Derivatives Alerter: ISDA Illegality - Force Majeure Protocol

Under the ISDA Illegality/Force Majeure Protocol, which was published by ISDA on 11 July 2012 and announced on 12 July 2012, users of the 1992 ISDA Master Agreements now have the opportunity to change their agreements to incorporate the Illegality and Force Majeure Termination Events from the ISDA 2002 Master Agreement.  While the Protocol is not limited to specific market events, market participants may particularly wish to consider adhering to the Protocol to account for some of the possible outcomes of a potential eurozone break-up.  Like other ISDA Protocols, the ISDA Illegality/Force Majeure Protocol allows parties to avoid changing their ISDA Master Agreements bilaterally by instead doing so on a multilateral basis.

In terms of the content itself, the Protocol broadly adopts the Illegality/Force Majeure provisions from the ISDA 2002 Master Agreement, although there are a couple of differences that are based predominantly on the broader differences across the different versions of ISDA Master Agreement (e.g., use of Market Quotation in the 1992 version instead of Close-out Amount).

There is a generally held belief that the Illegality Termination Event in the 1992 ISDA Master Agreement is not as sophisticated as that contained in the ISDA 2002 Master Agreement. In particular, there are concerns which have been raised in the context of a potential eurozone break-up, that for the 1992 Illegality provision to be triggered it must be illegal for "a party" (rather than an office of that party) to perform/receive performance of its obligations and that, before termination is permitted, the relevant party must seek to transfer the affected trade to another office for a period of 20 calendar days.

The general view is that this approach does not reflect what market participants consider to be the reality that, for day-to-day functions, offices operate broadly independently of each other and that they would prefer a termination right as soon as the illegality affects the relevant office (subject to a short waiting period to see if the situation is remedied).  This latter approach is the one adopted in the ISDA 2002 Master Agreement and therefore in the Protocol.  There are other differences of detail between the 1992 and 2002 versions (and therefore between the 1992 and Protocol versions), which may also be beneficial to one or both parties (for example, which party can terminate, and how many trades it can terminate).

In relation to Force Majeure, this is generally seen as a helpful addition to the ISDA Master Agreement to address those circumstances where, despite not being illegal, it is not possible to perform or accept performance.  An added benefit of incorporating the Force Majeure Termination Event is that, while the circumstances in which the English law doctrine of frustration might otherwise apply appear to be rather extreme, the introduction of a Force Majeure provision makes them even more remote (since frustration only applies if the consequence of non-performance is not dealt with by the parties in the contract itself). "Force majeure" is not a term of art under English law, and has no specific definition either under English law (unlike in many other jurisdictions) or under the ISDA Master Agreement.  It is therefore possible that the Force Majeure Termination Event may introduce a degree of uncertainty in some situations, where one party may consider that an Event of Default has occurred and the other party considers that the relevant event constitutes a Force Majeure Termination Event.  It is possible to adhere to the Protocol and then bilaterally agree with a counterparty a specific definition of "force majeure", but there is a limit as to how much certainty can be achieved as there are no legal precedents in the derivatives context. However, despite the absence of a definition of "force majeure", the inclusion of the provision is generally considered to be preferable.

The general market consensus is that these provisions are likely to be useful, particularly (but not solely) in respect of a eurozone break-up.  Of course, the provisions will only take effect between those counterparties who also adhere to the Protocol (and only if the ISDA Master Agreement is covered by the Protocol, which requires certain amendments not having been made bilaterally).  In the context of a eurozone break-up, there appears to be little incentive for counterparties in jurisdictions already considered to be at risk to sign up.  That said, there is no generally held view as to whether counterparties in those jurisdictions will adhere, and it is possible that they will be encouraged to do so by market momentum.  As such, its implications for those particular jurisdictions remains to be seen. 

In assessing whether it is in your interest to adhere to the Protocol, this ultimately depends on your view as to the likelihood of the provisions being triggered (and by whom - you or your counterparty) and your view as to general take-up in the market.  It is, of course, open for counterparties bilaterally to agree alternative wording which is, perhaps, more onerous (for example, disapplying the waiting period, or saying that a failure to pay still constitutes an Event of Default even though it was prevented by an illegality or force majeure event), but save in respect of specific relationships such onerous provisions are not uniformly being included across the market and negotiations may be protracted.

For more information on this topic or on derivatives generally please contact Guy Usher, Daniel Franks or Edward Miller at Field Fisher Waterhouse LLP.

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