ISDA publishes bilateral amendment to condition precedent in Master Agreements

By Margaret Scullin

The International Swaps and Derivatives Association (“ISDA”) has published an amendment that parties to a 1992 or 2002 ISDA Master Agreement may use to revise Section 2(a)(iii) of either agreement.  Section 2(a)(iii), as originally drafted, allows a nondefaulting party to suspend its delivery or payment obligations as long as a potential or actual event of default continues with respect to the other party.  It does this by establishing a condition precedent to a party’s payment or delivery obligations that no actual or potential event of default exists with respect to the other party.


The impetus for this amendment was a request from the UK Treasury to impose a time limit on the suspension provision.  ISDA states that the amendment arose out of discussions with UK authorities and analysis of decisions considering the provision in the UK and US courts in the Lehman bankruptcy case.  UK authorities were concerned that a future administrator of an investment bank might not be able to recover the close-out amount of transactions if swap counterparties relied on Section 2(a)(iii) rather than terminating the transactions.  The English and American courts reached different conclusions about the enforceability of the provision.  The English court ultimately upheld the provision, whereas the US bankruptcy court did not.

The US case involved Metavante Corporation, which relied on Section 2(a)(iii) to withhold periodic payments from a Lehman entity following Lehman’s bankruptcy.  Metavante did not elect to terminate its transaction with Lehman, as doing so would have required Metavante to pay a close-out amount to Lehman.  Lehman sought to compel Metavante’s performance.  The bankruptcy court judge held that Section 2(a)(iii) was an unenforceable ipso facto clause that violated the automatic stay in bankruptcy and was not protected by any safe harbor.  The judge ruled that the safe harbor provisions protect a nondefaulting swap counterparty’s right to terminate swap transactions or to offset or net termination payments.  He determined that Metavante’s failure to exercise those rights and instead to simply withhold performance in reliance on Section 2(a)(iii) was not permitted by the safe harbor provisions or otherwise.  The judge also ruled that Metavante had waived its right to terminate the transaction.  A year had passed since Lehman’s bankruptcy filing and Metavante had not yet exercised its termination right.  The judge, ruling from the bench, did not discuss the non-waiver language in the ISDA Master Agreement (providing that any delay in exercising a right does not constitute a waiver of that right).  He referred to the legislative history of the bankruptcy safe harbor provisions evidencing Congress’ intent to facilitate the prompt liquidation and closing out of transactions.  He said that, while Metavante might not have been obligated to terminate the transaction immediately upon Lehman’s bankruptcy filing, it was required to act promptly and had not done so.  Metavante was directed to perform under the agreement until such time as Lehman decided whether to assume or reject it.

The Amendment

ISDA’s form of amendment allows the defaulting party to trigger a time limit on the condition precedent in Section 2(a)(iii) by giving notice to the nondefaulting party.  Where such a notice is given, the condition precedent in Section 2(a)(iii) will cease to apply a pre-agreed number of days afterward (referred to as the “Condition End Date”).  ISDA has provisionally defined the Condition End Date as 90 days following notice, but has indicated that this may be subject to negotiation.  The 90-day period was included because the UK Financial Conduct Authority indicated that the suspension period should not exceed 90 days.

The imposition of a Condition End Date by the defaulting party does not prevent the nondefaulting party from terminating affected transactions at any time.  The sole purpose of the amendment is to limit the time during which the nondefaulting party may suspend performance.

Parties electing to apply this amendment to any Master Agreement having a Credit Support Annex should also consider whether to make corresponding changes to the condition precedent that allows a nondefaulting party to withhold the delivery or return of collateral to the defaulting party. 

ISDA has structured this amendment as a bilateral amendment rather than a protocol.  This means that parties wishing to use the amendment must execute an amendment with each of their counterparties.  By contrast, a protocol allows parties to adhere and the amendment is deemed to have been made to each agreement where both parties to the agreement have adhered.  ISDA’s explanatory memo does not discuss why a protocol is not being used.  Perhaps ISDA does not anticipate widespread adoption of this amendment.  

