29 March 2005
Key Points:
The NSW Court of Appeal confirms the effectiveness of certain aspects of the ISDA Master Agreement in an insolvency situation.
The New South Wales Court of Appeal recently affirmed the decision of the Supreme Court handed down in connection with Enron Australia v TXU Electricity on 24 December 2003. The Court of Appeal decision is significant because:
The facts
Enron Australia and TXU Electricity had entered into a number or electricity swaps governed by the 1992 ISDA Master Agreement. Enron defaulted under the ISDA Master Agreement when it commenced voluntary insolvency proceedings in December 2001, at which time a number of swaps were outstanding. If TXU had exercised its rights to close-out the outstanding swaps at that time, it would have owed Enron a net amount of approximately A$3.3 million, representing its net out-of-the money position across these transactions at the time of Enron's default. However, TXU chose not to exercise its close-out rights and instead relied on Section 2(a)(iii), the so called "flawed asset" clause. This clause makes it a condition precedent to each payment by a counterparty that the other party is not in default or potentially in default. As a result, TXU was able to suspend any further payments it would otherwise have been liable for under the outstanding transactions and indefinitely defer the crystallisation of its net out-of-the-money position.
The ISDA Master Agreement included an Additional Termination Event under which the defaulting party had rights to close-out outstanding transactions where the non-defaulting party refused to close-out in reliance of Section 2(a)(iii), provided the Defaulting Party had satisfied all if its present and future payment obligations to the other party. Because Enron had future payment obligations under the outstanding transactions, it was not able to exercise these rights until the expiry of the last outstanding swap.
The liquidator of Enron sought the leave of the Court to disclaim the outstanding transactions and at the same time sought additional orders under section 568(1B)(b) of the Corporations Act to the effect that Enron's net in-the-money position would be crystallised immediately, rather than at the expiry of the last outstanding swap. The liquidator sought the additional orders because without them, the disclaimed contracts would have had no value to Enron on the basis that they would have simply ceased to exist.
Section 568(1B)(b) of the Act empowers the Court, on an application for leave by a liquidator to disclaim a contract, to make such orders on matters relating to the contract as the Court considers just and equitable.
At first instance the Court rejected the liquidator's claim, refusing to make additional orders which interfered with the parties' express contractual rights to "decline to trigger early termination, and of the benefits that would derive from that course".
Limitations on the Court’s powers to make additional orders confirmed
The appeal by the liquidator was unanimously dismissed by the Court of Appeal which held that although the powers of the Court under section 568(1B)(b) are expressed in broad terms, they should be construed subject to the purpose of Division 7A of the Act, which is to facilitate the prompt and efficient liquidation of a company and "the means chosen to achieve that objective are not at large". The Court concluded that section 568(1B)(b) does not empower the courts, when granting leave to liquidators to disclaim contracts, to make additional orders which would have the effect of altering accrued contractual rights of non-disclaiming parties, where it was not necessary to affect those rights in order to release the company or its property from liability.
Effectiveness of the flawed asset provisions upheld on insolvency
The recognition by the Court of Appeal of the effectiveness of the flawed asset clause in the ISDA Master Agreement is a positive result for the OTC markets. It demonstrates that the clause is sufficiently robust to survive insolvency and highlights the reluctance of the courts to rewrite contracts, notwithstanding the undesirable or unintended consequences their terms may have for the parties.
Commercial considerations for OTC market participants
Enron v TXU is important for demonstrating some significant major implications of the flawed asset clause which, up until recently, have received relatively little attention from OTC market participants; the most significant of these being the ability of the flawed asset clause to deliver a windfall to an out-of-the-money non-defaulting party who refuses to make further payments under outstanding transactions in reliance on this clause. Where the defaulting party is insolvent, the ability of the flawed asset clause to deliver this windfall may be of little interest to the defaulting party (most of whom will not be concerned with the ability of their creditors to access their assets), but will be of critical importance to financiers and other creditors of the defaulting party, to financial institutions subject to capital adequacy regulation (see our comments below) and to regulators responsible for managing systemic risk in the financial markets.
The Additional Termination Event in Enron v TXU would have denied the non-defaulting party the windfall benefit if it had permitted the defaulting party to close-out outstanding transactions, whether or not it owed future or present obligations under them. The reason why it stopped short of this relates to the purpose for which it was originally conceived; namely to address concerns that Section 2(a)(iii) could operate unfairly in relation to a buyer of an option (or other derivative which requires the payment of an up front premium by one party) where the buyer is affected by an event of default (eg. insolvency) but has performed all of its payment or delivery obligations under the option (ie. by payment of the option's premium). The Additional Termination Event therefore did not contemplate the specific risks that could arise where a non-defaulting party refuses to make additional payments under outstanding transactions (in reliance on the flawed asset clause) in circumstances where the defaulting party continues to owe present or future obligations in relation to those transactions.
