Automatic Early Termination - ISDA Provision
2002 ISDA Master Agreement
Definition of Automatic Early Termination in full
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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.
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 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 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.