Cross Default - ISDA Provision
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ISDA Anatomy™
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General
This article is specifically about the Cross Default provision in the ISDA Master Agreement. See: cross default for a general discussion of the concept.
Under the ISDA Master Agreement, if the cross default applies, default by a party of a payment under “Specified Indebtedness” in an amount above an agreed “Threshold” will entitle the other party to close out the ISDA Master Agreement.
Specified Indebtedness is a claim against a party (by any third party) for borrowed money (e.g. bank debt; deposits etc.) and the Threshold which triggers it is usually defined as a cash amount or a percentage of shareholder funds. Some parties will try to widen this: do your best to resist that.
Cross default effectively imports all the default rights you might have given a third party under the Specified Indebtedness into the ISDA Master Agreement. For example, if you breach a financial covenant in a loan facility, even if the lender of the facility does not act on the breach your swap counterparty would be entitled to terminate the ISDA Master even though the ISDA Master itself contained no financial covenants.
Cross Aggregation
The 2002 ISDA updates the 1992 ISDA cross-default so that if the outstanding amount under the 2 limbs of cross-default, added together, breach the Threshold Amount, then that will trigger cross default. Normally, under the 1992 ISDA , cross-default is only triggered if an amount under one or the other limbs is breached.
As per the above, the two limbs are:
- a default or similar event under financial agreements or instruments that has resulted in indebtedness becoming capable of being accelerated and terminated by a Non-defaulting Party
- a failure to make any payments on their due date under such agreements or instruments after notice or 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
- The 1992 Version: 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 defaulted payment contributes to the Threshold Amount, not the principal amount of the Specified Indebtedness itself;
- The 2002 Version: 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:
- It can be triggered by any event of default, not just a payment default (I.e. the 1992 wording "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 size of the Specified Indebtedness, not just the value of the defaulted payment (if it even is a payment) itself.
For example: if you defaulted on a (relatively small) interest payment, which made the whole loan repayable, under the 1992 formulation you could only count the value of the missed interest payment to your Threshold Amount. But the risk to you ise whole size of the loan, as that is what could become repayable if the loan is accelerated.
It is innocuous, that is, unless you are cavalier enough to include derivatives or other payments which are not debt-like in your definition of Specified Indebtedness. But if you do that, you've bought yourself a wild old ride anyway.
In case it isn't clear, 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 - as starry-eyed credit officers like to - to apply it to contractual relationships which aren't debtor/creditor in nature, it will give you gyp.
Don't say you weren't warned.
Aggregation of limbs (1) and (2)
The 1992 version doesn't specifically provide that you can aggregate amounts calculated under each limb. Arguably that's implied - but you know what derivatives lawyers are like! DON'T IMPLY ANYTHING. IT MAKES AN IMP OUT OF L AND Y. You get the picture.
Rather uniquely attention-sapping drafting all round.
References
- ↑ And, to be candid, rightful.