The ISDA Master Agreement is the most commonly used legal contract to document over the counter financial derivatives and is used to document trades worth billions of dollars. The case concerned the correct calculation of the amount owed following the early termination of forward freight agreements (FFAs), a form of OTC financial derivative involving freight rates, which shipping companies typically use to either hedge or gain exposure to market movements in freight rates.
The case confirmed the market view of the 1992 ISDA Master Agreement as understood by financial institutions - that whoever is in the money gets paid irrespective of who caused the early termination. In other words, fault is irrelevant; all that matters is who is in the money at the time of early termination.
The result is of relevance to all players in the financial derivatives markets.
- The case was Britannia Bulk plc (in liquidation) v Pioneer Navigation Limited and Ors [2011] EWHC 692 (Comm).
- Both parties were shipping companies.
- Britannia Bulk went into insolvency in October 2008 following a dramatic decline in freight rates. This trigerred the automatic termination of its FFA trades with Pioneer Navigation and it was in the money by some USD 23m derived by calculating the remaining legs of the FFA trades with Pioneer Navigation using forward rates available at the time of Britannia Bulk's insolvency.
- The Parties had agreed to Loss and Second Method. The market understanding of Second Method is that it means that whoever is in the money gets paid that amount irrespective of who caused the trades to be terminated. In this case, this would mean that Britannia Bulk would be paid some USD 23m even though its insolvency triggered the termination of the FFAs.
- Pioneer Navigation was not happy with this result. It sought to argue that it owed Britannia Bulk nothing following the early termination of the FFAs because it tried to contend that, had the FFAs continued, it could have relied on a provision under the ISDA Master allowing it to withhold payments to Britannia Bulk indefinitely. On this basis, it owed nothing to Britannia Bulk.
- The court rejected Pioneer Navigation's argument because, in short, the court did not accept that the provisions allowing Pioneer Navigation to withhold payment could be relied upon following early termination.
- This result confirms the market view of the 1992 ISDA Master Agreement as understood by financial institutions - that whoever is in the money gets paid irrespective of who caused the early termination. In other words, fault is irrelevant; all that matters is who is in the money at the time of early termination. It seems that shipping companies who traded in the FFA market assumed that only the innocent party could demand a payment under the ISDA Master Agreement as this market is less familiar with the ISDA Master Agreement than financial institutions.
- Shipping companies need to bear in mind that the insolvency, or financial difficulties, of their counterparty could trigger a large payment obligation to their counterparty if they are out of the money when the difficulties arise. This is a result they may not be expecting and could cause a sudden and very large cash call which they may be unable to meet. If they cannot meet these cash calls then they could be forced into insolvency. These type of large and unexpected cash calls have caused significant problems in the shipping markets because of the huge decline in freight rates and a number of shipping companies trading FFAs have had to file for insolvency and more may follow.