Years go by without the courts being troubled by derivatives. However, the financial crisis and its aftermath have changed that, producing a surfeit of cases to be digested, alongside other developments such as clearing of derivatives and the so-called Big Bang and Small Bang protocols on auction settlement.
This article explores some of the recent cases in England, although there have been so many it cannot be comprehensive. Those omitted include a number of interesting jurisdiction cases. Meanwhile, the flow continues, including the possibility of appeals. The following provides a snapshot, to help understand the story so far.
Walk-away clause?
Section 2(a)(iii) of the Isda master agreement (whether the 1992 or 2002 version) makes each payment or delivery obligation of each party subject to the condition precedent that no event of default or potential event of default has occurred and is continuing with respect to the other party.
This is a far reaching provision, with neither materiality qualification nor time limit. A potential event of default includes a failure to comply with any obligation under an Isda master agreement or the confirmations it governs. This will become an event of default if not cured within the requisite period. The obligation could be, for example, a requirement to deliver information which neither party would regard as material.
For many years, the possibility that Section 2(a)(iii) might have unintended consequences was there to be seen, but it was hoped Section 2(a)(iii) would not be used by a non-defaulting party indefinitely as a shield, nor to reap windfall benefits. Generally, the non-defaulting party would be expected at some point to exercise close-out netting rights under Section 6 to achieve finality. After close-out netting occurs, the single net amount due under Section 6(e) is not subject to the condition precedent in Section 2(a)(iii).
Alarm bells were sounded in 2003 by the Australian case Enron Australia Finance Pty Ltd (in liquidation) v TXU Electricity, in which TXU decided not to close-out under Section 6 and sought instead to rely on Section 2(a)(iii) in order not to perform. The Court upheld the legality of TXU's decision.
The issue arose again in Marine Trade SA v Pioneer Freight Futures Co Ltd BVI and another, decided in October 2009. Marine and Pioneer had entered into 14 forward freight agreements, governed by the terms of a 1992 Isda master agreement. For the January 2009 contract month, Marine owed $12 million to Pioneer under some of the trades, while Pioneer owed $7 million to Marine under the others. The trades had the same monthly settlement date, so Pioneer invoiced Marine for the net amount of $5 million.
Marine believed a bankruptcy event of default had occurred with respect to Pioneer, with Pioneer unable to pay its debts as they fell due. However, Marine did not wish to close out under Section 6, as it was significantly out of the money overall. This would have left Marine owing a large amount to Pioneer, which Marine could not have paid. Instead, Marine asserted that under Section 2(a)(iii) it had no obligation to pay $12 million to Pioneer for January and it invoiced Pioneer for $7 million.
Pioneer responded by saying that Marine's non-payment was itself an event of default. Marine, fearing Pioneer would exercise close-out netting rights under Section 6, paid $5 million to Pioneer under protest. Marine then sued Pioneer for both the $5 million it had paid and the $7 million which it said was due from Pioneer for January.
The parties accepted that a bankruptcy event of default was continuing with respect to Pioneer at the settlement date for January. The court found that a bankruptcy event of default also occurred with respect to Marine some months later.
The issues which arose for decision included:
Do the settlement netting provisions in Section 2(c) of the Isda master agreement apply regardless, so that settlement netting occurs before any question of Section 2(a)(iii) conditionality arises? Answer: No. The Court said the condition precedent in Section 2(a)(iii) takes priority over Section 2(c) and prevents settlement netting from occurring. The gross amount of $7 million became due from Pioneer on the settlement date for January. Nothing had been due on that date from Marine, because a bankruptcy event of default was continuing in respect of Pioneer.
Did Pioneer's obligation to pay $7 million to Marine itself become conditional when a bankruptcy event of default later occurred with respect to Marine? Answer: No. The court said the condition precedent in Section 2(a)(iii) is tested only as of the due date for the relevant payment or delivery. If the obligation was unconditional on that date, it could not become conditional afterwards as a result of a subsequent event of default.