Permitting a defaulting party to close-out outstanding transactions, whether or not it owes future or present obligations under them, might also address other problems which Enron's liquidator may face if it seeks to exercise its close-out rights under the Additional Termination Event in Enron v TXU at the time the last outstanding swap it has with TXU expires. At this time, the Unpaid Amounts it will seek to recover will be defined by reference to "Terminated Transactions" which in turn will be defined as the relevant Transaction "in effect immediately before the effectiveness of the notice designating the Early Termination Date". The determination of the Unpaid Amounts will be problematic if no Transactions are in effect at the time Enron's liquidator designates an Early Termination Date.
Another question of general relevance is whether the flawed asset clause will apply to any claim by a liquidator to enforce payment of Unpaid Amounts after the expiry of outstanding transactions that have not been closed-out.
Questions for prudential regulators
The capital adequacy guidelines issued by the Australian Prudential Regulation Authority (APRA) permit Authorised Deposit-Taking Institutions (ADIs) to account for their derivatives exposure on a net basis if, among other requirements:
Dealing with the first two of these requirements, the existence of the flawed asset clause should not affect the ability of the ISDA Master Agreement to limit any claim by a party to receive or pay a net sum representing the positive and negative mark-to-market values of the transactions covered by the agreement. Similarly, legal opinions as to the enforceability of the netting provisions of an ISDA Master Agreement should not be affected by the Enron v TXU decision. In each case, this is because the flawed asset clause affects the timing for the trigger for the operation of the netting provisions, rather than the enforceability of these provisions once they have been triggered. In other words reliance on the flawed asset clause by a non-defaulting party may prevent (or at least defer) any claims or obligations arising from which a net payment or receipt can be determined, but should not affect the determination of a net payment or receipt in respect of these claims or obligations should (or once) they arise in the future.
Whether the flawed asset clause could be characterised as a "walkaway" clause for the purposes of APRA's capital adequacy guidelines is less certain. Clauses will be considered as walkaway for these purposes if they permit a non-defaulting counterparty to make only limited payments, or no payments at all, to a defaulting party, even if the defaulting party is a net creditor.
The type of provisions envisioned by this test are the rights created on the election of the First Method under the 1992 ISDA Master Agreement which have the result that the non-defaulting party is entitled to a close-out payment but avoids any obligation to make a close-out payment to a defaulting party.
Where a party has a net in-the-money position and has defaulted under a transaction, reliance by the non-defaulting party on the flawed asset clause to refuse to make further payments under the transaction can produce an effect similar to that created by a walkaway clause if there is no possibility of the default being cured (for example, the defaulting party is hopelessly insolvent) and the defaulting party has no close-out rights. However, even in this situation, it is possible that the non-defaulting party could decide to exercise its close-out rights notwithstanding that it is out-of-the-money (eg., it may consider that if the market were to move in its favour, its potential losses as a net creditor of the defaulting party would outweigh the loss it would crystallise if it closed-out immediately). If this were to occur, a defaulting party which has a net in-the-money position at close-out would be entitled to receive a net payment from the non-defaulting party, notwithstanding the existence of the flawed asset clause.
Whilst the similarities between a walkaway clause and the operation of the flawed asset clause could attract the attention of the regulators in certain limited circumstances, these similarities may not necessarily have implications for capital adequacy guidelines, which are more relevant to the ability of ADIs to meet depositors' demands on a going concern basis. Also, the regulators may have already considered the very narrow circumstances in which the flawed asset clause could operate on a basis similar to a walkaway clause and determined that this represents an acceptable risk for depositors.
Conclusions
Enron v TXU is significant from both an insolvency law and derivatives law perspective.
While it clarifies the Court’s powers to make additional orders when granting leave to liquidators to disclaim contracts it raises more questions than it answers in relation to the operation of the flawed asset clause in the ISDA Master Agreement from both a prudential and legal perspective. For these reasons it has attracted keen interest from other jurisdictions including Canada, the United States and the United Kingdom. It is not clear at this stage what APRA's reaction, if any, will be to the decision, and as yet we are not aware of any official announcements or recommendations by AFMA on the issues it raises. What is certain, however, is that the affirmation of Enron v TXU by the NSW Court of Appeal will focus the attention of the global OTC markets on its commercial implications and may lead to initiatives by participants in these markets to address the concerns it raises.
For further information, please contact Louise McCoach.
