Right to Terminate Following Event of Default - ISDA Provision
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2002 ISDA Master Agreement
Section 6(a) in a Nutshell™ Use at your own risk, campers!
Full text of Section 6(a)
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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.
Summary
Everyone’s hair will be on fire
This is likely to be a time where the market is dislocated, your credit officer is running around with her hair is on fire, your normally affable counterparty is suddenly diffident or evasive, and your online docs database has crashed because everyone in the firm is interrogating it at once.
This is also one time the commercial imperative will count for little, since you are terminating your trading relationship altogether and with extreme prejudice. Your normally iterated game of prisoner’s dilemma has turned into a single round game. Game theorists among you will know immediately that the calculus is therefore very different, and much, much less appealing.
So: good luck keeping your head while all around you are losing theirs.
Close-out sequence
Once you have designated an Early Termination Date for your ISDA Master Agreement, proceed to 6(c) to understand the Effect of Designation. Or learn about it in one place with the NC.’s handy cribsheet, “closing out an ISDA”.
The Notices provisions in Section 12 are relevant to how you may serve this notice. In a nutshell, in writing, by hand. Don’t email it, fax it, telex it, or send it by any kind of pony express or carrier pigeon unless your pigeon/pony is willing to provide an affidavit of service.
General discussion
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, to close out following a Failure to Pay or Deliver, you will need:
1. There must be a failure to pay or deliver under Section 5(a)(i)
A Failure to Pay or Deliver, by the Defaulting Party to make a payment or delivery when due on day T. This is not, yet, an Event of Default under Section 5(a)(i). But we are on the way.
2. You must give notice of the failure under Section 5(a)(i)
The Non-defaulting Party must give the Defaulting Party notice of the failure. This is not a Section 6(a) notice — calm, down, we will get to that in good time — but a Section 5(a)(i) notice of failure to pay or deliver. The sainted ISDA Master Agreement does not directly prescribe the format for this notice, but Section 12 cautions that it may not be by e-mail or 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.[1]
Since payments and deliveries are generally due at close of business on a given day, Q.E.D., a Section 5(a)(i) notice of Failure to Pay or Deliver can usually only be given after close of business on the due date.
Thanks to Section 12(a) (Notices), the Section 5(a)(i) notice will only be effective on the following Local Business Day: i.e., T+1. [2]
3. You must allow the grace period under Section 5(a)(i) to expire
At this point you have a Potential Event of Default, but not an actual one.
Once your Section 5(a)(i) notice of Failure to Pay or Deliver is effective, the Defaulting Party has a “grace period” in which it may sort itself out and make the payment or delivery in question, thereby heading off a full-blown Event of Default.
The standard grace periods are set out in Section 5(a)(i). Be careful: 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.
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).
Trick for the young players: check that the conditions precedent to payment under Section 2 remain fulfilled. For example, has the defaulting party got any grounds to suspend payment under Section 2(a)(iii)? Thanks to the loose way section 2(a)(iii) is drafted, it might, for example, if the putatively non-defaulting party has slipped into Bankruptcy or Cross Default in the meantime — though we think a more sensible reading is that 2(a)(iii) can only be measured as at the originally scheduled payment date. Note: a party does not have to invoke Section 2(a)(iii), or send a notice about it. It just applies. This is a bit of a banana-skin, as we discuss at length in our 2(a)(iii) article.
Let us imagine for a moment you are not yourself in default and have indeed waited the necessary time.
4. You may now send your Section 6(a) notice designating an Early Termination Date
At the expiry of the Section 5(a)(i) grace period, you finally have a fully operational Event of Default. Now Section 6(a) allows you, by not more than 20 days’ notice[3] to designate an Early Termination Date for all outstanding Transactions.
So, at some point in the next twenty days[3] outstanding Transactions will be at an end.[4] Now this is a different thing from knowing what the amounts will be, much less knowing when they will be paid: this is the date by reference to which termination amounts will be calculated.
5. Determine Close-out Amounts[5]
One 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).
Now armed with our crystalised Failure to Pay or Deliver Event of Default and with an Early Termination Date to target, we go directly 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.[6]
The trading and risk people need to come up with Close-out Amounts for all outstanding Transactions. Now note, even though you have designated an Early Termination Date not more than 20 days from your Section 6(a) notice, it may well take you a lot longer to close out your portfolio than that, and as long as you are acting in a commercially reasonable way, you can take longer. The 20 days notice period is a red herring. There is a longer essay about the meaningless of that 20 day time limit here.
Once they have done that you are ready for your Section 6(e) notice.
6. Calculate and notify
The Early Termination Date is the date on which the Transactions terminate; it is the date by reference to which you calculate their termination values, not the date by you have to have valued, much less settled outstanding amounts due as a result of their termination — that would be a logical impossibility for those not imbued with the power of foresight. Here we move onto Section 6(d), under which, as soon as is practicable after the Early Termination Date, your boffins work out all the termination values for each Transaction, tot them up to arrive at the Section 6(e) amount, and send a statement to the defaulting party, specifying the Early Termination Amount payable, the bank details, and reasonable details of calculations.
7. Pay your Early Termination Amount
Your in-house metaphysicians having calculated your Close-out Amounts,[5] and assembled all the values into an Early Termination Amount[7] the party who owes it must pay the Early Termination Amount. With ISDA’s crack drafting squad™ yen for infinite fiddlarity, this will depend on whether the Early Termination Date follows an Event of Default or an Termination Event. If the former, the Early Termination Amount is payable at once, as soon as the 6(d) statement is deemed delivered; if a Termination Event, only two Local Business Days — I know, right — after the 6(d) statement is delivered (or, where there are two Affected Parties and both are delivering each other 6(d) statements — I know, right — after both have done so).
