In 2014 ISDA published an optional amendment to the ISDA Master Agreement removing the option for non-defaulting parties on an Event of Default to cease to make payments but leave the Transaction outstanding rather than terminating it. This amendment is set to become ISDA standard wording in the near future and is already being required by some hedge providers.
However, the new wording could force borrowers who are seeking floating rate finance for their real estate investments, and who are required (as is typical) by their lenders to hedge their interest rate risk, to conduct “fire sales” of their assets or risk default and enforcement.
This article examines the issues faced by real estate borrowers as a result of this provision and considers potential
Section 2(a)(iii) of the standard pre-2014 ISDA Master Agreement (“Original Section 2”) provides that if an Event of Default or a Potential Event of Default has occurred and is continuing in respect of a party, the other party is not obliged to make payments under the relevant Transaction that it would otherwise be obliged to make.
The English courts have held that a non-defaulting party could rely on Original Section 2 for so long as the relevant Event of Default or Potential Event of Default is continuing, which could potentially be for the remaining term of the Transaction. However, the US courts have taken a different view on this point and have held that Original Section 2 does not suspend payments indefinitely but instead allows the non-defaulting party only to at some point either terminate the Transaction or accept the obligation to continue to perform. The court in the US said that inactivity by the non-defaulting party amounted to a waiver of its right to terminate the Transaction. The US case law suggests that the non-defaulting party may have less than one year to make this decision.
Reaction to the Case Law
These cases attracted considerable comment in the market with many feeling that certain decisions ran contrary to either the clear ordinary meaning of the provisions in question or the expectations of market participants as to how these provisions would operate in practice. It was also felt that the differences in approach taken in different jurisdictions were not helpful to the efficient operation of the global derivatives market.
In the UK, regulators expressed concern Original Section 2 would make it difficult for administrators of insolvent counterparties to administer their positions and monitor their risk. They felt that delaying termination could convert assets of the insolvent estate into losses, damaging the estate’s value and reducing recoveries for unsecured creditors. A consultation exercise was launched to devise a means of allowing the non-defaulting party to decide whether to terminate in an “orderly and commercially reasonable way” while providing certainty to administrators that termination would occur “within a reasonable period”.
ISDA’s response was to create an optional amendment to Section 2 of the Master Agreement (“Revised Section 2”) under which on the occurrence of an Event of Default or Potential Event of Default, the defaulting party can give notice to the non-defaulting party requiring it to elect within a period of 90 days to terminate the Transaction or continue to make payments. Revised Section 2 restricts the right of the non-defaulting party to suspend payments to only the duration of this 90-day period and removes the right of indefinite suspension.
At present, Revised Section 2 is optional. However, the standard form ISDA Master Agreement is set to make Revised Section 2 the standard wording. Additionally, market reports indicate that some hedge providers now require Revised Section 2 in all of their ISDA Master Agreements as a matter of policy. As such, it seems that parties seeking hedges will increasingly be asked to accept Revised Section 2.
Impact on Real Estate Finance
While it is easy to see the benefits of Revised Section 2 for hedge providers, its impact on their counterparties seems to have been given relatively little consideration. One particular area where it will have a significant impact relates to interest rate swaps provided to borrowers in connection with real estate loans.
Real estate finance in Europe is predominately floating rate and it is market-standard for lenders to require their borrowers to enter into interest rate hedges in relation to such loans. While a combination of low interest rates and negative experiences with complex pre–credit crunch hedging arrangements has resulted in the majority of hedges seen in recent years taking the form of interest rate caps, this will change as interest rates increase.
When an Event of Default or Potential Event of Default arises on an interest rate swap related to a real estate loan due to hedge provider insolvency, Original Section 2 gives the borrower the option whether to terminate the swap based on its Early Termination Amount. If the Early Termination Amount is likely to be due to the borrower, the borrower can be expected to terminate so as to crystallise its claim in the insolvency proceedings of its hedge provider. However, where the Early Termination Amount is likely to be payable by the borrower, different motivations will apply and the borrower may prefer delaying termination for some time in the hope that interest rate changes reduce the amount payable. The right to make this choice could be seen as recompense for the loss to borrowers of their hedges where they have not caused the default.
Where a real estate borrower faces having to pay an Early Termination Amount, Revised Section 2 will remove its right to defer termination of the Transaction. The importance of this right to suspend payments under Original Section 2 has been shown over recent years when the expected Early Termination Amounts on some interest rate swaps have fluctuated widely over relatively short periods of time. The expected Early Termination Amounts on some sterling interest rate swaps with remaining terms of over ten years have in recent years more than doubled.
Revised Section 2 allows the defaulting hedge provider to require the borrower to choose whether to make the payments due from it or to terminate immediately. Where an Event of Default arises because of insolvency of the hedge provider, this “option” has limited value as the borrower will have little if any prospect of ever receiving any payments from the hedge provider if interest rates move in its favour. As such, Revised Section 2 gives borrowers the impossible choice of making an indefinite series of payments for a hedge under which it will receive little benefit (as they will be unsecured creditors) or making a large payment to terminate the hedge.