If Pioneer were able to cure its own bankruptcy event of default in the future, would the Section 2(a)(iii) condition precedent be satisfied, so that Marine would become obliged to perform obligations which, until then, had been suspended? Answer: No. The court said the condition precedent in Section 2(a)(iii) is tested only as of the due date for payment or delivery. If the condition was not satisfied on that date, it could not be satisfied afterwards.
Was Marine entitled to recover the $5 million it had paid under protest? Answer: No. The court said this could be recovered only under an established head of restitution, such as mistake, and none applied. The payment had been made not as a result of a mistake, but rather in the pursuit of a particular strategy.
The court's view that a default cannot be cured later for Section 2(a)(iii) purposes is unfortunate. It increases, rather than reduces, the potential for unintended consequences and could make a lottery of parties' rights and obligations. The timing of a trigger (remember there is no materiality test) becomes all important. A difference of one day could result in a windfall for the non-defaulting party (although it would be lost if Section 6 close-out ever occurred, because obligations previously suspended by Section 2(a)(iii) would be taken into account as unpaid amounts).
The judgement also sits uneasily with Section 9(h)(i)(3)(A) of the 2002 Isda master agreement which provides that interest will accrue on suspended obligations, payable when the suspension ceases.
The Lehman bankruptcy gave rise to a judgement on Section 2(a)(iii) in New York, in the Metavante case. As in Marine Trade, the non-defaulting party was out of the money and decided neither to perform (relying on Section 2(a)(iii)) nor to close out. The court regarded this as "unacceptable". The decision concerned the scope of the safe harbour provisions in the US Bankruptcy Code, which protect close-out netting rights. The court held that the non-defaulting party will lose these rights if it does not exercise them within a reasonable time. In England, Lehman's administrators have applied to court for directions on whether LBIE's counterparties can rely indefinitely on Section 2(a)(iii) to avoid making payments.
In December 2009, HM Treasury published a consultation paper, Establishing resolution arrangements for investment banks, in which it commented on the potential for a party to walk away under Section 2(a)(iii). The paper hopes a market solution can be reached and says the government would encourage Isda to consult with its members to develop an appropriate solution, which should (i) preserve the necessary flexibility for the solvent party to decide whether to terminate transactions in an orderly and commercially reasonable way, so that it can manage its own risk effectively (and therefore minimise the systemic risk impact of such close-outs) and (ii) provide certainty to administrators that Section 6 close-out will occur within a reasonable period. The possibility of government intervention was not ruled out.
In its response, Isda said recent events, including the Marine Trade and Metavante decisions, justify a review by its members of Section 2(a)(iii), to preserve its protection for non-defaulting parties, clarify its effect and ensure it does not operate as a walk-away clause.
Meanwhile, it is worth noting that parties can choose to amend Section 2(a)(iii), particularly for transactions where the risk of unintended consequences could be material.
Flawed asset and anti- deprivation
Section 2(a)(iii) should help to protect close-out netting under Section 6. One concern is that there might be jurisdictions whose bankruptcy laws would allow a bankrupt company to cherry-pick profitable trades while disclaiming unprofitable ones, undermining Section 6. If the non-defaulting party's obligations are conditional under Section 2(a)(iii), the profitable trades are flawed assets in the hands of the bankrupt party. This should reduce the incentive for a bankrupt party to cherry-pick, not least because profitable trades would be brought into account in Section 6.
Does flawed asset protection work or is it an attempt to contract out of insolvency law? The question depends on the scope of the anti-deprivation rule, which invalidates an agreement to deprive a bankrupt estate of an asset upon the occurrence of the bankruptcy. This is quite a congested area of case law, with a number of old cases which are hard to reconcile, leading to some uncertainty about the rule's scope.
In July 2009, the rule was considered by the High Court in Perpetual Trustee Co Ltd v BNY Corporate Trustee Services Ltd and another and then again in August 2009 in Butters and others v BBC Worldwide Ltd and others (see also Mayhew v King and others, decided in May 2010, in which the rule was applied). Both cases went to the Court of Appeal, which issued a conjoined judgment in November 2009. Perpetual Trustee is being appealed to the Supreme Court, currently scheduled for 2011.
