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| David Geen |
The International Swaps and Derivatives Association is working on amendments to section 2(a)(iii) of its master agreements to reduce legal disputes in cases of default. “The changes we’re proposing reflect the market's expectations as to what the agreement says,” said David Geen, general counsel at ISDA in London. He went on to say that creating the amendment was ISDA’s way of pre-empting rulemaking on the matter that the U.K.’s HM Treasury had said was the alternative to a market solution.
Section 2(a)(iii) says that if one party in a swap defaults, the counterparty does not have to continue making payments. This part of the agreement was meant to protect market participants from increasing their exposure to a party about to default or that has already defaulted.
The section came into focus after four recent cases examined the enforceability of Section 2(a)(iii), where the defaulted companies sued their counterparties for stopping payments. At the same time, the counterparties did not close the deals. Three of the four recent cases involve Lehman Brothers. “The Treasury had the concern that in the winding up of a large investment bank, if these counterparties have the right to effectively withhold payments but not close out the transactions, that delays the process of finalizing the bankruptcy,” Geen said.
In late 2009, the U.K.’s Treasury called on ISDA to address the uncertainty in Section 2(a)(iii). The Treasury also made clear it could create its own rules on the matter if the market did not reach an adequate solution.
The main proposed change to 2(a)(iii) limits the length of time parties can withhold payments from counterparties to 90 or 180 days from the first payment date after the counterparty goes bankrupt. Beyond that time, the counterparty would have to close the transaction, which may result in some payments to the defaulted company. The exact length of time has yet to be decided. Currently there is no time limit.
Other changes would make it clear that even if payments are suspended, the company’s obligation to pay doesn’t disappear. The changes would also clarify in the 1992 Master Agreement that interest is due on those suspended payments; this is already made clear in the 2002 master.
The amendments should bring further clarity to the market in case of counterparty defaults. Questions will remain, however, over the interaction with bankruptcy law, Geen said. “Local bankruptcy law will override the agreement,” he added. “If provisions of the contracts are inconsistent with local bankruptcy law in a given jurisdiction, a court might find those provisions unenforceable.”
Once the amendments are agreed on, they will become part of agreements governing new swaps. ISDA may also issue a protocol to incorporate the changes in existing ISDA agreements. ISDA has asked for comments on the amendments by sometime in May.