Continue or heal? Suspension of swap payments following an event of default may not be unlimited | Hogan Lovells


The decision of the High Court (The joint administrators of Lehman Brothers International (Europe) against FR Acquisitions Corporation (Europe) Ltd and JFB Firth Rixson Inc [2022] EWHC 2532 (Ch)) arose in the context of a dispute between the co-directors of Lehman Brothers International Europe (LBIE) and swap counterparties FR Acquisitions Corporation (Europe) Ltd and JFB Firth Rixson Inc. (together, Firth Rixson) relating to certain interest rate swaps. The affected swaps were governed by the ISDA Master Agreement of 1992 and the ISDA Master Agreement of 2002 (the ISDA Master Agreements), respectively, and were due to mature in December 2010. Following a significant decline in the floating interest rates payable by LBIE under each swap, LBIE, although under administration, had the right to receive a net payment from the counterparties, but no payments were made due to events of default on the part of LBIE.

Since the appointment of LBIE’s directors in September 2008, Firth Rixson has relied on Section 2(a)(iii) of the ISDA Master Agreements to suspend its payment obligations to LBIE. This provision subjects swap payments 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”. In 2012, the Court of Appeal ruled that so long as the event of default relating to LBIE continued, Firth Rixson would have no obligation to make payments under the swap agreements, but that the payment obligations would be “re-roll if the Default Event is cured”.

After a decade of administration of LBIE, the joint administrators sought to terminate their appointments under Section 79 of Schedule B1 of the Insolvency Act 1986 and return LBIE to the control of its administrators . In this case, LBIE argued that no Event of Default or Potential Event of Default would “continue” under the ISDA Master Agreements and that the suspension of payment obligations would cease. The concept of what constitutes a “Continue” The event of default is not addressed in the ISDA Master Agreement and so there has been uncertainty as to how it works in practice.

Event of Default

A number of Default Events had initially occurred with respect to LBIE:

  • Section 5(a)(i): Non-payment by LBIE of two amounts due under the sterling swap: it has been agreed that this Event of Default will no longer continue since the corresponding payment obligation has been fully discharged by the insolvency operation trigger.

  • Section 5(a)(vii)(2): “The party, any credit support provider of that party or any applicable specified entity of that party … becomes insolvent or is unable to pay its debts or fails or admits in writing its general inability to pay its debts as they become due.“: it was common ground between the parties that this Event of Default ceased to be “persistent”.

  • Section 5(a)(vii)(3): “The party, any credit support provider of that party or any applicable specified entity of that party … (3) makes a general assignment, arrangement or composition with or for the benefit of its creditors.” (the “Scheme Event Of Default”): the Court examined whether the concordat concluded by LBIE within the framework of its administration (the “Scheme“) was an “arrangement” for the purposes of this provision and concluded that the scheme did not affect, much less adversely affect, the credit risk to which any creditor had accepted and that the scheme was and is not a “arrangement” entered into by LBIE “with or for the benefit of its creditors” within the meaning of Article 5(a)(vii)(3).

  • Section 5(a)(vii)(4): “The party … institutes or has instituted proceedings against it seeking an insolvency or bankruptcy judgment or other relief under any bankruptcy or insolvency law or any other similar law affecting the rights of creditors …” and Section 5(a)(vii)(6): “The party…requests or becomes subject to the appointment of an administrator, provisional liquidator, custodian, receiver, trustee, custodian or other similar official for it or for all or substantially all of its assets“: It is common ground that these Events of Default occurred with regard to LBIE due to the entry into administration of LBIE on September 15, 2008 and the appointment of the co-administrators of LBIE on the same date and continued at the date of the application to the Court, but where the dispute arose was whether these events of default would cease to be “continuing” if and when the appointments of the joint administrators of LBIE were terminated pursuant to paragraph 79 of Schedule B1 of the Insolvency Act 1986.

  • Section 5(a)(vii)(8): “The party…(8) causes or is subject to any event relating to it which, under the applicable laws of any jurisdiction, has an analogous effect to any of the events specified in clauses (1) to (7) above (included) “: Firth Rixson argued that the recognition of the aforementioned Scheme as a foreign proceeding under Chapter 15 of the U.S. Bankruptcy Code resulted in permanent and incurable events of default under Sections 5(a)(vii) )(4) and 5(a) )(vii)(8), which continue. The Court held that the Chapter 15 order was not a separate event of default and that, considered in context, Section 5(a)(vii)(4) should be limited to proceedings concerning distressed companies and that neither Chapter 15 nor the subsequent Chapter 15 order constituted an event of default if the plan had not

Carry on or Cure – the arguments

Firth Rixson asserted that the default events that occurred when LBIE came into operation have not, and cannot, be corrected and are therefore continuing. Concretely, since the transformation of the LBIE heritage into distributive administration, the administration has been “functionally equivalent” liquidation with realization of the assets and distribution of the proceeds in a significant and irretrievable manner. In this sense, events of default cannot be “cured” by the application of insolvency law by terminating the administration and to accept it as such would not be consistent with the meaning and the effect of the language used in the ISDA Master Agreements on the event having to be “continuing”.

With respect to the remaining default events other than the non-payment default event, LBIE argued that the term “continuing” indicates an ongoing process or a continuing situation. To decide whether an event of default continues, it is necessary to identify the process or state of affairs that constitutes the event of default and to decide whether that process or state of affairs continues to exist.

LBIE further argued that this is the only point that needs to be assessed in order to determine whether an Event of Default continues. Section 2(a)(iii) makes no reference to the continuing legal effects of an Event of Default, only to the continuation of the Event of Default itself. Where possible, deference should be given to the plain language of the clause in determining the relevant process or state of affairs. This is consistent with the requirement that the ISDA Master Agreement be interpreted, to the extent possible, in a reasonably foreseeable, objective and certain manner. For example, under Article 5(a)(vii)(4), the relevant process or state of affairs is a “proceed” below “insolvency law“.LBIE argued that it follows that when the insolvency proceedings end, the Default Event necessarily ceases to continue.

Sue or Cure – the conclusion

Judge Hildyard found that the insolvency events relating to “factual events or states of affairs” in the absence of any consideration of the effect of events on the Non-Defaulting Party. The appropriate test is therefore whether the situation which constituted the event of default continues and not whether the effects on the rights of creditors are continuous or irreversible. This means that, in the particular circumstances of LBIE, the termination of the appointment of the joint administrators will remedy the event of default currently existing under section 5(a)(vii)(4) and, as such, the Firth Rixson’s obligation to pay under the ISDA Master Agreements will cease to be suspended.

Looking forward

This judgment has significant ramifications for counterparties who have relied on the condition precedent set forth in Section 2(a)(iii) of the ISDA Master Documentation in relation to Lehman and other similar situations. When a defaulting party such as LBIE ceases to be in administration, positions that may have expired some time ago will need to be reviewed to assess whether a liability now arises, along with any applicable interest that has accrued on that amount. Each case will be specific to the facts and therefore the parties will need to both check the terms of their documentation and also have a detailed understanding of the situation with respect to the defaulting counterparty.

This decision is also likely to have implications for other funding documents and so the concept of whether or not a particular event will continue will need to be considered in a new light.

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