The International Swaps and Derivatives Association, Inc. (“ISDA”) is preparing forms of amendment to its boilerplate master agreements in connection with market practice relating to the suspension of payments by a non-defaulting party. ISDA is also considering a protocol to implement the amendments into existing agreements on a multilateral basis.
Currently, Section 2(a)(iii) of the ISDA master agreements permits a non-defaulting party to indefinitely withhold scheduled payments it owes on transactions while at the same time not requiring that party to terminate its outstanding transactions. This contractual provision has been treated differently across jurisdictions in disputes. Most recently, cases relating to the Lehman bankruptcy, both in New York and in the United Kingdom, have brought additional attention to this provision. In one case, known as Metavante (2009), a New York bankruptcy court concluded that by failing to terminate its existing transactions with Lehman for more than 11 months after its bankruptcy filing, the non-defaulting party had waived its right to terminate pursuant to the “safe harbor” provisions of the U.S. Bankruptcy Code and, therefore, no longer had the right to suspend scheduled payments. In another case, known as Lomas (2010), the English High Court decided that the non-defaulting party could withhold scheduled payments indefinitely (i.e., the court refused to imply that the parties had intended to limit such a suspension only for a “reasonable period”), and that the non-defaulting party was not obligated to terminate its five outstanding swap transactions (in which case it would have owed Lehman some US$57.3 million). The Lomas court also concluded that any suspended payments would be extinguished on the last scheduled payment date of a transaction, provided that the condition precedent had not been satisfied (i.e., the default had not been cured) at such time.
The original intent of Section 2(a)(iii) was to protect a non-defaulting party from increasing its exposure to a defaulting party (or a party that was approaching default). However, the conflicting decisions present significant uncertainty and litigation risk for market participants and have, in some respects, upended market expectations. As a result, ISDA is considering certain amendments that would clarify and restrict a non-defaulting party’s rights under Section 2(a)(iii). Specifically, ISDA may consider proposing a time limit for suspension of payments (e.g., 90-180 days after a party withholds a scheduled payment), after which a non-defaulting party must perform or terminate. ISDA also may consider clarifying that a party’s obligation to pay suspended payments survives—and is not extinguished—upon the scheduled termination of the relevant transaction. Of course, even with these amendments, contractual provisions permitting a party to suspend payments to a bankrupt entity would be subject to applicable local bankruptcy law.