Template:M gen 2002 ISDA Affected Party and 5(b)

The Definition of Close-out Amount

Remember the way a Determining Party values a Terminated Transaction is calculates its own close-out value — in our nutshell terms, “the losses the Determining Party would incur (positive) or gains it would realise (negative) in replacing the material terms and the option rights of the parties under a Terminated Transaction”. One assesses “the costs one would incur” from ones’ own side of the market. A large party of the question comes down to who the Determining Party is for a given termination event.

Defaulting Party

Under an Event of Default, it is the Non-Defaulting Party at all times (since on the theory of the game, the Defaulting Party is either a miscreant or a smoking hulk of twisted metal, there is no one else around to do this. Therefore, it being an Event of Default is always optimal for the Innocent Party, since it will always be the Determining Party.

One Affected Party

Where the terminating impetus is not so outrageous as to qualify as an Event of Default — i.e., it is only a Termination Event — but it only impacts one party, in most cases it is the same as for an Event of Default. There is one Affected Party, the Non-Affected Party is the sole Determining Party, so it closes out on its own side of the market ... unless the event in question is an Illegality or a Force Majeure Event, in which case there is a rider in Section 6(e)(ii)(3) applies and the Determining Party has to get mid market quotations that don’t take its own creditworthiness into account. But note that the most commonly triggered type of Termination Event is an Additional Termination Event, these tend to have a defaulty, turpidudinous character about them, almost never happen to two people at once, and therefore behave exactly like Events of Default.

Two Affected Parties

When both parties are affected — a scenario the ISDA only contemplates for Termination Events; Events of Default being more of a “she who draws first wins” sort of affair, where the first in time prevails — then each party is a “Determining Party” calculates its own close-out value — in our nutshell terms, “the losses the Determining Party would incur (positive) or gains it would realise (negative) in replacing the material terms and the option rights of the parties under a Terminated Transaction” — throws it into the ring and the Calculation Agent splits the difference. Assuming both parties calculate so the end result is necessarily a mid-market number.

All so confusing. If only there were someone to set it all out in a table for you.

Awwwwww.

JC’s cut-out-and-keep™ guide to terminating Transactions

Event	How many affected	What happens
Events of Default Q.E.D. there is only one Defaulting Party: 5(a)(i) Failure to Pay or Deliver 5(a)(ii) Breach of Agreement 5(a)(iii) Credit Support Default 5(a)(iv) Misrepresentation 5(a)(v) Default Under Specified Transaction 5(a)(vi) Cross Default 5(a)(vii) Bankruptcy 5(a)(viii) Merger without Assumption	Defaulting Party only	Non-defaulting Party calculates on its own side of market.
Termination Events where there is only one Affected Party And this odd rider in Section 6(e)(ii)(3) requiring a midmarket price does not apply: 5(b)(iii) Tax Event 5(b)(iv) Tax Event Upon Merger 5(b)(v) Credit Event Upon Merger 5(b)(vi) Additional Termination Event	One Affected Party only	Non-Affected Party calculates on its own side of market.
Termination Events where there is only one Affected Party but ... This odd rider in Section 6(e)(ii)(3) requiring a midmarket price does apply: 5(b)(i) Illegality 5(b)(ii) Force Majeure Event	One Affected Party only	Non-Affected Party seeks prices by reference to mid-market values and which do not reflect its own credit.
Termination Events where there are two Affected Parties 5(b)(i) Illegality 5(b)(ii) Force Majeure Event 5(b)(iii) Tax Event 5(b)(iv) Tax Event Upon Merger	Each party is an Affected Party	Both parties are Determining Parties, and Calculation Agent splits the difference ergo it is a midmarket rate.

In the heyday of ISDA negotiation just who was the Affected Party and how one should value and terminate an Affected Transaction used to be much more of a source of controversy than it is today.

This might be a function of the market’s general move to the 2002 ISDA closeout methodology, being far less fraught and bamboozling then the one in the 1992 ISDA, refraining as it does from absurdities like the First Method and alternative Market and Loss methods of valuing replacement transactions. Even those who insist on staying with the 1992 ISDA — Hello, Cleveland! — are often persuaded to upgrade the closeout methodology.

It might also be that the specific expertise as to what happens in a close out has dissipated over the years as swap dealers and investment managers have outsourced and downskilled their negotiation functions.

But the JC likes to think that in this mature market, the commercial imperative plays a part here. Termination Events come in two types: catastrophic ones, which signal the end of the relationship — and usually the ongoing viability of one of the counterparties — altogether; and Transaction-specific ones, which no-one intended or wanted, everyone regrets, but which will soon be water under the bridge, for parties who will continue to trade new derivatives into glorious, golden perpetuity.

Now any swap dealer who regards a Transaction-specific Termination Event as an opportunity to gouge its counterparty can expect a frosty reception next time its salespeople are pitching new trading axes to the CIO.

On the other hand if, when your valuation reaches her, the CIO is wandering around outside her building with an Iron Mountain box, she will be less bothered about the wantonness of your termination mark — it being no longer her problem — and as far as she does care about it all, will console herself with the reality that you are not likely to see much of that money anyway once her former employer’s insolvency estate has been wound up.