Affected Party - ISDA Provision
2002 ISDA Master Agreement
Definition of Affected Party and 5(b) in a Nutshell™
Use at your own risk, campers!
Full text of Definition of Affected Party and 5(b)
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Not even ISDA’s crack drafting squad™ could confect something worthwhile to say which might improve this Spartan piece of text. But note the concept of Affected Party is sprayed liberally throughout Section 5(b), and it means something different in almost every context so you’re guaranteed to have fun there.
One who is subject to a Section 5(b) Termination Event, but not a Section 5(a) Event of Default — thus one of a marginally less opprobrious character, seeing as Termination Events are generally not considered to be one’s fault as such, but just sad things that happen that no-one expected, or wanted, but bring what was once a beautiful relationship to an end. It’s not you, it’s — well, it’s not me either — it’s just that confounded tax event that occurred upon your recent merger.
Note that, in its wisdom, ISDA’s crack drafting squad™ chose not to have a generic term for the sort of person who is subject to either a Termination Event or an Event of Default, so there is much “Defaulting Party and/or Affected Party, as the case may be” sort of malarkey. This depresses we prose stylists, but ISDA’s crack drafting squad™ has never cared about us, so we should hardly be surprised.
The financial difference between an Affected Party and a Defaulting Party
What is the practical, economic difference between being closed out on the same Transaction for an Event of Default and a Termination Event? This is something that all ISDA ninjas know, or sort of intuit, in a sort of semi-conscious, buried-somewhere-deep-in-the-brain-stem kind of way, but they may mutter darkly and try to change the subject if you ask them to articulate it in simple English.
The topic might be chiefly of academic interest were it not for the unfortunate habit of the same “real world” event potentially comprising more than one variety of termination right. This leads to some laboured prioritisation in the ISDA, and sometimes some in the Schedule too. What if my Tax Event upon Merger is also a Credit Event Upon Merger, and also a Force Majeure? that kind of question.
So, with feeling, here it is:
The Definition of Close-out Amount
Remember the way a Determining Party values a Terminated Transaction is calculates its own close-out value — in our nutshell terms, “the losses the Determining Party would incur (positive) or gains it would realise (negative) in replacing the material terms and the option rights of the parties under a Terminated Transaction”. One assesses “the costs one would incur” from ones’ own side of the market. A large party of the question comes down to who the Determining Party is for a given termination event.
Under an Event of Default, it is the Non-Defaulting Party at all times (since on the theory of the game, the Defaulting Party is either a miscreant or a smoking hulk of twisted metal, there is no one else around to do this. Therefore, it being an Event of Default is always optimal for the Innocent Party, since it will always be the Determining Party.
One Affected Party
Where the terminating impetus is not so outrageous as to qualify as an Event of Default — i.e., it is only a Termination Event — but it only impacts one party, in most cases it is the same as for an Event of Default. There is one Affected Party, the Non-Affected Party is the sole Determining Party, so it closes out on its own side of the market ... unless the event in question is an Illegality or a Force Majeure Event, in which case there is a rider in Section 6(e)(ii)(3) applies and the Determining Party has to get mid market quotations that don’t take its own creditworthiness into account. But note that the most commonly triggered type of Termination Event is an Additional Termination Event, these tend to have a defaulty, turpidudinous character about them, almost never happen to two people at once, and therefore behave exactly like Events of Default.
Two Affected Parties
When both parties are affected — a scenario the ISDA only contemplates for Termination Events; Events of Default being more of a “she who draws first wins” sort of affair, where the first in time prevails — then each party is a “Determining Party” calculates its own close-out value — in our nutshell terms, “the losses the Determining Party would incur (positive) or gains it would realise (negative) in replacing the material terms and the option rights of the parties under a Terminated Transaction” — throws it into the ring and the Calculation Agent splits the difference. Assuming both parties calculate so the end result is necessarily a mid-market number.
All so confusing. If only there were someone to set it all out in a table for you.
|Event||How many affected||What happens|
Q.E.D. there is only one Defaulting Party:
|Defaulting Party only||Non-defaulting Party calculates on its own side of market.|
Termination Events where there is only one Affected Party
And this odd rider in Section 6(e)(ii)(3) requiring a midmarket price does not apply:
|One Affected Party only||Non-Affected Party calculates on its own side of market.|
Termination Events where there is only one Affected Party but ...
|One Affected Party only||Non-Affected Party seeks prices by reference to mid-market values and which do not reflect its own credit.|
Termination Events where there are two Affected Parties
|Each party is an Affected Party||Both parties are Determining Parties, and Calculation Agent splits the difference ergo it is a midmarket rate.|
One lump or two?
And given its relentless quest for infinitesimal particularity — and accepting for a moment it is warranted — perhaps ISDA’s crack drafting squad™ has a point, for “Affected Party” appears in subtly different guises in each of the Termination Events. Sometimes there is one Affected Party; sometimes there are two.
For all Termination Events except Credit Event Upon Merger, there is at least the theoretical potential that both parties could be affected: the same Illegality, can impede both parties’ performance, obviously enough; as can the same pandemic, plague of locusts or aquatic invastion be a Force Majeure for both. Likewise a Tax Event — if both parties are in the same jurisdiction — even if they are not, come to think of it — and for the same reason Tax Event Upon Merger might stretch its clammy claws to impact even the innocent b bystander. But a Credit Event Upon Merger affects only the party being merged, and while Additional Termination Events are al fresco, and therefore could potentially be affect both, in practice they tend to be heavily credit-focussed, and really should have been designated as “Additional Events of Default”.
