Template:Isda 5(a) summ

Section 5(a)(i)

{{{{{1}}}|Failure to Pay or Deliver}} under Section {{{{{1}}}|5(a)(i)}} of the ISDA Master Agreement: where a party fails to pay or deliver on time and does not remedy before the grace period expires. The grace period for a 2002 ISDA is one Local Business Day; shorter than the three Local Business Days in the 1992 ISDA. This fact alone has kept a number of market counterparties on the 1992 form, nearly thirty years after it was upgraded.

There’s a technical funny due to the American habit of insisting on a pledge-only 1994 NY CSA and then designating it as a {{{{{1}}}|Credit Support Document}} (against the hopes and dreams of ISDA’s crack drafting squad™ when it drafted the Users’ Guide, but still), and that is a failure to pay under an English law CSA is a Section {{{{{1}}}|5(a)(i)}} {{{{{1}}}|Failure to Pay or Deliver}}, whereas a failure to pay under a New York Law CSA is a Section {{{{{1}}}|5(a)(iii)}} {{{{{1}}}|Credit Support Default}}. Doth any difference it maketh? None, so far as we can see.

Funny old world we live in.

Section 5(a)(ii)

A failure to perform any agreement, if not cured within 30 days, is an {{{{{1}}}|Event of Default}}, except for those failures which already have their own special {{{{{1}}}|Event of Default}} (i.e., {{{{{1}}}|Failure to Pay or Deliver}}, under Section {{{{{1}}}|5(a)(i)}}), those that relate to a pre-existing default (for example, default interest on unpaid amounts) and those that only bear on the “defaulting” party’s tax position, meaning that non-performance is punishment enough in itself (and does not affect the “non-defaulting” party) — that is, the non-compliant party will just get clipped for tax it could have avoided had it performed.

These are the boring breaches of agreement: those of a not immediately existential consequence to a derivative relationship (like {{{{{1}}}|Failure to Pay or Deliver}}, or a party’s outright {{{{{1}}}|Bankruptcy}}), which are not therefore hugely time critical, but which, if not promptly sorted out, justify shutting things down with extreme prejudice. Note that, while the 2002 truncates a bunch of other grace periods in the agreement (notably for a {{{{{1}}}|Failure to Pay or Deliver}}, and for discharging a {{{{{1}}}|Bankruptcy}} petition) it does not truncate the grace period for “boring” defaults, which stays at the glacially long 30 days.

All rendered in ISDA’s crack drafting squad™’s lovingly tortured prose, of course: note a double negative extragvaganza in {{{{{1}}}|5(a)(ii)}}(1): not complying with an obligation that is not (inter alia) a payment obligation if not remedied within a month. High five, team ISDA.

Repudiation

New in the 2002 ISDA: repudiation of contract. Not actually breaching it, per se, but high-handedly saying that you are going to. In writing. Could you argue that by codifying that a repudiation must be in writing to count, in a counter-intuitive way this new clause dilutes the common law rules, rather than reinforcing them? A common law repudiation can, if clear enough, be oral, by conduct, body language, morse code, semaphore and so on,

So rather than empowering a {{{{{1}}}|Non-defaulting Party}}, the addition of a narrow definition of what counts as repudiation makes their avenue of redress that teeny bit narrower. Doubtful it has ever made a difference, but — well, they said that about LIBOR didn’t they?

Note that unlike {{{{{1}}}|Breach of Agreement}}, there is no grace period to cure a Repudiation of Agreement: If you say the magic words in writing and cast the spell The death eaters will come and take your ISDA away at once, as surely as if you had failed to pay — sooner indeed: even there there is a short grace period.