Understandably, parties may be reluctant to limit their rights in case of a counterparty default.  Regulators in the US apparently have not been urging ISDA to introduce this type of amendment.  That may be because the Metavante ruling discussed above is thought to be a sufficient deterrent to over-reliance on the suspension provision.  Counterparties to agreements with a US corporation or other entity subject to the US bankruptcy code should be mindful of that ruling in a bankruptcy scenario.  In case of an event of default other than bankruptcy, a condition precedent such as Section 2(a)(iii) is much more likely to be enforceable.  In the Metavante case, the judge did not disagree with Metavante’s argument that, under New York contract law, performance is excused where a condition precedent has not been satisfied.  He simply said that bankruptcy law trumped the governing law of the contract.  However, swap counterparties should be aware that a waiver of contractual rights can potentially be found in any case based on the facts and circumstances, despite having non-waiver language in the agreement. 


CFTC seeks input to fix swap data reporting problems

By Margaret Scullin

“[T]he data submitted to [swap data repositories] and, in turn, to the [Commodity Futures Trading] Commission is not usable in its current form.” So said Commissioner Scott O’Malia in a speech one year ago. He described the swap data reporting problem as a “nightmare”, explaining that the absence of a common language meant that the data being reported was not uniform. The sheer volume of data was also challenging the CFTC’s information technology capabilities.

In January 2014, the CFTC announced the formation of an interdivisional working group to review the CFTC’s swap data reporting and recordkeeping requirements and ultimately to resolve reporting challenges.

This month, the CFTC published approximately 70 questions for public input. Questions address such topics as the types of information that should be reported within certain categories (such as creation data and life cycle events), challenges being faced by reporting parties, and ownership and use of reported data. Responses are due within 60 days after the publication of the request for comment in the Federal Register.

CFTC Grants Interim Relief from Trade Execution Mandate for Package Transactions

By Margaret Scullin

Responding to concerns from various market participants, the Commodity Futures Trading Commission (“CFTC”) has granted time-limited no-action relief from the trade execution requirement, which will begin to take effect next week, for “package transactions”.  A package transaction involves more than one swap or financial instrument between two counterparties that is priced or quoted as a single transaction and where the components are executed simultaneously and are contingent on execution of the other components.  Concerns were raised that subjecting one or more swaps in a package transaction to the trade execution requirement would pose operational difficulties and that more time is needed to develop the necessary market infrastructure.  Isolating components of a package transaction would pose challenges for futures commission merchants conducting required pre-trade credit checks and could cause credit limit breaches that would not occur if the transaction were considered as a whole.  Derivatives clearing organizations may not be able to simultaneously process all components of a package transaction and, as a result, may reject some and accept others.

Market participants are working toward a common standard protocol to establish workflows for efficiently processing package transactions, but more time is needed to develop and implement the market infrastructure. 

The CFTC granted no-action relief from the trade execution requirement for package transactions through May 15, 2014.  This also allows the CFTC more time to consider the issues surrounding package transactions.  The CFTC is holding a public roundtable on package transactions on February 12, 2014 to gather more information and will consider whether further relief is appropriate.

Package transactions were discussed at the CFTC’s Technology Advisory Committee meeting on February 10, 2014.  The CFTC commissioners and staff were generally open to addressing market concerns and taking action to eliminate obstacles to trading on swap execution facilities.  However, they expressed skepticism and resistance toward suggestions that more time than is currently allowed by CFTC rules for acceptance or rejection of trades may be needed to communicate information to all parties in the workflow.

The agenda for the Technology Advisory Committee meeting also included a discussion of clearing issues, such as the CFTC’s void ab initio rule for swaps not accepted for clearing.  Those issues were briefly outlined by the final witness, who cited concerns about operational readiness and the impact of the void ab initio rule on parties’ ability to resubmit swaps not accepted for clearing.  Unfortunately, the meeting had run over time and was adjourned without any response to those concerns from the CFTC.        

