1
US bankruptcy court finds that payment conditionality is unenforceable under
section 2(a)(iii) of the ISDA master agreement
Freshfields Bruckhaus Deringer LLP, September 2009
to make payments to LBSF under the ISDA master
agreement, regardless of any alleged defaults by LBSF , and
to pay default interest.
The US bankruptcy court's reasoning
Judge Peck indicated that the reasons for the order were
discussed during a hearing on 15 September 2009. A
transcript of the hearing reveals the following points.
The
1. US bankruptcy court found that case law under
the US bankruptcy code makes it clear that, while
a debtor (in this case LBSF ) determines whether to
accept or reject an outstanding executory contract,
the counterparty to such contract must continue
to perform. The ISDA master agreement (unless it
involves only fully paid options) is an executory
contract.
The
2. US bankruptcy court found that the safe
harbour provisions of Sections 560 and 561 of the
US
bankruptcy code (which allow the exercise of
termination, liquidation, acceleration and offset
rights under swap agreements and master netting
agreements) are effective only to the extent that a
counterparty seeks either to liquidate, terminate or
accelerate its contracts because of a condition of the
kind specified in Section 365(e)(1) (ie a bankruptcy
filing) or to net out its positions. All other uses of a
contract's provisions that rely on the bankruptcy of
a party as a basis for modification or termination of
the contract (so-called ipso facto provisions) remain
unenforceable under the US bankruptcy code.
US bankruptcy court finds
that payment conditionality is
unenforceable under section
2(a)(iii) of the ISDA master
agreement
The judge responsible for the Lehman
bankruptcy proceedings in the United
States has found that the provisions of
the US bankruptcy code that exempt
swap agreements and master netting
agreements from the application of the
Code's automatic stay and other relevant
provisions do not permit a party to an
ISDA Master Agreement to suspend
performance under Section 2(a)(iii) of the
master agreement. This ruling is particularly
important to those that have elected not to
terminate ISDA master agreements because
their insolvent counterparty is in the money
on a mark to market basis, but have chosen
to suspend payments or deliveries to the
insolvent counterparty.
brIefIng
summary
september 2009
Introduction
Lehman Brothers Special Financing ( LBSF ) entered into
an ISDA master agreement with Metavante Corporation,
and Lehman Brothers Holdings ( LBHI ) guaranteed LBSF 's
obligations under the agreement. When LBSF and LBHI
filed for bankruptcy, Metavante used Section 2(a)(iii) of
the ISDA master agreement to suspend the performance
of its obligations. Section 2(a)(iii) provides that:
'Each obligation of each party under Section 2(a)(i) [to
make a scheduled payment or delivery] is subject to…
the condition precedent that no event of default or
potential event of default with respect to the other party
has occurred and is continuing…'
We understand that Metavante made no attempt to
terminate transactions under the ISDA master agreement
and that any such termination would have created a
receivable in favour of LBSF (ie LBSF was in the money).
Metavante did enter into a replacement hedge.
LBSF
moved, pursuant to Sections 105(a), 362 and 365 of
the US Bankruptcy Code, firstly to compel Metavante to
fulfil its scheduled payment obligations under the ISDA
master agreement and secondly to enforce the automatic
stay against Metavante to prevent it from exercising any
right to terminate transactions under the ISDA master
agreement due to the bankruptcy of LBSF and LBHI . On
17 September 2009, Judge Peck (the judge responsible for
the Lehman bankruptcy cases in the southern district of
New York) granted the motion. Judge Peck also ordered
that, pending assumption or rejection of the ISDA master
agreement by LBSF , Metavante must meet its obligations
2
US bankruptcy court finds that payment conditionality is unenforceable under
section 2(a)(iii) of the ISDA master agreement
Freshfields Bruckhaus Deringer LLP, September 2009
The
3. US bankruptcy court rejected Metavante's
argument that its election to suspend performance
was justified by the insolvent status of LBSF (and its
credit support provider, LBHI ) and also by the need
to establish whether other events of default may have
occurred. Instead, the court found that withholding
performance was not permitted under either the safe
harbour provisions of the US bankruptcy code or
under the terms of the ISDA master agreement itself.
