Automatic Early Termination - 1992 ISDA Provision
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1992 ISDA Master Agreement
Definition of 6(a) in a Nutshell™ Use at your own risk, campers!
Full text of Definition of 6(a)
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+++ COVID-19 UPDATE +++ COVID-19 UPDATE +++ COVID-19 UPDATE +++ See section 12 for what this all means in a time of global pandemic lockdown
See also the separate article all about Automatic Early Termination, which features in the last sentence of this Section, but deserves a page all of its own.
No change in the Early Termination Date definition from 1992 ISDA to 2002 ISDA (no real surprise there) but the close out methodology between the two versions, by which one works out what must be paid and by whom on an Early Termination Date, and which you are encouraged to follow in all its gory detail starting at Section 6(a), is really quite different, and notwithstanding the fact that the 2002 ISDA version was meant to address the many and varied complaints levelled by market practitioners at the 1992 ISDA we still find the 1992 version in use in the occasional market centred in unsophisticated rural backwaters like, oooh, I don’t know, New York.
Those with a keen eye will notice that, but for the title, Section 6(a) of the 2002 ISDA is the same as Section 6(a) of the 1992 ISDA and, really, not a million miles away from the svelte form of Section 6(a) in the 1987 ISDA — look on that as the Broadcaster to the 1992’s Telecaster.
Summary
Everyone’s hair will be on fire
This is likely to be a time where the market is dislocated, your credit officer is running around with her hair is on fire, your normally affable counterparty is suddenly diffident or evasive, and your online docs database has crashed because everyone in the firm is interrogating it at once.
This is also one time the commercial imperative will count for little, since you are terminating your trading relationship altogether and with extreme prejudice. Your normally iterated game of prisoner’s dilemma has turned into a single round game. Game theorists among you will know immediately that the calculus is therefore very different, and much, much less appealing.
So: good luck keeping your head while all around you are losing theirs.
Close-out sequence
Once you have designated an Early Termination Date for your ISDA Master Agreement, proceed to 6(c) to understand the Effect of Designation. Or learn about it in one place with the NC.’s handy cribsheet, “closing out an ISDA”.
The Notices provisions in Section 12 are relevant to how you may serve this notice. In a nutshell, in writing, by hand. Don’t email it, fax it, telex it, or send it by any kind of pony express or carrier pigeon unless your pigeon/pony is willing to provide an affidavit of service.
General discussion
Closing out an ISDA Master Agreement following an Event of Default
Here is the JC’s handy guide to closing out an ISDA Master Agreement. We have assumed you are closing out as a result of a Failure to Pay or Deliver under Section 5(a)(i), because — unless you have inadvertently crossed some portal, wormhole into a parallel but stupider universe — if an ISDA Master Agreement had gone toes-up, that’s almost certainly why. That, or at a pinch Bankruptcy. Don’t try telling your credit officers this, by the way: they won’t believe you — and they tend to get a bit wounded at the suggestion that their beloved NAV triggers are a waste of space.
In what follows “Close-out Amount” means, well, “Close-out Amount” (if under a 2002 ISDA) or “Loss” or “Market Quotation” amount (if under a 1992 ISDA), and “Early Termination Amount” means, for the 1992 ISDA, which neglected to give this key value a memorable name, “the amount, if any, payable in respect of an Early Termination Date and determined pursuant to Section 6(e)”.
So, to close out following a Failure to Pay or Deliver, you will need:
1. There must be a failure to pay or deliver under Section 5(a)(i)
A Failure to Pay or Deliver, by the Defaulting Party to make a payment or delivery when due on day T. This is not, yet, an Event of Default under Section 5(a)(i). But we are on the way.
2. You must give notice of the failure under Section 5(a)(i)
The Non-defaulting Party must give the Defaulting Party notice of the failure. This is not a Section 6(a) notice — calm, down, we will get to that in good time — but a Section 5(a)(i) notice of failure to pay or deliver. The sainted ISDA Master Agreement does not directly prescribe the format for this notice, but Section 12 cautions that it may not be by e-mail or electronic messaging system or (if you have a 1992 ISDA, at any rate), by fax. The proper form is to have it hand-delivered by someone prepared to swear an affidavit as to when and where they delivered it to the Defaulting Party.[1]
Since payments and deliveries are generally due at close of business on a given day, Q.E.D., a Section 5(a)(i) notice of Failure to Pay or Deliver can usually only be given after close of business on the due date.
Thanks to Section 12(a) (Notices), the Section 5(a)(i) notice will only be effective on the following Local Business Day: i.e., T+1. [2]
3. You must allow the grace period under Section 5(a)(i) to expire
At this point you have a Potential Event of Default, but not an actual one.
Once your Section 5(a)(i) notice of Failure to Pay or Deliver is effective, the Defaulting Party has a “grace period” in which it may sort itself out and make the payment or delivery in question, thereby heading off a full-blown Event of Default.
