OTC Derivative Litigation Update


Section 2(a)(iii) of the ISDA Master Agreement, Similar Clauses and Insolvency

There have been so many articles written and opinions expressed on the spate of cases on the effect of how netting provisions in over-the-counter ("OTC") derivative contracts work when a counterparty becomes in default, that you would be forgiven for being confused about the current position. Now that the dust has settled (for the time being at least), this article takes stock and seeks to make matters as straightforward as possible.

The starting point is to draw a contrast between what has been happening in the UK and how related or similar cases have been decided in the U.S. This contrast exists despite these jurisdictions sharing similar legal principles as to how the assets of an insolvent company should be distributed.

? In the UK, insolvency law requires that the assets of a bankrupt are distributed equally, depending on the proportion owed to each person. This is called the pari passu principle. The consequence of this principle is that a term in a contract that tries to get around this principle is unenforceable. However, pari passu only comes into play once formal bankruptcy proceedings have been commenced.

? U.S. legislation reaches a similar outcome by making clauses in contracts unenforceable if they try to alter the relationship between contracting parties because of the event of the bankruptcy of one of them. These kinds of clauses are called ipso facto clauses and are prohibited under bankruptcy law with very narrow exceptions.

? OTCs usually contain clauses that potentially challenge these principles. The most pertinent example of such clauses is Section 2(a)(iii) of the ISDA Master Agreement. In a normal fiscal environment, this potential challenge may go, for the most part, untested. But in the face of the scale of recession-induced OTC defaults, this has given rise to a number of important cases.

The U.S. Safe Harbors

In the United States, mainly as a result of the Enron collapse, an exception to the ipso facto rule was introduced so as to create what are known as "Safe Harbors" for derivatives. If the counterparty of the holder of a derivative becomes insolvent, these Safe Harbors permit him to act in several ways that the ipso facto law would normally prohibit...

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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