Legal Briefing

ISDA Master Agreement – “probably the most important standard market agreement used in the financial world”

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Corporate and commercial | 01 April 2011

In the recent Lomas & Ors v JFB Firth Rixson Inc & ors [2010], the joint administrators (the administrators) of Lehman Brothers
International (Europe) (LBIE) applied for directions as to the true meaning and effect of certain terms under interest rate swap agreements (the swaps), governed by the International Swaps & Derivatives Association (ISDA) Master Agreement (the Agreement).

As the judge, Briggs J, noted, the Agreement is ‘probably the most important standard market agreement used in the financial world’. The decision, therefore, has potentially important consequences for all businesses that rely on derivatives to manage risks arising from their financial obligations.


The respondent counterparties were all commercial manufacturing or trading companies that entered into the swaps with LBIE for the purpose of hedging floating interest risk arising from their borrowings. LBIE, which was the floating rate payer, went into administration on 15 September 2008.

Each swap incorporated the terms of one or other of the 1992 or 2002 version of the Agreement, under which LBIE’s entry into administration was an event of default. Under s6 of the Agreement, non-defaulting parties may elect early termination of the transaction. However, the respondents, who were significantly ‘out of the money’, elected not to terminate the swaps. Instead, they relied on s2(a)(iii) of the Agreement to justify withholding payments, which would otherwise have fallen due to LBIE following administration.


The Agreement is designed to provide standard contractual terms for participants in the over-the-counter derivatives market. Transactions will also be governed by a confirmation, which will set out the dates on which parties must make payments to one another and the formulae to calculate the amounts due. Parties to a transaction may also set out further terms in a schedule to the Agreement, but they do not always do so.

Section 2(a)(i) of the 1992 Agreement states as follows:1

‘i) Each party will make each payment or delivery specified in each confirmation to be made by it, subject to the other provisions of this agreement.’

Section 2(a)(iii) then states:2

‘iii) Each obligation of each party under s2(a)(i) 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;
  2. the condition precedent that no early termination date in respect of the relevant transaction has occurred or been effectively designated; and
  3. each other applicable condition precedent specified in this agreement.’

Following LBIE’s default, the respondents argued that they were under no obligation to make further payments for so long as the event of default was continuing. If the respondents had elected to terminate the swaps, that election would have crystallised an obligation to make substantial close-out payments to LBIE.


The administrators argued that the construction proposed by the respondents gave them a windfall rather than protection from, or compensation for, the consequences of LBIE’s default. This construction was, in their view:

‘So divorced from any reasonable understanding of the purpose of s2(a)(iii) that it must give way to a construction more in accordance with commercial common sense.’

Therefore, the administrators advanced three alternative interpretations of s2(a)(iii). These were (broadly) that:

  1. The condition precedent in s2(a)(iii)(1) should operate only for a reasonable period of time sufficient to enable the non-defaulting party to decide whether to elect for early termination, or to continue to perform its payment obligations in full;
  2. a term should be implied that the condition precedent in s2(a)(iii)(1) falls away at the end of the natural term of a transaction, leaving the parties with a mutual netting obligation in relation to all unpaid amounts (ie amounts that would have been payable but for an earlier default); and
  3. once it becomes clear that the other party’s default is permanent, or where the non-defaulting party decides to re-hedge, the non-defaulting party must exercise its discretion in favour of early termination.

Briggs J rejected these submissions that were, in his view, at variance with the clear meaning of the relevant terms of the Agreement. He preferred the respondents’ arguments that the Agreement is a clearly and precisely drafted document, developed over many years, into which the implication of terms (such as those suggested under alternatives a and b above) was unnecessary and undesirable, both because of the clarity of its meaning and because of the various options provided by ISDA whereby parties could, by additional provisions in the schedule or in any confirmation, make specific provision about particular matters (such as automatic early termination on the happening of an event of default).


Briggs J was also asked to consider whether the condition precedent in s2(a)(iii)(1) of the 1992 Agreement was a ‘once-and-for-all’ provision or merely suspensory. In other words, if the event of default (or potential event of default) were to be cured, would the non-defaulting party then become liable to make earlier post-default payments that would have been due on past payment dates but for the effect of s2(a)(iii) of the Agreement or only those payments falling due post-cure.

At trial it was accepted that the once-and-for-all submission could not be pursued in relation to the 2002 Agreement because of s9(h)(i)(3)(A), which expressly contemplates that an amount might become payable due to the satisfaction of the condition precedent after a payment date has passed.

When considering this point in relation to the 1992 Agreement, Briggs J was presented with conflicting (and non-binding) authorities in the form of:

  1. Flaux J’s obiter dicta in Marine Trade SA v Pioneer Freight Futures Co Ltd BVI [2009] that there was nothing in the 1992 Agreement to ‘suggest that if the condition precedent is fulfilled at some later date, some obligation to pay then springs up’; and
  2. the decision of the New South Wales Supreme Court in Enron Australia v TXU Electricity [2003], where the contrary view was expressed.

Briggs J held ‘on a fairly narrow balance’ that s2(a)(iii) of the 1992 Agreement was, like its counterpart in the 2002 Agreement, merely suspensory in effect. His main reason was that the once-and-for-all construction would produce a pointlessly draconian outcome in the event of a minor and momentary default.


Briggs J went on to consider (in relation to both the 1992 and the 2002 Agreements) how long the suspension of the non-defaulting party’s payment obligations would continue, and at what point they would finally be extinguished. The only candidates raised in argument were that the period of suspension should last:

  1. until the expiry of the term of the transaction(s) governed by the Agreement; or
  2. indefinitely.

Briggs J preferred the first of these two alternatives. He took the view that it would be ‘wholly inconsistent with any reasonable understanding of the Agreement’ for the non-defaulting party to be exposed to the risk of having to make potentially significant payments under a transaction long after the expiry of that transaction.


