Severability Clauses: Is Half A Loaf Always Better Than None?

  • 24 Mar 2003
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Many derivatives contracts, including the 1992 and 2002 International Swaps and Derivatives Association Master Agreement, do not include a severability clause, which addresses the enforceability of a contract, even though these clauses are usually in commercial contracts. The questions relating to severability are complex, and require careful analysis in the context of any particular derivatives transaction. This article looks at some of the situations, under both English and New York law, in which it may be advisable to consider including a severability clause.

ISDA & The Single Agreement Concept

Severability clauses are drafted to ensure that the non-offending terms remain operative and that the overall transaction remains in effect. A typical severability clause might read as follows: If any provision of this Agreement shall be held to be invalid or unenforceable for any reason, the remaining provisions hereof shall continue in full force and effect as if this Agreement had been executed with the invalid provision eliminated.

One reason for ISDA's decision not to include a severability clause in the Master Agreement was that participants viewed severability as inconsistent with the single agreement concept. The treatment of the Master Agreement as a single agreement may be necessary for the enforceability of close-out netting in an insolvency context. Also, in the U.S., it is important to the rights of creditors under the Uniform Commercial Code to set off against amounts owed to a debtor's third-party assignee. Single agreement treatment does not, however, address the question of whether particular provisions of a given Master Agreement are severable.

Some market participants elect not to add a severability clause to the Master Agreement because the enforceability of a severability clause depends on the choice of governing law. Some fear that if the contract's governing law does not recognize severability clauses, the inclusion of such a clause in the contract might itself render the contract invalid. Moreover, even in jurisdictions such as New York, where severability clauses are enforceable, a party may decide that applicable contract law makes a severability clause unnecessary.

The New York Rule: Finding The Benefit
Of The Bargain

Is The Agreement Separable or Entire?

If a provision in the Master Agreement is held to be invalid, a court must decide whether to invalidate the entire Agreement or to enforce the Agreement without that provision. In New York, courts generally attempt to enforce contracts in a manner consistent with the intent of the parties, so that the parties receive "the benefit of their bargain." A key issue is whether the contract is separable or entire­that is, are its terms independent of one another, or so central as to be inseparable?

The primary standard for answering this question is manifested intent, viewed in light of the contractual language and the surrounding circumstances. (Rudman v. Cowles Communications, Inc., 30 N.Y.2d 1 (N.Y. 1972)). In determining the parties' intent, a New York court may take into account whether the contract includes a severability clause. The absence of a severability clause has been cited as a factor indicating that the parties intended all terms in a contract to be viewed as interdependent with that contract's central purpose (F & K Supply, Inc. v. Willowbrook Development Co., 732 N.Y.S.2d 734 (N.Y. App. Div. 2001)). In such a case, a court might rule the entire contract to be unenforceable if even one of its terms is held to be invalid.

Are The Invalid Terms Essential?

Several cases highlight the importance of determining which provisions are essential. The inclusion of a severability clause supports the argument that not all provisions in a contract are essential and that the unenforceability of any one provision should not render the entire agreement invalid. Thus, in Gladys Ferro v. Rose Bologna, 31 N.Y.2d 30 (N.Y. 1972), the court enforced third-party-beneficiary rights under a separation agreement despite the illegality of terms exempting a husband from the support of his wife. Noting that the separation agreement contained a severability clause, the court reasoned that the illegal terms were not so essential to, and interwoven with, other provisions of the agreement as to be logically inseparable.

Savings Clauses

Notwithstanding the importance of contract preservation, parties to a Master Agreement also need to ensure that the contract will be terminated if any of its material terms are held to be invalid. For example, terms relating to payment netting may be necessary to the parties' ability to manage large books of trades with one another. Therefore, regardless of whether parties to a Master Agreement include a severability clause, they should consider incorporating a savings clause that clearly identifies the provisions which, if declared invalid, will cause the Agreement to be terminated.

