Automatic Early Termination - ISDA Provision

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2002 ISDA Master Agreement
A Jolly Contrarian owner’s manual

Section 6(a) in a NutshellTM
Use at your own risk, campers!

6(a) Right to Terminate following Event of Default. If one party (“Defaulting Party”) suffers an Event of Default, the other (the “Non-defaulting Party”) may, by not more than 20 days’ notice, designate an Early Termination Date for all outstanding Transactions. If Automatic Early Termination applies to the Defaulting Party and the Event of Default it is qualifying Bankruptcy event, the Early Termination Date will occur:

(i) upon the Bankruptcy event, if under 5(a)(vii)(1), (3), (5) or (6) or if analogous, (8); and
(ii) immediately before institution of the relevant proceeding, if under 5(a)(vii)(4) or if analogous, (8).

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Section 6(a) in full

6(a) Right to Terminate Following Event of Default. If at any time an Event of Default with respect to a party (the “Defaulting Party”) has occurred and is then continuing, the other party (the “Non-defaulting Party”) may, by not more than 20 days notice to the Defaulting Party specifying the relevant Event of Default, designate a day not earlier than the day such notice is effective as an Early Termination Date in respect of all outstanding Transactions. If, however, “Automatic Early Termination” is specified in the Schedule as applying to a party, then an Early Termination Date in respect of all outstanding Transactions will occur immediately upon the occurrence with respect to such party of an Event of Default specified in Section 5(a)(vii)(1), (3), (5), (6) or, to the extent analogous thereto, (8), and as of the time immediately preceding the institution of the relevant proceeding or the presentation of the relevant petition upon the occurrence with respect to such party of an Event of Default specified in Section 5(a)(vii)(4) or, to the extent analogous thereto, (8).
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Related agreements and comparisons

Related Agreements
Click here for the text of Section 6(a) in the 1992 ISDA
Comparisons
Click to compare this section in the 1992 ISDA and 2002 ISDA.

Resources and navigation

Resources Wikitext | Nutshell wikitext | 1992 ISDA wikitext | 2002 vs 1992 Showdown | 2006 ISDA Definitions | 2008 ISDA
Navigation Preamble | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 | 13 | 14
Events of Default: 5(a)(i) Failure to Pay or Deliver5(a)(ii) Breach of Agreement5(a)(iii) Credit Support Default5(a)(iv) Misrepresentation5(a)(v) Default Under Specified Transaction5(a)(vi) Cross Default5(a)(vii) Bankruptcy5(a)(viii) Merger without Assumption
Termination Events: 5(b)(i) Illegality5(b)(ii) Force Majeure Event5(b)(iii) Tax Event5(b)(iv) Tax Event Upon Merger5(b)(v) Credit Event Upon Merger5(b)(vi) Additional Termination Event

Content and comparisons

+++ 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.

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.
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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.
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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, you will need:

(i) a Failure by the Defaulting Party to make a payment or delivery when due;
(ii) a notice by the Non-Defaulting Party under Section 6(a) to the Defaulting Party that the failure has happened and designating an Early Termination Date, no more than twenty days in the future.
(i) The standard grace periods are set out in Section 5(a)(i). Be careful here: 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.
(ii) 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).
(iii) At the expiry of this grace period, you finally have a fully operational Event of Default. Now Section 6(a) gives you the right, by not more than 20 days’ notice[2] to designate an Early Termination Date for all outstanding Transactions. So, at some point in the next twenty days.
(iv) For this we go 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. For it not to be (i.e., 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.

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See also

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References

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 Netting. 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.

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.

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 Global Master Securities Lending Agreement 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[6] 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.[7]

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.

Tedious but harmless drafting tweaks

Even for the Non-Defaulting Party, AET is a necessary evil. It leaves the Non-Defaulting Party at risk of being un-hedged on a portfolio of Transactions that automatically terminated effective as of a Bankruptcy event without the NDP knowing that the Bankruptcy event had happened[8]. The NDP may want to capture the market risk between the Bankruptcy event and the date on which they should have known about it, and factor that into the Close-out Amount. If they do, expect to see language like the below.

If you are an AET counterparty, your credit officer may bridle at the sight of this, but you can reassure her that at any point where this language comes into play she will be wandering around outside in a daze clutching an Iron Mountain box full of gonks, comedy pencils and deal tomb-stones, and contemplating a career reboot as a maths teacher, so she shouldn’t really care anyway.

Adjustment for Automatic Early Termination: If an Early Termination Date occurs following an Automatic Early Termination event, the Early Termination Amount will adjusted to reflect movements in rates or prices between that Early Termination Date and the date on which the Non Defaulting Party should reasonably have become aware of the occurrence of the Automatic Early Termination.

Switzerland

Switzerland is — isn’t it always? — different, and a good place to go right now would be the Swiss bankruptcy language page. Switzerland itself is also a good place to go, especially in the skiing season. The JC loves Wengen.

AET under the 1987 ISDA

Note the somewhat difficult position for AET under the 1987 ISDA - a fuller discussion at that article - which was part of the reason for the move to the 1992 ISDA in the first place.

See also

References

  1. 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.
  2. See discussion on at Section 6(a) about the silliness of that time limit.
  3. Or their equivalents under the 1992 ISDA, of course.
  4. See previous footnote.
  5. 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”.
  6. See, especially, Swiss Bankruptcy Language.
  7. See the discussion on section 2(a)(iii) iof the ISDA Master Agreement for more about that.
  8. Unless credit department is constantly monitoring the regulatory newswires of all AET counterparties to check whether they go bankrupt each day, and they won’t be.