Consequences of an Event of Default - Pledge GMSLA Provision
2018 Global Master Securities Lending Agreement (Pledge Version)
Clause 11 in full
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There is little difference between the 2010 GMSLA and the 2018 Pledge GMSLA versions of Consequences of an Event of Default, as you can see more easily in this comparison of the nutshell versions. (There’s a comparison of the full provisions in the usual place in the panel). One thing you will notice is how utterly dismal is the drafting of the original provision. It was no small task to create nutshell versions — you can thank me later — but they boil down to not very much.
The differences that there are are significant, since the philosophical unpinning of what is going on is profoundly different, even if the commercial outcome is the same. Think VHS and Betamax. In a nutshell, under the 2018 Pledge GMSLA:
- Only the Borrower’s redelivery payments are accelerated, since by the theory of the game, the Lender never gets possession of the collateral and is not therefore in a position to redeliver it.
- There’s less fog and confusion because ICMA’s crack drafting squad™ in their wisdom removed Letters of Credit as a form of eligible Collateral from the 2018 Pledge GMSLA
- The reckoning of what is due under Paragraph 11.2(b) — setting off all sums owed by one party against all sums owed by the other — is less fraught, and will always be a net payable back to the Lender (because the Borrower never transferred title to the pledged Collateral in the first place)
- There is no concept in the2018 Pledge GMSLA of “Deliverable Securities” or “Receivable Securities”, seeing as there will not always be a receiver and a deliverer, so they don’t come into the frame for the reckoning of the Default Market Value in the same way.
ISLA thought leadership
ISLA published a curious piece of thought leadership in September 2018 which painted a worst-case scenario timeline for closing out a 2018 Pledge GMSLA which made it look quite a bit worse than the corresponding critical path under a normal — hardly calculated to set at ease the jittery nerves of a very modern agent lenderer. The perceived difference was this:
|2010 GMSLA||2018 Pledge GMSLA|
|Upon notice of default, Non-Defaulting Party can start immediately liquidate and has 5 days to trade and set pricing to allow for liquidity. You have to return any excess.||Upon notice of default Non-Defaulting Party can theoretically start liquidating but has value the pledged Collateral to be transferred. This may take a bit longer in an illiquid market. But seems to the JC there’s no reason you can’t execute trades in the collateral without physically holding it, seeing as it settles later. Any excess goes back to the pledgor.|
In either case for the Default Market Value, the main thing you’re valuing is the Loaned Securities not (primarily) the Collateral: as long as you aren’t under-collateralised, and you take steps to get a reasonable price, you can sell all the Collateral — remember, that’s how security works — the Defaulting Party is in the soup and can’t be too particular about what happens to its collateral as long as, once the debt is satisfied, it gets the remainder back. If you are under collateralised, it doesn’t make any odds whether you hold by pledge or title-transfer —either way, you are short.
So, how does default and close-out differ between title transfer and pledge versions of the GMSLA, then? Not as much as you might think. The mechanism for determining who owes what is broadly the same but, since the Borrower hasn’t parted company with the Collateral it has pledged — yet — and byt the theory of the game the pledged Collateral is sitting quietly in a segregated account with a triparty custodian, ready to be returned or seized and liquidated, as the circumstances require, all of the Securities valuation mechanisms focus on the Loaned Securities leg of the transaction, since the Borrower won’t, if it has a scooby doo what it is doing, be holding the Loaned Securities at any time during the Loan. It will have sold them short.
It only really comes in to play if the Borrower has defaulted
If the Lender has defaulted, you generally wouldn’t call an Event of Default under a 2018 Pledge GMSLA. There is no need: the Borrower just returns the Loaned Securities, security is released from its pledged Collateral and we all carry on our sedated ways. I mean sedate ways. Sure, if you’re a masochist you could invoke the default process of Paragraph 11, but why would you? The Loan is terminable at will; if you do want out, just terminate it and give Equivalent Securities back, and the security is released from your pledged Collateral. Far easier.
If the Borrower has defaulted, de l’autre main, there is the matter of getting Equivalent Securities back which (a) by our theory, the Borrower hasn’t got, and would therefore have to go out to the market and get, and (b) the Borrower couldn’t, without the permission of its insolvency administrator, give back to you even if it did have one. Therefore the netting and close out provisions are quite handy.
How the closeout works
- All Loans are all accelerated, and the Borrower is liable to return Equivalent Securities as at the time of default. It won’t be able to of course, for the reasons given above.
- So the Lender works out the Default Market Value of the Equivalent Securities. It does this selling Equivalent Securities, getting and averaging quotes for the sale of Equivalent Securities, or, if it can’t, or the quotes seem out of whack, it can come up with its own opinion of their value, factor in any notional Transaction Costs, and use that. Expect an aggrieved Lender to confabulate some difficulty in getting good quotes and to go for using its own opinion more often than you’d necessarily expect. The Borrower’s bust, so what does he care, right?
- The Lender can also confabulate I mean reasonably calculate its legal costs of closing out, and add those to the Default Market Value
- Lastly, it can set off against amounts it owes to the Borrower but, unlike under the title transfer 2010 GMSLA, there aren’t likely to be many, seeing as the Collateral leg is not a title transfer collateral arrangement and is still technically owned by the Borrower. But not for long.
Unlike under the 2010 GMSLA the netting mechanic doesn’t do much. There isn’t much to net. The Lender has a large claim against the Borrower, for the Default Market Value, and it satisfies this by enforcing its security under a separate Security Deed. To reiterate what should be obvious, under a pledged collateral arrangement the credit mitigation is by way of security, not netting.
So what about the Collateral then?
Your 2018 Pledge GMSLA leaves you will a closed-out big fat portfolio of receivables owing from the Borrower to the Lender, and a big fat pool of Collateral sitting with the triparty agent, in the Borrower’s name but pledged in favour of the Lender. So the heavy lifting in terms of taking the Collateral is done by the Security Deed. While, intellectually, this cleaves the normal arrangements under a title transfer 2010 GMSLA into two parts, they now work the same way. While it might take a while to work out the Default Market Value, the Lender can exercise on the Collateral immediately there is an Event of Default (though note the Borrower should want some kind of grace period built into failure to pay events reacquiring a period of notice before Collateral can be exercised. It is easier to build that into the definition of non-payment-style Events of Default in Paragraph 10.
- Well, we assume it will be the NDP: the 2018 Pledge GMSLA rather brilliantly puts it into an unattributed passive, as if God is going to to it, or it will magically happen by itself. Go, ISLA’s crack drafting squad™.
- Or purchase, but as discussed only an idiot Borrower would use the close-out provisions to terminate a Loan where a Lender defaulted.
- Hint hint — we’ve got some suggested language there!