Vol 12 (2015) - Issue 3

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Can ISDA’s Close-out Protocol Stay the Next Lehman Brothers?

Introduction
The ISDA Master Agreement contains the legal framework which governs the vast majority of global overthe- counter ('OtC') derivative transactions on broadly standardised terms. One of the fundamental principles protected under an ISDA Master Agreement is the right, either automatically or by notice, of a non-defaulting party to terminate and close-out an OtC derivative transaction upon the occurrence of a insolvency default by a counterparty.
Prior to the 2008 Global Financial Crisis it was widely assumed that insolvency defaults triggering termination and close-out provisions under ISDA Master Agreements were most likely to be relied upon by banks following an insolvency default by a non-bank counterparty. The collapse of Lehman Brothers in September 2008, however, changed this view, demonstrating the possibility that a significant global financial institution could fail, causing the simultaneous trigger of insolvency defaults across a large number of ISDA Master Agreements.
Existing English and US principles treat insolvency termination rights of OtC transactions slightly differently. Under English law a party is entitled to terminate a contract on the insolvency of a counterparty as long as the termination does not infringe the anti-deprivation principle, which prohibits a counterparty from exercising rights which have the effect of depriving the defaulting party's estate of any of its assets upon its insolvency. In contrast, under the US Bankruptcy Code (the 'Code'), contractual provisions governed by US law that purport to terminate or modify a contractual term when a party files for bankruptcy (so-called ipso facto clauses) are invalid. The effect of this limitation, however, is tempered by certain safe harbour provisions in the Code which allow qualified participants under swap contracts to exercise acceleration, termination and netting rights on the insolvency of a counterparty.
A further area of divergence between English and US principles concerns the enforceability of so-called 'flip-clauses' in swap contracts, under which obligations to swap counterparties are expressed to reverse from a pre-insolvency senior payment position to a post-insolvency subordinated position on the insolvency of the other swap party. Flip clauses were considered by both the UK Supreme Court and the US bankruptcy court in parallel Lehman Brothers' cases in which the UK Supreme Court held such clauses to be effective and the US bankruptcy court found such clauses to be ipso facto clauses and therefore invalid under the Code.

Lessons from Lehman Brothers
Since the collapse of Lehman Brothers and the ensuing global financial crisis, policymakers, central banks and regulators have sought to introduce a raft of new legislation designed to assist the resolution and recovery of systemically important financial institutions ('SIFIs'). Such legislation is intended to enable SIFIs that encounter severe financial difficulties to avoid the vagaries and value destruction caused by entering into an uncontrolled cross-border insolvency.