Hierarchy of Events

Note that a normal Section 5(a)(ii)(1) {{{{{1}}}|Breach of Agreement}} that also amounts to a Section 5(b)(i) {{{{{1}}}|Illegality}} or a Section 5(b)(ii) {{{{{1}}}|Force Majeure}} {{{{{1}}}|Termination Event}} will, thanks to section {{{{{1}}}|5(c)}}, be treated as the latter, but a repudiatory {{{{{1}}}|Breach of Agreement}} under section {{{{{1}}}|5(a)(ii)}}(2) willl not enjoy the same leniency. If you have repudiated your contract, the fact that there happens to be a concurrent {{{{{1}}}|Illegality}} — it is hard to see how a repudiatory breach could be an {{{{{1}}}|Illegality}} in itself — will not save you from the full enormity of section {{{{{1}}}|5(a)(ii)}} {{{{{1}}}|Event of Default}} style close out.

Section 5(a)(iii)

Before you even put your hand up: no, a Credit Support Annex between the two counterparties is not a “{{{{{1}}}|Credit Support Document}}”, at least under the English law construct: there it is a “{{{{{1}}}|Transaction}}” under the ISDA Master Agreement that offsets the net mark-to-market value of all the other Transactions, so can’t be a {{{{{1}}}|Credit Support Document}} per se. It is different with a 1994 NY CSA — being a pledge document it is a {{{{{1}}}|Credit Support Document}}, but even there the Users’ Guide cautions against treating a direct swap counterparty as a “{{{{{1}}}|Credit Support Provider}}” — the {{{{{1}}}|Credit Support Provider}} is meant to be a third party: hence references to the party itself defaulting directly under a {{{{{1}}}|Credit Support Document}}.

Therefore, tediously — and we think it was avoiding precisely this tediosity that the Users’ Guide had in mind, but, best-laid plans and all that — there is an ontological difference between the mechanics of close out when it comes to a failure under a New York-law CSA when compared to non-payment under an English-law CSA.

A failure to meet a margin call under an English-law CSA or any of its modern English-law successors is therefore a {{{{{1}}}|Failure to Pay or Deliver}} under Section {{{{{1}}}|5(a)(i)}} of the actual ISDA Master Agreement; a failure to post under a New York-law CSA is a Section {{{{{1}}}|5(a)(iii)}} {{{{{1}}}|Credit Support Default}}.

Does this make any difference at all? It may do, if you have negotiated different grace periods under your CSA than those under your ISDA Master Agreement proper.

Now, before you ask why anyone would ever do that, firstly let us say that far stupider things than that happen every freaking day in the negotiation of global markets documentation, and secondly that, for example, grace periods for regulatory initial margin may well be standardised — and dealers may not have the capacity or appetite to negotiate them tightly, given the paper war they will be in in any case — so you can quite easily see 2002 ISDAs with very brief grace periods, and Initial Margin CSDs with longer ones. So won’t this be fun when it comes to closeout.

Section 5(a)(iv)

A seldom-invoked grounds for terminating an ISDA Master Agreement but note a couple of things:

Firstly, unlike {{{{{1}}}|Breach of Agreement}}, there is no grace period allowing for rectification or correction of a misrepresentation. If you make a material false statement, you are thereafter immediately, and irrevocably, at your counterparty’s mercy.

Owning up to it, and trying to make things right, does not get you out of the schtuck. Nor is there any ticking clock by reference to which your Counterparty must use or lose its close-out right (though Americans may wonder about the “course of dealing”). This is, in equal parts, a boon and bane: it does not oblige a {{{{{1}}}|Non-Defaulting Party}} to take precipitate action, so it need not act rashly; on the other hand, it gives the {{{{{1}}}|Non-Defaulting Party}} a free option and the licence to pull something out of the bag long after the misrepresentation has ceased to have any practical effect. Would anyone actually behave like such a cad? You’d like to think no, but have you met any hedge fund managers?

In any case, there is a predictable cottage industry of credit officers tasking unwilling negotiations with the thankless task of sending out notices waiving misrepresentations about facts that the credit officer should not have asked for representations about in the first place.

Secondly, a misrepresentation is faster than a Breach of Agreement. The moment a misrepresentation is made, you can get out. No waiting for 30 days to see if anything comes right.

Given this, it is curious that Misrepresentation is not more frequently cited than it is — that may be to do with the liminal vagueness of the “materiality” requirement.

Misrepresentation? Or breach of warranty?

