Buy-side firms may be at risk of being sued for negligence if they agree to a new derivatives contract being drafted by the International Swaps and Derivatives Association (ISDA).
ISDA has been working on amending its master agreement – a standardised and widely used contract for OTC derivatives – for the past year after pressure from regulators to insert a short-term suspension of termination rights in the event of a default.
The association received a letter from senior regulators, including Bank of England governor Mark Carney, on the matter last November, with the goal to temporarily stop counterparties from claiming contracts and triggering cross-defaults as seen in during the collapse of Lehman Brothers.
Regulators are seeking to address the lack of an international law applicable across jurisdictions. The US has already implemented a stay on default clauses, but it is only valid for contracts subject to local laws. The European Union’s Bank Resolution and Recovery Directive would also only be valid within its own jurisdiction.
The new contract would remain voluntarily, raising concerns that some industry members, particularly buy-side firms, would not sign up to the new agreement.
Dick Frase, partner at law firm Dechert, told theTRADEnews.com asset managers were at risk of being sued for giving away contractual rights.
“If you voluntarily adhere to something that is contrary to your investors’ interests then there is a potential liability for negligence,” he said. “But I’m not sure you would even get that far if it’s really voluntary.”
Frase suspected the only way buy-side firms would be forced into signing the new derivatives contract is if dealers formally united and agreed to stop doing business with those that didn’t agree to the clause.
“At that point, then maybe the buy-side wouldn’t be liable for negligence because they’d have no option other than to deal on those terms,” he said. “But that would be an extreme position to take. It’s so remote from a free market that it would be hard to envisage.”
Richard Metcalfe, director of regulatory affairs at the Investment Management Association, agreed the contract could overlap with the responsibility of an asset manager to its clients. “Fund customers may turn around and ask why that right of early termination has been signed away.”
“Asset managers need to think about it before they sign. They potentially have to communicate with a lot of clients, particularly if it’s a collective investment fund with hundreds of end-customers.”
It is understood ISDA has the new framework ready from a legal perspective, but ISDA chairman Stephen O’Connor said it was important to think through the consequences of partial adoption. “The most important thing now is discussing what happens next.”
If only part of the industry signs up to the new ISDA framework, it could create unfairness by allowing some firms to get out of contracts, while trapping others. This would also hinder the ability to resolve an institution in an orderly way.
Asked whether inserting a grandfather clause could solve the problem, O’Connor said it would still not achieve the regulator’s aim.
“Some of these transactions can go out 10, 20 and 30 years. And the average life of any institution can be four, five, seven years. If we just do it for new transactions, the situation may get better with time, but it may take a long time,” he said.