High Court rules on continuing status of Lehman Brothers
24 October 2022
24 October 2022
On 11 October 2022, Mr Justice Hildyard handed down his judgment in Grant & Ors v FR Acquisitions Corporation (Europe) Ltd & Anor (Re Lehman Brothers International (Europe))1, the latest piece of Lehman Brothers litigation to be heard in the English High Court.
Key issues addressed
- Did the application of mandatory insolvency set-off in December 2009 cure LBIE's 2008 "Failure to Pay" Events of Default, such that they ceased to be "continuing" for Section 2(a)(iii) purposes? The Court held that it did.
- Was the LBIE Event of Default that occurred when LBIE admitted that it was unable to pay its debts as they fell due capable of "continuing", or was it merely a one-off event? The Court held that such an Event of Default is capable of continuing, and continues until actual or constructive notification of solvency is given.
- Can the LBIE Events of Default that occurred as a result of LBIE's entry into administration be cured? If so, can they only be cured if the effects of the administration on creditors are no longer continuing? The Court held that they can be cured, and will be cured upon LBIE's exit from administration as a solvent entity able to pay its debts as they fall due. Any permanent alteration of creditors' rights caused by the administration would not prevent this.
- Did the Scheme of Arrangement sanctioned by the Court in June 2018 constitute an "arrangement […] with or for the benefit of its creditors" under the ISDA Master Agreement, giving rise to an Event of Default? The Court held that, on the facts, it did not; however, if it had done, the ongoing nature of the Scheme would give it "continuing" status irrespective of the status of the administration.
- Did the Order made under Chapter 15 of the US Bankruptcy Code recognising and giving effect to the Scheme of Arrangement in the United States constitute an Event of Default under the ISDA Master Agreement? The Court held that it did not.
- Did the Spanish and French "exequaturs" constitute Events of Default under the ISDA Master Agreement? The Court held that they did not.
The Court also considered the commercial purpose of section 2(a)(iii), being to protect against increased credit risk when facing a potentially defaulting counterparty. Hildyard J found that, as the swaps terminated over ten years ago with Firth Rixson as the net debtor, none of the actual or alleged Events of Default increased Firth Rixson's credit risk on LBIE.
The case is principally concerned with whether the two Respondents, both of which are part of the Firth Rixson group of companies (Firth Rixson), can continue to rely on the application of Section 2(a)(iii) of the ISDA Master Agreement to withhold payments of approximately £8mn and $53.5mn (exclusive of interest) owed to Lehman Brothers International Europe (LBIE) under two interest rate swaps that terminated in 2010.
The answer depends on whether or not any Event of Default that has occurred in respect of LBIE is "continuing" within the meaning of Section 2(a)(iii). As part of his judgment, Hildyard J considered (i) the nature of certain acknowledged Events of Default and whether they were continuing or had been "cured", and (ii) whether additional, disputed, Events of Default had also occurred in respect of LBIE. He concluded that, once LBIE has exited administration and publicly confirmed that it is able to pay its debts as they fall due, Section 2(a)(iii) will no longer apply and Firth Rixson will be obliged to pay the outstanding sums owing to LBIE.
Those familiar with earlier case law relating to Section 2(a)(iii) and the duration of its suspensory nature will note that this most recent case follows the 2011 Court of Appeal conclusion in Lomas & Ors v JFB Firth Rixson Inc & Ors that the suspensive effect of Section 2(a)(iii) "continues in force until the Event of Default is cured. If it is never cured, there continues to be no obligation on the Non-defaulting Party to make payment"2. As part of his judgment, Hildyard J also considered the commercial purpose of Section 2(a)(iii), as discussed further below.
The case concerns two interest rate swaps entered into between LBIE and two members of the Firth Rixson group of companies: FR Acquisitions Corporation (Europe) Ltd and JFB Firth Rixson Inc. The swaps were entered into in November 2007 and terminated in December 2010. One was denominated in Sterling; the other in US Dollars. Each was governed by the ISDA Master Agreement.
After LBIE entered into administration in September 2008, it failed to make two payments under the Sterling swap, giving rise to a "Failure to Pay" Event of Default under Section 5(a)(i) of the ISDA Master Agreement. The entry into administration also gave rise to insolvency-based Events of Default under Sections 5(a)(vii) (2), (4) and (6) of the ISDA Master Agreement. Each Event of Default gave the Firth Rixson the right to close out the swaps.
The ISDA Master Agreement provides at Section 2(a)(iii) that, if an Event of Default or a Potential Event of Default has occurred and is continuing (our emphasis), the Non-defaulting Party is not obliged to make any payments to the party in default, or potentially in default. After much debate about how long a Non-defaulting Party may rely on Section 2(a)(iii), it was held by the Court of Appeal in Lomas & Ors v JFB Firth Rixson Inc & Ors that the suspensive effect of Section 2(a)(iii) "continues in force until the Event of Default is cured. If it is never cured, there continues to be no obligation on the Non-defaulting Party to make payment"3.
As they were out of the money to the tune of approximately £8mn and $53.5mn (exclusive of interest), rather than electing to close out the swaps upon LBIE's default, the non-defaulting Firth Rixson entities instead relied on Section 2(a)(iii) for over ten years. In the judgment, Hildyard J says that they "probably expected that the administration would end in LBIE's dissolution […]". In fact, the administration was very successful and at the time of the hearing LBIE's administrators were in the process of bringing the administration to an end and returning LBIE, as a solvent entity, to the control of its directors.
As a result, Hildyard J was required to determine (i) whether any of the Events of Default that had occurred in respect of LBIE was still continuing within the meaning of Section 2(a)(iii), allowing Firth Rixson to continue to rely on Section 2(a)(iii) and, (ii) if so, whether and how any such Event of Default could be cured such that it was no longer continuing.
