Legal development

Sanctions test illegality clauses in financial contracts

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    key points
    • Identify which master agreement covers the relevant relationship and transaction.
    • Disruption events or fallbacks may apply at transaction level.
    • A failure to pay might be characterised as an event of default, entitling the non-defaulting party to terminate all transactions under the agreement.
    • Particularly in the case of derivatives, illegality provisions may apply which avoid an event of default but give rise to separate termination rights.
    • Sanctions regimes may provide for alternative methods of payment, such as the use of blocked accounts.
    • Sanctions regimes may restrict or prevent a party’s right to exercise rights of termination or to pay or receive amounts which become due once the agreement is terminated.
    • In many cases the sanctioned entity will be the party required to carry out the close-out valuations, which may give rise to practical difficulties or challenges.

    The recent sanctions imposed in response to the war in Ukraine have meant that the consequences of illegality under financial transactions such as derivatives, repo and securities lending have again been in the spotlight for financial institutions and their clients. The legal position varies across different market standard agreements.

    This article considers the relevant provisions in the ISDA Master Agreement (2002 version) (ISDA Master Agreement), the Global Master Securities Lending Agreement (2010 version) (GMSLA) and the Global Master Repurchase Agreement (2011 version) (GMRA), in each case assuming that the governing law is English law.


    The ISDA Master Agreement is typically used to document OTC derivative transactions, which can be options, swaps, forwards, or a combination of these, and may be physically settled or cash settled.

    The GMSLA is used for securities lending transactions under which lenders typically charge a fee to lend securities on a title-transfer basis.

    The GMRA is used for repurchase transactions, which typically have a financing purpose. Securities are sold for a purchase price and then repurchased at a later date by the original seller for a repurchase price which includes a price differential.

    Regular payment obligations

    An OTC derivative transaction under an ISDA Master Agreement may involve periodic cashflows during the life of the transaction and at maturity, including collateral transfers. Both the GMSLA and the GMRA envisage the periodic payment of income amounts and/ or price differential on the securities, as well as daily collateral payments to offset changes in exposure. On maturity of the transaction the original securities (or equivalent securities) are transferred to the original lender or seller. In the case of a securities loan the collateral will be returned and in the case of a repo the repurchase price is payable. The imposition of sanctions may restrict one or both parties from making or receiving such payments either during the life of a transaction or at its maturity.

    Close-out netting

    All three types of agreement manage risk through close-out netting. This means that if there is an event of default or termination event, one or both parties becomes entitled to terminate transactions under the relevant agreement and net the resulting values of the terminated transactions into a single payment. Where sanctions apply, this payment obligation itself may be impacted, as the party making or receiving such payment may be subject to restrictions.

    Different approaches to illegality

    There are material differences between the different forms of agreement used under English law. The principal difference in the context of sanctions is that the ISDA Master Agreement contains express provision for illegality whereas, unless they are modified, the standard form GMSLA and GMRA do not.

    Illegality under the 2002 ISDA Master Agreement

    Under an ISDA Master Agreement, if a party fails to make a payment or delivery under a derivative transaction because sanctions apply, there are two main possibilities. The failure could constitute an Event of Default, subject to expiry of the relevant grace periods, under s 5(a) of the agreement. However, where it is unlawful on a particular day for a party to make or receive a payment or delivery, or it would be unlawful if the relevant payment or delivery were required on that day, “Illegality” may apply.

    An "Illegality" is a Termination Event under the ISDA Master Agreement and the party for which it is unlawful to make or receive the payment or delivery is defined as the "Affected Party".

    Contractual fallbacks

    The above is subject to any other contractual fallbacks that take precedence. The transaction confirmation may provide for alternative outcomes in the event of sanctions, or may incorporate provisions from relevant ISDA product definitions which govern the situation. For example, the 2002 ISDA Equity Derivatives Definitions contain a “Change in Law” provision that may trigger termination rights in respect of equity derivative transactions upon the imposition of sanctions. It is therefore important to establish whether any contractual terms apply prior to the illegality provisions in the ISDA Master Agreement.

    It will also be necessary to consider whether the relevant sanctions regime provides for payment to be made lawfully in a way that does not make the proceeds available to the sanctioned entity, for example by payment to a blocked account. However, this may still constitute a technical non¬performance of the contract as it may not comply with the terms of payment.

