Off to the Courts Again — as a Friend

Recently we provided some background to our decision to go to court over the CFTC’s position limits rules. As we noted, that was a first for ISDA. Never before had we sued a regulator, and it is not an action we take lightly.

The halls of justice are not, however, entirely unfamiliar territory to us. Over the last several years, we have had an active program of filing friend of the court, or amicus, briefs on a variety of issues. Most of these briefs relate to issues raised in litigation involving the ISDA Master Agreement or other ISDA documents. To be true to our mission of providing safe, efficient markets it is necessary at times to intervene in a court case and provide judges with the benefit of our quarter century of experience.

A case in point is our involvement in the case of Lomas v JFB Firth Rixson, Inc. in which hearings in the English Court of Appeal have just concluded. ISDA was granted permission to intervene in the Firth Rixson case at the original trial and in the Court of Appeal. The Firth Rixson appeal was consolidated with the appeals of three other cases that also dealt with related provisions of the ISDA Master Agreement. Our General Counsel, David Geen, observed the arguments in court, and he has worked with our counsel to present our view to both the trial court and the Court of Appeal.

Firth Rixson involves Section 2(a)(iii) of the ISDA Master Agreement, the so-called flawed asset provision. Under that provision a party’s obligation to make payments is contingent on there being no Event of Default or Potential Event of Default with respect to its counterparty. In Firth Rixson the non-defaulting parties had declined to terminate their ISDA Master Agreements with Lehman Brothers International Europe (LBIE) and had not made payments to LBIE in reliance on Section 2(a)(iii). At issue is the proper interpretation of the clause and (in one of the other cases) its compatibility with the anti-deprivation principle under English insolvency law.

We commented on the lower court ruling when it was handed down in December 2010. We found much to like in the decision of that court, but one aspect was surprising. The court held that a party’s “suspended” payment obligations may be extinguished on the last date of payment on the transaction. That’s at odds with market expectations. So we weighed in with the Court of Appeal to reverse that one aspect of the ruling and affirm the rest of the reasoning of the lower court.

The judicial process is, however, not only a means of resolving current disputes; it provides guidance for future evolution of ISDA documentation. Together with close-out netting and the single agreement concept, the flawed asset provision is one of the pillars of the ISDA Master Agreement. We firmly believe that it serves a useful purpose in default situations by allowing a non-defaulting party the time to consider how they wish to proceed in light of their counterparty’s default without having to make the periodic payments that come due under outstanding transactions. Still, we understand that there is also an interest, particularly in insolvency, in achieving finality so that the insolvent party’s estate can be wound up as expeditiously as possible.

In light of the experience of Firth Rixson and other cases, we are in the process of considering what type of time limit the market may wish to put on the ability to rely on Section 2(a)(iii). This is being done with active engagement of key regulators. We encourage those among our membership who have an interest in this issue to join the Section 2(a)(iii) Working Group on the Members’ Portal.

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