Revised Section 2 does not require the defaulting hedge provider to give this notice to the borrower within any particular timeframe. Accordingly, Revised Section 2 seems to allow insolvent hedge providers to choose when they want to force their borrowers to elect whether or not to terminate. It is presumed that hedge providers will exercise their rights under Revised Section 2 to maximise the Early Termination Payments due to them.
Apart from questions as to whether a defaulting party should be able to benefit from its own default, requiring fully-performing borrowers to terminate their swaps would have a series of detrimental effects:
- Where a borrower becomes obliged to terminate an interest rate swap under Revised Section 2, that borrower will likely be in breach of covenant under its loan agreement, triggering an event of default which could result in acceleration and enforcement.
- Borrowers are unlikely to have the resources to pay any significant Early Termination Amounts without selling real estate assets. Such sales will need to be completed quickly to meet the 90-day requirement and, at times, where the markets may be adverse to the borrowers, resulting in lower sales proceeds than might otherwise be the case.
- Revised Section 2 does not reflect the fact that hedge providers for real estate loans will be fully secured creditors of the borrowers but the borrowers will be unsecured creditors of the hedge providers. Where an Early Termination Amount is owed to the hedge provider, it is likely to be paid in full within the required 90-day period. However, where the Early Termination Amount is owed to the borrower, the borrower may not be paid until completion of liquidation of the hedge provider, which could take several years, and as an unsecured creditor the borrower is unlikely to recover in full. As such, the risk of loss arising on early termination is far greater for borrowers than for hedge providers and it seems unreasonable to restrict the rights of borrowers to try to minimise this.
Stronger real estate borrowers can be expected to seek to disapply Revised Section 2 entirely. However, as Revised Section 2 is the result of a regulatory initiative, it will not be abandoned lightly. Accordingly, it seems opportune to consider some possible compromises to reduce the most adverse effects of Revised Section 2.
From a real estate borrower’s perspective, Revised Section 2 would be less problematic if it did not apply where the defaulting party is fully secured. Where a defaulting hedge provider is fully secured, it has little or no credit risk and so should not need to be able to require its counterparty to dispose of its assets.
As regards unsecured hedges, Revised Section 2 could be partly mitigated by allowing the defaulting hedge provider to require payment or termination but for any resulting Early Termination Amount to be subordinated to a level below all amounts due on the related loan and to provide that the hedge provider cannot exercise any remedies to collect this payment. Similar provisions are required by the rating agencies for hedges used in highly rated securitisations and are widely accepted in the market.
Allowing a defaulting hedge provider only a single opportunity to exercise its rights under Revised Section 2 within a short stated period after the relevant Event of Default or Potential Event of Default would also reduce the risk that the defaulting hedge provider could choose the most advantageous time for it to exercise the right and so maximise the Early Termination Payment due to it. Section 6(d)(ii) of the ISDA Master Agreement could also be modified so that any Early Termination Payment is payable only to the extent that funds are available for such purpose in accordance with the terms of the loan agreement on the relevant loan interest payment dates so as to avoid triggering a cross-default under any of the borrower’s other transactions. Finally, the loan agreement should be clear that no loan-level event of default will arise for non-payment of the Early Termination Amount if the borrower has no funds available for this purpose.
ISDA’s Revised Section 2, while seeming a reasonable response to a regulatory concern in relation to insolvent financial institutions, risks creating an imbalance between the rights and remedies of parties to interest rate swap transactions that could seriously prejudice the interests of real estate borrowers. The imposition of the risks created by Revised Section 2 on all real estate borrowers seems a disproportionate response to the very unusual scenario of governments and regulators allowing a major financial institution to become insolvent rather than rescuing or restructuring it. It is hoped that lawmakers will come to realise this and a fair market based solution can be found to this matter.
For general ISDA and derivatives advice, please contact Karen Stretch, Christian Parker or Karina Bielkowicz at firstname.lastname@example.org.
 Where not expressly defined, capitalised terms used in this article follow ISDA definitions.
 Lomas and others v JFB Firth Rixson Inc. and others  EWCA Civ 419 and Marine Trade SA v Pioneer Freight Futures Co Ltd BVI  EWHC 2656 (Comm),  2 CLC 657.
 In re Lehman Brothers Holdings Inc., Case No. 08‐BK‐13555 (JMP) (Bankr. S.D.N.Y. Sept. 15, 2009). See Order Pursuant to Sections 105(a), 362 and 365 of the Bankruptcy Code to Compel Performance of Contract and to Enforce the Automatic Stay, In re Lehman Brothers Holdings Inc., No. 08‐BK‐13555 (JMP) (Bankr. S.D.N.Y. Sept. 17, 2009) (Docket no. 5209), known as the “Metavante” case.
 The FSA, as it then was, now the FCA.
 HM Treasury, Establishing resolution arrangements for investment banks, December 2009.
 Clause 8.3 of the standard form LMA Property Investment Facility prohibits borrowers from terminating their interest rate hedging arrangements.
 LMA ranks hedge payments (other than termination payments) pari passu with loan interest and hedge termination payments pari passu with loan principal.
 Note also that standard LMA provisions prevent a borrower from setting-off any Early Termination Amount owed to it against its liabilities under the related loan agreement.
 By way of example, unsecured creditors of Lehman have so far recovered only 35 cents on the dollar in the almost seven years since it entered Chapter 11.