The International Swaps and Derivatives Association ("ISDA") published on June 19 an amendment to Section 2(a)(iii) (hereinafter, the "Amendment") of the 1992 and 2002 versions of the ISDA Master Agreement (hereinafter, the "Master Agreement") in order to include a time limit on the condition precedent of that provision for the occurrence of an Event of Default (1) or a Potential Event of Default in relation to one of the counterparties.

Section 2(a)(iii) is a condition precedent that suspends a non-defaulting party's obligation to make payment or delivery to a defaulting party if there is a continuing Event of Default or Potential Event of Default. The purpose of this section is to protect the non-defaulting party from increasing its exposure against the defaulting party who may be unlikely to perform its obligations.

In the context of a bankruptcy scenario, non-defaulting parties which positions was out-of-the-money and upon termination would have owed monies to the insolvent (defaulting) counterparty, have tried to rely on Section 2(a)(iii) for as long as possible in order to avoid having to make any payments to the insolvent party. The principal legal issue with respect to Section 2(a)(iii) has been its enforceability under the insolvency laws of the defaulting counterparty's jurisdiction. These insolvency laws may have override or affected the effects of Section 2(a)(iii) even though they are generally enforceable under the governing law of the agreement. In this regard, the suspension of the non-defaulting party's obligation to make payment or delivery to a defaulting party has been subject of contradictory judicial interpretations –either that it is rendered completely unenforceable or that it allows for indefinite suspension- bringing uncertainty to counterparties in various jurisdictions (2).

In view of the above, ISDA formed a working group of members to study the need of several amendments to Section 2(a)(iii) and related provisions of the Master Agreement, in particular to incorporate a time limit to the suspension of payments pursuant to Section 2(a)(iii).

Amendment to Section 2(a)(iii) of the Master Agreement Section 2 of the Master Agreement is amended to add at the end a new Section (3) according to which upon the occurrence of an Event of Default, the defaulting party is entitled to provide notice to the non-defaulting party, thereby establishing a "Condition End Date" to the condition precedent in Section 2(a)(iii). The Condition End Date works as a time period of how long the non-defaulting party may suspend payment or delivery in accordance with Section 2(a)(iii). The Amendment includes the definition of Condition End Date (4) suggesting a 90-day period of time; however, the parties are entitled to negotiate a different term.

The Amendment also allows a party that has not yet committed an Event of Default, to invoke this time limit when a Potential Event of Default has occurred in respect of it. In order to get this benefit, the party must waive any requirement that notice be given or that any period of time elapse, by virtue of which waiver the Potential Event of Default will become an Event of Default.

Upon the expiry of the Condition End Date, the non-defaulting party must resume payment or delivery on the first Local Business Day after the Condition End Date, with accrued interest and, if relevant, compensation.

The Amendment also provides under its clause (iv) that if after a party has given notice with respect to an Event of Default or Potential Event of Default, another Event of Default or Potential Event of Default occurs with respect to that party, then no Condition End Date will have occurred for the initial Event of Default, and the defaulting party must provide a new notice to establish a new Condition End Date for the subsequent Event of Default. If a subsequent Event of Default is cured and the initial Event of Default still exists, however, then the defaulting party may give a new notice with respect to the initial Event of Default that is outstanding and thus re-establish a Condition End Date for that initial default. This clause will not apply when the earlier Event of Default, in relation to which notice was given, is Bankruptcy.

The Amendment follows the usual form of bilateral Amendments published by ISDA, which also includes a reaffirmation of the representations given by each of the parties under the relevant Master Agreement, and other standard clauses such as entire agreement, counterparts or governing law.

Spanish counterparties

In our view, the Amendment shall bring more certainty to derivative agreements during a pre-insolvency and insolvency scenario of a Spanish Company, as the establishment of the Condition End Date determines the length of the time period after which the condition precedent in Section 2(a)(iii) comes to an end. This shall be in detriment of the non-defaulting party who will no longer benefit from the indefinite suspension when its position is out of the money.

The Amendment allows the defaulting party to give, simultaneously with the declaration of pre-insolvency (5) or insolvency to the Court, notice to the non-defaulting party identifying the Potential Event of Default or Event of Default and establishing the Condition End Date to the condition precedent. Under this scenario, if the Condition End Date occurs and the relevant Event of Default is continuing, the non-defaulting party may choose between:

  1. to resume payment or delivery with accrued interests and, if relevant, compensation. If there exists a CSA between the parties it is advisable to raise this into a public deed along with the cash collateral account or other pledged eligible collateral in order to secure the position of the non-defaulting counterpart (6); or
  2. to terminate (7) the agreement and designate an Early Termination Date in which case the close-out amount shall need to be calculated in accordance with Section 6 of the Master Agreement (8). This may be the best option for those non-defaulting parties who have entered into a back to back derivative transaction in the market or a CDS although their positions are out-of-the-money, as they will be receiving an equivalent positive close-out amount from its other counterparty.