J).
• On implied terms the court applied the approach in Attorney General of Belize v Belize Telecom: it refused to imply time-limited revival or maturity-based revival terms because the Master Agreement expressly provides for suspension "while" an Event of Default "is continuing", gives the non-defaulting party an unqualified election to terminate, and the contract plainly operates without the administrators' suggested implications.
• Section 9(c) and the overall architecture of the Master Agreement do not support an implied rule of extinction on maturity; the court would not imply termination-by-expiry simply to avoid indefinite contingent liabilities.
• Section 2(c) must be read to effect contemporaneous netting of amounts that "would otherwise be payable", and section 6(e) close-out netting applies to all Transactions within the single agreement (including Transactions whose contractual performance date preceded AET), so close-out can take account of suspended payment obligations (assuming satisfaction of applicable conditions precedent for valuation).
• Applying Belmont, the anti-deprivation challenge failed: the suspensory mechanism is a commercially justifiable allocation of counterparty credit risk and does not amount to an impermissible deprivation of estate property; nor does the construction infringe pari passu, because no debt payable to the estate existed at the commencement of bankruptcy where the condition precedent remained unsatisfied.

The appeal by the administrators in the Lomas appeal is dismissed. The Court held that section 2(a)(iii) of the 1992 ISDA Master Agreement suspends the non‑defaulting party’s payment obligation while an Event of Default or Potential Event of Default is continuing (leaving the underlying debt intact), that suspension endures until cure or termination and is not to be limited by implied terms; the Master Agreement’s netting and close‑out provisions operate as explained above and the anti‑deprivation and pari passu challenges fail on the facts.

Appeal from High Court (Chancery and Commercial lists). The appeals arose from judgments of Briggs J and Flaux J in the High Court: [2010] EWHC 3372 (Ch); [2011] EWHC 718 (Ch); [2011] EWHC 1692 (Comm); and [2011] EWHC 692 (Comm). The Court of Appeal heard consolidated appeals and delivered this judgment ([2012] EWCA Civ 419).