Automatic Early Termination - ISDA Provision
2002 ISDA Master Agreement
Section 6(a) in full
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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.
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.
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.
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:
- A failure: A Failure to Pay or Deliver, on day T. This is an Event of Default under Section 5(a)(i). You must have:
- Notice of failure: The Non-defaulting Party must give notice of the Failure to Pay or Deliver (which since it is not due until the close of business on a given day, Q.E.D., can be validly given only after close of business on the due date for payment or delivery) and, by dint of Section 12(a) (Notices), will only be deemed effective on the following Local Business Day: ie T+1.  Note also: you cannot send a close-out notice by email, 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.
- Grace Period: Once the notice is effective, the Defaulting Party has a window (the grace period) in which it can remedy the failure to pay or deliver.
- (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 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.
- Determining Close-out Amounts: There is a bit of a chicken licken-and-egg situation here as you 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), but you can’t really work out their mark-to-market values for that date at any time before that date, unless you are able to see into the future or something. Anyway, that’s a conundrum for your trading people (and in-house metaphysicians) to deal with and it need not trouble we eagles of the law. For our purposes, the trading and risk people need to come up with Close-out Amounts for all outstanding Transactions. Once they have done that you are ready for your Section 6(e) notice.
- Early Termination Amount: Your inhouse metaphysicians having calculated your Close-out Amounts, you must assemble all the values into an Early Termination Amount.
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.
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 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.
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. 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 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.
- 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.
- See discussion on at Section 6(a) about the silliness of that time limit.
- Or their equivalents under the 1992 ISDA, of course.
- See previous footnote.
- 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”.
- See, especially, Swiss Bankruptcy Language.
- See the discussion on section 2(a)(iii) iof the ISDA Master Agreement for more about that.
- 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.