Template:Failure to pay procedure

Closing out an ISDA Master Agreement following an Event of Default

Here is the JC’s handy guide to closing out an ISDA Master Agreement. We have assumed you are closing out as a result of a {{{{{1}}}|Failure to Pay or Deliver}} under Section {{{{{1}}}|5(a)(i)}}, because — unless you have inadvertently crossed some portal, wormhole into a parallel but stupider universe — if an ISDA Master Agreement had gone toes-up, that’s almost certainly why. That, or at a pinch {{{{{1}}}|Bankruptcy}}. Don’t try telling your credit officers this, by the way: they won’t believe you — and they tend to get a bit wounded at the suggestion that their beloved NAV triggers are a waste of space.

In what follows “Close-out Amount” means, well, “Close-out Amount” (if under a 2002 ISDA) or “Loss” or “Market Quotation” amount (if under a 1992 ISDA), and “{{{{{1}}}|Early Termination Amount}}” means, for the 1992 ISDA, which neglected to give this key value a memorable name, “the amount, if any, payable in respect of an {{{{{1}}}|Early Termination Date}} and determined pursuant to Section 6(e)”.

So, to close out following a Failure to Pay or Deliver, you will need:

1. There must be a failure to pay or deliver under Section {{{{{1}}}|5(a)(i)}}

A {{{{{1}}}|Failure to Pay or Deliver}}, by the {{{{{1}}}|Defaulting Party}} to make a payment or delivery when due on day T. This is not, yet, an {{{{{1}}}|Event of Default}} under Section {{{{{1}}}|5(a)(i)}}. But we are on the way.

2. You must give notice of the failure under Section {{{{{1}}}|5(a)(i)}}

The {{{{{1}}}|Non-defaulting Party}} must give the {{{{{1}}}|Defaulting Party}} notice of the failure. This is not a Section {{{{{1}}}|6(a)}} notice — calm, down, we will get to that in good time — but a Section 5(a)(i) notice of failure to pay or deliver. The sainted ISDA Master Agreement does not directly prescribe the format for this notice, but Section {{{{{1}}}|12}} cautions that it may not be by e-mail or {{{{{1}}}|electronic messaging system}} or (if you have a 1992 ISDA, at any rate), by fax. The proper form is to have it hand-delivered by someone prepared to swear an affidavit as to when and where they delivered it to the Defaulting Party.

Since payments and deliveries are generally due at close of business on a given day, Q.E.D., a Section {{{{{1}}}|5(a)(i)}} notice of {{{{{1}}}|Failure to Pay or Deliver}} can usually only be given after close of business on the due date.

Thanks to Section {{{{{1}}}|12(a)}} ({{{{{1}}}|Notices}}), the Section {{{{{1}}}|5(a)(i)}} notice will only be effective on the following {{{{{1}}}|Local Business Day}}: i.e., T+1.

3. You must allow the grace period under Section {{{{{1}}}|5(a)(i)}} to expire

At this point you have a {{{{{1}}}|Potential Event of Default}}, but not an actual one.

Once your Section {{{{{1}}}|5(a)(i)}} notice of {{{{{1}}}|Failure to Pay or Deliver}} is effective, the {{{{{1}}}|Defaulting Party}} has a “grace period” in which it may sort itself out and make the payment or delivery in question, thereby heading off a full-blown Event of Default.

The standard grace periods are set out in Section {{{{{1}}}|5(a)(i)}}. Be careful: under a 2002 ISDA the standard is one Local Business Day. Under the 1992 ISDA the standard is three Local Business Days. But check the {{{{{1}}}|Schedule}} because in either case this is the sort of thing that counterparties adjust: 2002 ISDAs are often adjusted to conform to the 1992 ISDA standard of three {{{{{1}}}|LBD}}s, for example.

So: once you have a clear, notified {{{{{1}}}|Failure to Pay or Deliver}}, you have to wait at least one and possibly three or more {{{{{1}}}|Local Business Day}}s before doing anything about it. Therefore, you are on tenterhooks until the close of business T+2 {{{{{1}}}|LBD}}s (standard 2002 ISDA), or T+4 LBDs (standard 1992 ISDA).

Let us imagine for a moment you have indeed waited the necessary time.

4. You may now send your Section {{{{{1}}}|6(a)}} notice designating an {{{{{1}}}|Early Termination Date}}

At the expiry of the Section {{{{{1}}}|5(a)(i)}} grace period, you finally have a fully operational {{{{{1}}}|Event of Default}}. Now Section {{{{{1}}}|6(a)}} allows you, by not more than 20 days’ notice to designate an {{{{{1}}}|Early Termination Date}} for all outstanding Transactions.

