1992 or 2002 Master Agreement and long form confirmations

This analysis will discuss LSREF III Wight Limited v Millvalley Limited, in which the parties argued whether a swap confirmation was governed by International Swaps and Derivatives Association’s (ISDA) 1992 or 2002 Master Agreements. The case contains a particularly interesting discussion about the difference between construction and rectification. It also highlights the potential pitfalls of using long-form confirmations.

In the case of LSREF III Wight Limited v Millvalley Limited [2016] EWHC 466 (Comm), LSREF III Wight (Wight) sought a declaration as to whether an interest rate swap confirmation incorporated the terms of a generic 1992 ISDA Master Agreement or an executed 2002 master agreement.

What are the facts of the case?

In November 2006, Millvalley entered into an interest rate swap with Anglo Irish Bank Corporation plc (AIB) (the original swap). This was a hedging arrangement required by AIB in connection with a facility provided by AIB to Millvalley. The original swap was confirmed in a long-form confirmation dated January 2007. This long-form confirmation included standard language saying that the parties would put in place a 1992 ISDA Master Agreement promptly and until that ISDA Master Agreement was put in place, the standard 1992 ISDA Master Agreement would apply. The only election made was that English law would be applicable.

In July 2010, the Millvalley facility was restructured, as were some of the facilities between AIB and other members of the Millvalley group.

In mid-2011, certain of the members of the Millvalley group asked AIB for an extension of their facilities. AIB agreed to this but imposed a number of conditions, including a requirement that Millvalley should enter into an ISDA Master Agreement to document its existing hedging arrangements. Millvalley expressly agreed to this. At this time, the only hedging arrangement was the original swap and no ISDA Master Agreement or schedule had been entered into (as the parties had agreed in 2006).

In October 2011, AIB's lawyers sent a draft 2002 ISDA Schedule to Millvalley's lawyers, who agreed to the draft subject to a correction to the notice provisions. The 2002 ISDA Master Agreement and Schedule was executed by Millvalley and AIB's successor corporation, IBRC, and was dated as of 13 December 2011 (the Millvalley 2002 ISDA). In the Schedule, the following material provisions were included:

  • Part 5(a)—unless a past or future transaction had expressly applied the terms and conditions of another agreement or expressly disapplied the terms of the Millvalley 2002 ISDA, the Millvalley 2002 ISDA should be incorporated into the relevant agreement or confirmation, and
  • Part 1(g)(i)—this set out Additional Termination Events that applied pursuant to Section 5(b)(vi) of the Millvalley 2002 ISDA

In September 2012, two of the Millvalley group facilities were extended again in a further restructuring. In connection with obtaining these extensions, Millvalley agreed to use deferred consideration to reduce the outstanding amount of borrowing with a corresponding reduction in the notional amount of the original swap, to bring the notional amount of the original swap in line with the reduced amount of the facilities.

In December 2012, IBRC and Millvalley agreed to enter into a restructured swap on the same commercial terms as the original swap but for a reduced notional amount. The swap confirmation was dated 19 December 2012. Again the restructured swap confirmation was a long-form confirmation and referred to a generic 1992 ISDA Master Agreement. There was no discussion between the parties as to what ISDA terms would apply. Wight argued that the intention would have been for the restructured swap to be governed by the Millvalley 2002 ISDA and any reference to a generic 1992 ISDA Master Agreement was an administrative oversight.

In June 2014, one of the facilities was repaid early, triggering an Additional Termination Event under Part 1(g)(i) of the Schedule to the Millvalley 2002 ISDA and on the same day IBRC sent a Notice of Early Termination to Millvalley. In July 2014, IBRC sent Millvalley a statement of the sum due on early termination—the Early Termination Amount. Up until 16 July 2014 Millvalley took the view that no sums were due by virtue of section 2(a)(iii) of the Millvalley 2002 ISDA as IBRC was in the process of liquidation proceedings. However, on 17 July 2014 Millvalley argued that the Millvalley 2002 ISDA had no application to the restructured swap because the long-form confirmation to the restructured swap referred to a generic 1992 ISDA Master Agreement. IBRC subsequently served notice in August 2014 declaring an event of default. In September 2014 IBRC assigned to Wight its right, title and interest in the Early Termination Amount. Wight subsequently sent notices to Millvalley notifying it of the transfer and demanding payment of the Early Termination Amount and further interest.

Millvalley refused to pay the sums due on the basis that the Millvalley 2002 ISDA had no application to the restructured swap and that there was therefore no entitlement to any Early Termination Amount.

What did the judge rule?

Mistake in the contract

Mr Justice Cooke discussed the fact that AIB/IBRC should have notified their operations department about the existence of the Millvalley 2002 ISDA as typically this information would have been inputted onto their computer system and a long-form confirmation would not then have been sent out as it would have been clear that the confirmation was subject to an existing master agreement.

He set out that in order to construe a contract in a manner which is contrary to the language used, there must be a clear mistake and correction should be made to give effect to the parties' intentions. Millvalley argued that the threshold required to correct a mistake as a matter of construction was very high.

