Template:Isda Automatic Early Termination summ

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 — colloquially, “{{{{{1}}}|AET}}”, but not to be confused with “{{{{{1}}}|ATE}}” or “{{{{{1}}}|ETA}}” — is an odd, feared and misunderstood concept buried at the back end of Section {{{{{1}}}|6(a)}} ({{{{{1}}}|Right to Terminate Following Event of Default}}).

Acclimatisation

In a document stuffed with arcanities, {{{{{1}}}|AET}} is especially abstruse, so if you are hitting this article cold then, firstly: what the hell are you doing; and secondly some background reading is in order:

Recommended background reading

• Bankruptcy phase transition: The difference between insolvency and bankruptcy and why the phase transition between them is a weird dreamtime that freaks derivatives lawyers out.
• Single Agreement: The unbearable weirdness of ISDA’s single agreement concept.
• Regulatory capital: The rules on how much capital a regulatred financial instrument is required to hold, and how it is calculated.
• Closing out an ISDA: The law and lore of closing out an ISDA
• Flawed asset: ISDA’s notorious “flawed asset” provision: Section {{{{{1}}}|2(a)(iii)}}.

Overview

{{{{{1}}}|Automatic Early Termination}} provision is triggered when a party to whom it applies suffers an in-scope {{{{{1}}}|Bankruptcy}} {{{{{1}}}|Event of Default}}. If it is triggered, all outstanding {{{{{1}}}|Transaction}}s are instantly and automatically terminated, without the need for any action by — or even the knowledge of — the {{{{{1}}}|Non-Defaulting Party}}. This usually means instantly, but in one case, it is even quicker than that.

If the {{{{{1}}}|Bankruptcy}} event is the presentation to the court by a creditor of a formal petition seeking the entity’s bankruptcy under Section {{{{{1}}}|5(a)(vii)(4)}} — let us call this a “bankruptcy petition”, some creative warping of lexophysical swaptime is required. We will discuss this at some length and with wistful pedantry, in the premium content section.

In taking things out of the {{{{{1}}}|Non-Defaulting Party}}’s hands, AET subverts the normal order of things under the ISDA Master Agreement. Normally, the {{{{{1}}}|Non-Defaulting Party}} is in control. It may, but need not, call an {{{{{1}}}|Event of Default}} if the circumstances justifying one exist. AET is, well, automatic. It even obliterates the {{{{{1}}}|Non-Defaulting Party}}’s right to waive designation of an Event of Default, since by the time it is in a position to do so, the Event Default has already been declared.

(Could a {{{{{1}}}|NDP}} pre-waive in anticipation? See “Anticipatory waiver?” in the premium section.)

JC’s view is that {{{{{1}}}|Automatic Early Termination}} is a bad solution to an unlikely problem, but since it is embedded in every ISDA on the planet, and remains present in the minds of those who mandate capital calculations, we are stuck with it.

The theory

“Formal bankruptcy is a “phase transition”: the whole “legal context” surrounding a company changes. Erstwhile certainties vanish: normal rules of contract, debt and credit are suspended; in their place arise uncontrollable vagaries. The court appoints an insolvency administrator and invests her with wide, nightmarish discretions to do as she pleases, within reason, to sort out who gets what while ensuring the right thing is done by all the bankrupt’s creditors, customers, employees and, if there is anything left, shareholders. All, therefore, must fall upon her mercy”

—The phase transition of bankruptcy

Where a Defaulting Party’s bankruptcy regime allows its administrator to suspend its contractual terms or cherry-pick which of its {{{{{1}}}|Transactions}} to honour, it would help the {{{{{1}}}|Non-Defaulting Party}} if the ISDA were to automatically terminate before that phase transition occurred. To be safe, termination should happen at the exact moment — or even an infinitesimal moment before — that bankruptcy regime comes to life.

A bankruptcy regime could affect an innocent counterparty’s rights in at least two ways:

1. Discretionary termination right itself: Firstly, bankruptcy rules may prevent the {{{{{1}}}|Non-Defaulting Party}} closing out {{{{{1}}}|Transactions}} at all. They may give the administrator the discretion to affirm or avoid individual {{{{{1}}}|Transactions}}. This bigly messes with the fundamental philosophy of the ISDA Master Agreement.
2. Netting right: Having exercised its early termination right, the “single agreement” operates to net all {{{{{1}}}|Transaction}} exposures down to a single sum. Since a bankruptcy administrator may enforce some contracts and set aside others, that netting right is prejudiced.

History

We rarely look back to the 1987 ISDA these days; few Burmese Junglers remain out there fighting the good fight, but sometimes the fossil record gives us purchase on the state of modern biology all the same. So it is with {{{{{1}}}|Automatic Early Termination}} which was introduced, uncredited, in the 1987 ISDA.

As we note elsewhere, there is common confusion between the accounting status of insolvency, which has no formal legal status and therefore makes no particular difference to the effectiveness of contracts, and the legal status of bankruptcy, which does. Mere insolvency may lead to bankruptcy, but need not. They are different concepts and have different legal implications (in that bankruptcy has some, insolvency does not: only once you are into formal bankruptcy are bankruptcy shenaniganson the cards.

