Automatic Early Termination - 1992 ISDA Provision
Overview
+++ 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. There is one key difference, though: the evolution of the Automatic Early Termination provision. More about that below.
Here is a comparison between Section 6(a) in the 1987 ISDA and Section 6(a) in the 1992 ISDA for purists and weirdoes.
Summary
Automatic Early Termination is an odd and misunderstood concept which exists in Section 6(a) Right to Terminate Following Event of Default of the ISDA Master Agreement. As is so much in the ISDA Master Agreement, it’s all about close-out netting as it is about credit protection per se. Where a jurisdiction suspends terms of contracts in a period of formal insolvency, the idea is to have the ISDA break before that suspension kicks in — so close-out netting works. It was introduced in the 1987 ISDA, but was not labelled “Automatic Early Termination” in that agreement, possibly because it was not conceived as an optional election to be used with caution where needed: it just sat there and applied across the board.
AET is thus only triggered by certain events under the Bankruptcy event of default — formal bankruptcy procedures — and not by economic events that tend to indicate insolvency (such as an inability to pay debts as they fall due, technical insolvency or the exercise of security. Nor does it apply to other Events of Default. (Well — In the 1987 ISDA it covered a wider range of events, but they narrowed it down in the 1992 ISDA
Automatic early termination (“AET”) protects in jurisdictions (e.g., Germany and Switzerland) where certain bankruptcy events would allow a liquidator to “cherry-pick” those transactions it wishes to honour (those which are in-the-money to the defaulting party) and avoid those where the defaulting party is out-of-the-money.
It only has limited use
AET is only really useful:
(1) to a regulated financial institution, which
(2) would incur a capital charge if it doesn’t have a netting opinion, and
(3) where it wouldn’t get that netting opinion for a particular counterparty without AET being switched on in its ISDA Master Agreement.
There are only a few counterparty types where these conditions prevail: the German and Swiss corporates mentioned above, for example. There may be others, but not many, because AET is a good-old-days, regulators-really-are-dopey-if-they-fall-for-this kind of tactic. It only really survives these days because it is so part of the furniture no-one has the chutzpah to question it, despite the trail of destruction and confusion it has left across the commercial courts of the US an the UK.
I mean, really? Deeming your ISDA to have magically terminated, without anyone’s knowledge or action, the instant before that termination would become problematic as a result of your insolvency? Come on. Is any sophisticated insolvency regime going to buy that kind of magical thinking? (No slight meant on Germany or Switzerland here: the “Teutonic” AET does not deliver netting where unequivocally it would otherwise be forbidden, but rather buttresses residual doubt about the effectiveness of netting during insolvency as a result of looseness in insolvency regulations that aren’t categorical that you can net. The view is generally it should be okay in insolvency, but there are just some freaky discretions that may make life awkward if used maliciously. This is not legal advice.)
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- The JC’s famous Nutshell™ summary of this clause