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"SPRING IS SPRUNG"?1
FORWARD FREIGHT AGREEMENTS : THE EVENT OF DEFAULT CONDITION
PRECEDENT TO THE PAYMENT OF SETTLEMENT SUMS
INTRODUCTION
In Marine Trade SA v Pioneer Freight Futures Co Ltd [2009] EWHC 2656 (Commercial Court, 29th October 2009), Flaux J illuminated certain aspects of Forward Freight Agreements ("FFA") on the 2007 Terms of the Forward Freight Agreement Brokers' Association ("FFABA 2007"), incorporating the 1992 ISDA Master Agreement ?(Multicurrency- Cross Border) (without Schedule) ("the MA"). These complex "Over The Counter" transactions are widely used, but as yet little considered by the Courts. The Judge elaborated the "Bankruptcy" Event of Default under section 5(vii)(2) of the MA, and the operation of the "netting" provisions under section 2(c)(i) which allow two parties, in effect, to set-off the sums from each to the other under different FFAs provided the net creditor is not affected by an Event of Default. The case also confirmed that a payment made "under protest" was not made under a mistake, and was so could not be recovered back, if the payer believed it was probably liable to make it; this aspect is not analysed here.
It is said that the market is surprised by the Judge's decision that where a sum had become due and payable to a party, this would not be undone because that party was later affected by an Event of Default under the MA. Although this notion was apparently espoused by texts on derivatives, we think the Judge was clearly right both on legal principle and in terms of the legitimate expectations of the market. However, the Judge then said, effectively, that the converse was also true: where a sum had not initially become payable to a party because that party was affected by an Event of Default, that sum could not later "spring up" and become payable if that party ceased to be affected by the Event of Default. We are not so sure that the textbook writers are wrong here, or that the market's expectations are in this respect unjustified.
THE CASE
M and P had entered into 14 FFAs on FFABA 2007 terms incorporating the MA. In these contracts, the parties agree a "Contract Rate" by reference to indices maintained by the Baltic Exchange. Where the monthly "Settlement Rate" derived from those indices is higher than the "Contract Rate" then for that month, the "Buyer" is entitled to be paid by the "Seller" a "Settlement Sum" calculated by reference the difference between those rates; conversely, where the monthly "Settlement Rate" is below the "Contract Rate", for that month, the "Seller" is entitled to be paid a similarly calculated "Settlement Sum" by the "Buyer". From a trading perspective, the "Buyer" is taking a "long" position on freight movements (being "in the money" or profiting if the market, as reflected by the "Settlement Rate", rises relative to the "Contract Rate") and the "Seller" is taking a "short" position (profiting if the market falls relative to the "Contract Rate").
The dramatic fall in freight rates in the fourth quarter of 2008 meant that for January 2009: (1) M was owed about US$7 million of "Settlement Sums" by P, under FFAs where M was the Seller ; and (2) P was owed about US$ 12 million by M under FFAs where P was the Seller. M therefore owed P a potential net balance of about US$ 5 million.
However, M asserted that P was subject to the "Bankruptcy" Event of Default under clause 5(vii)(2) and so that P was not entitled to set off against M's claim, the sums payable to it by M. When M did not pay P's invoice, P served a notice of failure to pay under clause 5(a)(i), non-compliance with which would ostensibly be an Event of Default by M, prima face entitling service by P of an Early Termination Notice under clause 6(a) of the MA. As the Judge succinctly summarised the complex provisions: "the effect of [such a Notice] in simple terms would be a crystallisation of a liability on each party to pay all unpaid sums under the FFAs to whichever party was in the money. In the state of the market it as it then was, this would have meant a very substantial sum was payable by [M] to [P] by way of wash out of all the contracts".
M attempted to injunct P from serving a section 6(a) Early Termination Notice on it. This failed, so M paid the net balance of about US$5 million to P "under protest". M then served its own Failure to Pay notice to P in respect of the US$7 million owing to it, which sum remained outstanding and unpaid by P as at the time of Flaux J's judgment on 29th October 2009.
THE JUDGE'S FINDINGS ON THE ISSUES HE ULTIMATELY HAD TO DETERMINE
The issues were rather more elaborate at the beginning of the trial than at the end because, on the final day, P accepted that it was affected by the "Bankruptcy" Event of Default, at the time the January 2009 Contract Month was due for settlement (a day shortly after month end as defined in section 8 of FFABA 2007).
As far as the construction of the FFAs was concerned, the hub of the remaining arguments on the construction of the FFA was the interplay between:
-
the condition precedent set out in MA section 2(a)(iii)(1) that a party's obligation to pay the monthly Settlement Sum due to the other party, namely: "the condition precedent that no Event of Default?with respect to the other party has occurred and is continuing" (emphasis added).
and
- the delineation of "netting" in MA section 2(c)(i), whereby "If on any date amounts [in the same currency and in respect of two or more FFAs] would otherwise be payable" by each party to the other (emphasis added), then these would be automatically discharged and replaced by an obligation (effectively) upon the net debtor to pay the balance to the net creditor.
