Template:Failure to pay procedure

Closing out an ISDA Master Agreement following an {{{{{1}}}|Event of Default}}

Here is the JC’s handy guide to closing out an ISDA Master Agreement. We have assumed you are closing out as a result of a {{{{{1}}}|Failure to Pay or Deliver}} under Section {{{{{1}}}|5(a)(i)}}, because — unless you have inadvertently crossed some portal, wormhole into a parallel but stupider universe — if an ISDA Master Agreement had gone toes-up, that’s almost certainly why. That, or at a pinch {{{{{1}}}|Bankruptcy}}. Don’t try telling your credit officers this, by the way: they won’t believe you — and they tend to get a bit wounded at the suggestion that their beloved NAV triggers are a waste of space.

In what follows “{{{{{1}}}|Close-out Amount}}” means, well, “Close-out Amount” (if under a 2002 ISDA) or “Loss” or “Market Quotation” amount (if under a 1992 ISDA), and “{{{{{1}}}|Early Termination Amount}}” means, for the 1992 ISDA, which neglected to give this key value a memorable name, “the amount, if any, payable in respect of an {{{{{1}}}|Early Termination Date}} and determined pursuant to Section 6(e)”.

So, to close out following a {{{{{1}}}|Failure to Pay or Deliver}}, you will need:

1. There must be a failure to pay or deliver under Section {{{{{1}}}|5(a)(i)}}

A {{{{{1}}}|Failure to Pay or Deliver}}, by the {{{{{1}}}|Defaulting Party}} to make a payment or delivery when due on day T. This is not, yet, an {{{{{1}}}|Event of Default}} under Section {{{{{1}}}|5(a)(i)}}. But we are on the way.

2. You must give notice of the failure under Section {{{{{1}}}|5(a)(i)}}

The {{{{{1}}}|Non-defaulting Party}} must give the {{{{{1}}}|Defaulting Party}} notice of the failure. This is not a Section {{{{{1}}}|6(a)}} notice — calm, down, we will get to that in good time — but a Section 5(a)(i) notice of failure to pay or deliver. The sainted ISDA Master Agreement does not directly prescribe the format for this notice, but Section {{{{{1}}}|12}} cautions that it may not be by e-mail or {{{{{1}}}|electronic messaging system}} or (if you have a 1992 ISDA, at any rate), by fax. The proper form is to have it hand-delivered by someone prepared to swear an affidavit as to when and where they delivered it to the {{{{{1}}}|Defaulting Party}}.

Since payments and deliveries are generally due at close of business on a given day, Q.E.D., a Section {{{{{1}}}|5(a)(i)}} notice of {{{{{1}}}|Failure to Pay or Deliver}} can usually only be given after close of business on the due date.

Thanks to Section {{{{{1}}}|12(a)}} ({{{{{1}}}|Notices}}), the Section {{{{{1}}}|5(a)(i)}} notice will only be effective on the following {{{{{1}}}|Local Business Day}}: i.e., T+1.

3. You must allow the grace period under Section {{{{{1}}}|5(a)(i)}} to expire

At this point you have a {{{{{1}}}|Potential Event of Default}}, but not an actual one.

Once your Section {{{{{1}}}|5(a)(i)}} notice of {{{{{1}}}|Failure to Pay or Deliver}} is effective, the {{{{{1}}}|Defaulting Party}} has a “grace period” in which it may sort itself out and make the payment or delivery in question, thereby heading off a full-blown {{{{{1}}}|Event of Default}}.

The standard grace periods are set out in Section {{{{{1}}}|5(a)(i)}}. Be careful: under a 2002 ISDA the standard is one {{{{{1}}}|Local Business Day}}. Under the 1992 ISDA the standard is three Local Business Days. But check the {{{{{1}}}|Schedule}} because in either case this is the sort of thing that counterparties adjust: 2002 ISDAs are often adjusted to conform to the 1992 ISDA standard of three {{{{{1}}}|LBD}}s, for example.

So: once you have a clear, notified {{{{{1}}}|Failure to Pay or Deliver}}, you have to wait at least one and possibly three or more {{{{{1}}}|Local Business Day}}s before doing anything about it. Therefore, you are on tenterhooks until the close of business T+2 {{{{{1}}}|LBD}}s (standard 2002 ISDA), or T+4 LBDs (standard 1992 ISDA).

Let us imagine for a moment you have indeed waited the necessary time.

4. You may now send your Section {{{{{1}}}|6(a)}} notice designating an {{{{{1}}}|Early Termination Date}}

At the expiry of the Section {{{{{1}}}|5(a)(i)}} grace period, you finally have a fully operational {{{{{1}}}|Event of Default}}. Now Section {{{{{1}}}|6(a)}} allows you, by not more than 20 days’ notice to designate an {{{{{1}}}|Early Termination Date}} for all outstanding {{{{{1}}}|Transaction}}s.

So, at some point in the next twenty days outstanding {{{{{1}}}|Transaction}}s will be at an end. Now this is a different thing from knowing what the amounts will be, much less knowing when they will be paid: this is the date by reference to which termination amounts will be calculated.

