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The process of closing out an ISDA following a Termination Event and not an Event of Default. There is a lengthy discussion of this here for our premium readers.

Among financing documents, The ISDA is — unique? Pioneering? Overcomplicated? — in having two types of event that can induce parties to call the whole thing off. Or parts of it.

That’s a part of the explanation: some things bring down only some transactions and not others.

Termination Events

Specific taxation and regulatory changes that affect only certain transactions or transaction types, that justify terminating those transactions, but not the whole kitten-caboodle.

And there are things that do justify bringing down the whole kitten-caboodle, but are no-one’s fault as such, just one of these regrettable things that life throws at us every now and then. Changes in tax or regulation that affect a counterparty, or both counterparties, meaning the ongoing trading relationship is not allowed, or is no longer economically efficient.

These events are “Termination Events”: they are complicated two ways: what is affected, and who is affected, which in turn determines who is entitled to call termination and, importantly calculate what is due, according to whose marks. In many cases it will be both parties, and there will be a splitting of the difference.

Events of Default

Then there are events that are someone’s “fault” — in a “banky” way: in that they generally indicate credit failure of some kind, and which necessarily bring down the whole shooting match, but only if the innocent party actually wants that. The close out calculations here are different, and a bunch of other funky ISDA tricks hang off these events too: notably the Section 2(a)(iii) flawed asset provision that allows the Non-Defaulting Party to shoulder arms and just sit there. This doesn’t apply to Termination Events, only Events of Default.

Additional Termination Events

Which leaves Additional Termination Events: bespoke events which parties negotiate into their Schedules, which behave like Termination Events despite in most cases being a lot more like Events of Default in their basic nature: they almost always address credit-impairment of some kind or other (NAV triggers, key person triggers and so on).

Section 5(a)

Events of Default can generally be contrasted with Termination Events. They tend to be more focused on the outright creditworthiness of the Defaulting Party: whether it could, even if it wanted to, perform its obligations. Termination Events on the other hand tend to be extraneous factors preventing a party from continuing the contract (Or making the contract uneconomic) even though it has the financial resources to do so.

The broad thrust of the Events of Default is:

1. Direct failures under the Master Agreement itself: Direct contraventions of the ISDA Master Agreement itself and its Transactions by one of the principals to the contract. Within here we have:
   1. Failure to Pay, which became Failure to Pay or Deliver when the cash-only 1987 ISDA gave way to the broader range of non-cash underlying assets under the 1992 ISDA;
   2. Breach of Agreement: Breach of any obligation other than a payment or delivery obligation
   3. Misrepresentation: Breach of any cross-my-heart-and-hope-to-die sort of precontractual representation made undere the contract
   4. Credit Support Default: Failure to provide collateral under a Credit Support Document. While in ordinary banking world a credit support obligation would generally be provided by someone other than a party to the contract. This is not so on Planet ISDA: (some) CSAs and CSDs are “Credit Support Documents”. So this counts as these are mainly principal obligations of the parties themselves (though of course end users will often be guaranteed).

2. Direct failures under other Agreements: Direct contraventions by parties to the ISDA Master Agreement of other contractual obligations that are sufficiently serious to make the Non-Defaulting Party freak under the ISDA Master Agreement. Within this bucket we have:

   1. Default under Specified Transaction: The Defaulting Party fails directly to the Non-Defaulting Party to perform under a swap-like transaction, only one that is not documented under the ISDA Master Agreement itself, but under a different master trading agreement;
   2. Cross Default: The Defaulting Party fails directly to the Non-Defaulting Party to perform to someone else altogether under a loan-like Transaction, over a certain Threshold Amount;

3. Unacceptable credit deterioration: The Defaulting Party or its third-party Credit Support Providers suffers a dramatic non-transactional reversal of fortunes such that the Non-Defaulting Party has credible doubts it will ever see its net in-the-money positions realised, whether or not they are currently in-the-money. Into this bucket goes:

   1. Bankruptcy: The Defaulting Party suffers one of the many different ways a merchant can go titten hoch. There are a lot of them, and they are fraught;
   2. Merger Without Assumption: The Defaulting Party is somehow taken over, reincorporated, reconstituted through a corporate event or otherwise magicked into a spiritual realm in which its earthly debts and obligations are not taken up by whomever the resulting entity is.

