Additional Termination Event - ISDA Provision
Content and comparisons
Numbering Discrepancy: Note the numbering discrepancy in Section 5(b) between the 1992 ISDA and 2002 ISDA. This is caused by a new 5(b)(ii) (Force Majeure Event) in the 2002 ISDA before Tax Event, which is thus shunted from Section 5(b)(ii) (in the 1992 ISDA) to Section 5(b)(iii) (in the 2002 ISDA).
Other than the numbering discrepancy and a daring change of a “shall” to a “will”, Section 5(b)(vi) of the 2002 ISDA is the same as Section 5(b)(v) of the 1992 ISDA. That said, ATEs are likely to be the most haggled-over part of your ISDA Master Agreement.
Additional Termination Events are the other termination events your Credit department has dreamt up for this specific counterparty, that didn’t occur to the framers of the ISDA Master Agreement — or, at any rate, weren’t sufficiently universal to warrant being included in the ISDA Master Agreement for all. While the standard Termination Events tend to be “non-fault” events which justify termination of the relationship on economic grounds, but not on terms necessarily punitive to the Affected Party, Additional Termination Events are more “credit-y”, more susceptible of moral outrage, and as such more closely resemble Events of Default than Termination Events.
Common ones include:
- NAV triggers (for hedge funds)
- Key man provisions (for hedge funds)
- Investment manager insolvency or loss of licence
- Parent divestment (where counterparty is a financing subsidiary)
There is a — well, contrarian — school of thought that Additional Termination Events better serve the interests of the Ancient Guild of Contract Negotiators and the Worshipful Company of Credit Officers than they do the shareholders of the institutions for whom these artisans practise their craft, for in these days of zero-threshold CSAs, the real credit protections in the ISDA Master Agreement are the standard Events of Default (especially Failure to Pay or Deliver and Bankruptcy).
It’s a fair bet no-one in the organisation will have kept a record of how often you pulled NAV trigger. It may well be never.
“Ahh”, your credit officer will say, “but it gets the counterparty to the negotiating table”.
A “Termination Event” is defined as “an Illegality, a Tax Event or a Tax Event Upon Merger or, if specified to be applicable, a Credit Event Upon Merger or an Additional Termination Event”. Therefore, adding any new Termination Event must ALWAYS be achieved by labelling it a new “Additional Termination Event” under Section 5(b)(vi) (under the 2002 ISDA) or 5(b)(v) (under the 1992 ISDA), and not a separate new Termination Event under a new Section 5(b)(vii), or anything like that.
If you try to make it into a new “5(b)(vii)” it is therefore neither an “Illegality”, “Tax Event”, “Tax Event Upon Merger”, “Credit Event Upon Merger” nor an “Additional Termination Event”. Read literally, is will not be caught by the definition of “Termination Event” and none of the Section 6(b) Right to Terminate following Termination Event provisions will bite on it.
I mention this because I have seen it happen. Yes, you can take a “fair, large and liberal view” that what the parties intended was to create an ATE, but, in our age of anxiety, why suffer that one?
NAV trigger ATE
A NAV trigger is the right to terminate a master agreement as a result of the decline in net asset value of a hedge fund counterparty (other counterparty types generally won’t have a “net asset value” to trigger).
Like most events of default, NAV triggers are a second-order derivative for the only really important type of default: a failure to pay. A significant decline in NAV makes a payment default more likely. NAV declines in three main ways:
- The value of assets (be they physical or derivative) declines;
- The cost of financing those assets - the leverage - increases;
- Investors withdraw money from the fund.
Prime brokers hold initial margin to protect against the first, control the second in any weather, and one would expect the third to result in overall proportionate de-risking anyway.  In any case, the benefit to a second order derivative close-out right is that it might allow you to get ahead of the game. If I know the default is coming (because NAV trigger, right?) why wait until a payment is due to see if I get hosed?
Because, in this age of high-frequency trading, multiple payments are due every day, and even if one isn’t, in many cases you can force one by raising initial margin. All told, an actual failure to pay is deterministic. There is no argument. A NAV trigger breach — not so much.
Especially since an official NAV is only “cut” once for every “liquidity period” — monthly or quarterly in most cases — and it is hard to see how a credit officer, however enthusiastic, could determine what the net asset value of the fund was at any other time, not having knowledge of those positions held with other counterparties. On the other hand, credit officers don’t usually monitor NAV triggers anyway, so what do they care?
Key person ATE
In a gaucher times called a key man, the key person — or people — are those in a small financial services organisation who provide the lion’s share of the brains and nowse. In a hedge fund, this means the two genius ex-Goldman trading whizz founding partners.
As long as these two chaps — they tend to be chaps, though the revolution is coming — still show up for work for their colossal paycheques, the future of the organisation is relatively assured. Should one of them or, God forbid both, gallivant off to their newly-acquired Caribbean islands to play with their respective collections of racing cars, they will leave behind a bunch of mediocre financial services hacks and bullshit artists with whom neither the fund’s erstwhile clients nor its trading counterparties will any longer wish to do business.
Hence the “key person clause”, entitling one to terminate a trading arrangement should the nominated key persons bugger off. If there is more than one nominated key person expect complications are around how many of them must leave before the clause can be triggered. Should it be all of them? Any of them? A simple majority?
Negotiating a key person clause can be a fascinating exercise. Here psychology conflicts with normal imperatives of risk management because, while key person clauses undoubtedly represent an Achilles heel for a hedge fund, they play so egregiously to the principals’ egos that most will be upset the not to be asked for one. There is no better validation of one’s self-worth, after all, than to be told that without your continued personal involvement a training relationship is worthless.
- Not always precisely, of course: thanks to Mr. Woodford for reminding us all that a manager handling redemptions will tend to nix liquid positions first.
- Assuming you have under-cooked your IM calculations in the first place, that is. IM is designed to tide you over between payment periods after all.