CFTC to hold meetings to discuss SEFs and trade execution requirements

By Margaret Scullin

The Commodity Futures Trading Commission (“CFTC”) will hold two upcoming meetings to discuss issues related to swap execution facilities (“SEFs”) and the trade execution requirement, which will commence with the effectiveness of the first made-available-to-trade (“MAT”) determination on February 15, 2014.

The first meeting will be held by the CFTC’s Technology Advisory Committee on February 10, 2014.  The afternoon session will address MAT determinations and other SEF issues, including cross-border concerns and clearing issues.  The clearing discussion will cover the CFTC’s requirements for pre-trade credit checks and guidance that swaps executed on SEFs that fail to clear should be void ab initio (discussed in previous posts, such as here).  The meeting agenda is available here.

The CFTC will hold a public roundtable on February 12, 2014 to discuss the application of the trade execution requirement to multi-legged or “package transactions”.  Various market participants had raised concerns about subjecting a swap to the trade execution requirement when it is part of a larger transaction involving one or more other swaps that are not subject to the trade execution requirement.  In certifying the first MAT determination, the CFTC stated that swaps part of package transactions would not be exempt from the trade execution requirement but committed to holding a public roundtable to examine the issue in more detail and determine if and to what extent relief would be appropriate.  The agenda for this roundtable is expected to be published soon.

Clarification of these open issues will be welcome.  However, any changes to the trade execution rules will be challenging for SEFs and participants to implement prior to the start of mandatory trade execution within days after these meetings are held.

Mandatory Trade Execution Deadlines Approach as CFTC Continues to Certify “Made Available to Trade” Designations

By Margaret Scullin

On January 28, 2014, the Commodity Futures Trading Commission (“CFTC”) announced that it had deemed certified a made available to trade determination by a third swap execution facility (“SEF”), TW SEF LLC (Tradeweb).  This follows the certification of two previous made available to trade determinations submitted by Javelin SEF, LLC and trueEX, LLC, respectively.  Two further made available to trade determinations, submitted by Bloomberg SEF LLC and MarketAxess SEF Corporation, respectively, are pending certification during the CFTC’s 90-day review process.

The swaps listed in the certified made available to trade determinations will become subject to the trade execution requirement of section 2(h)(8) of the Commodity Exchange Act (“CEA”) 30 days after certification.  Section 2(h)(8) of the CEA requires that swaps subject to the mandatory clearing requirement of the CEA must be executed on a designated contract market (“DCM”) or SEF.  Therefore, from the effective date of a made available to trade determination, the swaps listed in that determination must be executed through a DCM or a SEF, in accordance with CFTC regulations, if those swaps are subject to mandatory clearing.  Because the determinations are product-specific, rather than SEF-specific, listed swaps will be subject to the trade execution requirement regardless of the trading platform on which they are offered.

All three of the certified made available to trade determinations include LIBOR-based fixed-to-floating interest rate swaps denominated in US dollars having fixed notional amounts with various full-year tenors.  The most recent certified made available to trade determination also includes certain credit default swaps.

Javelin SEF, LLC’s made available to trade determination will take effect on February 15, 2014, trueEX, LLC’s on February 21, 2014 and TW SEF LLC’s on February 26, 2014. 

Despite the looming deadlines, some uncertainty remains about how these determinations are to be implemented.  In particular, the CFTC noted that questions have been raised about the treatment of transactions involving multiple swaps (so-called “package transactions”) where not all of the swaps are subject to the trade execution requirement.  To address these questions, the CFTC intends to hold a public roundtable on package transactions to consider whether and in what form limited relief might be appropriate.  A public meeting of the CFTC’s Technology Advisory Meeting, originally scheduled for January 21, 2014, was to include discussion of the made available to trade determination process.  That meeting has been postponed until February 10, 2014.   

