English derivatives lawyers have become accustomed to waiting years for judicial guidance on the interpretation of market documentation. However, much like London buses, three significant judgments have recently been handed down in quick succession by the Courts. In this article, we summarise these recent decisions.

The anti-deprivation rule and its effect on modern commercial transactions

Belmont Park Investments Pty Limited v BNY Corporate Trustees Limited & Lehman Brothers Special Financing Inc [2011] UKSC 38

In a much anticipated decision, the Supreme Court (the UK's highest court) has upheld the validity of a "flip" clause (whereby the priority of claims to collateral held by a Security Trustee was altered in the event of default by the swap provider). The clause had been challenged by the American bankruptcy trustee of the swap counterparty (Lehman Brothers Special Financing Inc) on the grounds that it breached the English insolvency law 'anti-deprivation rule'. The anti-deprivation rule applies to invalidate arrangements which deliberately and intentionally seek to remove assets from an insolvent's estate to the detriment of its creditors.

The Court upheld the principle that freedom of contract lies at the heart of English commercial law and stated that where sophisticated commercial parties had entered into an arrangement in good faith, the courts should be slow to invalidate the bargain which had been struck. The Court also found that the anti-deprivation rule does not apply where the deprivation in question takes place for reasons other than insolvency.

Although the Court did not go so far as to say there should be a general exception to the anti-deprivation rule where the party who would receive the benefit of the 'deprivation' (in this case the noteholders) was the source of funds for the assets, they noted that this may well be "an important, and sometimes decisive, factor in a conclusion that a transaction was a commercial one entered into in good faith."

One issue which had previously been the subject of focus amongst commentators was the 'flawed asset theory' (that is, the idea that the interest was always subject to the condition of the counterparty not going into insolvency and therefore no deprivation occurred). This theory forms a central pillar of the drafting of the ISDA Master Agreements. Although the Court did not discredit the theory, for the majority the fact that the flip clause was contained in the documents from the outset was not determinative of the question whether it contravened the anti-deprivation principle.

Disappointingly, the Court's decision does not expressly address the question of the extent to which the anti-deprivation rule is applicable in circumstances where the insolvent company is not an English company or subject to English insolvency law. The US Bankruptcy Court has reached a contrary conclusion on the application of the equivalent rule in relation to the same flip clause (albeit involving different noteholders). It seems probable that further litigation will ensue (perhaps focused specifically on the question of recognition of US insolvency judgments in England which potentially conflict with English judgments on the same issue) and developments on this aspect of the case will continue to be monitored closely on both sides of the Atlantic. Certainly, given the different approach taken by the two courts, we may start to see the increasing use of English (or non-US) swap counterparties in these types of transactions.

The approach of the Supreme Court reflects the desire of the courts to give effect to contractual terms agreed between parties. It will be a relief to market participants to note that the Court's judgment gives significant weight to the commercial context and sophistication of the parties. However, although the guidance given by the Court is useful, the application of the anti-deprivation rule remains a question to be considered on a case-by-case basis.

Are suspended payment obligations taken into account for netting purposes?

Pioneer Freight Futures Company Limited (in liquidation) v TMT Asia Limited [2011] EWHC 1888

Pioneer and TMT entered into a series of forward freight agreements, which incorporated by reference the 1992 ISDA Master Agreement. When Pioneer went into liquidation in December 2009, the FFAs terminated automatically. Pioneer had been subject to an Event of Default prior to Automatic Early Termination. TMT, relying on section 2(a)(iii) of the Master Agreement, denied that it was liable to Pioneer in respect of sums which it would have had to pay Pioneer in respect of certain of the FFAs had Pioneer not been subject to an Event of Default.