Events of Default by nature, speak to fundamental and time-honoured verities of the financial system, so it should not be a great surprise that they have not really changed throughout the three major versions of the ISDA Master Agreement. Honourable mention should also go to the Additional Termination Events that credit department will insist on shoehorning into the schedule in a bid to stay relevant: while these are not Events of Default as such, they tend to have a same credit-related quality to them

Practical differences between “Affected Party” and “Defaulting Party”

What is the practical, economic difference between being closed out on the same Transaction for an Event of Default and a Termination Event?

This is something that all ISDA ninjas know, or sort of intuit, in a sort of semi-conscious, buried-somewhere-deep-in-the-brain-stem kind of way, but they may mutter darkly and try to change the subject if you ask them to articulate it in simple English.

To be fair the topic might be chiefly of academic interest were it not for the unfortunate habit of the same “real world” event potentially comprising more than one variety of termination right. This leads to some laboured prioritisation in the ISDA, and sometimes some in the Schedule too. What if my Tax Event upon Merger is also a Credit Event Upon Merger and, for that matter, also a Force Majeure Event? That kind of question.

A trap for Cinderella

When adding any new Termination Event you must ALWAYS label it a new “Additional Termination Event” under Section 5(b)(vi), and not a separate event under a new Section 5(b)(vii) etc.

If, instead of being expressed as an “Additional Termination Event”, which is how the ISDA Mechanism is intended to operate, it is set out as a new “5(b)(vii)” it is not designated therefore as any of an “Illegality”, “Tax Event”, “Tax Event Upon Merger”, “Credit Event Upon Merger” or “Additional Termination Event”, so therefore, read literally, is not caught by the definition of “Termination Event” and none of the Termination provisions bite on it.

I mention this because we have seen it happen. You can take a “fair, large and liberal view" that what the parties intended was to create an ATE, but why suffer that anxiety?

A Trap for Cinderella was a baffling 2013 remake of the old French thriller Piège pour Cendrillon, by the way.

Triggering formalities in Section 6(b)

The Termination Events themselves are crafted as absolute events, without the need for notices or actions on the part of the Transaction Counterparties to activate them.

But they do not go live automatically: they must be activated by the Non-affected Party.

The formal triggering process is set out in Section 6(b) and there is an amount of pre-trigger faffery (since not all of them will be apparent to a Non-affected Party, the Affected Party must give notice and then efforts must be made to fix or avoid them before there is any question of termination) before one gets onto the actual process, which is set out in Section 6(b)(iv).

Clause-by-clause

Section 5(b)(i) Illegality

An Illegality is a Section 5(b) Termination Event — being one of those irritating vicissitudes of life that are no-one’s fault but which mean things cannot go on, and not a Section 5(a) Event of Default, being those perfidious actions of one or other Party which bring matters to an end which, but for that behaviour, ought really to have been avoided.

Note also the impact of Illegality and Force Majeure on a party’s obligations to perform through another branch under Section 5(e), which in turn folds into the spectacular optional representation a party may make under 10(a) to state the blindingly obvious, namely that the law as to corporate legal personality is as is commonly understood by first-year law students. Who knows — maybe it is different in emerging markets and former Communist states?

For the silent great majority of swap entities for whom it is not, the curious proposition arises: what is the legal, and contractual, consequence of electing not to state the blindingly obvious? Does that mean it is deemed not to be true?

If the rules change, that is beyond your control, so it can’t be helped and hence Illegality is a Termination Event not an Event of Default. The 2002 ISDA develops the language of the 1992 ISDA to cater to insomniacs and paranoiacs but does not really add a great deal of substance.

An Illegality may only be triggered after exhausting the fallbacks and remedies specified in the ISDA Master Agreement.

Waiting Period

The point of Waiting Period is, for potential scenarios that might wind up justifying termination later, but you don’t yet know that, to build in a period to wait and see. For Illegality events (Section 5(b)(i)) is three Local Business Days — it is not so likely that an Illegality will sort itself out; for a Force Majeure Event (5(b)(ii) — where insh’Allah, things will come right and everyone can eventually go back to what they were doing, it is eight Local Business Days.

