Bankruptcy - ISDA Provision
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2002 ISDA Master Agreement
Section 5(a)(vii) in a Nutshell™
Full text of Section 5(a)(vii)
Related agreements and comparisons
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Content and comparisons
Differences between 1992 ISDA and 2002 ISDA definitions of Bankruptcy
There are two:
- Slightly more specific concept of insolvency: firstly, in limb 4 (insolvency proceedings) a new limb (A) has been included to cover action taken by an entity-specific regulator or supervisor (as opposed to a common or garden insolvency proceeding): If initiated by a regulator, the game’s up as soon as the action is taken. If initiated by a random, the action must have resulted in a winding-up order, or at least not have been discharged in 15 (not 30) days.
- Contracted grace period: The allowable period for dismissal of an insolvency petition (under 5(a)(vii)(4)) or the exercise of security over assets (under 5(a)(vii)(7)) is compressed from 30 days to 15 days. This, in aggregate over the whole global market, keeps many a negotiator in meaningful[1] employment, and you will see many large organisations, whom you’d think would know better, amending these grace periods back to the 1992 ISDA standard of 30 days or better still, insisting on sticking with a 1992 ISDA, but upgrading every part of it to the 2002 ISDA except for the Bankruptcy and Failure to Pay grace periods. This is a simply spectacular use of ostensibly limited resources.
Regional bankruptcy variations
The Germanic lands have peculiar ideas when it comes to bankruptcy — particularly as regards banks, so expect to see odd augmentations and tweaks to ISDA’s crack drafting squad™ standard language. Will these make any practical difference? Almost certainly not: it is hard to see any competent authority in Germany, Switzerland or Austria — storeyed nations all, in the long history of banking, after all — not understanding how to resolve a bank without blowing up its netting portfolio. Especially since Basel, where the netting regulations were formulated, is actually in Switzerland.
1987 ISDA
Note, for students of history, Automatic Early Termination is problematic under the 1987 ISDA.
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Summary
ISDA’s is the market standard way of defining “bankruptcy”
The ISDA bankruptcy definition is rarely a source of great controversy (except for the grace period, which gets negotiated only through custom amongst ISDA negotiators because, in its wisdom, ISDA’s crack drafting squad™ thought fit to halve it from 30 days to 15 in the 2002 ISDA.
So you have a sort of pas-de-deux between negotiators where they argue about it for a while before getting tired, being shouted at by their business people, and moving on to something more important to argue about, like Cross Default).[2]
Otherwise, the ISDA bankruptcy clause is a much loved and well-used market standard and you often see it being op-opted into other trading agreements precisely because everyone knows it and no one really argues about it.
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General discussion
TL;DR
Here are all the stages you must go through between becoming entitled to terminate and settlement for a Failure to Pay or Deliver. Note something very important:
Because you have been exchanging VM, as of the Early Termination Date, the MTM of the collateralised portfolio of Transactions should be more or less zero. A doughnut. Therefore, the final gain or loss that is secured by Posted Credit Support (IM) is a function of the change in portfolio value between the Early Termination Date and when you work out the Early Termination Amount.
That is to say, you will not know who is owed money until you have worked out the Early Termination Amount. For people who want to enforce on Posted Credit Support (IM) the moment there is an Event of Default, please consider this. You do not need to enforce security yet. You might not actually be owed anything.
Okay, so here goes with the timeline:
- T: There must be a Bankruptcy Event of Default on a day, T.
- T: You must send a Section 6(a) notice designating an Early Termination Date for all outstanding Transactions. It must be within 20 days. Let’s say it is the same day, for the hell of it
- T: You are “off risk” and must start calculating your Close-out Amounts for all outstanding Transactions. You must do this as soon as reasonably practicable. Let’s say that takes another 30 days.
- T+30: having calculated all Close-out Amounts and totted them all up into a single Early Termination Amount: You send your Section 6(d) statement advising of that amount, giving bank details and supplying your workings.
- T+31: Your Early Termination Amount is due.
In Full
So, to close out following a Bankruptcy, you will need:
1. There must be a Bankruptcy under Section 5(a)(vii)
There are nine different types of bankruptcy under the ISDA. Most are formal, public events (regulator institutes bankruptcy proceedings, administrator appointed, etc — watch too for local regulator actions and bail ins specified in the ISDA Master Agreement if your counterparty is a bank) that the would be widely known about. Others are less public and might happen more quickly. The ones most likely to happen first are:
- becoming unable to pay debts as they fall due or admitting it in writing
- making a composition with creditors
- a secured party enforcing against substantially all assets (though “substantially all assets” is a high bar, and would not be likely to apply to a significant financial institution)
Unlike a Failure to Pay, you do not need to wait for the close of business, or any grace periods to expire.
2. Send a Section 6(a) notice designating an Early Termination Date
Once there is a live Bankruptcy Event, Section 6(a) allows you, by not more than 20 days’ notice, to designate an Early Termination Date for all outstanding Transactions.
So, at some point in the next twenty days outstanding Transactions will be at an end. Now this is a different thing from knowing what the amounts will be, much less knowing when they will be paid or who will owe them: this is the date by reference to which Termination Amounts will be calculated.
Usually, you will want to go “off risk” as quickly as possible, so the Early Termination Date will likely be the date you send your Section 6(a) notice or soon after. The 20 days’ time limit on the notice period is a red herring.
3. Determine Close-out Amounts
Now, ascertain termination values for the Terminated Transactions as of the Early Termination Date per the methodology set out in Section 6(e)(i). Section 6(c) reminds us for the avoidance of doubt that even if the Event of Default which triggers the Early Termination Date evaporates in the meantime — these things happen, okay? — yon Defaulting Party’s goose is still irretrievably cooked. The trading and risk people need to come up with Close-out Amounts for all outstanding Transactions. Now note, even though you have designated an Early Termination Date not more than 20 days from your Section 6(a) notice, it may well take you a lot longer to close out your portfolio than that, and as long as you are acting in a commercially reasonable way, you can take longer. There is a longer essay about the meaningless of that 20-day time limit here. Once they have done that you are ready for your Section 6(e) notice.
4. Calculate and notify
The Early Termination Date is the date on which the Transactions terminate; it is the date by reference to which you calculate their termination values, not the date by which 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 6(d), under which, as soon as is practicable after the Early Termination Date, your boffins work out all the termination values for each Transaction, tot them up to arrive at the Section 6(e) amount, and send a statement to the defaulting party, specifying the Early Termination Amount payable, the bank details, and reasonable details of calculations.
5. Pay your Early Termination Amount
Your in-house metaphysicians having calculated your Close-out Amounts, and assembled all the values into an Early Termination Amount the party who owes it must pay the Early Termination Amount. With ISDA’s crack drafting squad™’s yen for infinite particularity, this will depend on whether the Early Termination Date follows an Event of Default or a Termination Event. If the former, the Early Termination Amount is payable at once, as soon as the 6(d) statement is deemed delivered; if a Termination Event, only two Local Business Days — I know, right — after the 6(d) statement is delivered (or, where there are two Affected Parties and both are delivering each other 6(d) statements — I know, right — after both have done so).
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See also
- Insolvency and bankruptcy generally.
References
- ↑ “meaningful” is in the eye of the beholder, you understand.
- ↑ This, by the way, is an ISDA In-joke. In fact, Cross Default is pretty much pointless, a fact that every ISDA lawyer and credit officer knows, but none will admit on the record.