This ruling focuses on the netting provisions of the 1992 ISDA Master Agreement (Multicurrency - Cross Border) and their relationship to the contractual set-off provision used by the parties in this case.
Each of the three defendants had entered into a Sterling Term Facilities Agreement (a Loan Agreement) with Anglo-Irish Bank plc, which on 1 July 2011 became the Irish Bank Resolution Corporation (the Bank) and each, to hedge its interest rate risk on loans drawn down under the Loan Agreement, had entered into related swaps with the Bank under a 1992 ISDA Master Agreement (Multicurrency - Cross Border) (the Master Agreement). Each Master Agreement was materially the same and had been amended, by a provision in the Schedule, to insert a contractual set-off provision in Section 6, as a new provision Section 6(f). This provision tracked the basic set-off provision contained in ISDA's User's Guide to the 1992 ISDA Master Agreements (at p56).
As the facts were essentially the same in relation to each defendant, Cooke J focused in his judgment on the defendant, Shanpark. One important fact was that Shanpark entered into the Loan Agreement with the Bank in December 2012, replacing all previous loan agreements. The swaps had been entered into under a Master Agreement concluded on 10 October 2007. So, the Loan Agreement post-dated the Master Agreement. Although it is not expressly stated in the judgment, presumably the same was true in relation to the other two defendants.
On 7 February 2013 the Bank was put into liquidation in Ireland, which constituted an Event of Default in relation to it. Shanpark did not exercise its early termination rights under the Master Agreement, but instead relied on Section 2(a)(iii), which provides that the payment and delivery obligations of a party under each Transaction under the Master Agreement are subject to the condition precedent that no Event of Default or Potential Event of Default has occurred in respect of the other party and that no Early Termination Date has occurred or been effectively designated.
On 20 December 2013 Shanpark repaid its loans in full. This constituted an Additional Termination Event under the Master Agreement, and the Bank as the Non?affected Party designated an Early Termination Date under Section 6(b)(i) of the Master Agreement, resulting in an Early Termination Amount, the amount of which was not disputed. The Bank notified Shanpark of this amount by letter on 6 January 2014, and it became payable to the Bank under Section 6(d)(ii) two business days later on 8 January 2014.
On 14 May 2015, the Bank, as part of its winding up, assigned to MHB-Bank AG (MHB-Bank) its claim for the Early Termination Amount due by Shanpark. MHB-Bank sought payment of the Early Termination Amount by these proceedings which it commenced on 24 June 2014.
Previously, Shanpark had separately sued the Bank alleging mis-selling of the swaps, in proceedings commenced on 26 November 2013 (the Parallel Proceedings).
When MHB-Bank sued for payment of the Early Termination Amount, Shanpark sought to net or set off (under Section 2(c) (Netting) and/or the inserted Section 6(f) (Set-off) of the Master Agreement) its unliquidated damages claim for mis-selling in the Parallel Proceedings against the Early Termination Amounts sought by MHB-Bank. Shanpark also alleged that, in its defence and counterclaim in the Parallel Proceedings, the Bank had exercised its contractual rights of set-off under the Loan Agreement and/or under Section s6(f) of the Master Agreement and the rights of MHB-Bank, as the Bank's assignee, were limited by and subject to that set-off.
The key issues considered by Cooke J, were the proper construction of Section 2(c) (Netting) and Section 6(e) (Payments on Early Termination) of the Master Agreement, the proper construction of the inserted Section 6(f) (Set-off) of the Master Agreement and the interrelationship between these provisions and certain provisions of the Loan Agreement. Cooke J also considered the effect of the Bank's statement of case in the Parallel Proceedings. There are some other interesting observations that are summarised in our "Comment" below.
One point to note when reading the judgment is that Cooke J makes the relatively common error of referring to the early termination of the Master Agreement, rather than the early termination of the Transactions. As a matter of construction, the Master Agreement is not terminated by notice designating an Early Termination Date under Section 6(a) or 6(b), and there is nothing in the judgment to suggest that the parties had amended the Master Agreement in this regard to provide otherwise. Cooke J set out the relevant provisions of the Master Agreement in his judgment in some detail. Fortunately, his analysis does not turn on this distinction. It is respectfully suggested that such references in his judgment can be read as shorthand for early termination of the Transactions, and the remainder of this note, for the sake of precision, will refer to early termination of the Transactions.
