2.1.4.70.9 Amended Condition Precedent or Additional Termination Event - Optional

This item contains two suggested approaches for dealing with an issue concerning Section 2(a)(iii) of the ISDA Master Agreement (commonly referred to as the "flawed asset" provision).

The issue

Section 2(a)(iii) of the ISDA Master Agreement provides that the obligation of a party to make a payment or delivery is subject to the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing.

There could be circumstances where, following a party becoming a Defaulting Party, the other chooses to exercise their rights under Section 2(a)(iii) to avoid making payments to the Defaulting Party. This could be to the disadvantage of the Defaulting Party because a Defaulting Party does not have the right to terminate the ISDA Master Agreement.

Examples of circumstances where a Non-defaulting Party may decide to exercise its rights under Section 2(a)(iii) are if the Defaulting Party:

  • would be entitled to receive the Section 6(e) amount if the ISDA Master Agreement were to be terminated; or
  • is holding only bought options and has fully met its premium obligations.

If Section 2(a)(iii) is not adjusted to deal with these types of circumstances, it can mean that the Non-defaulting Party is never required to pay (unless the event of Default or Potential Event of Default is no longer continuing), even if it is out-of-the-money[1]. Some parties may find the outcome of Section2(a)(iii) inequitable. If the parties want to address this issue, two methods of approaching it are commented on below.

First suggested approach - condition precedent

The first suggested approach for dealing with this issue is to include an additional provision in part 5 of the Schedule, as follows[2]:

"(#) The condition precedent in Section2(a)(iii)(1) does not apply to a payment or delivery owing by a party if the other party has satisfied in full all its payment and delivery obligations under Section 2(a)(i) and Section 9(h)[3] and has no future payment or delivery obligations, whether absolute or contingent, under Section 2(a)(i) or Section 9(h)." [4]

Care!  See "1992 ISDA Master Agreement" for necessary amendments if the parties are using a 1992 ISDA Master Agreement.

Here is an explanation of this clause (for ease of reference, the original Defaulting Party is referred to as Party X and the original Non-defaulting Party is referred to as Party Y):

  • The clause does not impact on Party Y's rights to close out. They remain free to exercise their right to terminate following an Event of Default in respect of Party X (in which case Section 6(e) operates);
  • The clause provides a mechanism to allow Party X to terminate in certain circumstances. This arises as follows:
    • Party X must satisfy in full all its payment and delivery obligations (including interest under Section 9) (and not have any possible additional obligations, eg when it only has fully paid options);
    • the satisfaction of those obligations removes the flaw contained in Section 2(a)(iii) with the result that Party Y must perform all their obligations in order to avoid becoming a Defaulting Party themselves under Section 5(a)(i). This includes:
      • all Section 2(a)(i) amounts payment of which have been deferred (because of Section 2(a)(iii)) while Party X has been in default; and
      • interest under Section9(h)(i)(3)(A) for the period of deferral;
    • accordingly, if Party Y fails to pay these amounts (or any other amounts) when due and that failure continues for the grace period set out in Section 5(a)(i), Party X is entitled to terminate the Agreement under Section 6(a) (ie it may be able to accelerate its rights if it is holding only fully paid options).
  • Care! Party X should act carefully in these circumstances. If Party Y elected to pay only its deferred Section 2(a)(i) amounts and not the accumulated interest, Party X should not terminate the agreement under Section 6(a) because the Unpaid Amounts of Party Y would not include deferred interest if Party Y had paid all of its Section2(a)(i) amounts but not the accrued interest.[5] Instead, Party X should sue for the deferred interest without terminating the agreement.

Second suggested approach - Termination Event

Another possible approach to deal with this issue is to include an Additional Termination Event as follows:

"(g) Additional Termination Event will apply. The following will constitute an Additional Termination Event:

An Event of Default occurs with respect to a party ("Party X"), Party X has satisfied all its payment and delivery obligations under Section 2(a)(i) and Section 9(h) with respect to all Transactions and has no future payment or delivery obligations to the other party ("Party Y") whether absolute or contingent under Section 2(a)(i) or Section 9(h)[6], and, for a period of one Business Day after Party X has satisfied all those obligations[7]and notified Party Y that it has done so, Party Y refuses to make a payment or delivery to Party X based upon the condition precedent in Section2(a)(iii).

For the purpose of the foregoing Termination Event, the Affected Party shall be Party X. However, despite Section 6(b)(iv), Party X is the party entitled to give the notice under Section 6(b)(iv) designating the Early Termination Date for the foregoing Termination Event."

Care!  See "1992 ISDA Master Agreement" for necessary amendments if the parties are using a 1992 ISDA Master Agreement.