    Effect of illegality

    Where there is a failure to pay arising from an “Illegality”, the ISDA Master Agreement provides that the relevant failure will not be treated as an Event of Default, but that either party will have a right to terminate after the expiry of a "Waiting Period". In the 2002 ISDA Master Agreement, this period is three Local Business Days from the occurrence of the relevant event or circumstance, except in the case of a failure to pay a margin call in which case there is no Waiting Period. This provision has the following effects:

    • first, the party that was unable to pay or deliver due to the Illegality is not treated as being in default by reason of such failure, although the obligation to pay is not itself extinguished. This avoids other adverse consequences for that party, such as the triggering of cross-default clauses in other trading or financing agreements;
    • second, the Waiting Period creates a period during which the situation might be resolved, for example if the Affected Party is able to apply for a licence from the relevant sanctions authority to perform payment or delivery obligations under existing contracts; and
    • third, the fact that Illegality constitutes a Termination Event means that either party can terminate the affected transactions by notice to the other.

    This termination right enables a party to crystallise the market exposure under the affected transactions and trigger a net termination payment by one party to the other based on the close-out value of the terminated transactions. Whilst sanctions may prevent the termination payment being paid or received, early termination means the parties do not continue to run market risk on trading positions which cannot be performed.  

    Process for termination

    The process for termination following an Illegality differs from termination for an Event of Default. In the case of an Event of Default, all transactions under the ISDA Master Agreement are terminated. Where a party terminates for Illegality, only the transactions affected by the Illegality can be terminated, although in practice this may mean all transactions. The terminating party can elect to terminate some, and not all, of the affected transactions. If it only terminates some transactions, then the other party can elect to terminate all affected transactions.

    The position is different where a party is unable to pay a margin call due to an Illegality. In this case, it is not entitled to terminate unless the other party terminates first in relation to some but not all of the affected transactions. These provisions are to avoid a situation where one party selectively terminates some but not all affected transactions.

    Who determines the close-out values

    If a failure to pay triggers an Event of Default, the non-defaulting party determines the early termination amount based on close-out valuations obtained by it. Where Illegality applies, assuming that there is only one Affected Party, the other party determines the early termination amount but must use mid-market valuations. This means that in many situations it will be the sanctioned entity that is in control of the close-out determination because the non-sanctioned entity will be the Affected Party, as the party which is prevented by the sanctions from making the payment. This can lead to difficulties if the sanctioned entity is unable to obtain market quotations or does not perform the necessary determinations.

    Payment of the early termination amount

    Following close-out, one party will have an obligation to pay the net amount to the other. This payment may itself be restricted by sanctions. The ISDA Master Agreement anticipates this situation in s 6(e)(iv), which provides that failure to pay the early termination amount will not constitute an Event of Default if such failure is due to circumstances that would constitute an Illegality. Where this applies, the amount is not extinguished but is left outstanding and accrues interest.

    Position under the GMSLA and GMRA

    Under the GMSLA and the GMRA the position is different in that neither agreement absolves a party from the consequences of a failure to perform an obligation or entitles a party to terminate transactions on the grounds of illegality. The GMRA does contain a “Tax Event” clause, applicable upon “a change in the fiscal or regulatory regime” having a material adverse effect on a party, although it is not clear whether this would apply to sanctions.

    In the absence of such provisions, it is possible that a failure to pay or deliver would constitute an Event of Default. The GMRA treats failure to pay the purchase price, repurchase price, margin transfers and manufactured income as events of default. The GMSLA contains similar provisions regarding payment of cash collateral and manufactured income. In the absence of an “illegality” provision, under an English law agreement the obligation to make such payments would not be excused by reason of sanctions contravention unless performance were illegal under the governing law of the contract or under the law of the place for payment. For this reason, it is advisable in term financing transactions in repo or securities lending form to include provisions to address potential illegality at transaction level.

    Author: Jonathan Haines

    Further reading:

    • Are sanctions sustainable? (2022) 5 JIBFL 295.
    • Master agreements, bridges and delays in enforcement, Part 2 (2004) 12 JIBFL 443.
    • LexisPSL: Banking & Finance: Practice Note: Scope of the ISDA Master Agreement – Section 5 (Events of Default and Termination Events).

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