Template:M intro isda on termination
Commerce gives the lie to the idea that life is a zero-sum game. This was Adam Smith’s great liberating insight: life need not be nasty, brutish and short after all. Each of us will only strike a bargain if, on our own terms, we will be better off as a result. That being the case, there is no logical end to a commercial relationship: it is an infinite game. If we are flexible enough, open-minded enough, and good enough at playing infinite games we can keep this positive feedback loop of mutual benefit going indefinitely. Infinitely, even.
Therefore, we wish our relationships well, pray Godspeed for their long and fruity lives and, should things come to an end game, a peaceful ultimate transition from the flush of vital ardour into the restful stasis of the hereafter. But we know this is not always possible. Things do not always work out.
Therefore, we pack our trunk with tools and weapons with which, if needed, we can engineer an exit. There is no more sacred a time in the lives of our commercial contracts than their departure from the earthly clutch. There are a host of different ways this can happen. While lawyers rabbit on about these things in the hypothetical specific, in general terms we do not talk about them enough. Below, I comes over all over-analytical and count the ways an agreement can meet its maker.
Customers and service providers
Now the great majority of financial contracts are between a “provider” on one side — a bank, broker or dealer who provides a service, broadly described: money outright, finance against an asset, or a financial exposure — and a “customer” on the other who buys that service. The customer is, as ever, king: the services exist for her benefit exclusively: the provider’s only interest is managing its own exposure that comes from providing that service and, as it does, extracting some fee, commission or economic rent by way of consideration.
This is to say, “providers” do not mean to be economically “the other side” of the services they provide. They are, loosely, intermediaries. Agents. They do not take a direct opposite exposure. All being well, they are indifferent to how well the instruments they provide perform — so, as long as they manage their own risks and costs, and as long as their customers remain in fine fettle, they should never need to terminate their services. Indeed, they should want to keep them going, vigorously, seeing how that is how they earn a crust.
So expectations on either side of a service contract are different: the customer has market risk and it is her prerogative to go off risk as she sees fit. She can exit whenever she wants, by paying the provider’s outstanding fees and whatever it needs to terminate the arrangements it made to provide the service in the first place: its “breakage costs”.
But all else being equal, the provider cannot just exit without the customer’s permission. A financial contract with a fixed term, therefore, binds the provider but not the customer to that term.
But things can change. The customer’s financial outlook may darken. She may not be as good as her word. The regulatory environment may change, making the services harder or more expensive to provide.
Hence, the provider must have a set of “weapons” it can use to get out of such a term arrangement where it can no longer be sure of its expected return. These fall into a bunch of different categories, as we shall see:
Categories of termination
We would put these “termination scenarios” into three categories: “without cause”[1]; unforeseen external events and counterparty failure. This last category — which we might also label “default” — in turn breaks into two: direct misbehaviour and indirect credit deterioration.
There is also an odd category of pseudo-termination rights that some regulated financial institutions must have, but would never intend to use which, curiously, relate to concerns about its own solvency.
“Without cause”
Terminations “without cause” arise just because — no fault, no pressing need; just a gradual drifting apart of interests. As we grow in life, the things we value change. Passions of youth dampen, we tend more towards songs of experience than those of innocent exuberance, and we sing those to a different tune. Here we prescribe a notice period long enough to allow our counterparty to make alternative arrangements it needs to keep its own house in order, but otherwise, we wish each other well and carry along on our way. These will generally be “clean-up” rights and they will exist under framework contracts, not specific transactions, and they will be expressed not to impact on the validity of in-flight services.
They are mainly of use to clear out low-value and dormant clients from the administrative record: there may be ongoing credit sanctioning or KYC obligations that the firm would rather not have to keep carrying out on a customer that no longer transacts any business.
“Pseudo-termination rights”
Where you do see dealer rights to terminate on notice without cause these will typically be pseudo-termination rights: here a regulated institution must have the power to terminate transactions for formalistic or regulatory capital reasons, even though it never expects to actually use them.[2] For example, a dealer’s right to terminate a synthetic equity derivative contract on notice. This entitles the dealer to treat the equity derivative exposure as a “short-term obligation” for regulatory purposes — because it could get out, if it wanted to— and this is enough to get optimised regulatory capital treatment. But a dealer having such a right is a different thing from a dealer ever in its right mind actually exercising it. It might be forced to, in the direst of circumstances (where its own survival was threatened) — but in that case — the dealer would be teetering — and the customers would likely long since have moved their positions away in any case.
“Termination Events”: regrettable, but no-one’s fault
It is in the nature of uncertainty that unexpected things can happen, Thanks to the machination of events beyond the knowledge or control of either party. Force majeure, changes in law, changes in taxation and regulatory capital treatment can make the continued provision of a service uneconomic or impractical.