The purist’s objection is that, since a representation is a pre-contractual statement which induced the wronged party to enter the contract and (ergo) was not, and could not be, itself, a contractual term at all — its bolt was shot, so to speak, before “minds met” — and, as such, one’s remedy for misrepresentation ought to be to set aside the contract altogether (ab initio, as Latin lovers — well, my one, at any rate — would say) voiding it on grounds of no consensus, and not suing for damages for breach of something which, by your own argument, never made it into the cold hard light of legal reality. The JC is nothing if not a purist. We feel that, as written, this provision is a bit misconceived.

Giving our friends at ISDA the benefit of the doubt we think ISDA’s crack drafting squad™ means “breach of warranty”, and were really just being loose with terminology. There again, unlike other, more fundamental obligations, misrepresentation as an {{{{{1}}}|Event of Default}} has neither a materiality threshold nor the accommodation to the wrongdoer of a grace period or even a warning notice, so perhaps not. Anyway.

This is where that mystifying Section {{{{{1}}}|3(d)}} representation comes in.

Section 5(a)(v)

The connoisseur’s negotiation oubliette.

{{{{{1}}}|Default Under Specified Transaction}} — colloquially, “{{{{{1}}}|DUST}}” — is often confused with {{{{{1}}}|Cross Default}}. In fact, they’re meant to be mutually exclusive. That won’t stop folks conflating them, though. Look, we all do it.

{{{{{1}}}|DUST}} is like {{{{{1}}}|Cross Default}}, but where {{{{{1}}}|Cross Default}} references indebtedness owed to third parties, {{{{{1}}}|DUST}} is all about non-“borrowing” style transactions — e.g., swap agreements, stock loans and repos, but only transactions between the two counterparties.

If a Counterparty experiences an {{{{{1}}}|Event of Default}} under a swap agreement (or other “{{{{{1}}}|Specified Transaction}}” with you, this will be an {{{{{1}}}|Event of Default}} under the ISDA Master Agreement.

Changes from the 1992 Master Agreement

DUST overwent quite a makeover in the 2002 ISDA. For example:

Mini-closeout carveout: Defaults require the acceleration of just the {{{{{1}}}|Specified Transaction}} in question (for general defaults) but off all outstanding transactions under the relevant master agreement (for delivery defaults). This change was made with mini-close-out under repos and stock loans in mind — a concept which the stock loan market invented after the 1992 ISDA was published, so you can’t blame ISDA’s crack drafting squad™ for overlooking it at first — where delivery failures under are common and do not of themselves indicate weakness in the {{{{{1}}}|Defaulting Party}}’s creditworthiness.

Credit support failures covered: DUST under the 2002 ISDA can be triggered by default under a credit support arrangement relating to a Specified Transaction. These weren’t included for the 1992 ISDA DUST.

Shortened cure period: In tune with the general tightening up of cure periods — you know, we’re in a new millennium, computers work properly nowadays, and all that — the cure period for a failure to make a final or early termination payment on a {{{{{1}}}|Specified Transaction}} has been reduced from three days to one. This caused many a credit officer to sadly shake her head and refuse to move to the new agreement.

Repudiation evidence: Repudiation was modified to add the phrase “...or challenges the validity of ... after “... disaffirms, disclaims, repudiates or rejects ...” to reduce ambiguity as to whether a party’s action constitutes a repudiation. Also, we imagine, by way of stiffening the criteria for what counts as a repudiation, the 2002 requires written evidence that the repudiating party has an extended middle finger. This rules out being able to close out cornered hedge-fund managers, having been “brought to the negotiating table” by their fund’svproximity to a NAV trigger and who are not enjoying having their “feet held to the fire”, shouting “Well, bugger you, I shan’t pay, and let’s see how you like that” in the heat of the moment, when they really didn’t mean it, only to discover they had inadvertently repudiated a contract they were otherwise in perfect compliance with. Of course, no risk officer would dream of closing out an ISDA Master Agreement based on an intemperate oral communication, or the proverbial extended middle finger, for which she could not subsequently prove with fairly compelling evidence. But still.

