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ISDA Master Agreement - Proposed Amendment to Section 2(a)(iii)

    • Financial institutions


    The International Swaps and Derivatives Association (“ISDA”) has published a draft set of amendments to the ISDA Master Agreement in respect of Section 2(a)(iii).

    Section 2(a)(iii)

    Section 2(a)(iii) of the ISDA Master Agreement is a condition precedent which states that if an event of default or a potential event of default has occurred and is continuing in respect of a party, the other party is not obliged to make payments or deliveries under derivatives transactions that it would otherwise be obliged to make.

    This has been a controversial section of the ISDA Master Agreement and has been the subject of litigation in numerous cases in both England and the United States over recent years. It has been especially problematic for insolvency officials acting for insolvent companies. Such companies will have triggered the bankruptcy event of default in the ISDA Master Agreement meaning that its counterparties were entitled to rely on Section 2(a)(iii). Where counterparties were out of the money, rather than terminate the open transactions under the ISDA Master Agreement, some counterparties decided to rely on Section 2(a)(iii) for as long as possible to avoid making any payments to the insolvent party.

    One of the key issues in many of the cases concerning Section 2(a)(iii) was how long a non-defaulting party could rely on Section 2(a)(iii) for, i.e. would there come a point when the non-defaulting party either had to pay sums owing (but for Section 2(a)(iii)) to the defaulting party or terminate the open transactions?

    In 2012 the Court of Appeal considered four High Court cases regarding Section 2(a)(iii) (Lomas and others v JFB Firth Rixson Inc and others [2012] EWCA Civ 419) and decided, amongst other points, that under the terms of the ISDA Master Agreement a non-defaulting party was entitled to rely on Section 2(a)(iii) until the relevant event of default or potential event of default ceased, i.e. potentially indefinitely.

    Although this judgment is generally accepted as the correct legal interpretation of the ISDA Master Agreement under English law, this position has been criticised by various bodies, including what was then, the Financial Services Authority.

    Proposed amendment

    ISDA’s proposed amendment to the ISDA Master Agreement seeks to include a mechanism where a defaulting party can force a non-defaulting party to stop relying on Section 2(a)(iii).

    The proposed new Section 6(g) allows a party that is affected by an event of default or a potential event of default and that is faced by a counterparty who is relying on Section 2(a)(iii) to give a notice to the non-defaulting party that it will no longer be able to rely on Section 2(a)(iii) from what is referred to as the Condition End Date. The Condition End Date is the date falling 90 days after the notice is effective.

    On the first local business day after the Condition End Date the non-defaulting party must fulfil its payment and delivery obligations that have been suspended by Section 2(a)(iii).  Interest at a non-default rate and compensation (if relevant) must also be paid.

    If a defaulting party gives a notice under Section 6(g), but is affected by another event of default or potential event of default before the Condition End Date, that notice is effectively deemed to fall away and no Condition End Date will occur in respect of that notice. In order to prevent a non-defaulting party from continuing to rely on Section 2(a)(iii), the defaulting party would need to give another notice under Section 6(g) and the 90 day period would start again.

    If a defaulting party has been affected by a bankruptcy event of default and gives a notice under Section 6(g) in respect of that event of default the Condition End Date will apply regardless of whether the defaulting party is affected by a new event of default or potential event of default.

    Next Steps

    The new Section 6(g) is still being consulted on and ISDA have invited comments by 21 February 2014.

    The FCA have indicated that they are satisfied that the 90 day period during which a non-defaulting party can continue to rely on Section 2(a)(iii) following a notice under Section 6(g) is a reasonable period.

    For more information contact

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