Automatic Early Termination - ISDA Provision
Content and comparisons
Those with a keen eye will notice that, but for the title, Section 6(a) of the 2002 ISDA is the same as Section 6(a) of the 1992 ISDA and, really, not a million miles away from the svelte form of Section 6(a) in the 1987 ISDA — look on that as the Broadcaster to the 1992’s Telecaster.
Summary
HAL 9000: Just a moment — just a moment — I just picked up a fault in the AET-87 Unit.
Frank Poole: What is it?
HAL 9000: It’s a device for optimising regulatory capital, but that’s not important right now.
David Bowman: What’s the problem, HAL?
HAL 9000: It’s going to go one hundred per cent. failure, within 72 hours.
Poole: Surely, you can’t be serious?
HAL 9000: I am serious. And don’t call me “Shirley”.
Bowman: (sticking to the script) I don’t know what you’re talking about, HAL?
Cue musical introduction
HAL9000: Well, I’ll tell you.
Chorus: He’s going to tell!
He’s going to tell!
He’s going to tell!
He’s going to tell! —Poole: Stop that! Stop that! No singing!
Carries on for three hours in this vein
- —Monty Python and the Magnetic Anomaly from Airplane!
Automatic Early Termination is an odd and misunderstood concept. It sits buried at the back end of Section 6(a) (Right to Terminate Following Event of Default). In essence it provides that where a party to whom AET applies suffers an in-scope Bankruptcy event, all outstanding Transactions are instantly terminated, without the need for any action by the Non-Defaulting Party.
This inverts the normal order of things under the ISDA Master Agreement wherein the Non-Defaulting Party generally has the right, but not the obligation, to call an Event of Default. Being automatic, therefore AET even obliterates the Non-Defaulting Party’s ability to waive this event, since by the time it is in a position to do so, the event has already happened.
(Could a NDP pre-waive in anticipation? See “anticipatory waiver?” in the premium section if that is the sort of thing that keeps you up at night.)
JC’s general view is that Automatic Early Termination is a bad solution to an unlikely problem, but since it is intractably embedded in every ISDA on the planet, after thirty-five years of folly, we are pretty much stuck with it.
Others — for example the learned author of Cluley on Close-Outs — have a different view. But, look: JC has to depart ways with the cool crowd every now and then, just to maintain his membership with the Worshipful Company of Contrarians. This is one of those times.
It’s not about the window
Triago: Herewith, hereinafter and hereinbefore-confirmed:
A custom aperture. Wall-inlaid,
Well-glazed and fringed by lintel stone.
A device to shed upon us light!Regolamento: Oh, a window?
Triago: Good heavens, No! Not that!
(Whispering) There are ways and means of saying ’t, ser —
Prithee, gird thy verbiage about with care
Lest th’Exchequer’s like for “levies upon transparency”
Untimely drains th’excess from our meagre chancelry—
Catcheth thou the drift?
Regolamento: It is not a window, then? These sound like solid facts?
Nuncle: ’Tis not so much a window
As a means of dodging tax.
Automatic Early Termination is as much to do with managing regulatory capital — in particular, vouching safe close-out netting — as it is about substantive credit risk mitigation.
Banks — those who calculate regulatory capital in banks, or are obliged to read netting opinions on their behalf at any rate, care a lot about it.
Other market counterparties, perhaps less so. Given that its potential effect is likely to be “iatrogenic” — worse than the risk it addresses — a non-bank counterparty could be forgiven for being a little blasé.[1]
The theory
Where a Defaulting Party’s insolvency regime allows its administrator to suspend its contractual terms or cherry-pick which of its Transactions to honour, it would help the Non-Defaulting Party if the ISDA were to automatically terminate before the administrator had a chance to do any such thing. To be safe, termination should happen at the exact moment — or even an infinitesimal moment before — that insolvency regime kicks in.
There are two things such a suspension could affect:
- Discretionary termination right: Firstly, insolvency rules may operate to prevent the Non-Defaulting Party closing out Transactions under the ISDA at all. They may give the insolvency administrator a discretion to affirm or avoid individual Transactions. This bigly messes with the fundamental philosophy of the ISDA Master Agreement:
All those hopes and dreams would be crushed if the ISDA Master Agreement were terminated on grounds of Bankruptcy. The Defaulting Party would immediately be liable to pay that full mark-to-market value in cash. A bankruptcy suspension right prevents the Non-Defaulting Party from crushing the bankrupt party’s dreams. Well, its other unsecured creditors’ dreams, at any rate.A swap counterparty to a portfolio of swap transactions scheduled to mature over the next five years may have no present obligation to pay any cash under those Transactions even if, from a mark-to-market perspective, the net present value of that portfolio is significantly negative. Who knows? Things may come right.
- Netting right: Beyond that, having exercised its early termination right the contractual provisions of the single agreement operate to net all transaction exposures down to a single sum. Since a bankruptcy administrator may have a right to enforce some contracts and set aside others that netting right is prejudiced.
AET It was introduced in the 1987 ISDA, but was not labelled “Automatic Early Termination” in that agreement, possibly because it was not conceived as an optional election to be used with caution where needed: it just sat there and applied across the board.
AET is thus only triggered by certain events under the Bankruptcy event of default — formal bankruptcy procedures — and not by economic events that tend to indicate insolvency (such as an inability to pay debts as they fall due, technical insolvency or a creditor’s mere exercise of default rights or enforcement of security. Though, interestingly, those events (captured in limbs (2) and (7) of the Bankruptcy definition) did trigger automatic early termination in the 1987 ISDA. This is just one more reason not to use that edition, if there are any Burmese Junglers out there looking for one.
AET does not apply to other Events of Default.