Widened definition of {{{{{1}}}|Specified Transaction}}: The “{{{{{1}}}|Specified Transaction}}” concept has been broadened to include additional transaction types such as repos, and to include a catchall clause designed to include any future derivative products that have not been thought of yet.

Voltaire and DUST

In which ISDA’s crack drafting squad™ got bogged down in the weeds once in 1987, doubled down in their in-weed bogged-downness in 2002, and we’ve been dealing with resulting confusion ever since. A case of perfection being the enemy of good enough, as Voltaire would say, in the JC’s humble opinion, especially in these modern times where, thanks to compulsory daily zero-threshold variation margining, DUST is even more of a dead letter than it even was in the good old days. To our knowledge, no ISDA Master Agreement in history has been closed out using, exclusively, Section {{{{{1}}}|5(a)(v)}}.

That said, the 1992 ISDA version is a bit skew-wiff as regards mini-closeout, and you may find assiduous counterparties hungrily licking their lips at the prospect of a hearty negotiation about this bald man’s comb.

We are talking about other derivative-like transactions, between you and the same counterparty, where the counterparty presents a clear and present danger of blowing up, but where that behaviour has not yet manifested under the present ISDA Master Agreement, meaning you have no grounds to blow them up directly. So, you know, fairly implausible scenario, but still. You want to use the event arising under this other {{{{{1}}}|Specified Transaction}} to detonate the present ISDA. The squad breaks your ability to do so down in to four scenarios:

• Counterparty fails to pay amounts falling due before maturity on a {{{{{1}}}|Specified Transaction}}, and you accelerate that transaction, but not necessarily others under the same master agreement. Here the principle is that any obligation to pay a sum of money on time is fundamental, of the essence and speaks indelibly to a merchant’s credit, whether or not one accelerates other related Specified Transactions (though, actually, walk me through the scenarios in which you wouldn’t, or even weren’t obliged to?)
• Counterparty fails to pay amounts falling due at maturity on a {{{{{1}}}|Specified Transaction}}, so you can’t “accelerate” as such on that {{{{{1}}}|Specified Transaction}}, as it has matured, but you are still out of pocket and of a mind to press a big red button — though, again, curiously, only on this Specified Transaction and not the other outstanding transactions under the same master agreement, even though you could;
• Counterparty fails to deliver assets due under a {{{{{1}}}|Specified Transaction}}, and as a result you accelerate the Specified Transaction (1992 ISDA) or all Specified Transactions under the affected master agreement (2002 ISDA — the 2002 version being designed to carve out things like mini close-out under a 2010 GMSLA as these are not credit-related;
• Counterparty presents you an extended middle finger generally with regard to any obligation under any Specified Transaction, whether you accelerate it or not. Here if your counterparty is playing craziest dude in the room, it has committed a repudiatory breach thereby losing what moral high-ground it might otherwise stand on to expect you to follow form and protocol before closing it out.

Section 5(a)(vi)

Cross Default covers the unique risks that come from lending money to people who have also borrowed heavily from others, likely on better terms than you. The basic vibe is:

If any of your other loans become payable, I want mine to be payable too.

In the ISDA Master Agreement that means I get an {{{{{1}}}|Event of Default}}. Sounds simple? Well: ride with me a while.

Origins in the loan market

Cross default grew out of the traditional loan market, and was transplanted into derivatives at the dawn of the Age of Swaps. Consider a traditional unsecured loan. Its characteristics are as follows:

Firstly, there is an identifiable lender — usually a bank — and borrower — usually a business — in a formalised relationship of dominance and subservience. Their roles in this power structure cannot change. The lender is, always, the lender: it gives away its money against the borrower’s bare promise to later give it back. The borrower does not have risk to the lender.

Secondly, a loan is an outright allocation of capital from lender to borrower. There, intrinsically, credit risk. The lender’s main concern is that the borrower can give the money back. It will want the right to force it to if the borrower’s creditworthiness takes a turn for the worse. The bank therefore wants its “weapons” pointed at the borrower. The borrower, in contrast, has no need to point any weapons at the bank.