The difference between netting and set-off
Cooke J recognised that for the purposes of the Master Agreement "netting and set-off are two distinct concepts". Netting relates to amounts due under the Master Agreement (whether before or after early termination of the Transactions), while set-off permits (in certain circumstances) amounts payable under any other agreement to reduce the Early Termination Amount, which is in itself the result of close-out netting following early termination.
Netting under Sections 2(c) (Netting) and 6(e) (Payments on Early Termination)
Cooke J recognised that there are two separate netting regimes in the Master Agreement, payment netting under Section 2(c) and close-out netting under Section 6(e).
In relation to the first regime, payment netting, Cooke J noted that Section 2(c) ceases to apply once all of the Transactions have been terminated by the giving of a notice designating an Early Termination Date under Section 6. Furthermore, Section 2(c) only relates to amounts payable "on any date", "in the same currency" and "in respect of the same Transaction" (or more than one Transaction if the parties have so elected, which they did not in this case).
Cooke J made clear that there is no room for the setting off of unliquidated damages under Section 2(c) of the Master Agreement. He dismissed Shanpark's submission that the wording of Section 2(c) is very wide and could encompass a claim for mis-selling which arises "in respect of the same Transaction." Cooke J gave a number of reasons why Section 2(c) was inapplicable in the circumstances, including the following:
- Once the Master Agreement has been terminated there is no outstanding Section 2(a) payment obligation in respect of which netting or set-off could occur.
- Section 2(c) is concerned with "netting" of sums "specified in each Confirmation", namely those which are payable under Sections 2(a)(i) or 2(e) on the same date, in the same currency and in respect of the same Transaction. It has nothing to do with the Early Termination Amount payable under Section 6(e) or any set-off against it in respect of any amount payable under another agreement under the inserted Section 6(f).
- Unliquidated damages are not payable in respect of the same Transaction and arise outside of the Master Agreement altogether.
- Section 2(c) relates to obligations to pay arising on the same date. Any mis-selling cause of action arose long before the Early Termination Amount became payable.
- Unliquidated damages are not "payable" as they only become "payable" at the point at which they are ascertained by a court or agreed by the parties, which had not yet happened at the time of this judgment. The claims for damages could not be said to be payable on the same date as the Early Termination Amount became payable.
The second regime, close-out netting, applies following designation of an Early Termination Date by reason of the occurrence of an Event of Default or Termination Event. Once an Event of Default or Termination Event has occurred, Section 6 (Early Termination) comes into play. If a party exercises its right to designate an Early Termination Date, then Section 2 (Obligations) no longer applies.
In the calculations applicable on early termination, Section 6(e) takes into account the outstanding Section 2(a)(i) sums due in the context of early termination, and there is no room for the operation of Section 2(a)(iii) since Section 6(e) makes full provision for the way in which outstanding sums on the Transactions are to be taken into account.
Having held that there is no room for the setting off of unliquidated damages under Section 2(c) or Section 6(e), Cooke J then turned to consider whether unliquidated damages could be set off against the Early Termination Amount under the contractual set-off provision in Section 6(f) of the Master Agreement.
Set-off under the contractual set-off provision inserted by the parties
Section 6(e) of the Master Agreement (as per the standard form 1992 ISDA Master Agreement) is expressly stated to be "subject to any Set-off". As mentioned, the inserted Section 6(f) of the Master Agreement tracked the basic set-off provision contained in ISDA's User's Guide to the 1992 ISDA Master Agreements. At first blush, set-off under Section 6(f), rather than netting under Section 2(c), was a more appropriate route for Shanpark to use as it expressly envisaged the set-off of obligations arising outside of the Master Agreement.