The standard grace periods are set out in Section 5(a)(i). Be careful: under a 2002 ISDA the standard is one Local Business Day. Under the 1992 ISDA the standard is three Local Business Days. But check the Schedule because in either case this is the sort of thing that counterparties adjust: 2002 ISDAs are often adjusted to conform to the 1992 ISDA standard of three LBDs, for example.
So: once you have a clear, notified Failure to Pay or Deliver, you have to wait at least one and possibly three or more Local Business Days before doing anything about it. Therefore, you are on tenterhooks until the close of business T+2 LBDs (standard 2002 ISDA), or T+4 LBDs (standard 1992 ISDA).
Trick for the young players: check that the conditions precedent to payment under Section 2 remain fulfilled. For example, has the defaulting party got any grounds to suspend payment under Section 2(a)(iii)? Thanks to the loose way section 2(a)(iii) is drafted, it might, for example, if the putatively non-defaulting party has slipped into Bankruptcy or Cross Default in the meantime — though we think a more sensible reading is that 2(a)(iii) can only be measured as at the originally scheduled payment date. Note: a party does not have to invoke Section 2(a)(iii), or send a notice about it. It just applies. This is a bit of a banana-skin, as we discuss at length in our 2(a)(iii) article.
Let us imagine for a moment you are not yourself in default and have indeed waited the necessary time.
4. You may now send your Section 6(a) notice designating an Early Termination Date
At the expiry of the Section 5(a)(i) grace period, you finally have a fully operational Event of Default. Now Section 6(a) allows you, by not more than 20 days’ notice[3] to designate an Early Termination Date for all outstanding Transactions.
So, at some point in the next twenty days[3] outstanding Transactions will be at an end.[4] Now this is a different thing from knowing what the amounts will be, much less knowing when they will be paid: this is the date by reference to which termination amounts will be calculated.
5. Determine Close-out Amounts[5]
One must now ascertain termination values for the Terminated Transactions as of the Early Termination Date per the methodology set out in Section 6(e)(i).
Now armed with our crystalised Failure to Pay or Deliver Event of Default and with an Early Termination Date to target, we go directly to Section 6(e), noting as we fly over it, that 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.[6]
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. The 20 days notice period is a red herring. 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.
6. 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 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.
7. Pay your Early Termination Amount
Your in-house metaphysicians having calculated your Close-out Amounts,[5] and assembled all the values into an Early Termination Amount[7] the party who owes it must pay the Early Termination Amount. With ISDA’s crack drafting squad™ yen for infinite fiddlarity, this will depend on whether the Early Termination Date follows an Event of Default or an 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).
8. Putting that all together
Here are all the stages you must go through between becoming entitled to terminate and settlement for a Failure to Pay or Deliver:
- T: There must be a Failure to Pay or Deliver on a day, T.
- T+1: After close of business on T, the Non-defaulting Party must give the Defaulting Party a Section 5(a)(i) notice of failure to pay of deliver. The prescribed grace period must expire. The grace periods may be between 1 and 3 LBDs. There may also be carve-outs for operational failures and so on, to add to the fun.
- T+4: You must send a Section 6(a) notice designating an Early Termination Date for all outstanding Transactions. Let’s say it is 3 LBSs. You must designate an Early Termination Date within 20 days. Let’s say it is 20 days, for the hell of it
- T+24: You are “off risk” and must start calculating your Close-out Amounts for all outstanding Transactions. You must do this ass soon as reasonably practicable. Let’s say that takes another 30 days.
- T+54: 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+54: Your Early Termination Amount is due.
See also
References
- ↑ Yes, it’s true: in ISDA’s alternative universe, e-mail and electronic messaging systems are different things.
- ↑ Spod’s note: This notice requirement is key from a cross default perspective (if you have been indelicate enough to widen the scope of your cross default to include derivatives, that is): if you don’t have it, any failure to pay under your ISDA Master Agreement, however innocuous — even an operational oversight — automatically counts as an Event of Default, and gives a different person to the right to close their ISDA Master Agreement with your Defaulting Party because of it defaulted to you, even though (a) the Defaulting Party hasn’t defaulted to them, and (b) you have decided not to take any action against the Defaulting Party yourself.
- ↑ 3.0 3.1 See discussion on at Section 6(a) about the silliness of that time limit.
- ↑ By a striking oversight, not actually so named in the 1992 ISDA.
- ↑ 5.0 5.1 Or their equivalents under the 1992 ISDA, of course.
- ↑ If Credit suddenly gets executioner’s remorse and wants to let the Defaulting Party off), the Non-defaulting Party will have to expressly terminate the close-out process, preferably by written notice. There’s an argument — though it is hard to picture the time or place on God’s green earth where a Defaulting Party would make it — that cancelling an in-flight close out is no longer exclusively in the Defaulting Party’s gift, and requires the NDP’s consent. It would be an odd, self-harming kind of Defaulting Party that would run that argument unless the market was properly gyrating.
- ↑ Or, in the 1992 ISDA’s estimable prose, “the amount, if any, payable in respect of an Early Termination Date and determined pursuant to this Section”.