Perpetual Trustee concerned the payment waterfall in documentation for synthetic credit default swaps (CDOs) under which the priorities switched if an event of default occurred with respect to the swap counterparty or its credit support provider. The swap counterparty (a Lehman entity) ranked after noteholders after such an event of default. The Butters case concerned a valuable IP licence which had been granted by the BBC to a joint venture (JV) with Woolworths. The IP licence could be terminated by the BBC following an insolvency event affecting Woolworths. The JV agreement also entitled the BBC to buy Woolworths' shares in the JV at market value following an insolvency event. This allowed the BBC to buy Woolworths' shares in the JV for almost nothing, because the IP licence was terminable.
The Court of Appeal confirmed the anti-deprivation rule forms part of a wider policy to stop parties from contracting out of statutory insolvency law. The distribution of an insolvent debtor's assets is a matter governed by law not contract.
However, the application of the rule becomes difficult where the asset in question is a contractual right. If the right changes upon insolvency, is that (i) an integral part of the asset (it is a flawed asset which always had that feature) or (ii) depriving the bankrupt debtor of an asset? This tension is evident in the Court of Appeal's judgements.
The good news so far is the Court of Appeal found none of the arrangements offended the anti-deprivation rule. A termination right in a licence is fine. It merely involves a limited interest being brought to an end (terminability is integral to the asset). The purchase provision in the JV agreement was fine, because it provided for purchase at market value (a requirement to sell at less than market value would have breached the rule). The switching of priorities in the waterfall caused more difficulty, but all the judges agreed it was fine, at least on these facts.
The Court of Appeal also found the anti-deprivation rule is not offended where the deprivation occurs before insolvency proceedings commence, even if the owner of the asset is insolvent when the deprivation occurs. Interestingly, it was common ground among the parties that the anti-deprivation rule applies not only upon liquidation, but also if a company (which could be a foreign company) goes into administration or files under Chapter 11 in the US.
Is there cause for concern about the anti-deprivation rule in the context of Section 2(a)(iii)? We think it unlikely an English court would find Section 2(a)(iii) offended the rule, which was mentioned in neither the Enron Australia nor Marine Trade cases.
Perpetual Trustee also gave rise to a decision in New York. The court found the change in priorities in the waterfall offended the US Bankruptcy Code, thus striking down as unenforceable in New York that which had been upheld in London. A conflict-of-laws question has arisen as to which of the two decisions should prevail. It is believed the English and US courts will work together to provide a coordinated response to this issue.
Close-out and the rule against penalties
BNP Paribas v Wockhardt EU Operations (Swiss) AG, decided in December 2009, concerned a 2002 Isda master agreement. Wockhardt missed a number of payments and BNP Paribas closed out under Section 6. In calculating the close-out amount, BNP Paribas added the PV of estimated future cashflows due from each party, using its standard internal pricing model. Wockhardt argued this offended the rule against penalties. The Court disagreed, finding neither Section 6 nor the manner in which BNP Paribas had exercised its rights had been extravagant or unconscionable.
Municipalities, capacity and professional negligence
The old chestnut of counterparty capacity arose again in Haugesund Kommune, Narvik Kommune v Depfa ACS Bank (High Court September 2009; Court of Appeal May 2010), which arose from loans to Norwegian municipalities documented as zero coupon swaps governed by Isda master agreements to avoid a Norwegian statutory restriction on municipalities borrowing. This manner of avoiding the statutory restriction appeared to have been blessed in a circular issued by the Norwegian Ministry on Municipalities. Depfa lent in this way to two municipalities, relying on capacity opinions given by a Norwegian law firm. The municipalities invested the proceeds first in credit-linked notes (CLNs), then in CDOs, which performed disastrously. The Norwegian Ministry of Justice issued advice that the transactions were loans infringing the statutory restriction and the municipalities stopped making payments.
A key issue was whether the municipalities had capacity to enter into the transactions, a question of Norwegian law. However, the case was heard in England, because the Isda master agreements had English jurisdiction clauses. The Norwegian lawyers therefore found themselves in the uncomfortable position of having their Norwegian capacity opinion ruled upon by an English court seeking to apply Norwegian law, on which the court was assisted by a number of expert witnesses.
