Derivatives industry eyes UK Lehman appeal ruling

Wed Dec 14, 2011 1:22pm EST

* UK payout appeal ruling gets under way

* Ruling due in first quarter of 2012

By Huw Jones

LONDON, Dec 14 (Reuters) - Regulators and the world's $700 trillion derivatives industry are closely watching a legal battle that began in Britain on Wednesday and which will fuel a sea change in swaps payouts.

Four cases, including one involving a unit of collapsed U.S. bank Lehman Brothers, are being presented in a five-day hearing at the UK Court of Appeal.

All revolve around payouts under the derivatives industry's "master agreement", a framework contract.

A bank that trades swaps with another bank typically has one master agreement which sets the terms for millions of transactions between them.

"For a long time there were hardly any cases to test the agreement, and disputes were settled out of court," said Edmund Parker, global co-head of derivatives at law firm Mayer Brown.

"I think the outcome of this will affect how the master agreement is updated and agreements across the world."

The master agreement was drawn up by the International Swaps and Derivatives Association (ISDA), an industry body, and covers around 90 percent of off-exchange derivatives transactions.

Under the agreement, Lehman's bankruptcy is considered a default.

However, in the four cases before the court this week, the other party in the contracts elected not to terminate them because they would have had to pay out to the defunct bank.

A U.S. court has ruled in a separate case that Lehman's swaps should be closed out and payment made, saying contracts should not continue indefinitely in such circumstances.

Parker said UK regulators want swaps to be automatically closed out within a certain period following a bankruptcy, and will be scrutinising the outcome of the court case.

AMENDMENT

Regulators want a master agreement that is clear and works when it comes to winding down an ailing bank or fixing the right amount of capital buffers.

This year, Lehman lost a UK court case against television company Carlton Communications, now part of ITV. The bank had wanted Carlton to make payments on interest-rate swap agreements.

Its appeal has been bundled with three similar disputes this week.

A ruling on the appeal is not expected until the first quarter of next year but the master agreement is set to be changed by then, regardless of the outcome of the court case.

"ISDA is in the process of preparing an amendment to the master agreement which would limit the amount of time a non-defaulting party could wait before declaring an early termination date following a default," said David Geen, ISDA's general counsel, who is attending the appeal hearings.

The change would have no impact on existing swaps.

Views differ over how much time should be given before a close-out, but it could end up being between 60 and 90 days.

The UK government has signalled it will push through legislation unless ISDA sets a time limit before an early termination.

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