Following a front page story in Derivatives Week, this article goes into more detail about the recent decision of the New South Wales Supreme Court in Enron Australia Vs. TXU Electricity [2003] NSWSC 1169. Although this court case happened in Australia we do not think the outcome would have been any different in England.
The Facts
Enron Australia (Enron) and TXU Electricity (TXU) were party to a large number of electricity swaps governed by a 1992 ISDA Master Agreement (the Master). For early termination purposes, "Market Quotation" and "Second Method" were stated to apply while "Automatic Early Termination" was disapplied.
In late 2001/early 2002, at a time when the swaps were net out-the-money to TXU, Enron was placed first into administration and then into liquidation. Each occurrence was an event of default under the Master. Although contractually so entitled, TXU chose not to designate an early termination date pursuant to s.6(a) of the Master, since that would have had the effect of crystallising its contingent liability--the net out-the-money amount--under the swaps. At the same time, relying on the standard "no default as a condition to payment" provision set out in s.2(a)(iii) of the Master, it ceased making payments to Enron.
Enron's liquidator sought leave of the court to have the swaps disclaimed in such a way as to compel TXU concurrently to designate an early termination date. The court declined, refusing to rewrite the Master so as to deprive TXU of its contractual entitlement (i) to choose whether and when to designate an early termination date and (ii) not to pay while Enron remained in default.
From TXU's perspective, the decision was welcome. From Enron's, it was anything but. Not only was it insolvent and therefore unable to realise value in the swaps by continuing to perform its side of the bargain; it had no means, either, to bring about designation of an early termination date that was a contractual prerequisite to that value being immediately crystallised in its favour.
Moral hazard--A New Low
Moral hazard is ever-present in today's financial markets. One need only consider the position of a bank holder of credit default protection on a distressed reference entity--to which the bank is at the same time a relationship lender--to see that this is so.
At the macro level, Enron Vs. TXU compounds the dilemma. For if such a credit protection holder is concurrently net out-the-money to the reference entity under a series of ISDA-governed derivative transactions to which Automatic Early Termination is stated not to apply, it has more incentive than ever to leave the reference entity to its fate (rather than accommodate it in restructuring), call in its credit protection and "walk away" from its net obligations under the derivatives.
There is a disquieting consequence at the micro level too. By electing Second Method, Enron and TXU had expressly agreed that on designation of an early termination date, neither would walk away from its obligations, irrespective of whichever was out-the-money and whichever was in default at the relevant time. It seems unprincipled, therefore, that TXU should be able subsequently to disregard that agreement, on the technical ground that an early termination date had not been designated, when TXU itself was the sole arbiter of the decision to designate and had a great deal to gain from not exercising its discretion. TXU's inaction is a classic example, in fact, of moral hazard in operation!
Credit/Systemic risk--A New High
Creditors, back-to-back counterparties and shareholders in any entity that undertakes significant derivative activity ought to be deeply troubled by Enron Vs. TXU. For it illustrates that, even if Second Method is elected, net in-the-money amounts attributable to such an entity (qua defaulting party) may nevertheless not be realisable.
If the defaulting entity is sizeable, the systemic implications are equally significant. Indeed, it is precisely a policy desire to mitigate systemic risk of this nature that predisposes e.g. the Financial Services Authority in its approach to walkaway provisions in netting agreements entered into by and between regulated entities. It is to this--perhaps the most disturbing--aspect of Enron Vs. TXU that we now turn.
What Now For Regulatory Capital Netting?
The minimum contractual features that the FSA considers a close-out netting agreement (such as the 1992 ISDA Master Agreement) should possess in order for it to be recognised for supervisory (including netting for capital adequacy) purposes are set out in section 6 of Chapter NE (Collateral and Netting) of The Interim Prudential Sourcebook for Banks. Parallel regulatory requirements, all of which have their genesis in the Basle Capital Accord, exist in many other jurisdictions. Section 6.4 of Chapter NE deals with walkaway clauses and provides as follows:
"The netting agreement should not contain a walkaway clause.
A walkaway clause is a provision which permits a non-defaulting counterparty to make limited payments, or no payments at all, to the estate of the defaulter, even if the defaulter is a net creditor.
