ISDA's clarification will put a time limit on how long the non-defaulting party is entitled to suspend its obligations under Section 2(a)(iii).
The legal session at the ISDA AGM covered a broad range of documentation developments, including updates to the ISDA Equity Derivatives Definitions and the development of a new Master Bridging Agreement to allow netting of cleared (through central counterparties) and uncleared products governed by separate ISDA Master Agreements.
However, the key focus of the legal session was ISDA's response to the growing uncertainty in the OTC derivatives market over the correct interpretation of Section 2(a)(iii) of the ISDA Master Agreement, which deals with a party's right not to pay or deliver if there is a default (or potential default event) with respect to its counterparty.
Section 2(a)(iii) – Reshaping a party's ability to suspend the obligation to pay or deliver under the ISDA Master Agreement
There have been differing views for some time as to whether Section 2(a)(iii) should be interpreted so that:
- the obligation to pay or deliver under Section 2(a)(iii) is suspended indefinitely (or subject to a time limit);
- the non-defaulting party is owed gross (or net) obligations by the defaulting party while Section 2(a)(iii) applies.
More recently, these issues have been thrown into sharp relief by the growing number of recent court cases (including Metavante and Lomas) and a recent UK Treasury consultation.
ISDA has been working on amendments to clarify the operation of Section 2(a)(iii) for some time, and on 8 April 2011 released a Memorandum for Members which proposes the following amendments and clarifications:
- the introduction of a time period for suspension of obligations of between 90 and 180 days – the expiry of which is referred to as a "Condition End Date". The Condition End Date will determine how long a non-defaulting party can suspend performance of its obligations following a default by the defaulting party;
- Section 2(a)(iii) applies only to the parties' net obligations after the operation of Section 2(c). In other words, the defaulting party's ongoing obligations subject to the suspension are netted against payments due by the non-defaulting party;
- the obligations of the non-defaulting party affected by Section 2(a)(iii) are suspended rather than fail to come into effect at all;
- the suspended obligations affected by the condition precedent are required to be performed once the condition precedent in Section 2(a)(iii) is satisfied, or the Condition End Date is reached; and
- amendments to align the 1992 ISDA Master with the 2002 ISDA Master by expressly requiring interest to be paid on suspended obligations.
ISDA members had until the end of May to comment on the above proposals. Once finalised, the amendments are likely to be implemented via a Section 2(a)(iii) ISDA Protocol.
Time limit issue
The proposed imposition of a time limit on how long the non-defaulting party is entitled to suspend its obligations under Section 2(a)(iii) is a particularly significant issue. Its introduction is being driven by:
- a US decision that US bankruptcy law will not allow an indefinite suspension;
- UK decisions that suggest Section 2(a)(iii) is likely to otherwise offend the "anti-deprivation" principle of UK bankruptcy law; and
- UK Treasury concerns that bankruptcy administrators and creditors should not have to wait indefinitely to know whether transactions are being closed out (which has lead to industry concerns that a time limit may be legislated if the amendments are not made).
Implications for Australia
In Australia, we have usually made our own amendments to ensure that Section 2(a)(iii) does not have an indefinite operation. However, if ISDA ends up publishing a Protocol to implement the proposed changes,we can expect to see the Protocol adopted in Australia as well.
Overall, the Protocol is very positive for the industry. The clarifications will enhance the certainty of the ISDA Master Agreement and may avoid some of the contrary interpretations that have been proposed as to how Section 2(a)(iii) is intended to operate.