English court rules that certain ISDA bankruptcy events of default can be cured

In October 2022, the English High Court delivered a long-awaited judgment¹ relating to whether or not certain Bankruptcy Events of Default can be cured under the ISDA 2002 and 1992 Master Agreements ("ISDA Master Agreements") - resolving an issue relating to the suspensory effect of conditions precedent to payments and performance under ISDA Master Agreements raised in the English Court of Appeal earlier in the Lehman administration. The decision considers key aspects of the ISDA Master Agreements and will be of interest to buy-side and sell-side parties in the derivatives market.

The key take aways are that:

• in determining whether a Bankruptcy Event of Default in respect of an administration and the appointment of administrators under an ISDA Master Agreement is continuing, “the test to be adopted is whether the identified event or state of affairs which constituted the Event of Default is continuing, rather than whether creditors' rights have been significantly and permanently altered or continue to be affected by the administration”;
• the Bankruptcy Events of Default relating to administration and the appointment of administrators can be cured by the termination of the appointment of the administrator, even if the administration did permanently adversely affect the rights of creditors; and
• a Bankruptcy Event of Default in relation to an English scheme of arrangement or a Chapter 15 proceeding cannot occur unless it is entered into by an entity in circumstances of financial distress or which involve a fundamental change in the status of the relevant entity (such as by dissolution or by winding up), materially affecting the counterparty’s credit risk.

The Case

The case involves two entities in the Firth Rixson group ("Firth Rixson") each of whom entered into a swap transaction (together, the "Transactions") with Lehman Brothers International Europe (“LBIE”) documented pursuant to an ISDA Master Agreement.

When LBIE entered into administration by court order in September 2008, it was agreed the Transactions were 'in-the-money' to LBIE. This means that, if the Transactions were terminated at the time LBIE entered into administration, an amount of roughly £8,000,000 and $53,000,000 would have been payable by Firth Rixson to LBIE.

The making of the administration order in relation to LBIE was a Bankruptcy ‘Event of Default’ under the ISDA Master Agreements. This gave Firth Rixson, but not the LBIE, a right but not the obligation to terminate the Transactions. Firth Rixson elected not to terminate and did not make any payments to LBIE.

Firth Rixson relied on the standard condition precedent set out at Section 2(a)(iii) of the ISDA Master Agreements to withhold and to continue to withhold payments that otherwise would have been due to LBIE under their existing Transactions.

The condition precedent states:

"Each obligation of each party under Section 2 (a)(i) [i.e. the requirement to make the payment and deliveries specified in each Confirmation] is subject to (1) the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing…"

Between 2010 and 2012, the administrators of LBIE engaged in litigation with Firth Rixson before the High Court and the Court of Appeal as to the meaning of Section 2(a)(iii) seeking payment of the amounts due from Firth Rixson. It was held that Firth Rixson were entitled to rely on Section 2(a)(iii) to suspend their payment obligations until such time as there were no longer any continuing Events of Default in respect of LBIE, or, as the Court of Appeal put it, until all Events of Default had been "cured"; confirming that "[i]f it is never cured, there continues to be no obligation on the Non-defaulting Party to make payment"².

Since the initial administration order, there have been a number of additional events which Firth Rixson contended should be categorised as continuing Events of Default, including:

• LBIE entering into a scheme of arrangement, by court sanction, in June 2018 (the "Scheme of Arrangement"); and
• the order made for the Scheme of Arrangement's recognition and enforcement in the United States under the US Bankruptcy Code (the "Chapter 15 Order") and perpetual injunction in respect of LBIE.

In addition, the administration of LBIE was converted into a distributing administration and it is now clear there will be surplus after making all mandatory distributions. The administrators are looking to bring the administration to an end and terminate their appointments on the basis that they have rescued LBIE as a going concern.

The Judgment

Failure to Pay Event of Default (Section 5(a)(i))

LBIE failed to make certain payments due to Firth Rixson. As a result of the position taken in the skeleton arguments and position papers it was unnecessary for the court to determine whether any payment Event of Default is continuing.

Bankruptcy Event of Default – Insolvency and inability to pay debts (Section 5(a)(vii)(2))

Firth Rixson agreed that the Events of Default which occurred by virtue of LBIE becoming insolvent and unable to pay its debts or failing to pay its debts when due, cannot be regarded as continuing if:

• LBIE is no longer insolvent on a cash flow and balance sheet basis;
• LBIE is paying its debts as they fall due; and
• provision has been made for all of its creditors that are not presently due.

LBIE had also admitted in writing that it was unable to pay its debts when they became due – also an Event of Default under Section 5(a)(vii)(2). The court noted that the general perception was that such admission would now be superseded but to the extent not cured already, this Event of Default would be cured if LBIE sent a notice to creditors indicating that LBIE now has a surplus of assets and is able to pay its debts as they fall due.

