Bankruptcy - ISDA Provision

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2002 ISDA Master Agreement
A Jolly Contrarian owner’s manual™

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Resources Wikitext | Nutshell wikitext | 1992 ISDA wikitext | 2002 vs 1992 Showdown | 2006 ISDA Definitions | 2008 ISDA | JC’s ISDA code project
Navigation Preamble | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 | 13 | 14
Events of Default: 5(a)(i) Failure to Pay or Deliver5(a)(ii) Breach of Agreement5(a)(iii) Credit Support Default5(a)(iv) Misrepresentation5(a)(v) Default Under Specified Transaction5(a)(vi) Cross Default5(a)(vii) Bankruptcy5(a)(viii) Merger without Assumption
Termination Events: 5(b)(i) Illegality5(b)(ii) Force Majeure Event5(b)(iii) Tax Event5(b)(iv) Tax Event Upon Merger5(b)(v) Credit Event Upon Merger5(b)(vi) Additional Termination Event

Index: Click to expand:

Section 5(a)(vii) in a Nutshell
Use at your own risk, campers!

5(a)(vii). Bankruptcy. A party of its Credit Support Provider or Specified Entity:―
(1) Dissolved: is dissolved (other than by merger);
(2) Insolvent: becomes insolvent, unable to pay its debts, or admits it in writing;
(3) Composition with Creditors: makes a composition its creditors;
(4) Insolvency Proceedings: suffers insolvency proceedings instituted by:
(A) a regulator; or
(B) anyone other than a regulator, and
(I) it results in a winding up order; or
(II) those proceedings are not discharged within 15 days;
(5) Voluntary Winding Up: resolves to wind itself up (other than by merger);
(6) Put in Administration: has an administrator, provisional liquidator, or similar appointed for it or for substantially all its assets;
(7) Security Exercised: has a secured party take possession of, or a legal process is enforced against, substantially all its assets for at 15 days without a court dismissing it;
(8) Analogous events: suffers any event which, under the laws of any jurisdiction, has the same effect as any of the above events; or
(9) Action in furtherance: takes any action towards any of the above events.

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Full text of Section 5(a)(vii)

5(a)(vii) Bankruptcy. The party, any Credit Support Provider of such party or any applicable Specified Entity of such party:―
(1) is dissolved (other than pursuant to a consolidation, amalgamation or merger);
(2) becomes insolvent or is unable to pay its debts or fails or admits in writing its inability generally to pay its debts as they become due;
(3) makes a general assignment, arrangement or composition with or for the benefit of its creditors;
(4)
(A) institutes or has instituted against it, by a regulator, supervisor or any similar official with primary insolvency, rehabilitative or regulatory jurisdiction over it in the jurisdiction of its incorporation or organisation or the jurisdiction of its head or home office, a proceeding seeking a judgment of insolvency or bankruptcy or any other relief under any bankruptcy or insolvency law or other similar law affecting creditors’ rights, or a petition is presented for its winding-up or liquidation by it or such regulator, supervisor or similar official, or
(B) has instituted against it a proceeding seeking a judgment of insolvency or bankruptcy or any other relief under any bankruptcy or insolvency law or other similar law affecting creditors’ rights, or a petition is presented for its winding-up or liquidation, and such proceeding or petition is instituted or presented by a person or entity not described in clause (A) above and either
(I) results in a judgment of insolvency or bankruptcy or the entry of an order for relief or the making of an order for its winding-up or liquidation or
(II) is not dismissed, discharged, stayed or restrained in each case within 15 days of the institution or presentation thereof;
(5) has a resolution passed for its winding-up, official management or liquidation (other than pursuant to a consolidation, amalgamation or merger);
(6) seeks or becomes subject to the appointment of an administrator, provisional liquidator, conservator, receiver, trustee, custodian or other similar official for it or for all or substantially all its assets;
(7) has a secured party take possession of all or substantially all its assets or has a distress, execution, attachment, sequestration or other legal process levied, enforced or sued on or against all or substantially all its assets and such secured party maintains possession, or any such process is not dismissed, discharged, stayed or restrained, in each case within 15 days thereafter;
(8) causes or is subject to any event with respect to it which, under the applicable laws of any jurisdiction, has an analogous effect to any of the events specified in clauses (1) to (7) above (inclusive); or
(9) takes any action in furtherance of, or indicating its consent to, approval of, or acquiescence in, any of the foregoing acts; or

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Related agreements and comparisons

Related Agreements
Click here for the text of Section 5(a)(vii) in the 1992 ISDA
Comparisons
Click to compare this section in the 1992 ISDA and 2002 ISDA.

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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:

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

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References


  1. “meaningful” is in the eye of the beholder, you understand.
  2. 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.