The judge thought that the parties' intentions were clear, holding that the Millvalley 2002 ISDA governed past and future transactions. The original swap was to be governed by the Millvalley 2002 ISDA and the use of the long-form confirmation for the restructured swap had been a mistake. On the face of the documents, there was no ambiguity and the reference to a 1992 ISDA was not commercially nonsensical. However, to construe the restructured swap as incorporating the Millvalley 2002 ISDA would mean rewriting it. The restructured swap did not reflect that common intention because of an administrative error and the judge considered what a hypothetical reasonable objective observer would think about this. He concluded that the restructured swap should be construed as being under the Millvalley 2002 ISDA.

Construction or rectification?

The judge differentiated between construction, which is concerned with the meaning of the instrument, and rectification, where the objective question is whether there is a common continuing intention to which the instruments failed to give effect. Therefore evidence of negotiations could only be admissible for the purposes of rectification.

He was satisfied that there was a continuing common intention that the restructured swap be governed by the Millvalley 2002 ISDA. He then considered the discussions between the parties, especially the fact that it was a condition that Millvalley entered into an ISDA Master Agreement. It was clear that the original swap was intended to be governed by the Millvalley 2002 ISDA. The swaps were always intended to be a pure hedge for the facilities and never intended to speculate on interest rate movements for profit. There was therefore no commercial reason why the Millvalley 2002 ISDA should not apply to the restructured swap after it had been agreed that it would apply to the original swap since the restructured swap had been agreed to hedge the facilities and not for a new speculative purpose.

The nature of the mistake was obvious—there had been a failure on the bank's part to input into their computer system the existence of the Millvalley 2002 ISDA, with the result that a standard long-form confirmation had been generated for the restructured swap. Any hypothetical reasonably objective observer, aware of all the relevant facts known to both parties, would conclude that the intention of the parties was that the Millvalley 2002 ISDA was to apply to the restructured swap.

The judge agreed that the restructured swap should be rectified so that the Millvalley 2002 ISDA applied. It would be unconscionable for Millvalley to retract from the common assumption that the Millvalley 2002 ISDA applied. On that basis, the Early Termination Amount was also due and payable by Millvalley.

Why did it matter which ISDA Master Agreement applied?

In this case the key difference between the 1992 ISDA Master Agreement and the Millvalley 2002 ISDA was that in the Schedule to the Millvalley 2002 ISDA, Additional Termination Events had been included. Additional Termination Events are often included in the Schedule to master agreements. However, they must be specified by the parties and no Additional Termination Events are included in the generic form of master agreement.

The Additional Termination Event that had been included meant that IBRC could terminate the swap in the event of the repayment of a loan. This made sense as the swap was a hedging tool and so if the loan was repaid, there was no need for the hedge to continue. Additional Termination Events such as this are very commonly included in Schedules to ISDA Master Agreements by banks, especially where the swaps are linked to facilities.

What should practitioners take away from the case?

As a matter of construction, it seemed clear on the face of the restructured swap that a 1992 ISDA Master Agreement to be agreed between the parties would apply. While it was not expressly discussed what master agreement should apply, the fact that the Millvalley 2002 ISDA had been executed between the parties, plainly applied to the original swap and would have applied to the restructured swap had the operations team inputted its details into their computer, showed that it would be unconscionable for Millvalley to say that it was not intended to apply to the restructured swap.

While the judgment should be welcomed, practitioners should also be aware of the arguments raised by Millvalley when documenting derivatives transactions. It is prudent when drafting confirmations to ensure that the correct confirmation is sent to external parties. Often in large financial institutions, lawyers do not send out, or even draft, the confirmations if they are of a very standard nature. However, lawyers should ensure that the operations team are aware of any pre-existing master agreements and that these are correctly referenced. The 1992 and 2002 ISDA Master Agreements do have important differences between them (aside from the Additional Termination Event that was negotiated in this specific case) and the correct form should always be referenced in any confirmation. Long-term confirmations should only be used where no master agreement is in place and if a long-form confirmation is used, practitioners should double check that this is necessary and, if it is, that a master agreement is put in place as quickly as possible.

In light of the judgment, lawyers should consider the Risk Mitigation Standards for Non-centrally Cleared OTC Derivatives report published by the International Organisation of Securities Commission (IOSCO) in January 2015. At para 2.3, IOSCO concedes that long-form confirmations can be used for one-off transactions. The report indicates that where more than one transaction is going to be used by parties, written trading relationship documentation should be entered into prior to or contemporaneously with the execution of a non-centrally cleared over the counter derivatives transaction. This is set out in Standard 2 of that report and is designed to mitigate risk and promote legal certainty.

Long-form confirmations should therefore not be used unless absolutely essential and as far as possible practitioners should try to negotiate and execute a master agreement prior to entering into derivative transactions. While this will not always be possible, as a matter of best practice and to avoid any confusion which could be brought about by mistakes in the long-form confirmation, short-form confirmations referencing an existing master agreement should always be preferred.

Emma Millington, solicitor in the Lexis®PSL Banking & Finance team

First published on LexisPSL Banking & Finance. Click here for a free trial.

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