Bankruptcy Event of Default – Administration (Section 5(a)(vii)(4) and (6))

LBIE’s entry into administration triggered both the Event of Default relating to seeking relief under any bankruptcy, insolvency or other similar law affecting creditors’ rights (Section 5(a)(vii)(4)) and the Event of Default relating to the appointment of an administrator (Section 5(a)(vii)(6)).

The question to be resolved was whether these Events of Default would be ‘continuing’ once the administrators’ appointment is terminated.

The subsequent conversion of the administration into a distributing administration (which would result in a solvent exit of the company from administration), in particular, made permanent changes to the rights of creditors as result of, for example, the operation of the mandatory statutory regime in respect of distributions on provable claims. Firth Rixson’s assertion was that as a result of such the administration involved the alteration of creditors’ rights which would not come to an end when the administration ended – and thus the Events of Default must be continuing.  

Notwithstanding this, Hildyard J concluded that the test to be adopted in relation to whether the event is continuing is:

“whether the identified event or state of affairs which constituted the Event of Default is continuing, rather than whether creditors’ rights have been significantly and permanently altered or continue to be affected by the administration…”

Applying this, neither an Event of Default under Section 5(a)(vii)(4) nor under Section 5(a)(vii) (6) will be continuing when the administration terminates. Supporting this conclusion, the court also found that the order for conversion of the administration into a distributing administration could not be a separate Event of Default.

Bankruptcy Event of Default – Scheme of Arrangement (Section 5(a)(vii)(3))

The court was asked to determine whether the sanctioning of the Scheme of Arrangement triggered a new Event of Default under Section 5(a)(vii)(3). The relevant Event of Default states:

“The party … makes a general assignment, arrangement or composition with or for the benefit of [the party’s] creditors…”

Although the words do not appear in the Event of Default, the court found that the phrase must be read:

“as descriptive of processes entered into by a debtor in circumstances of financial distress, or which involve a fundamental change in the status of the relevant entity (such as by dissolution or winding up), such as materially to affect the counterparty’s credit risk.”

In such circumstances, the court noted that “the counterparty may justifiably consider that this is not the risk to which it agreed”.

The court found that the Scheme of Arrangement “did not affect, let alone adversely alter, the credit risk to which any creditor agreed” since it related to the distribution of surplus in respect of which a creditor has no provable entitlement (i.e. unlike a scheme proposed by a financially distressed party which would typically seek to compromise creditor rights, the Scheme of Arrangement proposed to facilitate to return to creditors on a solvent basis). For these reasons, the Scheme of Arrangement was not an Event of Default.

Although the Scheme of Arrangement did not trigger an Event of Default, the court noted (obiter) that if the “arrangement” had constituted an Event of Default it would “continue to subsist even when all steps necessary to accomplish it have been taken” (i.e., after the administrators’ appointment is terminated).

Bankruptcy Event of Default – Chapter 15 (Section 5(a)(vii)(4) and (8))

Firth Rixson argued that the making of the Chapter 15 Order (and the granting of ancillary relief) was 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 an event with analogous effect.

The court found that no Event of Default had occurred in relation to the Chapter 15 Order because Section 5(a)(vii)(4) (and by implication Section 5(a)(vii)(8)), like Section 5(a)(vii)(3), should be read as being restricted to companies in financial distress. If the court was correct, that the Scheme of Arrangement did not constitute an Event of Default as it was essentially a solvent scheme, then the Chapter 15 Order recognising the Scheme of Arrangement cannot be an Event of Default.

Section 2(a)(iii)

The court referred to the “commercial purpose” of Section 2(a)(iii), citing previous case law noting that “the commercial function or purpose of the condition precedent to payment as set out in Section 2(a)(iii) is to mitigate counterparty credit risk during the currency of what may be numerous swap transactions under the umbrella of [the ISDA Master Agreement] and while they remain open … In other words, it prevents any increase in credit risk that might occur if actual payments were made.”

Firth Rixson relied on this right to withhold payment for over ten years.

For parties that wish to avoid such a result whilst an Event of Default is “continuing”, in 2014 ISDA, following a period of much focus and discussion on the ISDA condition precedent, published a standard amendment to the ISDA Master Agreements allowing contracting parties to insert an agreed time limit on the operation of the condition precedent in Section 2(a)(iii).

Footnotes

1. Grant & Ors v FR Acquisitions Corporation (Europe) Ltd & Anor (Re Lehman Brothers International (Europe)) [2022] EWCH 2532 (Ch)
2. Lomas v JFB Firth Rixson Inc [2012] 1 CLC 713 at [35] and [62].