The court decided that, as a matter of Norwegian law, the zero coupon swaps were loans restricted by the Norwegian statute and the Court of Appeal upheld this decision. The Norwegian law firm was found negligent in giving its capacity opinion and was liable to Depfa for damages. Depfa also had a claim in restitution to recover what it had advanced to the municipalities, because it had advanced the money in the mistaken belief the contracts were valid. The municipalities had no defence based on change of position, as a result of their investments having performed badly. However, the Norwegian law firm's liability was for the whole of Depfa's loss, ignoring the value of Depfa's restitutionary remedy, although it might have subrogation or other rights in respect of Depfa's restitutionary remedy.
Binding agreement?
Titan Steel Wheels Limited v The Royal Bank of Scotland plc concerned a number of structured foreign exchange (FX) forwards that had been entered into by Titan with RBS. Titan's income was mostly in euros, while much of its expenditure was in sterling, so it was often long euros relative to sterling. It had done reasonably well out of these FX trades in the past, but that changed when sterling devalued. Faced with losses of about £2.8 million on its trades with RBS, Titan sought to avoid its obligations.
Titan's arguments were comprehensive, ranging from lack of authority of the Titan employee who had done the trades to negligent advice by RBS, with breach of FSA rules thrown in for good measure. The High Court gave judgement in February 2010 on the preliminary issues including the following:
Had RBS acted as an adviser and did it owe a duty of care? Answer: No. The mandate letter, terms of business and other contractual materials stated that RBS was acting in an execution-only capacity and was not providing advice. The court regarded these provisions as effective and, in any case, regarded what RBS had said and done as being consistent with it acting as seller, not adviser.
Were relevant provisions in the mandate letter, terms of business and other contractual materials subject to the Unfair Contract Terms Act 1977 and, if so, could RBS rely on them? The terms included a straightforward exclusion clause, which was clearly within the scope of UCTA. The court regarded the exclusion clause as fair, having regard to the equality of bargaining power, competition in the market and the fact that such exclusions were common. The court also held that the terms relating to RBS acting in an execution-only capacity were not within the scope of UCTA, as they merely defined the basis on which RBS was providing its services.
Titan Steel is an example of a number of recent cases where a non-bank party has sought mis-selling or other relief in respect of loss-making trades (see also JP Morgan Chase Bank and others v Springwell Navigation, which concerned investments in debt securities).
One further point to note is the extensive use in evidence of recorded conversations, which meant the Court had little need to rely on witness evidence. Not all the recordings survived and Titan sought to make mileage out of this, asserting RBS had cherry-picked the favourable evidence, a serious allegation. On the facts, the judge disagreed. However, the case serves as a reminder both that recorded conversations can give rise to valuable evidence and that an adverse inference may be drawn if there are gaps.
| Author biography |
Richard Levitt
Slaughter and May
Richard has been a partner with Slaughter and May since 2000. He has a broad financing practice which covers a wide range of debt finance, derivatives and structured finance matters.
He has for many years advised a number of banks and other financial institutions on the development and execution of structured transactions. Deals are often collateralised, whether by title transfer or security arrangements, or involve set-off or netting and may necessitate the giving of opinions to the FSA. Richard also advises a number of corporate treasurers on their financing and hedging transactions.
In 2009, Richard was extensively involved in advising HM Treasury on its asset protection scheme and was a member of the team which drafted the APS rules. |
| Author biography |
Mark Dwyer
Slaughter and May
Mark has been a partner at Slaughter and May since 2005 and advises both corporates and banks primarily on debt finance, derivatives and structured finance matters. He advises leading UK, US and European investment banks on the development and execution of structured products and transactions, especially regulatory and tax enhanced products. He is also active in the capital markets area with a particular focus on convertible bonds.
He has advised regularly on collateral and custody arrangements including many involving reliance on the financial collateral regulations and frequently delivers legal opinions to satisfy bank regulatory requirements.
Mark is listed as an expert in relation to Derivatives and Structured Products in Legal Experts, 2010. |