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27 October 20228 minute read

ISDA Master Agreement: When does an event of default cease to be 'continuing', and what is an 'arrangement'?

The 11 October 50-page judgment of Hildyard J in The joint administrators of Lehman Brothers International (Europe) v FR Acquisitions Corporation (Europe) and JFB Firth Rixson will interest not only those who deal with ISDA Master Agreements (who may want to read the entire judgment), but also many lawyers and financial and commercial institutions. This is because the events of default which it had to consider, and especially the meaning of the word “continuing” in this context, are relevant to bonds, loans and various commercial contracts. 

Factual background

Firth Rixson had been withholding sums payable to LBIE (with a total aggregate value of about USD64 million) since LBIE went into administration. In 2011 the CA held in the original case, Lomas v Firth Rixson, that Section 2(a)(iii) of the ISDA Master Agreements (both 1992 and 2002) was enforceable and entitled Firth Rixson to do this, with Longmore LJ famously noting that:

"The purpose of Section 2(a)(iii) is to protect the Non-defaulting Party from the additional credit risk in performing its own obligations whilst the defaulting counterparty remains unable to meet its own. The indefinite suspension of the payment obligation of the Non-defaulting Party (like any attempt to balance competing interests) may on one view be criticised as imperfect but it cannot be said to be uncommercial."

The original Event of Default that occurred was caused by LBIE going into administration in 2009, since which Firth Rixson has been refusing to pay on the basis that Section 2(a)(iii) allows it, so long as LBIE’s event(s) of default are “continuing”. However, by 2021, we had almost reached the conclusion of the administration, with LBIE being substantially solvent, and all the creditors having been paid. Did that then mean that Firth Rixson would now have to pay? 

The arguments

The immediate reaction of many readers might be that Firth Rixson had gone as far as it could, and that the commercial rationale for section 2(a)(iii) (which, as the Court of Appeal had accepted in its 2011 Firth Rixson judgment, was “to protect a party from the additional credit risk involved in performing its own obligations whilst the defaulting counterparty remains unable to meet its own”) no longer justified any continuing suspension of payment, given that it is a fact that LBIE is solvent. 

However, Firth Rixson’s arguments were not weak, and were advanced by its legal team with great skill, so it is worthwhile examining them to understand the clause and meaning of relevant wording. Those arguments included that:

  • even when the formal administration process came to an end (as it shortly will once the administrators make their formal filing at court) the 10-year process will have resulted in certain creditor claims being permanently compromised as a result of a UK scheme of arrangement in 2018. The effects of the administration would therefore continue to exist and to be felt, and so it cannot be said that the event would no longer “continue”. The word used is ‘continuing’, not ‘unremedied’: ‘remedying a breach’ and an event of default being 'continuing’ are two different concepts. Accordingly, the administration event of default under Section 5(a)(vii)(6): 

“seeks or becomes subject to the appointment of an administrator, provisional liquidator, conservator, receiver, trustee, custodian or other similar official for it or for all or substantially all its assets”

would still be continuing;

  • the 2018 scheme of arrangement was itself a further event of default under Section 5(a)(vii)(3):

“makes a general assignment, arrangement or composition with or for the benefit of its creditors”

because it involved a composition of certain creditors’ claims and, since the scheme was not limited in time, it too would remain continuing; and

  • the scheme was registered in the USA under chapter 15 of the US Bankruptcy Code, and that included an open-ended ban on US creditors from bringing proceedings against LBIE. This was yet another event of default under Section 5(a)(vii)(4):

“institutes or has instituted against it a proceeding seeking a judgment of insolvency or bankruptcy or any other relief under any bankruptcy or insolvency law or other similar law affecting creditors’ rights, or a petition is presented for its winding-up or liquidation, and, in the case of any such proceeding or petition instituted or presented against it, such proceeding or petition (A) results in a judgment of insolvency or bankruptcy or the entry of an order for relief or the making of an order for its winding-up or liquidation”

which would similarly continue.

The administrators counter-argued that all these events of default were contained in Section 5(a)(vii), which is headed “bankruptcy”, and so only applied in the context of an insolvency: not because it was headed “bankruptcy” (because the master agreement has the usual “headings are to be disregarded” statement), but because the words should be read in their context, and the context here was financial distress. Although the ISDA Master Agreement has to be interpreted with very little regard to the surrounding factual context of any particular case, it was legitimate to read it in the context of the document as a whole, and necessary in order to avoid some commercial absurdities that could be envisaged on a purely literal interpretation – see paragraph 78 of the judgment.

Hildyard J held here that what had to be examined were the factual circumstances relating to the event: here, the fact of the administration. One should not go beyond this and look at the consequences of the event (as Firth Rixson had argued). 

Hildyard J’s judgment regarding Section 5(a)(vii)(3) – what is an “arrangement”?

Hildyard J held that the 2018 scheme was not an “arrangement” for these purposes because it was not done “in circumstances of financial distress” (it could be argued that he was writing these words into the contract to give business efficacy, although he did not state this and instead described himself simply as interpreting the words used in the context of the particular event of default, and the wider context of the clause as a whole). 

In reaching this conclusion, Hildyard J relied in part on passages from the ISDA User’s Guides to the Master Agreements which said that Section 5(a)(vii) was “drafted so as to be triggered by a variety of events associated with bankruptcy or insolvency proceedings”¸ which is a useful reminder for readers that the User Guides can be significant aids to interpretation. 

Hildyard J’s judgment regarding the Chapter 15 order

The order made under Chapter 15 of the US Bankruptcy Code did not trigger an event of default for the same reason, and while the US Bankruptcy Code was “a bankruptcy or insolvency law” it was not exclusively a law relating to insolvency and also deals with (as here) adjustments of debt in non-insolvent circumstances.

Bright lines?

Firth Rixson had further argued (paragraph 84 et seq.) that:

  • it was established law that a standard form – and especially the ISDA Master Agreements – should be interpreted in accordance with what it actually says, with very little scope for fact-specific implication of terms;
  • events of default should be interpreted ‘as they are written’, because they are drafted with specificity, with “bright lines”, so that involved parties know easily and clearly what they mean and know where they stand;
  • parties are given opportunity to modify the standard form if they do not want such “bright lines” and, if they do not take these opportunities, then it must be concluded that the parties have chosen to contract on the basis of the standard ISDA clause, complete with its bright lines and consequential risk of an unfair outcome; and
  • events of default are not only for the purposes of section 2(a)(iii) but also so that a party knows whether or not it can elect to terminate, if that is what it wants to do. If there are implied terms floating around them which means that the factual circumstances might or might not constitute an event of default (e.g. when there are proceedings under the US Bankruptcy Code) then the party can, in practice, never exercise its right to terminate rapidly, which will defeat the purpose of the event of default. 

Hildyard J was unpersuaded by this and held (see especially paragraph 170) that the correct contextual interpretation of the words of the ISDA Master Agreements was one of financial distress, and that none of the events of default on which Firth Rixson relied increased its credit risk, nor would it – since there was none, the relevant transactions having come to an end more than a decade previously, with Firth Rixson being the debtor.

Final considerations

Hildyard J’s interpretation on the events of default – that they must arise “in circumstances of financial distress” – would likely not be too difficult to apply in practice, and so ought not to hinder parties having to make a rapid judgment whether to call an insolvency event of default under Section 5(a)(vii). We wait to see whether Firth Rixson seek to appeal.