Early Termination Amount - ISDA Provision
2002 ISDA Master Agreement
Section 6(e) in a Nutshell™
Use at your own risk, campers!
Full text of Section 6(e)
Related agreements and comparisons
Content and comparisons
6(e) Payments on Early Termination
6(e)(i) Events of Default (Early Termination Payments)
6(e)(ii) Termination Events (Early Termination Payments)
6(e)(iii) Adjustment for Bankruptcy (Early Termination Payments)
6(e)(iv) Adjustment for Illegality or Force Majeure Event
6(e)(v) Pre-Estimate (Early Termination Payments)
Early Termination Amount is not actually defined in the 1992 ISDA, but is referred to obliquely in Section 6(e) as:
- ...The amount, if any, payable in respect of an Early Termination Date and determined pursuant to this Section ...
Correctly, it is best referred to as a “Section 6(e) Amount” under the 1992 ISDA, although of course everyone does call it the Early Termination Amount. This inevitability was recognised in the 2002 ISDA, where it is defined in Section 6(e) as follows:
- ... the amount, if any, payable in respect of that Early Termination Date.
But the 2002 ISDA also has a “Close-out Amount”, so you may want to know what the difference between the Early Termination Amount and the Close-out Amount, you know, is. Yes?
For our step-by-step guide to closing out an ISDA Master Agreement see Section 6(a).
On the difference between an “Early Termination Amount” and a “Close-out Amount”
The 1992 ISDA features neither an Early Termination Amount or a Close-out Amount, which many would see as a regrettable oversight. The 2002 ISDA has both, which looks like rather an indulgence, until you realise that they do different things.
A Close-out Amount is the termination value for a single Transaction, or a related group of Transactions that a Non-Defaulting Party or Non-Affected Party calculates while closing out an 2002 ISDA, but it is not the final, overall sum due under the ISDA Master Agreement itself. Each of the determined Close-out Amounts summed with the various Unpaid Amounts to arrive at the Early Termination Amount, which is the total net sum due under the ISDA Master Agreement at the conclusion of the close-out process. (See Section 6(e)(i) for more on that).
Section 6(e)(i) Events of Default (Early Termination Payments)
First terminate Transactions...
The effect of Section 6(e)(i) is that in closing out an ISDA Master Agreement, first you must terminate all Transactions to arrive at a Close-out Amount for each one.
The Close-out Amount is the replacement cost for the Transaction, assuming all payments up to the Early Termination Date have been made — but in a closeout scenario, of course, Q.E.D. some of those will not have been made — being the reason you need to close out.
Hence the converse concept of “Unpaid Amounts”, being amounts that should have been paid or delivered under the Transaction on or before the termination date, but weren’t (hence, we presume, why good sir is closing out the ISDA Master Agreement in the first place).
So once you have your theoretical replacement cost for each Transaction, you then have to tot up all the Unpaid Amounts that had fallen due but had not been paid under those Transactions at the time the Transactions terminated. These include, obviously, failures by the Defaulting Party, but also amounts the Non-defaulting Party didn’t pay when it relied on the flawed asset provision of Section 2(a)(iii) to withhold amounts it would otherwise have been due to pay under the Transaction after the default but before it was terminated.
...then calculate net Early Termination Amount
The close out itself happens under Section 6(e) of the ISDA Master Agreement and the recourse is to a net sum. Netting does not happen under the Transactions — on the theory of the game there are no outstanding Transactions at the point of netting; just payables.
Therefore, if your credit support (particularly guarantees or letters of credit) explicitly reference amounts due under specific Transactions, you may lose any credit support at precisely the point you need it.
Which would be a bummer. Further commentary on the Guarantee page.
Section 6(e)(ii) Termination Events (Early Termination Payments)
Where the close-out follows a Termination Event, we are generally in “well, it’s just one of those things; terribly sorry it had to end like this” territory rather than the apocalyptic collapse into insolvency or turpitude one expects in an Event of Default, and accompanying high-dudgeon, so the path to resolution is a little more genteel, and winding. Secondly — unless it affects all outstanding Transactions, which by no means all Termination Events do — the upshot is not necessarily a final reckoning, but rather the retirement of only those problematic Affected Transactions. The rest sail serenely on. (To remind you all, the customised Additional Termination Events that the parties have imposed on each other tend to look and behave more like Events of Default. Pre-printed Termination Events have more to do with mergers, taxes and law changes that were neither party’s fault as such).
So first, who is the Affected Party, to whom the event has happened? If there is only one then the Affected Transaction termination process that upon an Event of Default and the Non-Affected Party will have the option whether or not to call the event at all, and will generally be in the driving seat if it does. If, however, the Termination Event in question is an Illegality or Force Majeure Event, there’s a further softening and the Non-Affected Party must use a mid-market levels derived from quotations which disregard the value of the Non-Affected Party’s creditworthiness or credit support — again, the reason being, “look, this is just one of those things, man”. It isn’t about you.
If both sides are Affected Parties (likely upon an Illegality or Tax Event and, to a lesser extent, a Tax Event Upon Merger each side works out its own Close-out Amounts and they split the difference.
Section 6(e)(iii) Adjustment for Bankruptcy (Early Termination Payments)
Section 6(e)(iii) is somewhat gnomic, but is designed to build in some flex to allow for the weird things that happen in the netherworld of corporate insolvency, especially where your Early Termination Date happened, thanks to its automatic trigger, without anyone knowing about it.