The CFTC has not addressed concerns raised by the International Swaps and Derivatives Association, Inc. (“ISDA”) and the Securities Industry and Financial Markets Association (“SIFMA”) about cross-border issues arising from the trade execution requirement.  ISDA and SIFMA have commented that non-US persons could be subject to the trade execution requirement yet may have limited access to SEFs due to time differences.  They have recommended that at least one SEF should support trading of each listed swap 24 hours a day before a made available to trade determination takes effect.  ISDA and SIFMA also noted that non-US customers may be prohibited from trading on a SEF unless that SEF is registered with or licensed by that customer’s jurisdiction.  Further questions remain as to whether foreign trading platforms are required to register as SEFs with the CFTC.  The CFTC has been urged to address these concerns in order to avoid fragmentation of the market.

Perhaps more guidance will be issued before the trade execution requirement takes effect.  In the meantime, market participants that will be subject to this requirement must ensure that they have completed the onboarding process with one or more SEFs by the deadline and that they are operationally ready to comply.  This includes signing a participant agreement with each SEF and agreeing to be bound by the SEF’s rulebooks.  That alone has proven challenging, as the rulebooks have been amended frequently to incorporate evolving CFTC SEF rules and guidance.

New DCO Standards to Impact Banks and Other Clearing Customers

By Margaret Scullin

On December 2, 2013, the Commodity Futures Trading Commission (“CFTC”) published final regulations establishing additional standards for derivatives clearing organizations (“DCOs”). The primary purpose of these rules is to harmonize the CFTC’s core principles and rules governing DCOs with international standards. Specifically, the regulations were developed for consistency with the Principles for Financial Market Infrastructures (“PFMIs”) published by the Committee on Payment and Settlement Systems and the Board of the International Organization of Securities Commissions.

The PFMIs apply to all financial market infrastructures, including DCOs (also referred to as “central counterparties” or “CCPs”), which have been determined by a national authority to be systemically important. In addition to applying these new regulations to DCOs that the Financial Stability Oversight Counsel has designated as systemically important (“SIDCOs”), the CFTC will also allow DCOs that have not been designated as systemically important to elect to become subject to the CFTC regulations implementing the PFMIs. (DCOs that opt in to these regulations are called “Subpart C DCOs”, referring to the subpart of the regulations where the relevant provisions reside.)

Why would DCOs voluntarily subject themselves to additional regulation? The answer lies in the Capital Requirements for Bank Exposures to Central Counterparties published by the Basel Committee on Banking Supervision in 2012, which govern capital charges arising from bank exposures to CCPs related to derivatives. Banks’ capital charges will be significantly reduced for exposures arising from derivatives cleared through CCPs that are prudentially supervised in a jurisdiction that has adopted regulations consistent with the PFMIs (“qualifying CCPs”). Banks will face substantially higher capital charges for exposures arising from derivatives cleared through non-qualifying CCPs. Because of the incentives for banks to clear their derivatives through qualifying CCPs, non-qualifying CCPs may be at a competitive disadvantage. By electing to become Subpart C DCOs, otherwise non-qualifying CCPs are expected to be qualifying CCPs, similar to SIDCOs.

There will be costs associated with opting in, where applicable, and achieving and maintaining compliance with the CFTC’s additional standards. The Chicago Mercantile Exchange, Inc. (“CME”) and ICE Clear Credit LLC (“ICE”) have been designated as SIDCOs and therefore are automatically subject to these new rules. LCH.Clearnet LLC and LCH.Clearnet Ltd. are CFTC-registered DCOs that have not been designated as SIDCOs and therefore will have a choice as to whether to become Subpart C DCOs. Based on comments submitted on the proposed rule by LCH.Clearnet Group Limited (“LCH”), it appears that they intend to opt in to the regulations. LCH stated that it “strongly supported” the CFTC’s proposal to allow non-SIDCOs to become qualifying CCPs by complying with stricter standards. In fact, LCH proposed that the heightened standards should automatically apply to all currently registered DCOs instead of making compliance optional for non-SIDCOs.

The new and revised standards introduced by the CFTC for consistency with the PFMIs address: governance arrangements, financial resources, system safeguards, default rules and procedures for uncovered losses or shortfalls, risk management, additional disclosure requirements, efficiency, and recovery and wind-down procedures.

