Automatic Early Termination - GMSLA Provision

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In a Nutshell Clause Automatic Early Termination:

Automatic Early Termination is defined in paragraph 10.1(d);
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2010 GMSLA full text of Clause Automatic Early Termination:

Automatic Early Termination has the meaning given in paragraph 10.1(d);
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A concept of some interest and controversy in the 2010 GMSLA and 1995 Overseas Securities Lender's Agreement (OSLA).

In a Nutshell, Automatic Early Termination in 10.1(d) works like this:

10.1(d) Act of Insolvency: An Act of Insolvency occurring to Lender or Borrower. If Automatic Early Termination applies, if anyone presents a winding up petition or appoints a liquidator, it will be an Automatic Early Termination and the Non Defaulting Party need not serve written notice.

AET Generally

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 is only really useful to a regulated financial institution which is incurs a capital charge if it doesn't have a netting opinion.

In most other cases the remedy is worse than the disease: it means your master agreement terminates whether you like it or not and whether you know about it or not.

Normally, these are things you would like to control:

  • A termination right is a right, not an obligation. That means you have the option not to terminate: you may well not want to if your contract is significantly out of the money (because it would involve you paying out that negative mark-to-market value.
  • AET happens automatically, and doesn't require you to know about it. This leaves you potentially unhedged for market risk between the automatic termination date and the date you found out about it.This is particularly so in the case of the 2010 GMSLA and 1995 Overseas Securities Lender's Agreement (OSLA), where the close out mechanism is nuanced.

Applying AET against a counterparty in a jurisdiction where it is not needed

Automatic early termination is predominantly useful in jurisdictions which recognise “zero-hour” rules in their insolvency regimes. Only a few jurisdictions recognise those rules (eg Switzerland[1] and Germany) - here AET is potentially useful. Where they are not recognised, AET puts a non-defaulting party in a manifestly worse position than it would otherwise be in: it is deprived of the option not to terminate.[2]

There are two reasons why, historically, a party might want to apply AET to an English company:

  • To avoid the risk of a winding up order being made in respect of the bank where the non-defaulting party was unaware of the event (not a likely scenario in the case of [Counterparty]) and therefore had not terminated the agreement. Where that happens, the determination of the present value of future cashflows follows a formula prescribed in the insolvency regs rather than being determined across the part of the relevant depo curve rate which a trading desk might otherwise apply under section 6, (and obligations are required to be set off as of the date of the winding up order) and
  • historic sensitivity around the availability of set-off rights in respect of contingent debt obligations (such as fully paid options) owed to the defaulting party - the argument being that the exercise of rights under section 6 removes the contingency - this latter concern was relieved by a case before the House of Lords in 2004 and a subsequent change to the Insolvency rules in 2005 so should be redundant.

Beyond that I doubt it is helpful to include. If the ETA falls on a Monday because of the AET but the non defaulting party is not aware of the trigger till Friday, then it could be challenged by as to the timing of the close out and the basis of obtaining prices. That issue was looked at in the High Risk v litigation and was also discussed in the Peregrine v JP Morgan litigation in New York in 2005.

See also

References

  1. See, especially, Swiss Bankruptcy Language.
  2. See the discussion on section 2(a)(iii) iof the ISDA Master Agreement for more about that.