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.
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.