However, Section 6(e) which specifically allows for "any Set-off" conflicted with the Loan Agreement, which included a provision excluding Shanpark's ability to make any deduction or exercise any set-off in relation to amounts due under the Loan Agreement or the Master Agreement but without prejudice to netting under Section 2(c) and Section 6(e) of the Master Agreement. Cooke J held that the Loan Agreement exclusion of set-off prevailed over Section 6(f) of the Master Agreement because the former post-dated the latter. The Loan Agreement provision should be read as recording the final agreement between the parties on the availability of set-off to Shanpark. This means that, even if Section 6(f) were otherwise available to Shanpark, it would not be entitled to exercise a right of set-off under Section 6(f) in any event.
But, in fact, it was clear that, regardless of the Loan Agreement, Shanpark was not entitled to exercise any right of set-off under the inserted Section 6(f). That provision was engaged only when there was a Defaulting Party or an Affected Party arising as a result of a Termination Event under Section 5(b)(iv) (Credit Event upon Merger) and was exercisable, in either case, only by the party that was not the Defaulting Party or the Affected Party. Shanpark argued that the Bank's entry into liquidation in February 2013 made it a Defaulting Party, entitling Shanpark, as the Non-defaulting Party, to exercise a right of set-off under Section 6(f). Shanpark had not, however, served a notice pursuant to Section 6(a) (Right to Terminate Following Event of Default) of the Master Agreement designating an Early Termination Date, but had chosen instead to exercise its right to rely on Section 2(a)(iii) of the Master Agreement.
The Bank subsequently terminated the swaps under Section 6(b) by reason of the repayment by Shanpark of the loans, which constituted an Additional Termination Event in respect of which Shanpark was the Affected Party. Cooke J held that while the Bank may, in a sense, have been a Defaulting Party from the time of its entry into liquidation, it ceased to be so upon the designation of an Early Termination Date under Section 6(b). Accordingly, there was no Defaulting Party for the purpose of Section 6(f) and no Affected Party in respect of Section 5(b)(iv). Accordingly, Section 6(f) was not engaged.
The effect of the Bank's statement of case in the Parallel Proceedings
In the Bank's statement of case (that is, its defence and counterclaim) in the Parallel Proceedings, it initially set out its position in the following words:
"If, which it is denied, the claimants have any claims against the Bank, the Bank will by way of defence set off against those claims amounts claimed by way of Counterclaim herein."
The statement of case then set out the Bank's entitlement to the Early Termination Amount plus accrued interest.
In its original defence in these proceedings Shanpark claimed that the statement quoted above in the Bank's statement of case in the Paralell Proceedings meant that the Bank had exercised its right of set-off under the Master Agreement and/or the Loan Agreement. In its amended defence served in December 2014, Shanpark also attempted to argue that either (i) it had exercised its right of set-off under Section 6(f) when responding on 7 January 2014 to the Bank's letter of 6 January 2014 setting out the Early Termination Amount, or (ii) if the defendants did not have any right to set off or net against that amount, then Shanpark became a Defaulting Party by failing to pay the Early Termination Amount, and the Bank had exercised its right of set-off against Shanpark. This is significant because if either party effectively exercised its right of set-off as argued by Shanpark, then no Early Termination Amount was due from Shanpark to MHB-Bank (as assignee of the Bank's claim for the Early Termination Amount), because the amount claimed under the mis-selling action in the Parallel Proceedings substantially exceeded the Early Termination Amount.
Cooke J gave short shrift to these submissions on the basis that (a) Section 6(f) of the Master Agreement was not available to either party (as there was no Defaulting Party or Affected Party further to a Credit Event upon Merger) and (b) the set-off clause contained in the Loan Agreement was also not available to either party. Regarding the latter point, Clause 31 (Set-off) of the Loan Agreement only permitted the Bank to exercise a contractual right of set-off and only in relation to "matured obligations". Therefore, the Bank could not have effectively exercised a right of set-off under that clause in relation to Shanpark's claim for unliquidated damages.