So, at some point in the next twenty days there will be a final reckoning and one Party will pay the other the Early Termination Amount.But we have a ways to go before we even know what that amount will be. But observe: the payment date is now locked in. Time to get your skates on and start closing out {{{{{1}}}|Transactions}}.

5. Determine {{{{{1}}}|Close-out Amount}}s

One must now ascertain termination values for the {{{{{1}}}|Terminated Transaction}}s as of the Early Termination Date per the methodology set out in Section {{{{{1}}}|6(e)(i)}}.

Now armed with our crystalised {{{{{1}}}|Failure to Pay or Deliver}} {{{{{1}}}|Event of Default}} and with an {{{{{1}}}|Early Termination Date}} to target, we go directly to Section {{{{{1}}}|6(e)}}, noting as we fly over it, that Section {{{{{1}}}|6(c)}} reminds us for the avoidance of doubt that even if the {{{{{1}}}|Event of Default}} which triggers the {{{{{1}}}|Early Termination Date}} evaporates in the meantime — these things happen, okay? — yon {{{{{1}}}|Defaulting Party}}’s goose is still irretrievably cooked.

There is a bit of a chicken licken-and-egg situation here as you can’t really work out their mark-to-market values for that date at any time before that date, unless you are able to see into the future or something. Anyway, that’s a conundrum for your trading people (and in-house metaphysicians) to deal with and it need not trouble we eagles of the law. For our purposes, the trading and risk people need to come up with Close-out Amounts for all outstanding {{{{{1}}}|Transaction}}s. Once they have done that you are ready for your Section {{{{{1}}}|6(e)}} notice.

6. Calculate and notify

The {{{{{1}}}|Early Termination Date}} is the date on which the {{{{{1}}}|Transaction}}s terminate; it is the date by reference to which you calculate their termination values, not the date by you have to have valued, much less settled outstanding amounts due as a result of their termination — that would be a logical impossibility for those not imbued with the power of foresight. Here we move onto Section {{{{{1}}}|6(d)}}, under which, as soon as is practicable after the {{{{{1}}}|Early Termination Date}}, your boffins work out all the termination values for each {{{{{1}}}|Transaction}}, tot them up to arrive at the Section {{{{{1}}}|6(e)}} amount, and send a statement to the defaulting party, specifying the {{{{{1}}}|Early Termination Amount}} payable, the bank details, and reasonable details of calculations.

7. Pay your {{{{{1}}}|Early Termination Amount}}

Your in-house metaphysicians having calculated your Close-out Amounts, and assembled all the values into an {{{{{1}}}|Early Termination Amount}} the party who owes it must pay the {{{{{1}}}|Early Termination Amount}}. With ISDA’s crack drafting squad™ yen for infinite fiddlarity, this will depend on whether the Early Termination Date follows an Event of Default or an Termination Event. If the former, the {{{{{1}}}|Early Termination Amount}} is payable at once, as soon as the {{{{{1}}}|6(d)}} statement is deemed delivered; if a {{{{{1}}}|Termination Event}}, only two {{{{{1}}}|Local Business Day}}s — I know, right — after the {{{{{1}}}|6(d)}} statement is delivered (or, where there are two {{{{{1}}}|Affected Parties}} and both are delivering each other {{{{{1}}}|6(d)}} statements — I know, right — after both have done so).

8. Putting that all together

Here are all the stages you must go through between becoming entitled to terminate and settlement for a {{{{{1}}}|Failure to Pay or Deliver}}:

• T: There must be a {{{{{1}}}|Failure to Pay or Deliver}} on a day, T.
• T+1: After close of business on T, the {{{{{1}}}|Non-defaulting Party}} must give the {{{{{1}}}|Defaulting Party}} a Section {{{{{1}}}|5(a)(i)}} notice of failure to pay of deliver. The prescribed grace period must expire. The grace periods may be between 1 and 3 {{{{{1}}}|LBD}}s. There may also be carve-outs for operational failures and so on, to add to the fun.
• T+4: You must send a Section {{{{{1}}}|6(a)}} notice designating an {{{{{1}}}|Early Termination Date}} for all outstanding {{{{{1}}}|Transaction}}s. Let’s say it is 3 {{{{{1}}}|LBS}}s. You must designate an Early Termination Date within 20 days. Let’s say it is 20 days, for the hell of it
• T+24: You are “off risk” and must start calculating your {{{{{1}}}|Close-out Amount}}s for all outstanding {{{{{1}}}|Transaction}}s. You must do this ass soon as reasonably practicable. Let’s say that takes another 30 days.
• T+54: having calculated all {{{{{1}}}|Close-out Amount}}s and totted them all up into a single {{{{{1}}}|Early Termination Amount}}: You send your Section 6(d) statement advising of that amount, giving bank details and supplying your workings.
• T+54: Your {{{{{1}}}|Early Termination Amount}} is due.