Waiting Periods — as defined in the ISDA Master Agreement also sometimes show up sometimes in other booklets — for example, ISDA’s Emissions Annex.

Through the good offices of Section 5(d), payments and deliveries which otherwise would be due during a Waiting Period are suspended.

Section 5(b)(ii) Force Majeure (2002 only)

For the last word on force majeure, the JC’s ultimate force majeure clause is where it’s at. Breaking what must be a habit of a lifetime, somehow ISDA’s crack drafting squad™ managed to refrain from going crazy-ape bonkers with a definition of force majeure and instead, didn’t define it at all. In the 1992 ISDA they didn’t even include the concept.

Interlude: if you are in a hurry you can avoid this next bit.

I don’t know this, but I am going to hazard the confident hypothesis that what happened here was this:

ISDA’s crack drafting squad™, having convened its full counsel of war, fought so bloodily over the issue, over so long a period, that the great marble concourse on Mount Olympus was awash with the blood of slain legal eagles, littered with severed limbs, wings, discarded weapons, arcane references to regional variations of tidal waves, horse droppings from Valkyries etc., that there was barely a soul standing, and the only thing that prevented total final wipe-out was someone going, “ALL RIGHT, GOD DAMN IT. WE WON’T DEFINE WHAT WE MEAN BY FORCE MAJEURE AT ALL.”

There was then this quiet, eerie calm, when remaining combatants suddenly stopped; even those mortally wounded on the floor looked up, beatifically; a golden light bathed the whole atrium, choirs of angels sang and the chairperson said, “right, well that seems like a sensible, practical solution. What next then?”

“We thought we should rewrite the 2002 ISDA Equity Derivatives Definitions in machine code, your worship.”

“Excellent idea! Let’s stop faffing around with this force majeure nonsense and do that then!”

Ok back to normal.

Force Majeure in the 1992 ISDA

We may have said this before but, just because there isn’t a Force Majeure proper in the preprinted 1992 doesn’t mean people don’t borrow the concept from the 2002 — which has been around for, you know, 21 years now — and put it in anyway. One thing we can’t fathom is what possessed ISDA’s crack drafting squad™ to put it in at Section 5(b)(ii), rather than Section 5(b)(iv) just before the Additional Termination Event section, because for absolute shizzle anyone familiar with one version of the ISDA Master Agreement is going to get confused as hell if they start misunderstanding clause references in the other.

Act of state

Note the reference to “act of state”. Now a state, rather like a corporation, is a juridical being — a fiction of the law — with no res extensa as such. It exists on the rarefied non-material plane of jurisprudence. There are, thus, only a certain number of things that, without the agency of one if its employees, a state can do, and these involve enacting and repealing laws, promulgating and withdrawing regulations, signing treaties, entering contracts and, where is has waived its sovereign immunity, litigating their meaning.

Thus, a force majeure taking the shape of an act of state is, we humbly submit, a change in law which makes it impossible for one side or the other to perform its obligations. Compare, therefore, with Illegality.

Waiting Period (2002)

The point of Waiting Period is, for potential scenarios that might wind up justifying termination later, but you don’t yet know that, to build in a period to wait and see. For Illegality events (Section 5(b)(i)) is three Local Business Days — it is not so likely that an Illegality will sort itself out; for a Force Majeure Event (5(b)(ii) — where insh’Allah, things will come right and everyone can eventually go back to what they were doing, it is eight Local Business Days.

Waiting Periods — as defined in the ISDA Master Agreement also sometimes show up sometimes in other booklets — for example, ISDA’s Emissions Annex.

Through the good offices of Section 5(d), payments and deliveries which otherwise would be due during a Waiting Period are suspended.

Section 5(b)(ii)/(iii) Tax Event

Basically, the gist is this: if the rules change after the Trade Date such that you have to gross up an Indemnifiable Tax would weren’t expecting to when you priced the trade, you have a right to get out of the trade, rather than having to ship the gross up for the remainder of the Transaction.

That said, this paragraph is a bastard to understand. Have a gander at the JC’s nutshell version (premium only, sorry) and you’ll see it is not such a bastard after all, then.