In any case, where there are two Affected Parties there is not a “victim” and a “perpetrator” as such, but you are in this odd new millennial world where everyone’s a victim, either party may trigger the Termination Event, both may estimate replacement prices on termination and they have to split the difference.
Note that the 2002 ISDA includes a Force Majeure Event, using language that was already agreed and widely inserted into the 1992 ISDA Schedule prior to its publication. Because this was entered as Section 5(b)(ii), this necessitates some numbering differences between the two versions of the ISDA Master Agreement — a drafting trick for young players to watch out for.
Events of Default vs. Termination Events: Showdown
Puzzled ISDA ingénues may wonder why there are Events of Default and Termination Events under the, er, eye-ess-dee-aye. In any weather, there seem to be rather a lot of them. And there is a third, hidden category: Additional Termination Events that the parties crowbar into the Schedule.
Do we really need all these, and what is the difference?
- Events of Default tend to imply fault, turpitude, moral outrage, and are comprehensive — some would say overcomprehensive — Failure to Pay; Breach; Credit Support Default; Misrepresentation; Bankruptcy and — here we’re well and truly in over-comprehensive territory — Cross Default.
- Termination Events tend to be unwanted vicissitudes of commercial life which neither party could anticipate, and are often Transaction-specific — Illegality, Force Majeure; Tax Events.
- Just in case you are worried ISDA’s crack drafting squad™, with the collective weight of the whole derivatives industry urging it on, might have forgotten something important over 30 years of the ISDA Master Agreement you can make up your own ones. These are the “Additional Termination Events”: they are treated like Termination Events, but tend to be more (in terms of moral outrage) like Events of Default. You will spend many years of your life arguing about these, but they will never get used.
So, with feeling:
- Naughtiness: Imply a degree of turpitude on the part of the TRANSGRESSOR. Termination Events are sort of gentler and fluffier (although ATEs are often quite turpitudinous);
- All or none: Exercising an Event of Default necessitates terminating all outstandingTransactions; invoking a Termination Event may only affect specific “Affected Transactions” (but again, ATEs are often both turpitudinous and (for that very reason) impact necessarily on all outstanding Transactions;
- Calculations: The Non-Defaulting Party always makes the termination calculations; in a Termination Event (if both parties are affected) they share it and split the difference;
- Default interest: The interest accrual rate for your Close-Out Amount is different (i.e., higher) following an Event of Default than following a Termination Event. Because — turpitude, right?
- Notice: oblige the Affected Party to fess up about them — a fair expectation, since the Affected Party hasn’t been actively turpitudinous in the Termination Event coming about and can be still expected to act in good faith; Events of Default generally don’t, for the same reason: Dude has materially breached your contract. What skin is it off dude’s nose to further breach it, by not owning up?
- Some Termination Events only arise only once the Affected Party has failed to transfer obligations away to a party who wouldn’t be an Affected Party.
- Potential number of Affected Parties: Most Termination Events, at least in theory, can be suffered by both parties simultaneously. Credit Event Upon Merger is the exception — well I guess both parties could contemporaneously merge with materially crappier credits: who knows? — and the stentorian in me feels that — it being plainly credit-related, if it were necessary to include at all — it would not have hurt to put Credit Event Upon Merger and Additional Termination Events — which are typically all credit-related — in the Events of Default bucket.
For details freaks
This might be a function of the market’s general move to the 2002 ISDA closeout methodology, being far less fraught and bamboozling then the one in the 1992 ISDA, refraining as it does from absurdities like the First Method and alternative Market and Loss methods of valuing replacement transactions. Even those who insist on staying with the 1992 ISDA — Hello, Cleveland! — are often persuaded to upgrade the closeout methodology.
It might also be that the specific expertise as to what happens in a close out has dissipated over the years as swap dealers and investment managers have outsourced and downskilled their negotiation functions.
But the JC likes to think that in this mature market, the commercial imperative plays a part here. Termination Events come in two types: catastrophic ones, which signal the end of the relationship — and usually the ongoing viability of one of the counterparties — altogether; and Transaction-specific ones, which no-one intended or wanted, everyone regrets, but which will soon be water under the bridge, for parties who will continue to trade new derivatives into glorious, golden perpetuity.
Now any swap dealer who regards a Transaction-specific Termination Event as an opportunity to gouge its counterparty can expect a frosty reception next time its salespeople are pitching new trading axes to the CIO.
On the other hand if, when your valuation reaches her, the CIO is wandering around outside her building with an Iron Mountain box, she will be less bothered about the wantonness of your termination mark — it being no longer her problem — and as far as she does care about it all, will console herself with the reality that you are not likely to see much of that money anyway once her former employer’s insolvency estate has been wound up.
- ~Grimaces~ Right. Moment over.
- The sorts of people who are interested in learning about sw-æps under an eye-ess-dee-aye. Come on, you were one once.
- Controversial view: No, except to protect the livelihoods of an entire cottage industry of sheeple.
- You will never guess who.
- Please write to me, at email@example.com, if you ever encounter a close-out — a real, actually-gone-through-with-it, Section 6, whole-ISDA close out based purely on an Additional Termination Event (or, actually, any event other than a Failure to Pay or Deliver or a Bankruptcy) You will be my Black Swan.
- I mean the Defaulting Party.
- Though this won’t stop excitable credit officers seeking to add that obligation in the negotiation.
- by no means clear: has ever anyone seen a live example of a credit event upon merger?
- For the record, I put the golden age of ISDA negotiation as late 90s, early noughties. We were young, carefree, crazy kids.