There was some discussion as to how set-off under the inserted Section 6(f) can be effected. Cooke J made clear that the Bank's reference to set-off in its statement of case in the Parallel Proceedings, which the Bank subsequently withdrew, did not amount to the exercise of set-off. Instead, it was merely an expression of its intention to exercise a set-off, contingent on Shanpark establishing liability against it either by agreement or the obtaining of a relevant judgment (which as at the date of the trial in these proceedings, Shanpark had not).
Interestingly, Cooke J stated that if Shanpark had had a right of set-off under Section 6(f), it would not have mattered that it purported in its letter to the Bank of 7 January 2014 to exercise such right under Section 2(c) of the Master Agreement or under a provision of law which did not justify it. In Cooke J's view, its assertion of its intent to set off its damages claim against the Early Termination Amount (which, as noted above, became payable on 8 January 2014) would have been good enough despite the lack of an explicit reference to Section 6(f).
Notwithstanding Cooke J's conclusion that the set-off provisions in the inserted Section 6(f) of the Master Agreement did not apply on the facts, Cooke J went on to consider in obiter dicta whether, if Shanpark had in fact had a right of set-off under that provision, a claim for unliquidated damages could fall within it. Although Cooke J accepted that Section 6(f) had been drafted with contractual debts in mind, he held that the terms of the provision were wide enough also to allow unliquidated damages to be set off against the Early Termination Amount:
"Section 6(f) specifically allows for the set off of amounts which are not yet due and which are only contingently due. Claims for unliquidated damages will only become a debt upon judgment being given by a court or upon agreement between the parties but Section 6(f) allows for a good faith estimate to be made, which in itself involves a good faith estimate of the existence of duty and breach, as well as damages". (para 73)
Cooke J thought that this was the effect, in particular, of two specific parts of the inserted Section 6(f), namely:
- The definition of "Other Agreement Amounts", which refers to the amounts due to the party exercising the set-off to be used to discharge an Early Termination Amount owed by that party, and which is defined as follows "any amount(s) - payable (whether at such time or in the future or upon the occurrence of a contingency) by the Payee [the party entitled to payment of the Early Termination Amount] to the Payer (irrespective of the currency, place of payment or booking office of the obligation) - under any other agreement(s) between the Payee and the Payer or instrument(s) or undertaking(s) issued or executed by one party to, or in favour of, the other party)"; and
- The provision permitting that party, in the case of an obligation that is unascertained, to estimate it in good faith and set off in respect of the estimate, subject to the relevant party accounting to the other when the obligation is ascertained.
Cooke J was not deterred from this conclusion by the argument of MHB-Bank that unliquidated damages are not "payable" under an agreement, instrument or undertaking between the parties. It does, however, appear to have been part of his reasoning that the claim for unliquidated damages must arise from a breach of a contract between the parties and not on some other basis. Query whether a claim for damages for mis-selling arose in this case from a breach of contract or as a breach of a fiduciary duty owed to Shanpark (and each other defendant) by the Bank.
Comment
While Cooke J affirms the distinction between netting and set-off, he makes it clear that he is doing so in the context of the Master Agreements at issue in this case, including the inserted Section 6(f) setting out a contractual set-off provision. He limits his delineation of the distinction to pointing out that payment netting is the mechanism in Section 2(c), close-out netting is the mechanism in s6 and set-off, in this case, is the mechanism set out in the inserted Section 6(f). He does not attempt a deeper analysis of the distinction (of the type, for example, set out in our opinion addressed to ISDA on the enforceability under English law of close-out netting under the ISDA Master Agreements). In fact, in para 55 of his judgment, he also says that "the netting specifically provided for in Sections 2(c) and 6(e), which are the netting provisions, ... could be seen as a form of set off". So, this judgment is of limited utility on the question of the distinction between netting and set-off.
Another point that limits the potential utility of this judgment is the fact that it turns on the construction of a form of contractual set-off provision that is not part of the standard form of the 1992 ISDA Master Agreement but was instead added by the parties. While the added provision tracks the basic set-off provision in the 1992 User's Guide, that provision is not in universal use in the market. Some parties do not include a contractual set-off provision in the 1992 version of the ISDA Master Agreement, and many that do include one, either substantially amend the User's Guide version or simply use a different form of contractual set off provision. It is perhaps worthy of note that the contractual set-off provision in Section 6(f) of the 2002 version of the ISDA Master Agreement varies in some important ways from the basic set-off provision in the 1992 User's Guide, and so this judgment will be of limited relevance to the construction of Section 6(f) of the 2002 version.
