In recent years, one clause of the ISDA Master Agreement has been the source of a great deal of consternation among derivatives lawyers: the condition precedent set forth in Section 2(a)(iii), which purports to suspend a party’s payment obligations in the event of a continuing default by the other party. Although this clause has been included in standard form swap template documents since the original 1985 ISDA Code of Standard Wording, Assumptions and Provisions for Swaps, cases arising out of the recent financial crisis have tested the parameters of such suspension and highlighted the uncertainty regarding the ability of a non-defaulting, non-performing party to rely thereupon. Because trillions of dollars of transactions are governed by these provisions[1] there has been a great desire to adopt uniform language to resolve the uncertainty. Practitioners in this area have come up with a variety of solutions, but so far no provision has yet emerged as “standard.” The International Swaps and Derivatives Association (“ISDA”) has been attempting to address the lack of standard provisions and recently released draft language for consideration by ISDA members.

I. Section 2(a)(iii) 

Under Section 2(a)(iii), a party’s payment obligations under the ISDA Master Agreement are subject to the condition precedent, among others, that there is no Event of Default or Potential Event of Default with respect to the other party. In other words, a non-defaulting party is excused from performance while a default exists with respect to the defaulting party.

The purpose of Section 2(a)(iii) is to protect a non-defaulting party from incurring additional exposure to a defaulting party. If the non-defaulting party terminates soon after a default, other provisions of the ISDA Master Agreement will take over to administer the rights and remedies of the parties. If the non-defaulting party does not terminate after a default, however, it may decide to continue to perform. But if the non-defaulting party does not terminate, and does not perform (in reliance upon the defaulting party’s failure to satisfy the condition precedent in Section 2(a)(iii)), a deadlock of sorts can be created.[2]

II. Legal Interpretations and Unresolved Issues 

In the wake of Lehman Brothers’ insolvency, the U.S. Bankruptcy Court in the Southern District of New York found in Metavante[3] that a non-defaulting party that relied upon Section 2(a)(iii) to withhold payment for one year following its Lehman counterparty’s Chapter 11 filing had forfeited the right to then terminate the ISDA Master Agreement once its position under the swap moved in-the-money. In similar cases in the UK[4], however, the English High Court found that Section 2(a)(iii) is effective to suspend payment obligations of the non-defaulting party until the relevant default is cured, although the High Court stated that obligations suspended by Section 2(a)(iii) themselves are terminated on the expiry of the relevant underlying transactions; thus, Section 2(a)(iii) could potentially be effective indefinitely. Interpretation issues arising in the context of Section 2(a)(iii) include, among others, how long a non-defaulting party may rely on Section 2(a)(iii) in order to suspend its own payment or performance, how long it may wait to decide whether to terminate the ISDA Master Agreement and to what extent defaults are curable for purposes of Section 2(a)(iii).[5]

III. Current Developments 

In light of these cases and the uncertainty arising from the divergent outcomes under different jurisdictions, market participants have often negotiated potential contractual solutions, including, among others, insertion of provisions that would limit the application of Section 2(a)(iii) to a specific time period,[6] “fish or cut bait” provisions that would deem defaults to be waived if termination rights are not exercised within a certain specified period, adding clarifying language stating that Section 2(a)(iii) only applies unless and until a default is cured, or permitting a novation to a creditworthy counterparty as a potential default cure.

ISDA has also established an internal working group to explore issues related to Section 2(a)(iii) and analyze potential solutions. Most recently the group has circulated a draft that, among other things, would grant a defaulting party the right to designate a 90-day time limit on the non-defaulting party’s ability to suspend its payment obligations in reliance on Section 2(a)(iii).[7]

ENDNOTES:

1. As of end-June 2013, statistics released by the Bank for International Settlements show $693 trillion in total notional amount and $20 trillion in gross market value (replacement cost) of outstanding over-the-counter derivatives contracts. Bank for International Settlements, Statistical Release: OTC Derivatives Statistics at End-June 2013, November 2013, available at: http://www.bis.org/publ/otc_hy1311.pdf.

2. Where the non-defaulting party is out-of-the-money at the time of the default, it is incentivized not to terminate the ISDA Master Agreement in order to avoid paying out a termination payment, at the same time that Section 2(a)(iii) purportedly grants it the right to withhold performance.

3. In re Lehman Brothers Holdings, Inc., Case No. 08-13555 (JMP), Bankr. SDNY, September 15, 2009.

4. Lomas v JFB Firth Rixson, Inc, [2010] EWHC 3372 (Ch), 21 December 2010; Lehman Brothers Special Financing Inc. v Carlton Communications, [2011] EWHC 718 (Ch), 28 March 2011.

5. This is distinct, but related to, a non-defaulting party’s right to set-off obligations in a close-out netting scenario after the occurrence or designation of an early termination date.

6. Note that similar amendments already exist in the ISDA Global Physical Coal Annex, the U.S. Emissions Allowance Transaction Annex and Sub-Annex F (ISDA North American Power Annex) to the 2005 ISDA Commodity Definitions.

7. Under the draft language, if the relevant default is a bankruptcy Event of Default, the 90-day time limit would continue to apply notwithstanding the occurrence of a second default; if the original default is a non-bankruptcy Event of Default, however, the occurrence of a second default during the specified 90-day period would eliminate the 90-day limit (although the defaulting party would be free to designate a new 90-day limit with respect to the non-defaulting party’s ability to suspend performance due to the second default).

The full and original memo was published by Haynes & Boone on April 23, 2014 and is available here.