In doing so, Hildyard J considered the commercial purpose of Section 2(a)(iii), which was originally described in Pioneer Freight Futures Co Ltd v TMT Asia Ltd4 as being "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."
A similar analysis was also applied in Lomas v Firth Rixson Inc.5 : "… the purpose of Section 2(a)(iii) is to protect the Non-defaulting Party from the additional credit risk involved in performing its own obligations whilst the defaulting counterparty remains unable to meet its own."
Hildyard J returns to this point several times throughout his judgment, including in the summary, in which he says that none of the actual or alleged Events of Default on which Firth Rixson relies affects, or will affect, their credit risk to LBIE. The swaps terminated in 2010 with Firth Rixson as the net debtor: therefore, there is no risk to Firth Rixson of LBIE failing to make any payments to it, as no such payments are, or ever will be, due.
The analysis applied to each of the LBIE Events of Default is summarised below.
As discussed above, LBIE had failed to make two payments under the Sterling swap, giving rise to an Event of Default under Section 5(a)(i) of the ISDA Master Agreement. Firth Rixson did not exercise its right to terminate the swap, choosing instead to rely on the suspensory nature of Section 2(a)(iii). Thereafter, movements in interest rates meant that Firth Rixson became a net debtor under the Sterling swap, and continued to rely on Section 2(a)(iii) to withhold payment.
In December 2009, LBIE's administrators gave notice of their intention to make a distribution to unsecured creditors under the Insolvency Rules 1986 (now the Insolvency (England and Wales) Rules 2016). The notice engaged the mandatory set-off regime under the Rules, under which, where an administrator intends to make a distribution, and has provided notice thereof, "an account must be taken as at the date of the notice of what is due from the company and a creditor to each other in respect of their mutual dealings and the sums due from the one must be set off against the sums due from the other"6.
The effect of the mandatory set-off was to discharge the cross-claims owing between the parties and replace them with a single claim by LBIE against Firth Rixson. According to Hildyard J, this meant that the Failure to Pay Event of Default had effectively been cured, as the amounts owing by LBIE had been repaid by way of the mandatory set-off.
LBIE asserted that its admission of its inability to pay its debts as they fell due was an incurable, "one-off", Event of Default 7, that was by its very nature incapable of "continuing" once the admission had been made. They went on to say that, in any event, any "continuing" nature of the event had been nullified by the fact of solvency.
Firth Rixson argued that the Event of Default would continue until the admission had been formally withdrawn or corrected.
The Judge agreed with Firth Rixson on the first point, saying that any such admission "speaks to a continuing inability in that regard unless and until it is corrected". However, the Judge went on to say that, in his view, LBIE's original notice of its inability to pay had been corrected, by the administrators' positive reports and the related widespread publicity. He said that, as a practical matter, the general perception would be that the original admission had been superseded and that creditors would consider LBIE to be a solvent entity again.
Notwithstanding this, LBIE was ordered to publish a formal notice to the effect that it had a surplus of assets over liabilities and was able to pay its debts as they became due, to settle the matter for both parties.
Both Firth Rixson and LBIE accepted that LBIE's entry into administration gave rise to Events of Default under Sections 5(a)(vii)(4) and (6) of the ISDA Master Agreement. Both parties also accepted that the events were continuing for Section 2(a)(iii) purposes at the date of the hearing. What was in dispute here was whether the Events of Default would cease to be continuing once LBIE had exited administration as a solvent entity.
LBIE's argument was that, once the administrators' appointments had been terminated, and LBIE was no longer in administration, these Events of Default would no longer be continuing and would therefore have been cured.
Firth Rixson disagreed, arguing that court-sanctioned distributions to creditors had made the administration "functionally equivalent" to a liquidation and permanently altered creditors' rights. They maintained that it was not the administration itself that had to be continuing to allow continued reliance on Section 2(a)(iii), but the effect on creditors' rights. As creditors' rights had been permanently and irrevocably altered, the Event of Default would continue indefinitely.
Hildyard J agreed with LBIE on this point, holding that the relevant test is whether the identified event or state of affairs (i.e. the administration) is continuing, rather than whether creditors' rights continue to be affected by the administration. The conclusion was therefore that, once the administration had been discharged, the Events of Default would no longer be continuing.
In addition to the above issues, the Court was also asked to consider whether various additional Events of Default under the ISDA Master Agreement had also occurred.
Firth Rixson alleged that:
Firth Rixson also asserted that, because of the ongoing nature of the Scheme, the Order and the Exequaturs, each of the alleged Events of Default was still continuing, and would remain so while the Scheme remained in place, allowing for Firth Rixson's continued reliance on Section 2(a)(iii) to withhold payment to LBIE.
However, the Court did not agree. Hildyard J held that none of the above developments gave rise to an Event of Default, for multiple reasons, including that:
Notwithstanding this, of particular note is Hildyard J's comment, albeit obiter, that if the Scheme had been held to constitute an "arrangement" under Section 5(a)(vii)(3), and had therefore triggered an Event of Default, that Event of Default would remain continuing for as long as the Scheme had effect, irrespective of the cessation of the administration itself. In so commenting, the Judge appears to be distinguishing between (i) the duration of the effects of an administration, in respect of which the permanent alteration of creditors' rights was not considered sufficient for the related Event of Default to continue indefinitely, and (ii) the duration of the effects of an "arrangement", which, according to the Judge, continue to subsist after termination of the administrators' appointment, "even when all steps necessary to accomplish [the arrangement] have been taken".
Authors: Jonathan Haines and Kirsty McAllister-Jones