Automatic Early Termination - ISDA Provision

Automatic Early Termination is a concept which exists in Section 6(a) Right to Terminate Following Event of Default of the ISDA Master Agreement. it is relevant to Netting.

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 uin the first place.

In gory detail

1992 ISDA 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), (Bankruptcy) 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). (view template)

2002 ISDA 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). (view template)

Analysis

Note that AET is only triggered by certain events under the Bankruptcy event of default, and isn't triggered by Cross Default for example.

Discussion

AET Generally

Automatic Early Termination is only useful where the Defaulting Party is based in a jurisdiction which prevents or jeopardises a Non-Defaulting Party;s ability to close out Transactions where a Defaulting Party has become insolvent. AET addresses the potential for a liquidator in such a jurisdiction to "cherry pick" those transactions it wishes to honour (namely, those in the money to the Defaulting Party) and which of those it will avoid (those where the Defaulting Party is out of the money. Such cherry-picking completely destroys the concept of Close-out Netting, of course.

• Under the ISDA Master Agreement a Non-defaulting Party has a right (but not an obligation) to designate an Early Termination Date upon the occurrence of an Event of Default - cue a lengthy discussion on Metavante and Section 2(a)(iii).
• However, where AET applies against a counterparty an Early Termination Date is deemed to have taken place immediately prior to an insolvency event with respect to that party, without the need for any action by the Non-Defaulting Party.
• This isn't an unequivocally good thing for a Non-defaulting Party, particularly where:

• its net position is out of the money to the Defaulting Party.
• it is not be aware of the insolvency event (because by the time it does learn of it, and gets round to terminating its hedges, the markets have moved, leaving a MTM gap between the termination value of the Transactions and the termination value of the hedges).

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

AET is predominantly useful in jurisdictions which recognise zero-hour rules in their insolvency regimes. England is not one of those jursidictions. Playing devil's advocate I can only think of two reasons why a party might historically want to apply AET to an English company:

1. to avoid the risk of a winding up order being made in respect of the bank in circumstances where the non-defaulting cpty was unaware of the event (not a likely scenario in the case of [Counterparty] - not least because of the public nature of the exercise of tri-partite powers under the Banking Act) 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
2. 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 s.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 ETD falls on a Monday because of the AET but cpty does not price up its books until e.g., the Friday (because it was not aware of the trigger), then the cpty could be expected to be challenged by our liquidators as to the timing of the close out and the basis of obtaining prices. That issue was looked at in the High Risk v Credit Lyonnais litigation and was also discussed in the Peregine v JP Morgan litigation in New York in 2005.

Overall, arguments for applying AET seem weak, and potentially put the Non-deafulting Party in a worse position than they would otherwise be in as it necessitates termination on our insolvency even where they’re out of the money, which (per Section 2(a)(iii) and equivalents) they wouldn’t necessarily need - or want- to do otherwise (i.e. where it would lead to a capital *inflow* to [Counterparty]).

• Right to Terminate Following Event of Default