These events, under the ISDA framework, are described as Termination Events. They typically are measured Transaction-by-Transaction, so do not have the necessary consequence of shutting down all exposure under the agreement in one fell swoop; only under those Transactions which are directly affected.
Secondly, there is generally more flexibility and leeway granted for the parties to explore workarounds and solutions to avoid having to terminate Transactions, seeing as no one is at fault. So the eventual decision to terminate Affected Transactions, while regretted, is likely to be arrived at in a state of relative psychological clarity, no malice, and probably even consensus. For the same reason, Default Rates of interest do not automatically apply.
Thirdly, at least where both parties are Affected Parties, both will act as Determining Party to calculate their own replacement costs for the Transaction, so the ultimate Close-out Amounts will split the difference and will be situated at a “mid-market” rate rather than on the Non-defaulting Party’s side of the market, again reflecting the fact that no one is at fault.[3]
“Default Events”: do we have a problem here?
Then there are termination rights that flow from something untoward about your counterparty. This being a contract, the main category of “untoward facts” about your counterparty will be things it is meant to do by the express terms of the contract but it has failed to: call these performance failures.
Performance failures
Direct performance failures — in old money, breaches of contract — tend not to be uncontroversial: if you think “failing to do a certain something” is an unreasonable ground for terminating a contract, you should not agree to do it in the first place. As a result there is almost no negotiation on Section 5(a)(i), outside the grace period.
The classic “performance failure” is Failure to Pay or Deliver. There could not be an obligation more “of the essence” to a swap contract than payment or delivery of what you promised when you promised it. Ninety-five per cent of all close-outs — yes, I did just make that number up out of thin air, but I challenge you to disprove it — are triggered by a Failure to Pay or Deliver.
There is an inverse relationship between how long you will have to argue about a given close-out right during onboarding and how likely you are to ever have to use it in anger.
The other direct performance failure Events of Default, by order of how quickly you can accelerate them, are:
| Event of Default | Section | Grace period |
|---|---|---|
| Repudiation of Agreement | 5(a)(ii)(2) (Defaulting Party) or 5(a)(iii)(3) (Credit Support Provider) | None. |
| Misrepresentation | 5(a)(iv) | None. |
| Credit Support Default (Total failure) | 5(a)(iii)(2) | None. |
| Failure to Pay or Deliver | 5(a)(i) | One Local Business Day after due date. |
| Breach of Agreement | 5(a)(ii)(1) | 30 days after notice of default. |
| Credit Support Default (direct default) | 5(a)(iii)(1) | Expiry of grace period in Credit Support Document. |
Why isn’t Repudiation more commonly invoked to close out an ISDA? Because it would require not just non-performance but bone-headedness. However dire the situation gets, it remains within a struggling counterparty’s gift to be a good egg and not disavow the contract altogether.[4]
“Credit deterioration” events
Depending on how you look at them, there are between three and four indirect Events of Default, that do not require the Defaulting Party to directly fail to perform under the ISDA Master Agreement but rather arise from independent indications that the Defaulting Party shortly might be about to go titten hoch.
These are the “credit deterioration” Events of Default: Default Under Specified Transaction — where the Defaulting Party has defaulted to the Non-defaulting Party specifically, only under a separate master trading agreement (such as a stock lending agreement or a repo; Cross Default, when it has defaulted to someone else altogether under an unrelated borrowing arrangement; Bankruptcy, where the Defaulting Party crosses that [[phase transition into formal resolution or protection, and Merger Without Assumption where, through a corporate action the Defaulting Party is transformed into a different legal entity which is somehow no longer bound by the ISDA Master Agreement at all. However you could also consider this last one a direct failure under the present contract as well.[5]
Being less directly connected with the performance of the ISDA itself, these “credit” Events of Default have the potential for sod’s law. Cross Default particularly — JC has a long and overblown article about that — but there are aspects of the Bankruptcy (especially Automatic Early Termination) that have the potential for severe unintended consequences.
- ↑ You hear these described as “no-fault” terminations, but there is no fault in a termination brought about by unforeseen externalities, either.
- ↑ See here Automatic Early Termination, which is an extreme example of such pseudo termination right: in that it triggers automatically. Much more to say about that on the AET page.
- ↑ Of the ISDA Termination Events Illegality; Force Majeure Event; Tax Event have some prospect of affecting both parties: this is less likely for Tax Event Upon Merger,Credit Event Upon Merger and the Additional Termination Events, which tend to be more “credit defaulty”.
- ↑ Repudiation of Agreement does go a bit runny at the edges, however.
- ↑ MWA is an unusual one because, as far as I can tell, its existence in the ISDA Master Agreement is basically a practical joke. There is never a time at which one could exercise a Merger Without Assumption Event of Default.