Anyone with a passing knowledge of derivatives law will be aware of the controversy created by section 2(a)(iii) of the ISDA Master Agreement. Differing interpretations of 2(a)(iii) have emerged in litigation in London and the United States since the collapse of Lehman Brothers. The recent judgement of the Court of Appeal in London in Lomas v. JFB Firth Rixson Inc brings significant clarity from the English perspective. The decision upholds the interpretation of section 2(a)(iii) favoured by the derivatives market. This Client Alert puts the case in an international context, considers the impact on other agreements, and looks at how changes to the regulatory framework and proposed changes to section 2(a)(iii) may also affect the decision’s long-term significance.

Section 2(a)(iii) – the issues

Section 2(a)(iii) of the ISDA Master Agreement is a condition precedent to payment and delivery obligations arising out of transactions governed by the ISDA Master Agreement. If an Event of Default or Potential Event of Default has occurred and is continuing in respect of a party (the “Defaulter”), the effect of section 2(a)(iii) is that the other party (the “Non-defaulter”) does not have to make payments or deliveries to the Defaulter. Except where automatic early termination applies, where the Defaulter is subject to an Event of Default, the ISDA Master Agreement also leaves the Non-defaulter free to choose whether or not to call an Early Termination Date resulting in the close-out of all transactions under the ISDA Master Agreement. These two features have caused some Non-defaulters that would be net payers on a resulting close-out to seek to rely on section 2(a)(iii) to avoid calling an Early Termination Date, with the ultimate objective of escaping forever the obligation to make a net payment.

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