A case in point is Courtesy Sandwich Shop, Inc. v. Port of New York Authority, 237 N.Y.S.2d 820 (N.Y. App. Div. 1963). In that case, the court considered whether the unconstitutionality of a statutory provision authorizing the development of a trade center rendered the entire law, including authorization for a rail facility, unenforceable. The statute contained a traditional severability clause as well as a savings clause indicating an intent that the statute fail if the rail facility and the World Trade Center could not be completed as a unified project. Because the savings clause stated the interdependence of the project's phases, the lower court ruled that the entire statute was invalid.

What Of The Law In England?

When a particular contractual provision is held to be invalid, English courts seek to answer the same question--whether the valid part may be severed from the remainder of the contract--but they do it with a different approach.

The Traditional Blue Pencil Test

The English courts apply a test known as "the blue pencil test." The court runs a pencil through the unenforceable part of the contract (case law demands that only a blue one will do) and determines whether the contract is, on its face, sensible without it. If striking the offending part does not affect the meaning of what remains, the contract will survive in reduced form. If it ceases to make sense, the whole contract will fail, regardless of the parties' intent. In the classic case, Goldsoll v. Goldman [1915] 1 Ch 292, a dealer sold his business and agreed not to compete as "a dealer in real or imitation jewelry in . . . any part of the UK . . . [or elsewhere]." The court severed the words "real or," as well as the language referring to places outside the U.K., finding those portions to be unreasonable.

The concept becomes more problematic in the context of the derivatives business. What is left after running a pencil through an invalid netting provision would still make sense as a contract, even if, for either or both parties, the commercial rationale may be wholly undermined.

There is little authority on the attitude of the English Courts toward severability clauses. They are common boilerplate in many commercial agreements but are not necessarily enforceable. A clause that provides for the possibility of renegotiating the offending term to one that is legally acceptable is probably unenforceable because it is an agreement to agree. Similarly, an English court probably would view as void for uncertainty a clause that provides for the automatic replacement of an offending provision with a similar permissible one.

Severability in a Modern Commercial Context

Market practice in the U.K. is not to include severability clauses in the context of derivatives. Generally, parties to Master Agreements are content to leave the issue of severance to the common law and hesitate to interfere with the standard documentation. The general view is that including a severability clause probably makes little difference under English law. The English cases on severability do tend, however, to be old, and there might well prove to be temptation for a court considering the issue in a modern commercial context to look to interpret or develop the law to factor in, for example, regard to underlying commercial intention. The parties may be able to guard against the uncertainty of such an approach by including a severability clause. For example, in the context of a derivative embedded in a larger structure, the overriding concern might be to reduce the risk that the entire Master Agreement could be poisoned by the invalidity of non-essential terms. In such a case, including a severability clause may marginally improve the chance that the valid portions of the Agreement would survive.

Saving the Parties' Intent

Regardless of whether severability clauses are included, courts may take a different view from one or both of the parties as to the provisions that are critical. Because English law traditionally has not considered the intent of the parties, the risk of the contract's survival despite the substantial defeat of its commercial purpose is perhaps more acute under English law than under New York law. For this reason, it is useful to include a savings clause such as the following, which identifies critical terms in a Master Agreement: "This Agreement shall be deemed to be invalid if any provision of Sections 1(c), 2, 5, 6, or 13 (or any definition relating thereto) shall be so held to be invalid."

Parties may disagree about whether, in view of the applicable law, it is advisable to incorporate a provision that preserves an Agreement containing flawed non-material provisions or ends one containing invalid material terms. Nonetheless, the most important goal of severability is to reflect the parties' goals in plain terms and to avoid arrangements that are unwanted by either party.

This week's Learning Curve was written byJamila A. Roos, an associate in the commodities and derivatives practice group atStroock & Stroock & Lavanin New York, andRobert Turner, a litigation partner in the financial markets department atSimmons & Simmonsin London.

  • 24 Mar 2003

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