5. Determine {{{{{1}}}|Close-out Amount}}s

One must now ascertain termination values for the {{{{{1}}}|Terminated Transaction}}s as of the {{{{{1}}}|Early Termination Date}} per the methodology set out in Section {{{{{1}}}|6(e)(i)}}.

Now armed with our crystalised {{{{{1}}}|Failure to Pay or Deliver}} {{{{{1}}}|Event of Default}} and with an {{{{{1}}}|Early Termination Date}} to target, we go directly to Section {{{{{1}}}|6(e)}}, noting as we fly over it, that Section {{{{{1}}}|6(c)}} reminds us for the avoidance of doubt that even if the {{{{{1}}}|Event of Default}} which triggers the {{{{{1}}}|Early Termination Date}} evaporates in the meantime — these things happen, okay? — yon {{{{{1}}}|Defaulting Party}}’s goose is still irretrievably cooked.

The trading and risk people need to come up with {{{{{1}}}|Close-out Amount}}s for all outstanding {{{{{1}}}|Transaction}}s. These are intended to be determined “as of” the {{{{{1}}}|Early Termination Date}}, being the date designated in your Section {{{{{1}}}|6(a)}} notice which had to be within 20 days of that notice. Now that makes it seem like you are facing a rather untimely cliff-edge if you can’t practicably close out your whole hedge book in 20 days, but note:

Each {{{{{1}}}|Close-out Amount}} will be determined as of the {{{{{1}}}|Early Termination Date}} or, if that would not be commercially reasonable, as of the date or dates following the {{{{{1}}}|Early Termination Date}} as would be commercially reasonable.

This is very important. This means you don’t have to liquidate a portfolio in its entirety within 20 days, or even take the values as of that {{{{{1}}}|Early Termination Date}}. If you can, you should — but it may well not be commercially reasonable — or even possible — to. The Lehman insolvency took months to unwind. Note also that commercial reasonableness is viewed from the Non-Affected Party’s perspective. It is not a licence to do whatever the hell you want — but the court won’t second guess prudent application of your own models.

Once they have done that you are ready for your Section {{{{{1}}}|6(e)}} notice.

6. Calculate and notify

The {{{{{1}}}|Early Termination Date}} is the date on which the {{{{{1}}}|Transaction}}s terminate; it is the date by reference to which you calculate their termination values, not the date by you have to have valued, much less settled outstanding amounts due as a result of their termination — that would be a logical impossibility for those not imbued with the power of foresight. Here we move onto Section {{{{{1}}}|6(d)}}, under which, as soon as is practicable after the {{{{{1}}}|Early Termination Date}}, your boffins work out all the termination values for each {{{{{1}}}|Transaction}}, tot them up to arrive at the Section {{{{{1}}}|6(e)}} amount, and send a statement to the defaulting party, specifying the {{{{{1}}}|Early Termination Amount}} payable, the bank details, and reasonable details of calculations.

7. Pay your {{{{{1}}}|Early Termination Amount}}

Your in-house metaphysicians having calculated your Close-out Amounts, and assembled all the values into an {{{{{1}}}|Early Termination Amount}} the party who owes it must pay the {{{{{1}}}|Early Termination Amount}}. With ISDA’s crack drafting squad™ yen for infinite fiddlarity, this will depend on whether the Early Termination Date follows an Event of Default or an Termination Event. If the former, the {{{{{1}}}|Early Termination Amount}} is payable at once, as soon as the {{{{{1}}}|6(d)}} statement is deemed delivered; if a {{{{{1}}}|Termination Event}}, only two {{{{{1}}}|Local Business Day}}s — I know, right — after the {{{{{1}}}|6(d)}} statement is delivered (or, where there are two {{{{{1}}}|Affected Parties}} and both are delivering each other {{{{{1}}}|6(d)}} statements — I know, right — after both have done so).

8. Putting that all together

Here are all the stages you must go through between becoming entitled to terminate and settlement for a {{{{{1}}}|Failure to Pay or Deliver}}:

• T: There must be a {{{{{1}}}|Failure to Pay or Deliver}} on a day, T.
• T+1: After close of business on T, the {{{{{1}}}|Non-defaulting Party}} must give the {{{{{1}}}|Defaulting Party}} a Section {{{{{1}}}|5(a)(i)}} notice of failure to pay of deliver. The prescribed grace period must expire. The grace periods may be between 1 and 3 {{{{{1}}}|LBD}}s. There may also be carve-outs for operational failures and so on, to add to the fun.
• T+4: You must send a Section {{{{{1}}}|6(a)}} notice designating an {{{{{1}}}|Early Termination Date}} for all outstanding {{{{{1}}}|Transaction}}s. Let’s say it is 3 {{{{{1}}}|LBS}}s. You must designate an Early Termination Date within 20 days. Let’s say it is 20 days, for the hell of it
• T+24: You are “off risk” and must start calculating your {{{{{1}}}|Close-out Amount}}s for all outstanding {{{{{1}}}|Transaction}}s. You must do this ass soon as reasonably practicable. Let’s say that takes another 30 days.
• T+54: having calculated all {{{{{1}}}|Close-out Amount}}s and totted them all up into a single {{{{{1}}}|Early Termination Amount}}: You send your Section 6(d) statement advising of that amount, giving bank details and supplying your workings.
• T+54: Your {{{{{1}}}|Early Termination Amount}} is due.