Automatic Early Termination - ISDA Provision

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2002 ISDA Master Agreement
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[[{{{1}}} - 1992 ISDA Provision|This provision in the 1992]]

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Definition of Automatic Early Termination in a Nutshell

Use at your own risk, campers!
Automatic Early Termination” is defined in Section 6(a).

Full text of Definition of Automatic Early Termination

Automatic Early Termination” has the meaning specified in Section 6(a).

Related agreements and comparisons

Click here for the text of Section Automatic Early Termination in the 1992 ISDA
There is no difference between the versions.

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Content and comparisons

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

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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General discussion

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[1]. 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.

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See also

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References

  1. 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.