It appears that the
4.
US
bankruptcy court's decision
ultimately rests, however, on policies underlying the
US
bankruptcy code rather than New York contract
law. The court found that the policy behind the safe
harbour provisions of the US bankruptcy code trump
any state law excuse of nonperformance. The court
looked to the legislative history of the safe harbour
provisions as evidence of Congress's intention to
enable the prompt closing out or liquidation of open
accounts upon the commencement of a bankruptcy
case as being necessary to protect all parties in the
light of potentially rapid changes in the financial
markets.
Going beyond the issue of the enforceability of
5.
Section 2(a)(iii) of the ISDA master agreement
(and no doubt relying on the same congressional
policy), the court found that Metavante's decision
to delay terminating transactions under the ISDA
master agreement would act to prevent Metavante
from taking further action under the safe harbour
provisions. The court indicated that, while there is
no obligation to terminate immediately following
a bankruptcy filing to come within the safe
harbour afforded by Sections 560 and 561 of the US
bankruptcy code , Metavante had waited too long to
act.
The court held that Metavante's withholding of
6.
payments violates the automatic stay imposed
by Section 362 of the US bankruptcy code, and
directed Metavante to make scheduled payments,
including interest at the default rate, until such time
as LBSF determines whether to accept or reject the
transactions under the ISDA master agreement. If LBSF
elects to accept the transactions under the ISDA master
agreement, it will be required to pay any amounts
owed by it to Metavante under such transactions.
effect of the ruling where the counterparty
is subject to the US bankruptcy code
The condition in Section 2(a)(iii) should continue
to be effective following the occurrence of events of
default that do not relate to the insolvency or financial
condition of the debtor, the commencement of a case
under the US bankruptcy code or the appointment
of, or taking possession by, a trustee in a case under
the US bankruptcy code or a custodian before such
commencement.
Other market documentation similar to the ISDA master
agreement will also be subject to the US bankruptcy
court's decision. Loan agreements and other similar
agreements to extend credit are not executory contracts
and therefore do not come within the scope of the US
bankruptcy court's ruling.
Although the ruling primarily affects Lehman
counterparties that have elected not to terminate where
Lehman is in the money on a mark to market basis, it
applies equally to transactions where Lehman is out of
the money.
further implications
Although the ruling is based on policies that underlie the
US
bankruptcy code, rather than on general contract law
principles, it may also influence other courts' analysis
of the enforceability of section 2(a)(iii) in proceedings
where the US bankruptcy code is not applicable. In
Enron Australia v. TXU Electricity [2003], a case in which
the liquidator of Enron Australia sought to disclaim
transactions under an ISDA master agreement based on
a provision of the Australian Corporations Act, the New
South Wales supreme court confirmed the enforceability
of Section 2(a)(iii). However, the administrator of
Lehman Brothers International (Europe) may well make
a similar challenge to the enforceability of Section 2(a)
(iii) in the UK courts.
In addition, parties to ISDA master agreements with
counterparties that are or may become debtors under
the US bankruptcy code will need to consider whether
the US bankruptcy court's ruling results in an 'Illegality'
under such ISDA master agreements and the impact of
the ruling on their rights and obligations under other
material provisions of the ISDA master agreement.
3
US bankruptcy court finds that payment conditionality is unenforceable under
section 2(a)(iii) of the ISDA master agreement
Freshfields Bruckhaus Deringer LLP, September 2009
In any event, the US bankruptcy court's ruling must now
be taken into account by any party to an ISDA master
agreement when it decides whether or not to declare
an early termination event upon the insolvency of its
counterparty.
This material is for general information only and is not intended to provide
legal advice.
© Freshfields Bruckhaus Deringer LLP 2009
www.freshfields. com
For further information please contact
Perry Sayles
T +
852 2846 3412
F +
852 2810 6192
E
perry.sayles @ freshfields.com
Clive Rough
T +
852 2846 3432
F +
852 2810 6192
E
clive.rough @ freshfields.com
James Lawden
T +
813 3584 8509
F +
813 3584 8501
E
james.lawden @ freshfields.com
Freshfields Bruckhaus Deringer LLP is a limited liability partnership registered in England and
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