In other words, the walkaway clause would have the effect of taking away or limiting the right to receive payment, which a party which is a net creditor would otherwise have, by virtue of the fact that such party is a defaulting party."
As we have intimated, the policy reason behind the FSA's diktat in relation to walkaway clauses is a desire to limit risk in the financial sector--the systemic implications of large numbers of non-defaulting parties walking away from net out-the-money positions to an insolvent counterparty being obvious. The "reward" for regulatory compliance in this regard is that, subject to meeting various other criteria, regulated entities are permitted to allocate capital in respect of mastered derivative exposures on a net, as opposed to gross, basis.
It is instructive to consider the effect of regulatory attrition in this regard. Whereas the 1987 ISDA Interest Rate and Currency Exchange Agreement embeds a walkaway provision as standard (see s.6(e)(i)(1)), the 1992 ISDA Master Agreement allows parties to make a positive election one way or the other (compare First Method with Second Method under s.6(e)(i)(1)-(4)). The 2002 ISDA Master Agreement does away with First Method as a concept altogether.
The key point is that the debate has hitherto centred exclusively on s.6(e). Enron Vs. TXU, on the other hand, moves the goal posts and brings into sharp and unpalatable focus the fact that s.2(a)(iii) and 6(a) (ISDA Master 'ever-presents', whatever the vintage) are capable, when working in tandem, of behaving in similar 'walkaway' fashion. In effect, they reintroduce First Method via the back door. If that is the right conclusion--and looking at the final paragraph of section 6.4 of Chapter NE as set out above, we think it must be--then netting for capital adequacy purposes is catastrophically undermined pending at the very least (i) a change to ISDA (and similarly drafted master netting) documentation and (ii) related clarification from the FSA.
Regulated entities that seek to net under Chapter NE are required, by section 6.1 of the same, to obtain reasoned independent legal opinions that confirm, among other things, the absence of walkaway provisions from their netting agreements. It is a further requirement that those same opinions are updated annually and that their validity is confirmed by the relevant entity to the FSA. Since no law firm will be able to give an opinion that is not materially (and adversely) qualified as a result of Enron Vs. TXU, reporting entities and the FSA will be forced to act. Opinion providers, reporting entities and regulators in many other jurisdictions will be confronted by a similar conundrum.
Some Good News
If anything good comes out of Enron Vs. TXU, it is the support that it lends to the enforceability of flawed asset provisions on insolvency. It is to be remembered that First Method (or its s.2(a)(iii)/s.6(a) 'in tandem equivalent') is an example of a flawed asset provision insofar as it subjects the contingent rights of an in-the-money party to the condition (or "flaw") that such rights are only enforceable if the in-the-money party is not itself in default. In this regard, Enron Vs. TXU not only upholds the principle of flawed asset provisions generally but also illustrates that the "flaw" attaching to a flawed asset cannot be disclaimed unless the asset to which it is attached is also disclaimed. Those venerating ISDA documentation for this reason alone in the aftermath of Enron Vs. TXU would, however, do well to consider some of the wider issues to which the decision has given rise.
Solutions & Next Steps
There are some obvious solutions to the difficulties presented by Enron Vs. TXU. Electing for Automatic Early Termination would have saved Enron in relation to its insolvency (although not in relation to most other events of default - see s.6(a) of the 1992 ISDA Master Agreement). Equally, had Enron held sufficient collateral, particularly if under an ISDA CSA, TXU may well have been persuaded to make the required designation, close-out the relevant transactions and set off.
Perhaps the most simple and compelling solution, however, would have been a pre-trading amendment to s.6(a) of the Master that had the effect of obliging TXU (qua non-defaulting party) to designate an early termination date within a certain number of days of the occurrence of Enron's insolvency. Certainly, the latter suggestion has been made in more than one quarter subsequent to the decision; and the fact that it runs counter to conventional bias against defaulting counterparties does not diminish its practical value in circumstances such as those that arose in Enron Vs. TXU.
Any solution will, however, require industry examination and consensus that ought readily to be forthcoming given the imperatives discussed in this article.
This week's Regulatory Focus was written by Gary Walker and Guy Usher partners at Field Fisher Waterhouse in London.