The main question for decision in the judgment was whether payment obligations which are suspended by virtue of section 2(a)(iii) are nonetheless taken into account for netting purposes under section 2(c).  In this regard, Gloster J reached a decision seemingly at odds with the much-criticised decision of Flaux J in Marine Trade SA v Pioneer Freight Futures Co Ltd BVI [2009] EWHC 2656.
Gloster J's general impression of the 'landscape' of the Master Agreement was that it strongly demonstrates an intention to provide for an equitable netting or set off of payments and obligations. She noted that a construction that entitles a Non-defaulting Party to insist on payment from a Defaulting Party on a gross basis "wholly undermines the commercial purpose [of section 2(a)(iii)] of mitigation of counterparty risk."  Gloster J noted that a construction of section 2 which enables a Non-defaulting Party to claim against a Defaulting Party on a 'gross' basis is contrary to the ethos of the Master Agreement and the "clear commercial purpose of the parties" that all amounts outstanding under all Transactions subject to one ISDA should be subject to automatic payment netting in respect of payments due on the same date.
Gloster J concluded that, for the purposes of determining what is due and payable under the automatic netting process in section 2(c) of the Master Agreement, the aggregate or gross amounts that are due from each party to the other in respect of Settlement Sums payable in the same currency on the same date are set off across the board, without regard to whether one or other party has complied with the conditions precedent specified in section 2(a)(iii).

The determination of Loss under the 1992 Master Agreement

Anthracite Rated Investments (Jersey) Limited v Lehman Brothers Finance S.A. (in liquidation) [2011] EWHC 1822

The final case involved structured notes issued by Anthracite, a special purpose vehicle which had entered into cash-settled put options transactions with Lehman under 1992 ISDA Master Agreements. The put options were intended to provide principal protection in respect of the collateral underlying the notes. Upon the bankruptcy of Lehman, the put options were automatically terminated pursuant to the Master Agreements and the question arose as to how the termination payment should be determined. The case concerned whether Anthracite could claim the replacement cost of the put option transactions based on the Loss methodology under the Master Agreements or whether the trigger of an early redemption of the notes allowed Lehman to claim that there had been a mandatory early termination of the put options which would entitle it to receive an early termination cash settlement amount under the terms of the Master Agreements.

The court held that Lehman was not entitled to claim the early termination cash settlement amount because the automatic early termination of the options precluded a subsequent mandatory early termination. The payments on early termination were instead to be determined under section 6(e) of the Master Agreement using the Loss methodology. The burden was on Lehman, as the defaulting party, to show that it was unreasonable for Anthracite to ascertain its loss using replacement transaction quotations, a technique that it was entitled to adopt under the Loss definition. The court concluded that it was not unreasonable for Anthracite to assess its Loss on the basis of the cost of a replacement transaction that would provide equivalent principal protection to the noteholders for the whole term of the notes, even though the notes were subject to early redemption as a result of the termination of the put options.

In affirming previous case law, Briggs J provided a useful summary of the considerations that the court would take into account when assessing the Loss calculation under the 1992 Master Agreement. In particular, Briggs J stated that (a) the dual control tests of commerciality and reasonableness override any assumption that the meaning of particular provisions in one transaction can be slavishly applied to the wide variety of transactions which may be entered into under the Master Agreement; (b) Loss and Market Quotation are aimed at achieving broadly the same result so can be used to cross-check each other; (c) Loss must be determined on the assumption that the terminated transaction would have proceeded to maturity and both parties would have performed their obligations (however improbable that might be); and (d) while common law principles provide guidance to the interpretation of 'loss of bargain' in the Loss definition, there must be no disapplication of the provisions of the contract in favour of general application of common law.


One of the key common themes in the recent cases highlighted above is the court's desire to give effect to the commercial intention of the parties and the commercial context of the transactions. Increasingly, the English courts have shown that they understand the intricacies of ISDA and other market documentation and have paid regard to the effect that decisions would have on market expectations. The increased legal certainty that the decisions bring should be welcomed, not just by impatient derivatives lawyers, but by all market participants.

Chris Arnold, a partner in the Derivatives and Structured Products practice, and Kristy Zander, Litigation partner at Mayer Brown International LLP