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 insight: things need not be nasty, brutish and short and, when it comes to commerce, generally aren’t.

Each of us will only strike a bargain if we think, on our own terms, we’ll be better off as a result. That being so, once we’ve built a good business relationship, there is no good reason to end it. All being well, trade is an infinite game. If we are good enough at it, we can keep its positive feedback loop going, for the mutual betterment of everyone, indefinitely. Infinitely, even.

Therefore, we wish our relationships well and pray Godspeed for their long and fruity lives. Should the plums dangling from this or that branch shrivel; if things become more trouble than they’re worth, we can of course call time and bid our relationship a peaceful transition to the hereafter.

But still, things do not always work out quite so equably. Sometimes, an ill wind blows. Relationships become fraught, counterparties get themselves in a pickle.

Therefore, we pack our trunk with tools, implements and weapons with which, if we must, we can engineer a faster exit from our contracts.

There are a few different ways this can happen. While lawyers will happily rabbit on about these hypotheticals in the gruesome specific, we do not talk about them in general terms often enough. So let’s do that now.

Below, we count the types of ways to safely put a commercial relationship in the ground.

Customers and service providers

Now the great majority of financial contracts are between a “provider” on one side — a bank, broker or dealer providing a “service”, broadly described: money outright, finance against an asset or a financial exposure — and a “customer” on the other who pays for that service. The customer is, as ever, king: the service exists for her exclusive benefit: the provider’s only wish is to manage its resources to most efficiently provide that service and extract a fee, commission or economic rent by way of consideration for it.

“Providers” are indifferent to how the instruments they serve perform. They do not mean to be “the other side” of the trade. They are, loosely, intermediaries. Agents. They match risk-takers, collect a fee and wish the parties well without taking sides: they are “compassionate”, not “empathetic”. As long as their customers remain in fine fettle, they should never need, much less want, to terminate their services, for that is how they earn a crust.

But all the same we should note something important here: the expectations of parties to a service contract are very different: the customer takes risk and retains the prerogative to go off risk as she sees fit, as long as she pays 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, a provider cannot exit a service contract early without the customer’s permission. A fixed term financial contract, binds a provider in a way it does not bind its customer.

As long as the customer remains in good health, no problem. But the customer’s general 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 costly to provide. There are times where a service provider may, justifiably, want out.

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.

Put these “termination scenarios” into three categories: without cause; external events and counterparty failure.

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 scabrous songs of experience than exuberant songs of innocence. If this should mean our commercial paths diverge, we prescribe a notice period long enough to allow each other to make reasonable alternative arrangements, but otherwise, we wish each other well and carry on our way.

“Without cause” termination rights for a service provider will generally be “clean-up” arrangements: to clear out low-value and dormant clientry whose mere presence on the books implies ongoing compliance or operational costs. These rights will not usually impair in-flight Transactions, which a service provider must still see through before it can be allowed to move on.

Pseudo-termination rights

Dealers sometimes must have rights to terminate in-flight customer Transactions on notice without reason. These will often be “pseudo” rights that a dealer must have but will never actually use. These rights help to optimise their liquidity and capital buffers, therefore reducing the dealers’ own costs of doing customer business. For example, a swap dealer’s right to terminate a customer’s synthetic equity swap position on (longish) notice. If it has such a right, the dealer can treat its equity swap exposures 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 sound-minded dealer having such a termination right is a different and distant thing from ever exercising it. It might be forced to, in the direst of stress circumstances, where its own survival was threatened — we are in September 2008 territory here — but in that case, with the dealer teetering, most vigilant customers would be moving valuable positions away in any case.

Pseudo-termination rights, in that dealers absolutely must have them but would never use them, are a marker of incipient failure in the battle between substance and form. What matters is that the termination right exists, not that it is ever used. It is sometimes hard to persuade neurotic buy side types that such termination rights are harmless, but in large part they are.

Termination Events

It is in the nature of uncertainty that unwanted things can happen that are no one’s fault, but yet beyond anyone’s power to control or stop. Force majeure and changes in law, taxation and regulatory capital treatment can make the continued provision of a service uneconomic or impractical.

Under the ISDA framework, these events are described as Termination Events. Typically, they are measured Transaction-by-Transaction, so do not shut down all exposure under the Agreement at once; only under those Transactions which are directly “affected”.

Since no one is pointing fingers or swearing, there is generally more leeway for the parties to get heads together and explore workarounds and solutions to avoid termination. An eventual decision to terminate, while regretted, may well arrive during a time of relative psychological calm, sans malice, and probably even by agreement.

The ISDA Master Agreement allows, too, for customised Additional Termination Events. While these are filed under “Termination Event” they tend to be “defaulty” in nature, so we will deal with them below.

Counterparty failures

Then there are termination rights that flow from something wicked about your counterparty. These the Non-defaulting Party will exercise unilaterally, without so much as a by-your-leave. We might break these down into performance failures, credit deterioration indicators, and ISDA in-jokes.

Performance failures

Being a contract, the main category of “wicked facts” about your counterparty justifying termination will be things it promised under the contract that did not happen. Let us call these “performance failures”. Direct performance failures — in old money, breaches of contract — tend not to be controversial: 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” in a financial contract is a failure to pay. There could hardly be an obligation more “of the essence” of a financial contract than rendering in full 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 anyone 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 termination right during onboarding and how likely you are to ever have to use it afterwards.