One issue raised in the parties’ agreed list of issues was whether a non-defaulting party choosing to take advantage of the condition precedent in s2(a)(iii)(1) by not making a payment otherwise due, while the counterparty is in default, may nonetheless enforce the defaulting party’s payment obligations in full. In the context of an interest rate swap, where the floating rate payer is in default, the question is whether the fixed rate payer was entitled to receive the whole of any floating rate payment due from the defaulting party, without giving credit for its fixed rate payment obligation due on the same payment date.

This issue had arisen previously in Marine Trade, where Flaux J held that the non-defaulting party did not have to give credit. His view was that the clear language, in particular of s2(c), meant that credit only had to be given, by way of netting, for an amount that was payable, and not for an amount that, because of an unfulfilled condition precedent under s2(a)(iii), was not payable.

Despite this finding by Flaux J, the parties in Lomas agreed to proceed on the basis of the net approach. Briggs J, therefore, considered that no issue arose for the court to decide. He did, however, comment that, if the issue had been contentious, he might have found it difficult to disregard the findings of Flaux J.


The administrators also argued that s2(a)(iii) fell foul of the anti-deprivation rule of insolvency law. Briggs J described the anti-deprivation rule as a principle ‘which is easy to state, but difficult to apply’. The rule prevents parties, as a matter of public policy, from contracting out of the provisions of the insolvency legislation that govern the way in which assets are to be dealt with in a liquidation. For example, any attempt to deprive an insolvent company of an asset that would otherwise be available for distribution pari passu among the company’s unsecured creditors will be void.

The administrators argued that the effect of the condition precedent in s2(a)(iii) (as interpreted by the respondents) was that, on going into administration, LBIE was deprived of a valuable asset, namely the right to receive payments due from the respondents (assuming LBIE to be in the money). Therefore the condition precedent fell foul of the anti-deprivation rule.

Briggs J took as his starting point the fact that LBIE’s right to receive payments was subject to the condition precedent from the very outset of the swaps, and that the nature of that right did not change as a result of LBIE entering into administration. However, he accepted the administrators’ submission that the fact that such a flaw in an asset exists ab initio does not mean that in every case the contractual provision creating the flaw escapes the anti-deprivation rule.

Briggs J then went on to distinguish between the following two sets of circumstances:

  1. Where the asset of the insolvent company is a chose in action representing thequid pro quo for something already done, sold or delivered before the onset of insolvency. In this case the court will be slow to permit the insertion, even ab initio, of a flaw in that asset triggered by the insolvency process.
  2. Where the right in question consists of the quid pro quo (in whole or in part) for services yet to be rendered or something still to be supplied by the insolvent company in an ongoing contract. In this case the court will permit the insertion, ab initio, of such a flaw, there being nothing contrary to insolvency law in permitting a party either to terminate or adjust what would otherwise be an ongoing relationship with the insolvent company at the point when it becomes insolvent.

In the first example an attempt is made to deprive an insolvent company of a right it has already earned, whereas in the second case the parties are trying to regulate an ongoing relationship in which the insolvent company has an obligation to provide further services (which it may be unable to provide as a result of its insolvency).

In Lomas, the contingent rights to future net payments enjoyed by LBIE, as at 15 September 2008, under each of the swaps, were the quid pro quo not merely for services previously rendered to the swap counterparties, but for the ongoing provision of an interest rate hedge. LBIE’s insolvency was one of those events that was sufficient to undermine the basis of that ongoing relationship with its counterparties. Reduced to its bare essentials, the condition precedent that there should be (inter alia) no bankruptcy event of default was a provision designed to ensure that LBIE would only receive its quid pro quo for providing an interest rate hedge for as long as it was in a financial condition to be able to do so. Section 2(a)(iii) of the Agreement did not, therefore, fall foul of the anti-deprivation principle.

Briggs J warned, however, that his judgment was based on the interest rate swaps at issue in Lomas where there was an ongoing relationship between the parties. It was perfectly possible that a different analysis might be appropriate where an Agreement was used for a different kind of transaction. He also stated that he might have reached a different conclusion if the counterparties had not conceded that they were not entitled to prove in LBIE’s insolvency for any sums due to them without giving credit for any sums that would be payable by them but for s2(a)(iii) of the Agreement (see the section entitled ‘proving’ above). This was because, without such a concession, the effect of s2(a)(iii) of the Agreement could be to impose a greater financial obligation on LBIE in favour of a particular creditor by reason of LBIE’s insolvency, than would otherwise have been the case.


The administrators’ arguments were, to a large extent, based on the premise that the respondents’ interpretation of the Agreement afforded them a windfall at the expense of LBIE’s creditors. However, it should be noted that this will not be so in every case. The respondents were, as a result of LBIE’s insolvency, deprived of the right for which they had contracted; namely hedging protection against the risk of a rise in the relevant floating interest rate. While the Agreement provides, in theory, for the non-defaulting party to be compensated for the cost of finding an alternative transaction (having given credit for any unpaid amounts), that ‘apparently happy equivalence’ (to use the words of Briggs J) will be of little benefit where, as here, the defaulting party is not good for the money.

According to ISDA, the Agreement provides the contractual foundation for more than 90% of over-the-counter derivatives transactions globally. Briggs J noted that, given the importance and widespread use of the Agreement, it was axiomatic that it should, as far as possible, be interpreted in a way that serves the objectives of clarity, certainty and predictability, so that the very large number of parties using it should know where they stand. In providing clear guidance on the meaning and effect of s2(a)(iii) of the Agreement, the decision in Lomas goes some way to achieving that end. Counterparties remain free to provide for particular eventualities in a schedule.