The enhanced financial resources requirements are likely to have the most direct and immediate impact on users of DCOs. Under previously adopted CFTC regulations, all DCOs are required to maintain, at minimum, financial resources in excess of the amount required to enable the DCO to meet its financial obligations to its clearing members notwithstanding a default by the clearing member creating the largest financial exposure for the DCO in extreme but plausible market conditions (“Cover One”). SIDCOs and Subpart C DCOs will be required to maintain financial resources sufficient to enable the DCO to meet its financial obligations to its clearing members notwithstanding a default by the two clearing members creating the largest combined financial exposure for the DCO in extreme but plausible market conditions (“Cover Two”) if the SIDCO or Subpart C DCO is either systemically important in more than one jurisdiction or involved in activities with a more complex risk profile. The CFTC has defined “activity with a more complex risk profile” to include the clearing of credit default swaps, credit default futures, or derivatives referencing either of the foregoing, as well as any other activity designated by the CFTC as having a more complex risk profile. Both of the existing SIDCOs, CME and ICE, will be subject to a Cover Two requirement. The new regulations clarify that DCOs are prohibited from including assessments as a financial resource in meeting either the Cover One or Cover Two requirement. Therefore, guaranty fund contributions must be pre-funded in order to be included in the calculation of the DCO’s available financial resources.

All SIDCOs and Subpart C DCOs are required to maintain eligible liquidity resources sufficient to enable them to perform their settlement obligations under a wide range of stress scenarios, including the default of the clearing member creating the largest liquidity requirements under extreme but plausible circumstances. Such liquidity resources must be maintained in all relevant currencies in which the SIDCO or Subpart C DCO has settlement obligations to its members. Only a short list of defined “qualifying liquidity resources” will satisfy the minimum liquidity requirements (generally, cash and certain committed funding arrangements). Several commenters raised practical concerns about the eligibility requirements, particularly the requirement to maintain resources in all settlement currencies, the requirement that sovereign obligations, such as U.S. Treasuries, be subject to prearranged funding arrangements, and the disqualification of funding arrangements including material adverse change conditions. It was argued that the restriction on eligibility of U.S. Treasuries as resources would require clearing members to deposit more cash with the DCO and that bank-affiliated clearing members could be subject to higher capital charges as a result. Despite these comments, the CFTC adopted the regulations largely as proposed with only minor modifications to the language.

Most of the new regulations will become effective on December 31, 2013; some will be effective earlier. The CFTC determined to waive the effective date requirements prescribed by statute to facilitate attainment of qualifying CCP status by year end. In order for non-SIDCOs to obtain qualifying CCP status by December 31, 2013, their election forms must be received by the CFTC by December 13, 2013. The CFTC declined to phase in the implementation of these new standards, as recommended by several commenters, but will consider individual requests for extensions of up to one year to comply with certain of the regulations.

CFTC Modifies No-Action Relief for Swaps Intended to be Cleared

By Margaret Scullin

On November 15, 2013, the CFTC Division of Swap Dealer and Intermediary Oversight (“SDIO”) issued a letter (CFTC Letter No. 13-70) providing no-action relief from certain external business conduct standards for swaps that are intended to be cleared. This letter modifies and effectively supersedes CFTC Letter No. 13-33, which was published on June 27, 2013 (the “June No-Action Letter”). According to the more recent letter, “circumstances in the market…have changed” since the June No-Action Letter was issued. Specifically, swap execution facilities (“SEFs”) have become subject to mandatory registration and the CFTC Divisions of Clearing and Risk and Market Oversight have jointly issued staff guidance on swaps straight-through-processing requirements (“STP Guidance”, discussed in a previous post).

Swap dealers and major swap participants are subject to extensive requirements under the Dodd-Frank Act and related regulations when entering into swaps with counterparties. These include the CFTC’s external business conduct standards and the requirement to execute swap trading relationship documentation, meeting prescribed standards, prior to or contemporaneously with entering into a swap transaction with a counterparty. Relief was requested due to the practical difficulties of meeting those requirements where the identity of a counterparty is unknown prior to execution (“anonymous swaps”) and because certain requirements are unnecessary and unduly burdensome in cases where swaps are of a type accepted for clearing by a derivatives clearing organization (“DCO”) and are intended to be submitted for clearing contemporaneously with execution (“Intended-To-Be-Cleared Swaps”). SDIO granted such relief in the June No-Action Letter but has now revised the scope and conditions for availing of such relief.