Here is an explanation of this clause:

  • Again, the clause does not impact on Party Y's rights to close out. It remains free to exercise their right to terminate following an Event of Default in respect of the other party (in which case Section 6(e) operates);
  • The clause provides a mechanism to allow Party X to terminate in certain circumstances. This arises as follows:
    • Party X must satisfy in full all its payment and delivery obligations (including interest under Section 9) (and not have any possible additional obligations);
    • Party Y must refuse to make a payment or meet a delivery obligation (based on the condition precedent in Section 2(a)(iii)) for a period of one Business Day after Party X satisfies all its obligations and has notified Party Y that it has done so;
    • following this refusal, Party X can terminate. If Party X only has fully paid options at the time of default, it could terminate all transactions as soon as the next payment or delivery falls due under an option they exercise following the default. If Party X continues to have contingent obligations (such as a current interest rate swap), it cannot terminate until all those obligations have matured.

Comments:

  • Party Y does not become a Defaulting Party under this approach. Importantly, this means that if an Event of Default occurs which cannot be remedied (such as insolvency), interest never becomes payable under Section 9(h)(i)(3)(A) in respect of Party Y's Section 2 (a)(i) amounts (ie the failure to satisfy the condition precedent under Section 2(a)(iii) of no Event of Default means that Party Y's Section 2(a)(i) amounts never become "payable")[8]. Thus if Party X paid all amounts owing (including interest), Party Y could avoid having to pay deferred interest by paying their accumulated Section 2(a)(i) amounts within the required timeframe. It is considered that this is not as even-handed as the suggested solution first set out in this item;
  • As for the first suggested approach, in some situations this approach could result in Party X being able to accelerate its rights (ie when it only has fully paid options).

1992 ISDA Master Agreement

Care should be exercised when using these suggestions in the context of a 1992 ISDA Master Agreement. Although the same analysis applies the reference to "Section 9(h)" in each alternative should be replaced with a reference to "Section 2(e)".

 

[1]  This principle was confirmed in the NSW Supreme Court decision of Austin J, in Enron Australia v TXU Electricity [2003] NSWSC 1169 (confirmed on appeal to the NSW Court of Appeal (Sims and Singleton as Liquidators of Enron Australia Pty Limited v TXU Electricity Limited & Anor [2005] NSWCA 12)).

[2]  This is the approach suggested on page 7 of the User's Guide to the 1992 ISDA Master Agreements (apart from the reference to Section 9(h)). Although the suggestion has not been repeated in the User's Guide to the2002 ISDA Master Agreement, we think the issue remains equally as valid for the 2002 ISDA Master Agreement.

[3]  The reference to "Section9(h)" has been included as a result of the decision in Enron Australia Finance v Yallourn Energy [2005] NSWSC 56. One finding in that decision (confirmed on appeal in Yallourn v Enron Australia (in liq) [2005] NSWCA 326, 20 September 2005) was that it was not necessary for Enron to pay accrued default interest in order for it to have satisfied all its payment obligations. The reference to Section9(h) means that accrued default interest would have to be paid in order for the Defaulting Party to take advantage of the clause.

[4]  It is not considered necessary to refer to a one Business Day cure period in this provision because it already applies because of the operation of Section 5(a)(i) of the 2002 ISDA Master Agreement (cf with the reference to one Business Day in the other possible approach explained below).

[5] This is because "Unpaid Amounts" is defined as the sum of an amount that becomes payable under Section 2(a)(i) that remains unpaid at the Early Termination Date, together with interest on that amount. The difficulty is that if Party Y (the Non-defaulting Party) pays the Section 2(a)(i) amounts but not accrued interest, then it will only be default interest under Section 9(h) that remains unpaid. The default interest on its own is not an Unpaid Amount. Accordingly, in this scenario the obligation to pay it would be extinguished.

[6]  The reference to Section9(h) has been included for the same reason as in the Suggested approach above.

[7]  The phrase relating to the one day waiting period is included to clarify how long the period of refusal must be before the Defaulting Party can terminate (this ties in with the one Business Day cure period for a failure to pay in Section 5(a)(i) of the 2002 ISDA Master Agreement).

[8]  The Court of Appeal in Yallourn v Enron (ibid) made a finding relevant to this point. This is that, in order to avoid the Defaulting Party terminating because the Non-defaulting Party refuses to pay, the Non-defaulting Party need not pay interest on its Unpaid Amounts from the time they would have fallen due, but for the Defaulting Party's default, up to the time they actually fall due. This is because no interest accrues until the Non-defaulting Party fails to pay when required. Because of Section 2(a)(iii), no obligation to pay accrues while the Defaulting Party is in Default.


Last Update Date 29 Jun 2011