Thirdly, the borrower has few payment obligations: usually, only periodic interest and final repayment. Most of the borrower’s obligations come at the end of the contract.

Fourthly, unless the borrower defaults, the bank cannot get its money back before expiry of the term. All it is entitled to is periodic interest on the amount loaned.

Because the borrower has infrequent payment obligations, and they are large, the bank will want to be able to call a default as soon as it thinks the customer will not be able to repay. It will not want to wait and see.

But what default events can it look to? “Failure to pay” or “breach of agreement” won’t do, because there might not be any payment obligations due under the loan. If the borrower has loans with other banks, it may owe interest on them before it owes anything under this loan.

This will make all bank lenders nervous: if the borrower becomes distressed, everyone will want to use their weapons as soon as possible: there is an advantage to being the first lender to pull the trigger. If one lender shoots — if it even becomes entitled to shoot — then the other banks will want to be able to shoot, too.

Hence, the concept of “cross default”: should a borrower be in material default under a third-party loan, cross default permits the bank to call in its loan, too, even though the borrower has not missed any payments directly. Even if none were even due.

This puts the borrower’s lenders into a standoff: all will have “twitchy trigger fingers”. All will want to accelerate their loans as soon as anybody else is entitled to.

There is a curious “systemantic” effect here: though {{{{{1}}}|Cross Default}} is designed as a credit mitigant, its very existence makes a credit default more likely.

The loan market therefore developed some “thresholds” around the cross-default concept: firstly, you could only invoke {{{{{1}}}|Cross Default}} if the borrower’s default exceeded a certain monetary value. {{{{{1}}}|Cross Default}} should only apply to events material enough to threaten the borrower’s solvency.

Recap: {{{{{1}}}|Cross Default}} is meant to protect against the risk of material uncollateralised indebtedness, on terms containing infrequent payment obligations, where the borrower also has significant indebtedness to other lenders in the market. It is a one-way right. A borrower has no cross-default right against a lender.

The ISDA evolved from the loan market

We have seen that the ISDA Master Agreement developed out of the loan market. Early swaps were offsetting loans. They were documented by lawyers who were banking specialists: they were used to thinking about the world in terms of lending.

It was only natural that early versions of the ISDA Master Agreement included the usual set of banker’s “weapons” to manage the risk of default. That included {{{{{1}}}|Cross Default}}.

Swaps are different

But swaps are not very much like outright loans. They are financing, not lending arrangements: The swap dealer does not allocate capital outright to the customer, as a lender does. Financing and lending are fundamentally different activities. They present different risks.

Swaps, also, are by their nature fully bi-directional. There is no fixed lender and borrower. (In theory, there’s no lender or borrower at all). Under a swap, either party can “owe money”. Who is “in-the-money” can change suddenly, without warning and it has nothing to do with the parties’ relative creditworthiness.

This means the {{{{{1}}}|Events of Default}} under the ISDA Master Agreement must be symmetrical and bi-directional: if there is to be a {{{{{1}}}|Cross Default}} right, it must point in both directions. Therefore, unlike in a traditional loan the {{{{{1}}}|Cross Default}} in the ISDA Master Agreement applies equally to the bank as it does to the customer.

This presents some rather curly conceptual challenges, as we will see.

Cross default is not needed in a swap

In any case, the risks of loans that {{{{{1}}}|Cross Default}} address, broadly, do not hold for swaps:

Firstly, swaps are not primarily instruments of uncollateralised indebtedness.

Secondly, there tend to be multiple small Transactions rather than a single big one: therefore payments under the ISDA architecture are frequent and flow in both directions, especially under an ISDA Master Agreement with multiple Transactions. You don’t have the “no coupon due for six months” problem.

Thirdly, ISDA Master Agreements are typically margined, so even though it is conceptually possible for uncollateralised exposure to arise under an ISDA, in practice, it there won’t be much and it will be quickly reset.

