Automatic Early Termination - ISDA Provision: Difference between revisions

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Automatic Early Termination is a concept which exists in Section {{isdaprov|6(a)}} {{isdaprov|Right to Terminate Following Event of Default}} of the {{isdama}}. it is relevant to [[Netting]]. Click here for the [http://sharepoint/sites/legal/Shared%20Library/Netting.aspx Jurisdictional Netting Matrix], should that seem like a useful place to go.
{{nman|isda|2002|Automatic Early Termination}}
 
*'''AET under the {{1987ma}}''': Note the somewhat difficult position for AET under the {{1987ma}} - a discussion at that article.
 
{{isdasnap|6(a)}}
 
==Analysis==
Note that AET is only triggered by a {{isdaprov|Bankruptcy}} [[Events of Default - ISDA Provision|event of default]], and isn't triggered by {{isdaprov|Cross Default}} for example.
 
==Discussion==
===AET Generally===
Automatic Early Termination is only useful where the {{isdaprov|Defaulting Party}} is based in a jurisdiction which prevents or jeopardises a {{isdaprov|Non-Defaulting Party}};s ability to close out {{isdaprov|Transaction}}s 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 {{isdama}} a Non-defaulting Party has a right (but not an obligation) to designate an {{isdaprov|Early Termination Date}} upon the occurrence of an {{isdaprov|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 {{isdaprov|Non-defaulting Party}}, particularly where:
:*its net position is out of the money to the {{isdaprov|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).
 
===Should we allow AET versus BBPLC?===
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:
 
#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 {{Bank}} - 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
#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 {{isdaprov|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 {{Bank}}).
 
 
{{isdaanatomy}}
*{{isdaprov|Right to Terminate Following Event of Default}}

Latest revision as of 16:44, 30 January 2024

2002 ISDA Master Agreement

A Jolly Contrarian owner’s manual™

Automatic Early Termination in a Nutshell™

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Original text:

“Automatic Early Termination” has the meaning specified in Section 6(a).
The Varieties of ISDA Experience
Subject 2002 (wikitext) 1992 (wikitext) 1987 (wikitext)
Preamble Pre Pre Pre
Interpretation 1 1 1
Obligns/Payment 2 2 2
Representations 3 3 3
Agreements 4 4 4
EODs & Term Events 5

Events of Default
FTPD • Breach • CSD • Misrep • DUST • Cross Default • Bankruptcy • MWA
Termination Events
Illegality • Tax Event • TEUM • CEUM • ATE •

5

Events of Default
FTPD • Breach • CSD • Misrep • DUST • Cross Default • Bankruptcy • MWA
Termination Events
Illegality • Tax Event • TEUM • CEUM • ATE •

5

Events of Default
FTPD • Breach • CSD • Misrep • DUST • Cross Default • Bankruptcy • MWA
Termination Events
Illegality • FM • Tax Event • TEUM • CEUM • ATE •

Early Termination 6

Early Termination
ET right on EOD • ET right on TE • Effect of Designation • Calculations

6

Early Termination
ET right on EOD • ET right on TE • Effect of Designation • Calculations • Set-off

6

Early Termination
ET right on EOD • ET right on TE • Effect of Designation • Calculations • Set-off

Transfer 7 7 7
Contractual Currency 8 8 8
Miscellaneous 9 9 9
Offices; Multibranch Parties 10 10 10
Expenses 11 11 11
Notices 12 12 12
Governing Law 13 13 13
Definitions 14 14 14
Schedule Schedule Schedule Schedule
Termination Provisions Part 1 Part 1 Part 1
Tax Representations Part 2 Part 2 Part 2
Documents for Delivery Part 3 Part 3 Part 3
Miscellaneous Part 4 Part 4 Part 4
Other Provisions Part 5 Part 5 Part 5

Resources and Navigation

Index: Click ᐅ to expand:
ISDA

Overview

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+++ 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.

No change in the Early Termination Date definition from 1992 ISDA to 2002 ISDA (no real surprise there) but the close out methodology between the two versions, by which one works out what must be paid and by whom on an Early Termination Date, and which you are encouraged to follow in all its gory detail starting at Section 6(a), is really quite different, and notwithstanding the fact that the 2002 ISDA version was meant to address the many and varied complaints levelled by market practitioners at the 1992 ISDA we still find the 1992 version in use in the occasional market centred in unsophisticated rural backwaters like, oooh, I don’t know, New York.

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. There is one key difference, though: the evolution of the Automatic Early Termination provision. More about that below.

Here is a comparison between Section 6(a) in the 1987 ISDA and Section 6(a) in the 1992 ISDA for purists and weirdoes.

Summary

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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 close-out netting as it is about credit protection per se. 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. It was introduced in the 1987 ISDA, but was not labelled “Automatic Early Termination” in that agreement, possibly because it was not conceived as an optional election to be used with caution where needed: it just sat there and applied across the board.

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. (Well — In the 1987 ISDA it covered a wider range of events, but they narrowed it down in the 1992 ISDA

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 only has limited use

AET is only really useful:

(1) to a regulated financial institution, which
(2) would incur a capital charge if it doesn’t have a netting opinion, and
(3) where it wouldn’t get that netting opinion for a particular counterparty without AET being switched on in its ISDA Master Agreement.

There are only a few counterparty types where these conditions prevail: the German and Swiss corporates mentioned above, for example. There may be others, but not many, because AET is a good-old-days, regulators-really-are-dopey-if-they-fall-for-this kind of tactic. It only really survives these days because it is so part of the furniture no-one has the chutzpah to question it, despite the trail of destruction and confusion it has left across the commercial courts of the US an the UK.

I mean, really? Deeming your ISDA to have magically terminated, without anyone’s knowledge or action, the instant before that termination would become problematic as a result of your insolvency? Come on. Is any sophisticated insolvency regime going to buy that kind of magical thinking? (No slight meant on Germany or Switzerland here: the “Teutonic” AET does not deliver netting where unequivocally it would otherwise be forbidden, but rather buttresses residual doubt about the effectiveness of netting during insolvency as a result of looseness in insolvency regulations that aren’t categorical that you can net. The view is generally it should be okay in insolvency, but there are just some freaky discretions that may make life awkward if used maliciously. This is not legal advice.)

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  • JC’s “nutshell” summary of the clause
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See also

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References

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