* Solvent party cannot avoid paying defaulting counterparty
* Automatic close-out periods still on the cards
By Huw Jones
LONDON, April 3 Trade derivatives and end up
owing money to a counterparty who goes bust and you will still
have to pay out, a UK court decided on Tuesday, in a ruling that
shelves radical changes to a framework contract governing
millions of transactions worldwide.
The judgement from the Court of Appeal in England and Wales
looked at early termination and payouts under the "master
agreement" contract when one counterparty goes bust.
One of the cases the court looked at involved a contract
with Lehman Brothers, whose collapse in 2008 triggered global
market turmoil and a trail of disputed contracts.
The court ruled that a counterparty still in business could
not rely on a "Section 2" clause in the master agreement to
avoid paying out to the bust counterparty.
A lower court judge had ruled it was unfair on the
non-defaulting side of the contract to pay out in such a case.
This had piled pressure on the International Swaps and
Derivatives Association (ISDA) to plan radical changes to its
master contract, which covers around 90 percent of the world's
$700 trillion off-exchange derivatives market.
ISDA said Tuesday's ruling affirmed its long-standing views
on how the master agreement operates.
"The judgement makes many of the changes we had proposed to
make to Section 2(a)(iii) and related provision of the ISDA
master agreement unnecessary," an ISDA spokeswoman said.
TIME LIMITS LOOM
There had been few cases to test the master agreement, the
bulk of which are completed under UK or U.S. law.
Under the agreement, Lehman's bankruptcy was considered a
default but some of the bank's counterparties had elected, based
on their interpretation of Section 2, not to terminate their
contracts as they would have had to pay out to the defunct bank.
"The Court of Appeal judgment is in line with what the
market always understood the position to be. It's normal service
being resumed," said Marc Florent, a partner at Allen & Overy
who represented ISDA in court.
Markets had always assumed that if you wanted certainty
following a default by a counterparty, it was best to close out
the contract, Florent said.
"There is now a stronger incentive to close out rather than
sit back and rely on Section 2," Florent said, adding that most
financial institutions had always preferred to close out early
in any case to avoid uncertainties on their books.
The ability to avoid payouts was going to be short-lived in
Britain's government is putting pressure on ISDA to
introduce automatic close outs of contracts with bankrupt
companies, say after 60 or 90 days. Regulators want a master
agreement that is clear and works when it comes to winding down
an ailing bank.
"The proposed time limitation is still relevant, and so we
will continue our discussions on that," the ISDA spokeswoman
A U.S. court has also 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.