Lastly, the majority of swap end users will not have significant unmargined third-party debt: investment funds tend to invest on margin. They do not borrow under uncollateralised loans. So there are few instances of specified indebtedness that they are likely to trigger. It is far more likely that a bank counterparty or swap dealer will have material specified indebtedness. This is a bit of a self-own.

You would not expect {{{{{1}}}|Cross Default}} to often arise as a sole means of closing out an ISDA Master Agreement. Usually, there would long since have been a {{{{{1}}}|Failure to Pay or Deliver}} or {{{{{1}}}|Bankruptcy}}, and both of those events are a much more deterministic, identifiable and therefore safe means of bringing an ISDA arrangement to an end.

How does Cross Default work?

Imagine swap counterparty N who, alongside its ISDA Master Agreement with you, has significant {{{{{1}}}|Specified Indebtedness}} to lenders A, B and C.

Should N default under any of that indebtedness — that is, should any of those lenders become entitled to call in their loans, whether or not they actually do — in a total sum greater than your agreed “{{{{{1}}}|Threshold Amount}}”, you would be entitled to close out your ISDA, even though N had not defaulted in any way directly to you.

“Specified Indebtedness”

What counts as “{{{{{1}}}|Specified Indebtedness}}”? The ISDA itself defines it as “borrowed money” without further elaborating on what that means. Generally speaking, it means loans.

Financing arrangements

“Borrowed money” excludes margined financing arrangements. “Financing arrangements” include a wide selection of capital markets transactions including margin loans, synthetic prime brokerage, swaps, stock loans and repos.

These are “asset transformations” rather than borrowings and do not involve uncollateralised “indebtedness” as such: at inception, the party raising money gives title to an asset of greater value to the financer, and is subsequently margined to that asset value. Therefore net, the financing beneficiary is not a debtor at all, but a creditor.

This does not stop excitable credit officers expanding “{{{{{1}}}|Specified Indebtedness}}” to bring financing arrangements into scope. A favourite tweak is to include derivatives and securities financing arrangements without stopping to clarify how the “borrowed money” under them (hint, under a margined ISDA, there will not be any) is to be measured. Notional? Mark-to-market exposure? Outstanding payment obligations? Present value of all future payments?

Bank deposits

Bank deposits plainly are “borrowed money”, and they mightily add up: as we will see, aggregation is important when calculating the {{{{{1}}}|Threshold Amount}}.

Bank deposits illustrate the problem of having cross-default in a financing contract like an ISDA. In the traditional loan market, bank deposits tend not to trigger cross default obligations, because the sort of parties having cross default obligations do not have deposits. Only banks accept deposits. Since they are usually the lender in a commercial loan they, and their deposits, are not subject to cross default.

But ISDAs are bilateral, so a bank dealer’s deposits will be in scope and could trigger a {{{{{1}}}|Cross Default}} against a bank. It is not out of the question that a bank could be prevented from honouring deposits through operational error, IT outage or geopolitical incident. This would put it in technical default on a large number of its deposits at once.

Therefore, banks exclude retail deposits from the ambit of {{{{{1}}}|Specified Indebtedness}}. They will not lightly resile from this position, so buy-side legal eagles looking for a ditch to die in are advised to avoid this one.

Public indebtedness

With the honourable exception of public bond issuances, most {{{{{1}}}|Specified Indebtedness}} arises under private arrangements about which the market will have no reliable real-time information. No one will know how much a given borrower owes, much less whether it has defaulted and when.

This makes practical policing and enforcement of {{{{{1}}}|Cross Default}} fraught, where it is even possible.

“Default”

“Default” is described widely and (at least in the 2002 ISDA) is not restricted to payment defaults. A technical breach of representations as long as it entitles the lender to accelerate would count towards an actionable {{{{{1}}}|Cross Default}}.

Vitally, the lender need not actually accelerate the loan. The cross-default right arises as soon as it is entitled to accelerate. This makes the {{{{{1}}}|Cross Default}} event a powerful and sensitive tool. Too powerful. Too sensitive.

There is now an entirely different page dedicated to cross acceleration — a weakened version of {{{{{1}}}|Cross Default}} that requires the loan to be actually called in.

