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 imperative to end a commercial relationship: all being well, it is an infinite game. If we are flexible enough, open-minded enough, and good enough at the infinite game of business, we can keep this positive feedback loop going, for the mutual betterment of everyone, indefinitely. Infinitely, even.

Therefore, we wish our relationships well, pray Godspeed for their long and fruity lives and, should the twigs on this or that branch dry up, or things in general feel more trouble than they are worth, we can call time and bid a peaceful transition from the flush of vital ardour into the restful stasis of the ultimate hereafter. But we know such equanimity is not always possible. Things do not always work out. There is no more sacred a time in the lives of our commercial contracts than their departure from the earthly clutch.

Therefore, we pack our trunk with tools, implements and weapons with which, if we have to, we can engineer a faster exit. There are a host of different ways this can happen. While lawyers will happily rabbit on about these hypotheticals in the gruesome specific, in general, big picture, terms we do not talk about them enough.

Below, JC comes over all over-analytical and counts the types of ways we can bid a commercial relationship to the earth.

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 resources so it can best provide that service and extracting some fee, commission or economic rent by way of consideration for it.

This is to say, “providers” are indifferent to the substance of their services. They do not mean to be economically “the other side” of the trades they execute. They are, loosely, intermediaries. Agents. A match risk takers together, collect a fee and wish them well. They do not take a side. They are “compassionate” not “empathetic” in psychological terms. All being well, they are indifferent to how the instruments in which they deal perform. As long as their customers remain in fine fettle, they should never need, much less want, to terminate their services. 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 risk and a prerogative to go off risk as she sees fit. She can exit whenever she wants, by paying the provider’s 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 ostensible fixed term, binds a provider in a way it does not bind the customer to its term.

But things can change. The customer’s financial prospects may darken. She may turn out not to be as good as her word. The regulatory environment may change, making the services harder or more expensive to provide.

Where it is no longer sure of its expected return, the provider must have a set of “weapons” it can use to get out of its contracts. 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”; unforeseen external events and counterparty failure. This last category — which we might also label “default” — in turn breaks into two: direct misbehaviour, indirect credit deterioration, and [[Merger Without Assumption - ISDA Provision|ISDA’s crack drafting squad™ in-jokes]].

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. These are a marker of our incipient failure in the battle between substance and form.

“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. For example, a swap dealer’s right to terminate a customer’s synthetic equity swap position on notice. The dealer can thereby treat its exposure as a “short-term obligation” for capital purposes — because it could get out, if it wanted to— and this is enough to get optimised regulatory treatment.

But a dealer having such a termination right is a different and distant thing from a sound-minded dealer ever exercising it. It might be forced to, in the direst of stress circumstances (where its own survival was threatened) — but in that case, with the dealer teetering, most vigilant customers would likely have long since 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. (Of the Termination Events, Illegality, Force Majeure Event and Tax Event have some prospect of affecting both parties. That is less likely for party-specific Tax Event Upon Merger and Credit Event Upon Merger events, or for Additional Termination Events which tend to be more “credit defaulty”).

“Default Events”: do we have a problem here?

Then there are termination rights that flow from something untoward about your counterparty. These the Non-defaulting Party exercises unilaterally. This being a contract, the main category of “untoward facts” about your counterparty will be things it promised 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.

The classic “performance failure” is a failure to pay. There could hardly be an obligation more “of the essence” of a financial contract than then rendering in full of what you promised when you promised it.

As a result there is little negotiation of payment failure default events. Nor, when it comes to it, is there much room for doubt as to whether one has happened. The payment either settled or it didn’t. Ops can tell you a few minutes after the cut-off time.

Ninety-five per cent of all ISDA 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. It rather makes you wonder why we waste so much time haggling over the rest of the Events of Default.

Parkinson’s law of triviality exemplified: 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.

The other direct performance failure Events of Default are slightly more oblique. Technical non-performance measures that are less “essential” than payment failure tend to have longer cure periods before being actionable: whereas payment failure might have a one-day grace period, other breaches of agreement may have a 30 day period. Performance failures that imply bad faith, like repudiation, tend to have no grace period, but it is quite hard to goad a counterparty into committing one of these.

By order of how quickly you can accelerate them, then, here are the ISDA Master Agreement’s “performance failure” {{isdaprov|Events of Default, are:

Itchy Trigger Finger Guide

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.

Seeing as it has no grace period, why aren’t Repudiation or Misrepresentation more commonly invoked to close out an ISDA then they are (i.e., almost never)? Because it would require not just artless non-performance, but bone-headedness. However dire the situation gets, it remains within a struggling counterparty’s gift to be sensible enough to keep its trap shut and not denounce the contract altogether, or make untrue statements about its own financial condition.

“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 more fraught, because the evidence for whether they have happened may not be in your possession, if they can even be determined at all.

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 — these ones you will know about; Cross Default, when it has defaulted to someone else altogether under an unrelated borrowing arrangementand Bankruptcy, where the Defaulting Party crosses that [[phase transition into formal resolution or protection.

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.

How are you meant to know the size of your customer’s private indebtedness, much less that it has categorically defaulted on it? What is a lender has granted a hastily cobbled waiver or amendment? Is it still a default?

These sorts of doubts will wrack the credit department. A senior relationship manager will storm in and insist his platinum client would never default. Any firm not populated in its senior echelons by lizards will sit on its hands. (This excludes Goldman).

ISDA in-jokes

You might call 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 — as a type of credit deterioration event, but you could also consider it a direct failure under the present contract as well.

But the best way of looking at it is as a practical joke. A kind of forensic pun, stuck in there at a dark moment in the sacred Wording in which , to lighten the mood, someone lobbed in a harmless nonsense. As far as I can tell — and I checked this with the learned author of Cluley on Close-Outs, and my young apprentice , and they both agree — Merger Without Assumption as articulated 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.