Reed Smith Client Alerts

In the light of increased volatility across many markets and disruptions to economic activity, parties to transactions that are subject to ISDA Master Agreements1 will need to think about what strategies they would adopt if an Event of Default occurs with respect to their counterparties.


Depending on the commercial and legal position, there may be a wide range of responses a party (the Non-defaulter) may consider in response to its counterparty (the Defaulter) becoming subject to an Event of Default. These responses might vary from restructuring the trading relationship to reduce exposure, taking additional credit support, to terminating all outstanding Transactions on the grounds of the occurrence of an Event of Default. In some situations, applicable law may prohibit or invalidate a particular approach.2

Where the Non-defaulter is out-of-the-money under the ISDA Master Agreement a key consideration is the Non-defaulter’s ability to rely on the condition precedent set out in section 2(a)(iii) of the ISDA Master Agreement.

Relying on section 2(a)(iii) of the ISDA Master Agreement

Section 2(a)(iii) of the ISDA Master Agreement provides that the payment or delivery obligations of each party under each Confirmation3 is subject to the condition precedent that (1) no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing; and (2) no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated (“Section 2(a)(iii)”).

These two features of Section 2(a)(iii) provide the Non-defaulter with the potential to avoid the obligation to make a net payment to the Defaulter.

Following the financial crisis in 2008/2009, Section 2(a)(iii) was the subject of several conflicting first instance decisions of the English courts whilst parallel matters were being considered by U.S. courts in respect of ISDA Master Agreements governed by New York law. These issues were resolved by the Court of Appeal in Lomas v. JFB Firth Rixson Inc,4, where the Court of Appeal confirmed that the effect of this provision under English law is that the Non-defaulter does not have to make payments or deliveries to the Defaulter during the continuance of an Event of Default in respect of the Defaulter. However, the U.S. courts, on the facts of their case did not reach the same conclusion (see further below).

Lomas determined that this right to suspend performance (a) does not extinguish any debt, and (b) continues indefinitely while an Event of Default in respect of the Defaulter is continuing unless otherwise agreed in the ISDA Master Agreement. In 2014, following the Court of Appeal’s decision in Lomas, ISDA issued a template amendment agreement enabling parties to amend Section 2(a)(iii) to provide for a time limit upon its reliance. This time-limited exemption was a reflection of the Financial Conduct Authority’s (FCA) discussions with ISDA and the market’s adopted position on Section 2(a)(iii) going forward. However, since this is an amendment to the ISDA Master Agreement, this provision only applies to those ISDA Master Agreements that include this amendment. Where included, the clause limits the length of time for which suspension may occur. The FCA has indicated that a period of “not longer than 90 days” would be appropriate.

It is important to note that if the Defaulter ceases to be subject to an Event of Default, then the Non-defaulter risks being called upon to perform the suspended obligation, even if the relevant Transaction has passed its scheduled maturity date. Especially in volatile markets, the value of such obligations may have changed significantly and could potentially not be in the Non-defaulter’s favour.

As a result of these issues, an important preliminary consideration before relying on Section 2(a)(iii) may be whether the relevant type of Event of Default is capable of cure. Depending on the circumstances and the terms of the ISDA Master Agreement, there may be some uncertainty about whether a particular Event of Default is curable.

Further, in the meantime, the Non-defaulter remains exposed in respect of the outstanding Transactions and may have accounting issues for these contingent liabilities to the Defaulter. Accordingly, this option is not without its risks.