“Threshold Amount”

The {{{{{1}}}|Threshold Amount}} is the level over which accumulated defaults in {{{{{1}}}|Specified Indebtedness}} trigger {{{{{1}}}|Cross Default}}. It is usually expressed as a cash amount or a percentage of shareholder funds, or both, in which case — schoolboy error hazard alert — be careful to say whether it is the greater or lesser of the two.

Because of the extreme risk {{{{{1}}}|Cross Default}} presents, the {{{{{1}}}|Threshold Amount}} should represent an existential threat to the counterparty’s solvency. For a bank counterparty, that is typically two or three per cent of its shareholders’ equity or the cash equivalent.

A cash equivalent runs the risk of “decoupling” from the value of shareholders’ equity — especially in times of great market stress — so while it is easier to measure and monitor, it presents a greater systemic risk, and you may find it more prudent to stick with an equity-linked threshold.

Snowball risk

This “accumulation” feature means relatively trivial amounts of indebtedness can be problematic. This is particularly so where there are a lot of them — see bank deposits and swap transactions — or where the default is technical, systemic or operational. Should a system outage prevent a counterparty from honouring a class of contracts it might instantly trigger a catastrophic cross-default right across all ISDA Master Agreements.

For buy-side parties (especially for thinly capitalised investment vehicles) the {{{{{1}}}|Threshold Amount}} may be a lot lower than that — like, ten million dollars or so — and, of course, for fund entities will key off NAV, not shareholder funds.

Problematic derivatives

Bear in mind, too, that if even one of your ISDA contracts has a lower {{{{{1}}}|Threshold Amount}}, that can create a chain reaction: because the exposure under that ISDA, once it has been triggered by a {{{{{1}}}|Cross Default}}, then contributes to the total amount of defaulted Specified Indebtedness and may itself lead to {{{{{1}}}|Threshold Amount}}s being triggered in other ISDAs. And each of those then contributes … you get the idea.

The obvious solution is to exclude derivatives and similar financing arrangements from the definition of {{{{{1}}}|Specified Indebtedness}}. That is, to revert to the ISDA standard.

Cherry-picking

One last problem with including swaps: how do you measure the “indebtedness” under a Transaction?

You could, in theory, cherry-pick all out-of-the-money {{{{{1}}}|Transactions}}, total them up and cross a {{{{{1}}}|Threshold Amount}} fairly easily.

Nothing requires you to apply a Single Agreement concept or cross-transactional netting to those exposures. (Why would it? ISDA contracts are meant to be out of scope for {{{{{1}}}|Cross Default}}).

Even if you calculate {{{{{1}}}|Specified Indebtedness}} by reference to a net close-out amount, this only really highlights the imbalance between dealers and their customers. Sure, big fund managers may have ten, twenty or even fifty ISDA Master Agreements, but they will be split across dozens of different funds, each a different entity with its own {{{{{1}}}|Threshold Amount}}. Swap dealers, on the other hand, will have literally hundreds of thousands of master agreements, all facing the same legal entity. Dealers are the wrong side of this risk.

Now, you could manage this by careful negotiation — but there is a better way: excluding financing transactions altogether, for the perfectly sensible reason that they are not “borrowed money”.

Cross default as a “most favoured nation” clause

While the ISDA {{{{{1}}}|Events of Default}} are standardised, bilaterally-negotiated default events under private loans will be highly customised.

Especially since Section {{{{{1}}}|5(a)(vi)}} is pretty loose about what counts as a qualifying default:

“a default, event of default or other similar condition or event (however described) in respect of such party”.

This could include potential events of default (those which will become an event of default on expiry of a grace period). In any case, it would haul into the ISDA’s ambit any weird or sensitive default triggers in that loan documentation that deal with peculiarities of the lending arrangement and have no real bearing on the general credit position of the borrower as a derivatives counterparty.

In other words {{{{{1}}}|Cross Default}} functions as a gated “most favoured nation” clause. This is a wide, swingeing term and is likely to be much more severe against bank and dealer counterparties than end-users, since banks will have a lot more indebtedness.