Other direct “performance failures” are a bit more oblique. Technical non-performance measures that are less “essential” than payment failure tend to have longer cure periods: whereas payment failure might have a one-day grace period, you might have as long as 30 days to put right less material breaches of an agreement, after being asked to do so, before they become outright Events of Default. But if a week is a long time in politics, a month is a geological timescale in the capital markets, so this makes less-material breaches of contract more or less useless.

Performance failures that imply bad faith or moral shortcomings, like repudiation, tend not to have grace periods at all, but seeing as it is quite hard to goad a counterparty into committing one of these, this does not make them any more useful.

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

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 of contract)	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.

Credit deterioration indicators

Depending on how you look at them, there are between three and four indirect Events of Default that do not require the Defaulting Party’s direct performance failure but instead arise from independent indications that it might be about to go titten hoch. These are more fraught, because hard evidence may not be readily available to the Non-defaulting Party, if it exists at all.

These are the “credit deterioration” events: Default Under Specified Transaction — where the Defaulting Party has failed under a separate master trading agreement to the Non-defaulting Party specifically; Cross Default — where it has defaulted to someone else altogether under an unrelated borrowing arrangement; and Bankruptcy, where it has crossed that phase transition from rude health into formal corporate resolution or protection.

These events have great potential for the intervention of sod’s law. Cross Default particularly — JC has a long and overblown article about that — but there are aspects of the Bankruptcy Event of Default (especially Automatic Early Termination) that have the potential for severe unintended consequences.

How are you meant to know how much your customer privately owes, much less that it has categorically defaulted? What if a lender granted a waiver or amendment? Is it still a default?

These sorts of doubts will wrack the credit department. Even senior credit officers will be cowed. A silvery senior relationship manager, reeking of Evyan skin cream and L’Air du Temps, will storm in, hotly denying his platinum client would ever default — that it is sacrilegious even to think things like that. He will have roped in any number of fragrant senior colleagues from the wealth management division to huff outragedly on his client’s behalf. Any firm not populated in its senior echelons by lizards will wilt before such a dominance display and sit on its hands for the minutes of hours it takes for the counterparty to miss its next margin call. (Except Goldman, which is populated in its senior echelons by lizards.)

Additional Termination Events

The tailored Additional Termination Events your credit officer would bid you crowbar into the Schedule tend to have the character of customer-specific credit deterioration indicators: NAV triggers, key person events, ratings downgrade thresholds and like events that suggest the customer may shortly fail under your contract, even if it hasn’t yet.

These you will spend the most time haggling about, and by immutable laws of soddery, they will also cause you the most bureaucratic fusspotting afterwards, without ever being of any practical use. For every NAV trigger you pull, a hundred you will have to gently, and apologetically waive when they are tripped in benign circumstances, lest you be descended on by a gaggle of aromatic SRMs. Actually, more than that. No one ever pulls a NAV trigger.

The real-world life experience of ATEs — I should say, lack of experience — tells a counterintuitive story: that dealers should not worry too much if a customer rejects their favourite ATEs; that customers need not worry too much if your dealer won’t back down about the ones it wants, since it will never use them anyway. (Except Goldman. Goldman will definitely use its ATEs.)

In any case, we all have our roles in the great pantomime.

ISDA in-jokes

This leaves Merger Without Assumption — where, through a corporate action the Defaulting Party is transformed into a different legal entity that, through mystical rules of corporate succession, is somehow no longer bound by the ISDA Master Agreement its ancestor signed at all. You might call this a type of “credit deterioration” event, but you could also consider it a direct “performance failure” — an outright ontological denial, almost — under the present contract.

As far as I can tell, and I checked this with the learned author of Cluley on Close-Outs and my go-to real-world ISDA ninja — both know a lot more than I do, and neither put me off the idea — Merger Without Assumption as articulated in the ISDA Master Agreement is basically a practical joke. A kind of documentary pun, stuck in there at a dark moment in the sacred Wording ritual in which, to lighten the mood, someone lobbed in this harmless nonsense while fully-armoured ISDA knights wrangled canonical text through the medium of hand-to-hand combat. But here we are, nearly thirty years later.

Recap

So, there are three broad means of terminating a financial contract: in order of controversy, on notice, on account of externalities, and upon default.

When negotiating these rights it is always worth bearing in mind the parties’ respective interests in the contract. An end user wants cheap and reliable exposure to risk. A service provider wants a cheap, reliable and capital-efficient source of commission income. Neither, beyond beating down the other’s expectations about what is cheap and reasonable, wishes her counterparty ill.

We can sand edges off potential rancour by appealing to good faith and commercial reasonableness: take a step back and it becomes apparent that this is all anyone wants. Take the nightmarish hypotheticals of your legal advisers — including their grave warnings about the dangers of a commercially reasonable standard — with a grain of salt: worrying you into marginally less reasonable and therefore more debatable positions suits their own expectations about fee income.

And of the default events, remember, in a financial contract, it all comes down to a failure to pay, or a fear of a failure to pay.

Those representations, downgrade triggers and key person terms only matter at all to the extent they lead to, or forewarn of, a failure to pay.