It is now an election
Though the 1987 ISDA triggered automatic termination upon any type of Bankruptcy event for any counterparty in any jurisdiction, it has since turned out that the mischief against which AET guards does not really arise in most jurisdictions: only those a history of Teutonic jurisprudence.
In those (e.g., Germany, Austria, Switzerland and Japan) immediately upon commencement of formal bankruptcy proceedings a bankruptcy administrator would be entitled “cherry-pick” those Transactions it wishes to honour (typically, those that are in-the-money to the Defaulting Party whose estate it is administering) and those it wished would just conveniently vanish from the financial record (namely those where the Defaulting Party is out-of-the-money).
Since the whole point of the Single Agreement and the close-out netting concept is to get to a market exposure as close as possible to zero before launching any recovery actions, this kind of cherry-picking would completely demolish the entire capital theory on which the ISDA Master Agreement is founded. Hence, Automatic Early Termination!
In any case, since the 1992 ISDA AET has been an election that you toggle on or off for each counterparty in Part 1 of the Schedule.
It only has limited use
AET is only really useful:
(1) to a regulated financial institution, which
(2) would incur a capital charge if it doesn’t have a netting opinion, and
(3) where it wouldn’t get that netting opinion for a particular counterparty without AET being switched on in its ISDA Master Agreement.
There are only a few counterparty types where these conditions prevail: the German and Swiss corporates mentioned above, for example. There may be others, but not many, because AET is a good-old-days, regulators-really-are-dopey-if-they-fall-for-this kind of tactic. It only really survives these days because it is so part of the furniture no-one has the chutzpah to question it, despite the trail of destruction and confusion it has left across the commercial courts of the US an the UK.
I mean, really? Deeming your ISDA to have magically terminated, without anyone’s knowledge or action, the instant before that termination would become problematic as a result of your insolvency? Come on. Is any sophisticated insolvency regime going to buy that kind of magical thinking? (No slight meant on Germany or Switzerland here: the “Teutonic” AET does not deliver netting where unequivocally it would otherwise be forbidden, but rather buttresses residual doubt about the effectiveness of netting during insolvency as a result of looseness in insolvency regulations that aren’t categorical that you can net. The view is generally it should be okay in insolvency, but there are just some freaky discretions that may make life awkward if used maliciously. This is not legal advice.)
Why not just switch it on, to be on the safe side?
Master trading agreements are unusual in that upon an Event of Default, there is no guarantee a given portfolio of Transactions will be in-the-money to the Non-Defaulting Party.
The last thing an NDP will want to do is accelerate Transactions under ISDA if that means it winds up realising mark-to-market losses. Indeed, the “flawed asset” provisions of the ISDA Master Agreement are designed precisely to allow a Non-Defaulting Party to suspend its own performance — therefore not make its position any worse — without crystallising its Transaction exposures.
Having Transactions automatically accelerate is undesirable: one would only choose that if the alternative was catastrophically worse.
In the minds of those who framed the early ISDAs, mendacious application of discretions by foreign bankruptcy administrators was just such a catastrophic worseness.
But —time having passed, water flowed under the bridge and tempers mellowed with age and wisdom — JC wonders whether there are not better things the world’s risk officers to be fretting about instead of the capital implications of general rules of governance that apply to local corporations.
There is an extended rant on the close-out netting page.
General discussion
Tedious but harmless drafting tweaks
Even for the Non-Defaulting Party, AET is a necessary evil. It leaves the Non-Defaulting Party at risk of being un-hedged on a portfolio of Transactions that automatically terminated effective as of a Bankruptcy event without the NDP knowing that the Bankruptcy event had happened[2]. The NDP may want to capture the market risk between the Bankruptcy event and the date on which they should have known about it, and factor that into the Close-out Amount. If they do, expect to see language like the below.
If you are an AET counterparty, your credit officer may bridle at the sight of this, but you can reassure her that at any point where this language comes into play she will be wandering around outside in a daze clutching an Iron Mountain box full of gonks, comedy pencils and deal tomb-stones, and contemplating a career reboot as a maths teacher, so she shouldn’t really care anyway.
- Adjustment for Automatic Early Termination: If an Early Termination Date occurs following an Automatic Early Termination event, the Early Termination Amount will adjusted to reflect movements in rates or prices between that Early Termination Date and the date on which the Non Defaulting Party should reasonably have become aware of the occurrence of the Automatic Early Termination.
Switzerland
Switzerland is — isn’t it always? — different, and a good place to go right now would be the Swiss bankruptcy language page. Switzerland itself is also a good place to go, especially in the skiing season. The JC loves Wengen.
AET under the 1987 ISDA
Note the somewhat difficult position for AET under the 1987 ISDA - a fuller discussion at that article - which was part of the reason for the move to the 1992 ISDA in the first place.
See also
References
- ↑ For the little it is worth, JC gets to that conclusion as follows: the risk that without AET a counterparty (a) goes bankrupt without an intervening Event of Default (b) is significantly out of the money on a collateralised basis (c) has a receiver who takes the decision to cherry pick transactions (d) is successful doing so in its own jurisdiction and (e) then successfully manages to enforce its judgment in the Non-Defaulting Party’s home jurisdiction notwithstanding the contract being robust there is, we think, vanishingly low, supported by the fact that it does not seem to have happened even once in the 43-year history of the global OTC derivatives market. Against that is the present risk of being catapulted into closing out Transactions that were adequately capitalised and for which you might have been prepared to use a bit of optionality to close out risks at a time of lower volatility, thereby reducing the risk of off-market loss for both parties.
- ↑ Unless credit department is constantly monitoring the regulatory newswires of all AET counterparties to check whether they go bankrupt each day, and they won’t be.