Section 5(a)(vii)

The truncating the grace period from 30 days in the 1992 ISDA to 15 days in the 2002 ISDA has, in aggregate over the whole global market, kept many a negotiator in “meaningful” employment. It has also been a large reason why many organisations did not move to the 2002 ISDA and of those who eventually did — organisations whom you’d think would know better — then set about amending these grace periods back to the 1992 ISDA standard of 30 days or better still, insisted on sticking with the 1992 ISDA, but upgrading every part of it to the 2002 ISDA except for the {{{{{1}}}|Bankruptcy}} and {{{{{1}}}|Failure to Pay}} grace periods. A spectacular use of ostensibly limited resources, and an insight into whose benefit organisations really operate for.

Regional bankruptcy variations

The Germanic lands have peculiar ideas when it comes to bankruptcy — particularly as regards banks, so expect to see odd augmentations and tweaks to ISDA’s crack drafting squad™ standard language. Will these make any practical difference? Almost certainly not: it is hard to see any competent authority in Germany, Switzerland or Austria — storeyed nations all, in the long history of banking, after all — not understanding how to resolve a bank without blowing up its netting portfolio. Especially since Basel, where the netting regulations were formulated, is actually in Switzerland.

We have a whole page about Swiss Bankruptcy Language. True story.

The market standard “bankruptcy” definition

The ISDA {{{{{1}}}|bankruptcy}} definition is rarely a source of great controversy (except for the grace period, which gets negotiated only through custom amongst ISDA negotiators because, in its wisdom, ISDA’s crack drafting squad™ thought fit to halve it from 30 days to 15 in the 2002 ISDA.

So you have a sort of pas-de-deux between negotiators where they argue about it for a while before getting tired, being shouted at by their business people, and moving on to something more important to argue about, like {{{{{1}}}|Cross Default}}).

Otherwise, the ISDA {{{{{1}}}|bankruptcy}} clause is a much loved and well-used market standard and you often see it being co-opted into other trading agreements precisely because everyone knows it and no one really argues about it.

1987 ISDA and Automatic Early Termination

Note, for students of history, Automatic Early Termination is (was, right? Oh, come on, guys —) problematic under the 1987 ISDA.

Section 5(a)(viii)

When a firm merges into, or is taken over by, another, some magical — or unexpected — things can happen. Not for nothing does the ISDA Master Agreement labour over the very description: that this might be a “consolidation, amalgamation, merger, transfer, reorganisation, reincorporation or reconstitution” — prolix even by the lofty standards of ISDA’s crack drafting squad™ — should tell you something. Generations of corporate lawyers have forged whole careers — some never leaving the confines of their law practices for forty or more years — out of the manifold ways one can put companies together and take them apart again.

Your correspondent is not one of those people and has little more to say about mergers, except that what happens to live contracts at the time of such chicanery will depend a lot on just how the companies and their assets are being joined together or torn assunder.

If the ISDA Master Agreement and its extant {{{{{1}}}|Transactions}} carry across — which, in a plain merger, they ought to — all well and good - though watch out for traps: what if both merging companies have ISDAs with the same counterparty, but on markedly different terms? Which prevails? Do they both? Which one do you use for new {{{{{1}}}|Transaction}}s? This you will have to hammer out across the negotiating table.

But in some cases, {{{{{1}}}|Transactions}} might not carry across. Perhaps the resulting entity has no power to transact swaps. Perhaps it is in a jurisdiction in which they — or ISDA’s sainted close-out netting provisions, about which so many tears and so much blood is annually spilled — cannot be enforced. Perhaps the new entity just refuses to honour them.

{{{{{1}}}|Merger Without Assumption}} addresses all of these contingencies.

This is the clause that would have been covered by Section {{{{{1}}}|5(a)(ii)}}(2) repudiation, had the resulting entity accepted the contract at all in the first place. It can be triggered if the resulting party repudiates any outstanding Transactions under the ISDA Master Agreement (or otherwise they are not binding on it); or any Credit Support Document stops working as a result of the merger.