April 3, 2012 / 2:50 PM / in 6 years

Counterparty gone bust? You still have to pay

* Solvent party cannot avoid paying defaulting counterparty

* Automatic close-out periods still on the cards

By Huw Jones

LONDON, April 3 (Reuters) - 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.


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 any case.

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 said.

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.

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