Differences in Scope

• The June No-Action Letter was limited to Intended-To-Be-Cleared Swaps executed off-facility. The modified relief is available, to varying degrees and subject to conditions, for Intended-To-Be-Cleared Swaps executed off-facility as well as those executed on a SEF or designated contract market (“DCM”).
• For non-anonymous swaps, the extent of relief will vary depending on whether the swap is of a type that is accepted for clearing as of the date of the no-action letter (November 15, 2013) or is subject to mandatory clearing as of the date of execution. If the swap is not of a type that is accepted for clearing as of the date of the no-action letter and is not subject to mandatory clearing as of the date of execution, then more limited relief will be available and compliance with the “core pre-execution material disclosure requirements” of the external business conduct standards will be required. This new distinction is due to concern on the part of SDIO that swaps accepted for clearing in future that are not subject to mandatory clearing may not be “sufficiently standardized” to warrant broad relief from the business conduct standards.

Differences in Conditions

The number of conditions to be eligible for relief has been reduced. Under the modified relief, the swap dealer or major swap participant must either be a clearing member of the DCO to which the Intended-To-Be-Cleared Swap will be submitted or must have entered into an agreement with a clearing member of that DCO for clearing swaps of the relevant type. (This condition is unchanged from the June No-Action Letter.) A new condition has been introduced that the swap dealer or major swap participant may not require its counterparty or its clearing futures commission merchant (“FCM”) to enter into a breakage agreement or similar agreement as a condition to executing the Intended-To-Be-Cleared Swap. This is a major departure from the June No-Action Letter, which required entry into a written fallback agreement to address the consequences of a failure to clear. Such fallback agreements were required to provide that trades failing to clear would either be void as of execution (with no amount payable to either party) or terminated upon failure to clear (with amounts payable as agreed between the parties). The latter alternative would constitute a breakage agreement and largely tracked the existing market practice of parties entering into the FIA-ISDA Cleared Derivatives Execution Agreement to govern Intended-To-Be-Cleared Swaps. The Cleared Derivatives Execution Agreement has been met with continuing opposition from the CFTC. The STP Guidance prohibited SEFs, DCMs, FCMs and swap dealers from requiring breakage agreements as a condition for access to trading on a SEF or DCM. The recent no-action letter would extend the prohibition on breakage agreements to all Intended-To-Be-Cleared Swaps, whether executed on a SEF or DCM or off-facility, as a condition of availing of the no-action relief.

Eligibility for the relief has changed in another important, and curious, way. Under the June No-Action Letter, the swap dealer or major swap participant was required to have a written agreement with its counterparty that each party would submit the Intended-To-Be-Cleared Swap to the DCO or its clearing member as quickly as technologically practicable after execution. Under the modified relief, the written agreement requirement has been replaced with an obligation on the part of the swap dealer or major swap participant to “ensure” that both parties submit the Intended-To-Be-Cleared Swap for clearing “as quickly after execution as would be technologically practicable if fully automated systems were used”. Not only does this accelerate the timing requirement (to a degree that may be unattainable by many counterparties), it also places an unreasonable burden on the swap dealer/major swap participant to ensure the occurrence of something beyond its control (submission to clearing by its counterparty). This requirement only applies to off-facility swaps but it applies regardless of whether the identity of the counterparty to the swap is known prior to execution or not. For anonymous swaps, ensuring that the counterparty submits the swap for clearing within the required timeframe would seem to be impossible. In removing the requirement for a written fallback agreement, SDIO stated its belief that no fallback, breakage or other agreement should be necessary for off-facility Intended-To-Be-Cleared Swaps, provided they are submitted for clearing within the same timeframe that would be required had the swap been executed on a SEF or DCM. The question of what would happen if such a swap fails to clear was neither raised nor answered.