In the context of cleared swaps, you typically add a third limb, which is along the lines of:

(3) required to make a deduction from a payment under an Associated LCH Transaction where no corresponding gross up amount is required under the corresponding Transaction Payment under this Agreement.

Section 5(b)(iii)/(iv) Tax Event Upon Merger

This is you can imagine, a red letter day for ISDA’s crack drafting squad™ who quite outdid itself in the complicated permutations for how to terminate an ISDA Master Agreement should there be a Tax Event or a Tax Event Upon Merger. Things kick off in Section 6(b)(ii) and it really just gets better from there.

So, Tax Event Upon Merger considers the scenario where the coming together of two entites — we assume they hail from different jurisdictions or at least have different practical tax residences — has an unfortunate effect on the tax status of payments due by the merged entity under an existing Transaction.

It introduces a new and unique concept — the “Burdened Party”, being the one who gets slugged with the tax — and who may or may not be the “Affected Party” — in this case the one subject to the merger.

Section 5(b)(iv)/(v) Credit Event Upon Merger

Known among the cognoscenti as “CEUM”, the same way Tax Event Upon Merger is a “TEUM”. No idea how you pronounce it, but since ISDA ninjas communicate only in long, appended, multicoloured emails and never actually speak to each other, it doesn’t matter.

Pay attention to the interplay between this section and Section 7(a) (Transfer). You should not need to amend Section 7(a) (for example to require equivalence of credit quality of any transferee entity etc., because that is managed by CEUM.

Note also the interrelationship between CEUM and a Ratings Downgrade Additional Termination Event, should there be one. One can be forgiven for feeling a little ambivalent about CEUM because it is either caught by Ratings Downgrade or, if there is no requirement for a general Ratings Downgrade, insisting on CEUM seems a bit arbitrary (i.e. why do you care about a downgrade as a result of a merger, but not any other ratings downgrade?)

Section 5(b)(v)/(vi) Additional Termination Events

Additional Termination Events are the other termination events your Credit department has dreamt up for this specific counterparty, that didn’t occur to the framers of the ISDA Master Agreement — or, at any rate, weren’t sufficiently universal to warrant being included in the ISDA Master Agreement for all. While the standard Termination Events tend to be “non-fault” events which justify termination of the relationship on economic grounds, but not on terms necessarily punitive to the Affected Party, Additional Termination Events are more “credit-y”, more susceptible of moral outrage, and as such more closely resemble Events of Default than Termination Events.

Common ones include:

• NAV triggers (for hedge funds)
• Key man provisions (for hedge funds)
• Investment manager insolvency or loss of licence
• Parent divestment (where counterparty is a financing subsidiary)

There is a — well, contrarian — school of thought that Additional Termination Events better serve the interests of the Ancient Guild of Contract Negotiators and the Worshipful Company of Credit Officers than they do the shareholders of the institutions for whom these artisans practise their craft, for in these days of zero-threshold CSAs, the real credit protections in the ISDA Master Agreement are the standard Events of Default (especially Failure to Pay or Deliver and Bankruptcy).

It’s a fair bet no-one in the organisation will have kept a record of how often you pulled NAV trigger. It may well be never.

“Ahh”, your credit officer will say, “but it gets the counterparty to the negotiating table”.

Hmmm.

Section 5(c)

Compared with its Byzantine equivalent in the 2002 ISDA the 1992 ISDA is a Spartan cause indeed: it is as if ISDA’s crack drafting squad™ assumed all ISDA users would be cold, rational economists who instinctively appreciate the difference between causation and correlation — or hadn’t considered the virtual certainty that they would not be — and therefore did not spell out that where your Event of Default is itself, and of itself, the Illegality, this hierarchy clause will intervene but it will not where your it simply is coincidental with one. I.e., if you were merrily defaulting under the ISDA Master Agreement anyway, and along came an Illegality impacting your ability to perform some other aspect of the Agreement, you can’t dodge the bullet.

In the 2002 ISDA the JC thinks he might have found a bona fide use for the awful legalism “and/or”. What to do if the same thing counts as an Illegality and/or a Force Majeure Event and an Event of Default and/or a Termination Event.