The apocalyptic act of bringing your derivative relationship with your counterparty to an unscheduled conclusion.
Usually, this will only happen in a time of utter market panic. In this way the circumstances in which your trading arrangement expires could scarcely be further from the atmosphere of cool tedium which prevailed when you began it.
Each hot second will be accompanied by fear and loathing. Your defaulting counterparty will have transformed from a being a nice chap with a ready quip and emotionally intelligent chat about your kids to a shadowy stranger who won’t return your calls. When you can find him he will restrict himself to aphorisms and gnomic utterances, swearing blind his operations team have given irrevocable instructions to a new depositary — of whom, in all your happy conversations until today, there has been no mention — who is all set to pay you, in full, later in the day.
His assurances will be patently unlikely and categorically unprovable, but will still fall maddeningly, brilliantly, short of the fence which bounds the farthest reach of commercial probability. So you just won’t know if he’s shitting you. Well, you will know, but there that nagging fear will just crawl ticklishly around the back of your mind, that he isn’t and, if he isn’t, and you pull the trigger, the whole world will turn on you.
This is a time when even the sensible folk in the organisation have lost their heads and are blaming it on you, and what you need is a calm, collected and easy-to-follow guide that will help you step through the labyrinth of closing out an ISDA while your risk guy calls you every forty-five seconds.
And guess what: the JC is here for you, folks.
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.
- 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”.