ISDA’s definition of “{{{{{1}}}|Bankruptcy}}” somewhat jumbles the concepts up. Some of the varieties of Bankruptcy event (especially cashflow/balance sheet insolvency and composition with creditors) are not accompanied by formal changes in the application of laws of contract and should not trigger {{{{{1}}}|Automatic Early Termination}}.

In the 1987 ISDA {{{{{1}}}|Automatic Early Termination}}, they do anyway. It applies across the board, to all {{{{{1}}}|Bankruptcy}} events, and to all counterparties: it was not even an optional election, to be engaged judiciously when needed against counterparties in jurisdictions vulnerable to bankruptcy shenanigans. It just sat there and applied across the board, if any {{{{{1}}}|Bankruptcy}} {{{{{1}}}|Event of Default}} should be declared.

This presented a real risk of “Schrodinger’s Cat” ISDAs, where the facts determining a Bankruptcy were not public or even easily determinable (balance-sheet insolvency in particular is more a matter of art than science) and if automatically triggered, it would be impossible to know whether a given ISDA were alive or dead, or whether one had suspended one’s obligations under the flawed asset provision or not. There is this really weird thing: where automatic early termination could be triggered without notice, action or knowledge, and that would trigger a section {{{{{1}}}|2(a)(iii)}} suspension, also without notice, action or knowledge, so it is really hard to see what parties were to make of unexplained non-performance by the other party of its rights under the contract. Was it bankrupt? Or did it think you were bankrupt?

the history since has been to walk AET back — not fast enough, in this commentator’s opinion — from that highly unsatisfactory epistemological state. By 1992, ISDA’s crack drafting squad™ limited AET to circumstances with a live risk of bankruptcy shenanigans. The “soft” economic insolvency events were excluded. It also does not apply across the board. The 1992 ISDA converted {{{{{1}}}|AET}} into an election that you toggle on or off for each counterparty in Part 1 of the {{{{{1}}}|Schedule}}. For most parties, in most jurisdictions, it stays off.

For various reasons described below {{{{{1}}}|AET}} is sub-optimal for the {{{{{1}}}|Non-Defaulting Party}}, so it only gets elected against counterparties where it would make a difference and by counterparties to whose regulatory capital calculations it would make a day-to-day difference — that is, those counterparties who have to make regulatory capital calculations.

In 2002 a further refinement was implemented in the definition of “bankruptcy petition”. ISDA’s crack drafting squad™ split Section {{{{{1}}}|5(a)(vii)(4)}} in two: a bankruptcy petition instituted by a regulator was not subject to a grace period. A bankruptcy petition instituted by anyone else — such as a creditor — would only mature into an Event of Default if ordered by the Court, or not otherwise discharged within a 15-day grace period.

If a regulator is taking formal action against you, the game is certainly up. A grace period serves no real purpose. A mere creditor doing so is a fairly ordinary debt-collection tactic: it may not indicate a genuine inability to pay debts, but in that case can be fairly easily discharged. Hence the grace period.

Ultimately, in JC’s view, however you draft them, {{{{{1}}}|Automatic Early Termination}} and its nemesis, the flawed asset clause Section {{{{{1}}}|2(a)(iii)}} are well-meant but basically unwise, Quixotic attempts to control an impossibly unruly universe when it would have been a better idea to try to control an unruly Basel Committee on Banking Supervision and beseech it to be more realistic in its rulemaking.

Few and far between

There are only a few counterparty types in a few jurisdictions where the conditions for {{{{{1}}}|AET}} prevail. There are not many because — let’s be clear, here — {{{{{1}}}|AET}} is a bit of try on: any self-respecting netting-hostile bankruptcy regime would see straight through it. It’s a bit cute, in other words.

A piece of time-travelling contractual magic — deeming an ISDA to have terminated, without anyone’s knowledge or action, the instant before the event that, on expiry of a grace period would later trigger it, to avoid the ambit of discretionary rules designed to ensure fairness and prevent just that kind of preference seems — a bit optimistic?

There is a more benign view, but it is still a bit hopeful: {{{{{1}}}|Automatic Early Termination}} helps buttress what is really a permitted outcome, dispelling residual doubt about ambiguous or untested regulatory provisions that come into force followinging the phase transition to bankruptcy. Sort of a “better be safe than sorry”.

Then there is a pragmatic view. This is blunter: ISDA Master Agreements once were weird innovations that bamboozled and outraged bankruptcy administrators. Now, they are not. Everyone knows what ISDAs are, why they net, and why the single agreement is a sensible plank in the capital structure of the financial system, and why the bankruptcy shenanigans they seek to avoid would not produce a fair result for anyone.

But, still: this is all well and good. But if, unwittingly, {{{{{1}}}|Automatic Early Termination}} now creates practical risk where once it avoided theoretical ones, it still should be a source of concern.

We will talk about that at great length in the premium section.