The ISDA Master Agreement contains a condition precedent at Section 2(a)(iii) which provides that a non-defaulting party is not obliged to make payments it would otherwise be obliged to make to the other party under the agreement if an event of default, or potential event of default, has occurred or is continuing.  A recent amendment to the Master Agreement introduced by ISDA enables parties to agree a time limit on the operation of Section 2(a)(iii).

Background

Section 2(a)(iii) was considered in multiple conflicting High Court decisions between 2009 and 2011, in addition to rulings by the US Bankruptcy Court in New York.  A key issue covered by these cases concerned the length of time during which a non-defaulting party could rely on Section 2(a)(iii) to withhold payments from a defaulting party under the Master Agreement.  

ISDA set up a working group with the (then) FSA and HM Treasury in 2009 to consider (inter alia) establishing a time limit on the operation of this clause.  This followed a request from the administrators of Lehman Brothers International (Europe), who were encountering difficulties recovering from some counterparties under various interest rate swaps as a result of the operation of Section 2(a)(iii) of the Master Agreement.

Decision in Lomas v JFB Firth Rixson

We reported on the outcome of Lomas v JFB Firth Rixson Inc. (2012) EWCA Civ 419 (which heard the appeals for four previously separate cases together) in our May 2012 edition of LFRN.  The Court of Appeal held that the non-defaulting party could rely on Section 2(a)(iii) to withhold payments until the event of default or potential event of default ceases.  The payment obligation of the non-defaulting party was suspended until the event of default or potential event of default was cured.

The Court of Appeal held that the payment obligation would be revived if the event of default was cured before the outstanding transactions were terminated.  The effect of this suspension could be indefinite and was not limited to a reasonable time or until the maturity of the transaction. The Court declined to imply terms into the Master Agreement which would revive the suspended payment obligation without the event of default being cured.  HM Treasury expressed concerns that suspending payments to insolvent counterparties indefinitely may create uncertainty as to when the sums owed may become due and have an adverse impact on creditors.  However, the Court's view was that the indefinite suspension of the payment obligation might be considered "imperfect" but was not "uncommercial".

Amendment to the Master Agreement

Following the decision in Lomas, ISDA considered proposals to amend the Master Agreement to limit the indefinite effect of Section 2(a)(iii).  In June 2014, ISDA published a proposed amendment to the Master Agreement which allows a defaulting party to require a non-defaulting party to make payments under the agreement and prevents the non-defaulting party from relying on Section 2(a)(iii) indefinitely. The proposed amendment inserts a new Section 2(f) into the 2002 Master Agreement (Section 2(e) in the 1992 Master Agreement), which incorporates the option of a time limit on the operation of Section 2(a)(iii) via insertion of a "Condition End Date".  It is open to the parties to negotiate an appropriate time limit (the ISDA amendment suggests 90 days, which the FCA has previously indicated it considers to be reasonable).

The new amendments cover both events of default and potential events of default.  Where an event of default has occurred, Section 2(f)(i) of the amendment means that a defaulting party can give notice to the non-defaulting party to invoke the new Section inserted by the amendment, bringing the condition precedent in Section 2(a)(iii) to an end on the Condition End Date.  Where a potential event of default has occurred, Section 2(f)(ii) operates in the same way as Section 2(f)(i) to enable a party to bring the condition precedent in Section 2(a)(iii) to an end. Once the Condition End Date has passed, the suspended obligations become payable on the first following business day with accrued interest.

Comment

All parties using the Master Agreement should consider whether to include this amendment and the appropriate time limit to apply, to avoid the uncertainty of either party relying on Section 2(a)(iii) indefinitely, should an event of default or potential event of default occur.  The amendment wording, along with a more detailed explanatory memorandum, is available for download fromhttp://www.isda.org/publications/isdamasteragrmnt.aspx.