Accordingly, while this is a sound and sensible decision that is largely in accord with what we believe to be the general market understanding of the relevant provisions of the 1992 ISDA Master Agreement, it is principally a careful and sensible application of well known principles to a particular set of facts. It does not break new ground (and it is doubtful that Cooke J would consider that it did), and therefore the judgment may not be of particular importance as a precedent. It may, however, be helpful in dissuading future litigants from running some of the hopeless arguments raised by Shanpark in this case.
Having said that, some interesting points are raised by this case:
- The case illustrates the importance of Shanpark's decision to rely on Section 2(a)(iii) after the Bank went into liquidation rather than having taken the initiative by designating an Early Termination Date under Section 6(a). Had it done so, then it would have been able to rely on the inserted Section 6(f) and avoided having to pay the Early Termination Amount to MHB-Bank while holding an irrecoverable mis-selling claim against an insolvent bank. While it is comparatively rare for a Non-defaulting Party to rely on Section 2(a)(iii) indefinitely (as was indirectly confirmed by the Lomas v Firth Rixson case, where the respondents were, in fact, the only counterparties out of hundreds of Non-defaulting Parties relative to Lehman Brothers (International) Europe as the Defaulting Party, to do so), this case provides a further cautionary tale pointing to the wisdom of a Non-defaulting Party closing out following an Event of Default within a reasonable period of time.
- In one part of the judgment, Cooke J considers First Method in order to contrast it, for purposes of his analysis, with Second Method, which actually applied in this case. While he only does so in passing, it is interesting that he does not raise a hint of a suggestion that First Method would not be enforceable under English law. While this is hardly a ringing judicial endorsement of First Method, it may provide some comfort to any parties who have elected First Method in their 1992 ISDA Master Agreement (which would these days be a relatively rare case), given the relative scarcity of other judicial consideration of the issue.
Cooke J dealt robustly with Shanpark's argument (in order to be able to exercise the right of set-off under Section 6(f)) that the Bank was the Defaulting Party under the Master Agreement, by virtue of its entry into liquidation, notwithstanding that Shanpark had never designated an Early Termination Date in respect of that Event of Default). Cooke J made it clear that the term "Defaulting Party" is defined in Section 6(a) and simply refers to the party in respect of whom an Early Termination Date is designated by the other party, defined as the "Non-defaulting Party". He notes that the Non-defaulting Party:
"is the one who sends the notice specifying the relevant Event of Default and designating the Early Termination Date, whether or not that party is itself in default in any material respect and whether or not the other party could have served a notice under Section 6(a) (but did not do so)".
In our view, this is obvious and clearly the correct construction of Section 6(a), but it is helpful to have judicial endorsement of the point.
One aspect of the judgment that might seem surprising to some was Cooke J's conclusion, albeit obiter, that the form of contractual set-off in this case (the inserted Section 6(f)) was broad enough to permit the party exercising the right of set-off to include claims for unliquidated damages in order to reduce its liability to pay an Early Termination Amount to the Defaulting Party or Affected Party in relation to a Credit Event Upon Merger. While Cooke J's conclusion appears to be limited to claims for unliquidated damages arising from a breach of agreement, it may be that parties wish to amend their contractual set-off provision, whether it is one added to a 1992 ISDA Master Agreement or it is Section 6(f) of the 2002 ISDA Master Agreement, to exclude claims for unliquidated damages. Having said that, a Non-defaulting Party will generally want the broadest possible right of set-off against a Defaulting Party and will generally have an interest in submitting a claim in administration or winding up proceedings in respect of the Defaulting Party that is less, rather than more, likely to be challenged. In practice, therefore, there may be a danger of overstating the risk that a Non-defaulting Party will abuse the possibility of including claims for unliquidated damages within the scope of a contractual set-off under the ISDA Master Agreement.
Further information
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