If an AET has been “dark triggered” (this is an expression I made up to cover an event that has happened to the contract by operation of circumstance without the knowledge of either party), and therefore the parties (especially the Non-Defaulting Party) have blithely carried on with their business of making payments and deliveries unaware that the technical insolvency of one of them meant all payment and delivery obligations were suspended — Section 2(a)(iii) and all that — then you will find you have the opposite of Unpaid Amounts: you will have overpaid Amounts. This provision half-heartedly allows you to adjust to take account of them, without saying how: can you credit their full amount back? Do you have to apply some recovery rate?
We suspect most counterparties will credit the full amount and wait, with arguments pre-marshalled about insolvency set-off and restitution for money had and received, for use should the insolvency administrator comes at them.
Section 6(e)(iv) Adjustment for Illegality or Force Majeure Event
If you have a legitimate excuse for failing to pay — that it was due to aqueous invasion, rust, operation of trade winds, or the mendacity of His Majesty’s Royal Enemies etc and therefore a Force Majeure Event, or payment would have been Illegal, then it isn’t an Event of Default, none of this closing out of Terminated Transactions applies — yet — but you are still left with this odd situation where you have what looks like, but otherwise technically wouldn’t be, an Unpaid Amount, and also nothing to do with it.
Well, ISDA’s crack drafting squad™ abhors a vacuum.
Section 6(e)(iv) fills it. Firstly, it says such a non-paid amount is an Unpaid Amount, even though you weren’t required to pay it, and secondly, it allows you therefore to save it up, for any subsequent Early Termination Date that might arise (should the operating Illegality or Force Majeure Event not lift), and it allows you to also accrue interest on the Unpaid Amount due in the mean time, so you don’t get stung for your carry cost should the circumstances resolve before it becomes an Early Termination Date.
Section 6(e)(v) Pre-Estimate (Early Termination Payments)
From “the lady doth protest too much” school of contractual drafting, a neat and theoretically vacuous attempt to ensure that Early Termination Amounts determined under an ISDA Master Agreement are not seen as (unenforceable) penalty clause, but rather a liquidated damages clause — i.e., a “genuine pre-estimate of loss” caused by a breach of contract, as enunciated by Lord Dunedin in that famous contract case on penalty clauses, Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd.
But it either is or it isn’t. As it happens, it probably is a liquidated damages clause, but the parties agreeing in a standard form that it is one doesn’t really help that analysis.
For details freaks
Relevance of Section 6 to the peacetime operation of the Credit Support Annex
The calculation of Exposure under the CSA is modelled on the Section 6(e)(ii) termination methodology following a Termination Event where there is one Affected Party, which in turn tracks the Section 6(e)(i) methodology following an Event of Default, only taking mid-market valuations and not those on the Non-Defaulting Party’s side.
This means you calculate the Exposure as:
- (a) the Close-out Amounts for each Terminated Transaction plus
- (b) Unpaid Amounts due to the Non-defaulting Party; minus
- (c) Unpaid Amounts due to the Defaulting Party.
There aren’t really likely, in peacetime, to be Unpaid Amounts loafing about — an amount that you are due to pay today or tomorrow wouldn’t, yet, qualify as “unpaid”, but would be factored into the Close-out Amount calculation.
There is a little bit of a dissonance here, since “Exposure” is a snapshot calculation that treats all future cashflows, whether due in a day, a month or a year from today, the same way: it discounts them back to today, adds them up and sets them off. Your Delivery Amount or Return Amount, as the case may be, is just the difference between that Exposure and whatever the existing Credit Support Balance is. The future is the future: unknowable, unpredictable, but discountable, whether it happens in a day or a thousand years.
All the same, this can seem kind of weird when your CSA you have to pay him an amount today when he owes you an even bigger amount tomorrow. It’s like, “hang on: why am I paying you margin when, tomorrow, you are going to be in the hole to me? Like, by double, if I pay you this margin and you fail to me tomorrow.”
The thing which, I think, causes all the confusion is the dates and amounts of payments under normal Transactions are deterministic, anticipatable, and specified in the Confirmation, whereas whether one is required under a CSA on any day, and how much it will be, depend on things you only usually find out about at the last minute. CSA payments are due “a regular settlement cycle after they are called” — loosey goosey, right? — (or even same day if you are under a VMV CSA and you are on the ball with your calls) whereas normal swap payments are due (say) “on the 15th of March”
So, a scenario to illustrate:
- Day 1: Party A has an Exposure — is out of the money — to the tune of 100. Its prevailing Credit Support Balance is 90, so (let’s say, for fun, after the Notification Time on the Demand Date) Party B has called it for a Delivery Amount of a further 10, which it must pay, but not until tomorrow.
- Day 2: Meanwhile, Party A has a Transaction payment of 10 that falls due to Party B, also tomorrow. The arrival of this payment will change Party A’s Exposure to Party B so it is 90. Assuming Party A also pays the Delivery Amount, by knock-off time tomorrow it will have posted a Credit Support Balance of 100, and its Exposure to Party B will only be 90. This means it will be entitled to call Party B for a Return Amount of 10.
This seems rather a waste of operational effort, and will also take years off your credit officer’s life and may even cause his hair to catch fire. Can Party A just not pay the further Delivery Acount in anticipation of what will happen tomorrow?
Fun times in the world of collateral operations.
- ↑ This is not to say it isn’t hugely over-engineered, all the same: regular readers will know that the JC would never not say that about the output of ISDA’s crack drafting squad™.
- ↑ There is a technical exception here for Parties under a 1992 ISDA under which the First Method applies. But since the First Method is insane and no-one in their right mind would ever have it in a live contract, we mention it only for completeness.