ISDA seeks to address the section 2(a)(iii) insolvency unfairness with respect to derivatives.

Both of the ISDA master agreements which are used for over the counter derivatives from small scale interest rate swaps to larger equity derivatives transactions include a provision (which is generally not disapplied) that if there is a potential event of default or an event of default (such as a bankruptcy event) in place in respect of the other party (the defaulting party) then (unless automatic early termination applies) the non-defaulting party has the following remedies whilst the event continues namely:

  1. to choose at its option to close out the contract; or
  2. to simply suspend making payments under it.

The issue
The insolvency mischief has been that, whilst if the non-defaulting party chooses to close out the contract there is generally a full valuation of both party’s rights against each other (via loss or market quotation etc.), in the United Kingdom the English courts (particularly in Lomas and others v JFB Firth Rixson Inc and others [2012] EWCA (Civ) 419) have determined that, if a non-defaulting party is out of the money under the contract and simply chooses to suspend making payments then, if the event of default is never cured (and most bankruptcy events of default never are cured), that party can walk away from the contract without any obligation to account for the suspended payments which would have otherwise fallen due from it or been taken into account if it had closed out the contract. That means that, typically, the defaulting party’s creditors lose out. By contrast the US courts have found that a party that sought to suspend its payment obligations forfeited the right to terminate the ISDA master agreement once its position had moved into the money. As you can imagine, these issues were heavily tested in the Lehman bankruptcy.

ISDA’s solution
ISDA has now proposed that the parties can choose to incorporate a new section 2(f) (or 2(e) in the case of the 2002 ISDA master agreement) into their swap contracts. In the new section, the parties agree that, following a notice from the defaulting party, the non-defaulting party only has the agreed time limit (the condition end date) to continue to postpone its payment obligations. That means that after that agreed time the non-defaulting party will have to continue making its payment obligations unless it elects to close out the contract. ISDA has also taken the decision to suggest a 90 day period might be an appropriate starting position for agreeing the relevant time limit and the Financial Conduct Authority has gone further by suggesting that the relevant time period should be no longer than 90 days.

We will wait to see how extensive the take up of this new option is (we would generally recommend its inclusion). Where, though, it is taken up it should generally result in a fairer deal for the defaulting party’s creditors.


By Marcus Jamson