Those arguments were:
- M's argument that P could not "net off" the US$12m due from it to P, because that sum was not "otherwise?payable" under section 2(c)(i) as P was affected by the "Bankruptcy" Event of Default- i.e. the condition precedent to "payability" in section 2(a)(iii)(1) requiring that the payee was not affected by an Event of Default was not fulfilled. The Judge had little difficulty upholding this argument: "[W]here [P] is affected by an Event of Default, as a consequence of Section 2(a)(iii) [M] has no obligation to make payment to [P] at all".
- P's argument that M, though not affected by an Event of Default when the January Settlement Sums were due, subsequently became affected by the "Bankruptcy" Event of Default: therefore, argued P, the condition precedent under section 2(a)(iii)(1) of no Event of Default was no longer fulfilled, the sum due to it was no longer "otherwise?payable" under MA section 2(c)(i) and so there was no longer an obligation on P to pay M the sum it owed M for January. This view was apparently supported by writers of text books on derivatives.
The Judge found that M was affected by the "Bankruptcy" Event of Default from May 2009 onwards. This was defined by section 5(vii)(2) (so far as relevant) as being where a party "becomes insolvent or unable to pay its debts or fails?generally to pay its debts as they become due" (section 5(vii)(2)). This had two distinct, non- cumulative elements: (a) inability to pay debts as they become due and (b) failure generally to pay debts as they become due". The Judge confirmed that guidance on the first limb could be found in the authorities on s 123(e) Insolvency Act 1986, whereby a company is deemed unable to pay its debts 'if it is proved to the satisfaction of the court that it is unable to pay its debts as they fall due"- particularly that failure to pay a debt other than for a substantial reason is itself evidence of inability to pay a debt. As to "failure generally to pay debts as they become due", it was not necessary to demonstrate a general failure to pay, but there must be evidence that the party has failed to pay a substantial volume of its debts on time; a few isolated instances would not suffice. The Judge held on the evidence that from May 2009 M was so affected on the basis of its dealings with other counter parties under other FFAs.
Nevertheless, the Judge still held that P's argument was wrong: it overlooked that the party seeking payment was not "bankrupt" at the time that the obligation accrued and the relevant conditions precedent were fulfilled. Further, the paying party should not be able to take advantage of its failure to pay in the interim. This is, with respect, clearly right on the wording of the provision and is consonant with general principle that, absent the rare cases where rescission ab initio lies or where the parties clearly agree otherwise, accrued rights (even those vested in a contract breaker) under a contract are not undone even by subsequent termination of the contract: Johnson v Agnew [1980] AC 367. Also, we submit that it would clearly be absurd if the debtor in respect of a due and payable Settlement Sum could benefit from delaying payment of it in the hope that the creditor might later be affected by an Event of Default and the payable debt would then be wiped out (at least suspended until the Event of Default was cured again). This cannot be intended by the parties nor expected by the market in which they operate.
However, the Judge went further and opined that by parity of reasoning, clauses 7 and 8 of the FFABA and section 2(a)(i) of the Master Agreement were "one time" provisions for the calculation and assessment at the end of the Contract of Month of whether a sum is owed. If the party seeking payment could not comply with the conditions precedent, then no obligation to pay the Settlement Sum came into existence, and there was nothing to suggest that if at some later date the condition precedent was fulfilled, some obligation to pay then "springs up"; the Judge noted that the text books on derivatives, particular Simon Firth Derivatives: Law and Practice did not identify which terms of the FFABA 2007 or the MA supported the contrary view.
As to this, with the greatest respect to the Judge, surely there is little if any parity of reasoning between reversing the vesting of accrued rights resulting from a fulfilled condition precedent; and the vesting of those rights simply taking place later, because of the condition precedent being fulfilled later. We submit that the natural wording of the provisions contemplates that the condition precedent (of absence of Event of Default affecting the creditor in respect of the Settlement Sum) may be fulfilled and the Settlement Sum therefore become "payable" to it, after that sum is ascertained and "due" after month end; otherwise the words "and is continuing" in section 2(a)(iii)(1) would seem to have no real content. In fact, we would respectfully suggest that the contractual intention that there be a temporal distinction between the time when the Settlement Sum is "due" and when it is "payable" is rather more clear and express in the MA than in respect of the freight provided for in the voyage charter construed in the "DOMINIQUE" [1989] AC 1056. We also submit that this approach is consistent with the normal operation of a condition precedent. Really, we would respectfully say, one would need to find clearer terms in the FFABA 2007/MA excluding such normal operation (and expressly confirming the intention that the condition precedent can only be fulfilled "one time" only) rather than the reverse.
If you would like any further information on this case or to discuss FFAs or any other form of derivatives please contact Stephen Limbert or Kish Sharma who are experienced in these areas.
December 2009
1 From "Spring in the Bronx": "Spring is sprung, the grass is riz/I wonders where the boidies is?/They say the boids is on the wing/ Ain't that absoid? I always thought the wing was on the boid" Anon.
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