Cross Default - ISDA Provision
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ISDA Anatomy™
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This article is specifically about the Cross Default provision in the ISDA Master Agreement. For a general discussion of the concept, see cross default.
Want to quickly convert Cross Default to Cross Acceleration? Click here.
General
Cross Default is intended to cover off the unique risks associated with lending money to counterparties who have also borrowed heavily from other people. If you try to apply it to contractual relationships which aren't debtor/creditor in nature — as starry-eyed young credit officers in the thrall of the moment like to — it will give cause trouble. This will not stop credit officers doing that. Note also that it is, as are most ISDA provisions, bilateral. If you are a regulated financial institution, the boon of having a Cross Default right against your counterparty may be a lot smaller than the bane of having given away a Cross Default right against yourself.
Under the ISDA Master Agreement, if the cross default applies, default by a party under a contract for “Specified Indebtedness” with a third party in an amount above the “Threshold Amount” is an Event of Default under the ISDA Master Agreement.
Specified Indebtedness is generally any money borrowed from any third party (e.g. bank debt; deposits, loan facilities etc.).Some parties will try to widen this: do your best to resist the temptation.
The Threshold Amount is usually defined as a cash amount or a percentage of shareholder funds. It should be big: be a life-threatening failure - because the consequences of triggering it are dire. Expect to see 2-3% of shareholder funds, or sums in the order of hundreds of millions of dollars.
Cross default imports all the default rights from the Specified Indebtedness into the ISDA Master Agreement. For example, if you breach a financial covenant in your Specified Indebtedness, your swap counterparty could close you out even if the lender of the facility took no action on the breach. Cross default is, therefore, theoretically at least, a very dangerous provision. Financial reporting dudes get quite worked up about it. Oddly enough, it is very rarely triggered: It is actually very nebulous, and most credit officers would prefer to act on a clean Failure to Pay or a Bankruptcy event. Generally one will be along presently.
Cross Aggregation
The 2002 ISDA updates the 1992 ISDA cross-default so that if the combined amount outstanding under the two limbs of Cross Default exceed the Threshold Amount, then it will be an Event of Default. Normally, under the 1992 ISDA, Cross Default requires one or the other limbs to be satisfied — you can’t add them together.
As per the above, the two limbs are:
- a default under a financial agreement that would allow a creditor to accelerate any indebtedness that party owes it;
- a failure to pay on the due date under such agreements after the expiry of a grace period.
Differences between cross default and DUST
Ideally, cross default and DUST should be mutually exclusive. They are meant to dovetail with each other, not cross over. This will not stop mission creep from over-zealous credit departments, who will try to expand the scope of each, leading to all kinds of cognitive dissonances and righteous[1] indignation from the counterparty’s negotiator. As ammunition for your fruitless attempts to persuade the credit department to live in the real world for once, try these:
- Cross default generally references indebtedness where the exercising counterparty has significant loan-type exposure to the defaulter; DUST references bilateral derivative and trading transactions which tend not to be in the nature of indebtedness (it is true to say that the line between these can be gray, especially in the case of uncollateralised derivative relationships;
- Cross default is only triggered once a certain threshold amount of indebtedness is defaulted upon; DUST is triggered upon any breach;
- Cross default references your Counterparty owes to a third party outside your control; DUST references other obligations your counterparty owes you or an affiliate you can reasonably be expected to be in league with. (ie you can't generally trigger if your counterparty defaults on Specified Transactions it has on with third parties)
- DUST only comes about if the Specified Transaction in question has been actually accelerated, whereas cross default is available whether the primary creditor has accelerated or not. (A cross default which requires acceleration is called “cross acceleration”.)
The difference between the two formulations
Measure of the Threshold
- 1992 ISDA: This contemplates default “in an aggregate amount” exceeding the Threshold Amount which would justify early termination of the Specified Indebtedness: that is to say the value of the failed payment, and not the whole principal amount of the Specified Indebtedness it was owed under, contributes to the Threshold Amount, ;
- 2002 ISDA: This contemplates an event of default under agreements whose “aggregate principal amount” is greater than the Threshold Amount: that is to say it is the whole principal amount of the agreement which is picked up, not just the amount of the payment.
This change, we speculate, is meant to fix a howler of a drafting lapse from ISDA’s crack drafting squad™:
- It can be triggered by any event of default, not just a payment default (i.e. the 1992 ISDA requirement for "an Event of Default ... in an amount equal to...” impliedly limits the clause to payment defaults only since other defaults aren't “"in an amount"”...);
- It captures the whole value of the Specified Indebtedness, not just the value of the default (if it even is a payment capable of being valued) itself.
For example: if you defaulted on a small interest payment on your Specified Indebtedness which made your whole loan repayable, under the 1992 ISDA you could only count the value of that missed interest payment to your Threshold Amount. But the whole loan is at risk of being accelerated — so this is a much more significant credit deterioration than is implied by the missed payment.
It is innocuous, that is, unless you are cavalier enough to include derivatives or other payments which are not debt-like in your Specified Indebtedness. But if you do that, you've bought yourself a wild old ride anyway.
Don't say you weren't warned.
See also
References
- ↑ And, to be candid, rightful.