8. Putting that all together
Here are all the stages you must go through between becoming entitled to terminate and settlement for a Failure to Pay or Deliver:
- T: There must be a Failure to Pay or Deliver on a day, T.
- T+1: After close of business on T, the Non-defaulting Party must give the Defaulting Party a Section 5(a)(i) notice of failure to pay of deliver. The prescribed grace period must expire. The grace periods may be between 1 and 3 LBDs. There may also be carve-outs for operational failures and so on, to add to the fun.
- T+4: You must send a Section 6(a) notice designating an Early Termination Date for all outstanding Transactions. Let’s say it is 3 LBSs. You must designate an Early Termination Date within 20 days. Let’s say it is 20 days, for the hell of it
- T+24: You are “off risk” and must start calculating your Close-out Amounts for all outstanding Transactions. You must do this ass soon as reasonably practicable. Let’s say that takes another 30 days.
- T+54: having calculated all Close-out Amounts and totted them all up into a single Early Termination Amount: You send your Section 6(d) statement advising of that amount, giving bank details and supplying your workings.
- T+54: Your Early Termination Amount is due.
For details freaks
“by not more than 20 days’ notice”
What is the significance of the maximum notice period of 20 days that one may use to close out the ISDA Master Agreement? Poor defaulted Counterparty is in pieces, on its knees, bleeding out, but really, as long as it gets some notice, does it really care how much? Surely, the longer the period, the more hope you have? While the agreement remains in termination but un-terminated, en route to that crater in the ground but not there yet — the chance remains, however remote, that things will come right; that you, its counterparty, will see sense, or unexpectedly discover the one compassionate bone in your body that, until now, has gone wholly unnoticed and, in a cloying bout of clemency, will change your mind and withdraw your notice of termination? Well, a little hedge fund can dream, can’t it? So why deprive it, and yourself, of that option?
I teach you the Children of the Woods
Now, this is deep ISDA lore. It is of the First Men[8] — yea, even the Children of the Woods. As such — since they didn’t have a written tradition back in 1986 and legends were passed down orally from father to son[9] and much has been lost to vicissitude and contingency — it is not a subject on which there is much commentary: That dreadful FT book about derivatives sagely notes that, usually, much less notice is given than 20 days (I mean, you don’t say) but doesn’t give a reason for this curious outer bound, in the same way it doesn’t give a reason for much else in the ISDA Master Agreement despite costing a monkey and that being its express purpose. Nor, for that matter, does the official ISDA User’s Guide to the 2002 ISDA Master Agreement.
One is just expected to know. Yet, in point of fact, no-one seems to. And no-one wants to risk looking stupid by asking, right? Well, companions, just not knowing is not how we contrarians roll. We like looking stupid. Compared with plain old ignorance, it speaks to having at least put in some effort, even if wasted: noble but futile toil is flattering in some lights. So, in the absence of a credentialised, plausible reason,[10] let us speculate.
“Not more than 20-days notice” does not impose a cliff edge
The first thing to say, is the Early Termination Date is not the date on which you must pay an Early Termination Amount nor, for that matter, even have calculated it: it is the date by reference to which you must calculate an Early Termination Amount. Thanks to the good graces of Sectrion 6(d), provided you so as soon as reasonably practicable, you have time to calculate your values diligently and properly.
And even that “by reference to” is heavily qualified: Close-out Amounts[11] are intended to be determined “as of” the Early Termination Date, being the date designated in your Section 6(a) notice which had to be within 20 days of that notice. Now that makes it seem like you are facing a rather untimely cliff-edge if you can’t practicably close out your whole hedge book in 20 days, but note:
Each Close-out Amount will be determined as of the Early Termination Date or, if that would not be commercially reasonable, as of the date or dates following the Early Termination Date as would be commercially reasonable.[12]
This is very important. This means[13] you don’t have to liquidate a portfolio in its entirety within 20 days, or even take the values as of that Early Termination Date. If you can, you should — but it may well not be commercially reasonable — or even possible — to. The Lehman insolvency took months to unwind. Note also that commercial reasonableness is viewed from the Non-Affected Party’s perspective. It is not a licence to do whatever the hell you want — but the court won’t second guess prudent application of your own models.
Therefore no-one has any reason to wait any days, let alone 20
So this leaves the mystery of why a party designating an Early Termination Date, for any reason, wouldn’t just designate it now — and for those peculiar types who don’t want to do that, why there should be this arbitrary long-stop of 20 days.
Remember the ISDA Master Agreement was invented by banking folk: people who who view the Cosmos chiefly through the prism of indebtedness[14]. A lender whose borrower has defaulted will not dilly dally: she will bang in a default notice and seize whatever assets she can get her hand in poste haste. I lend, you owe. I don’t muck about. Breakage costs on a loan are easy to calculate and they are not especially volatile. There is nothing to be gained by waiting around: interest continues to accrue, at a penalty rate: the longer I take to terminate my exposure, the larger it is likely to be.
But, but, but. ISDAs are different. They are not, principally, a contract of indebtedness, and while a large uncollateralised mark-to-market exposure[15] is economically the same as indebtedness, the contract is bilateral, these days almost always fully collateralised, and who is indebted at any time is dependent on the net exposure: it can and does swing around.
Also, the mark-to-market exposure on swap transaction is a wildly volatile thing: With a loan, less so: you know you have (a) principal, (b) accrued interest and (c) break costs — the last of which might be significant for a long term fixed rate loan,[16] but generally will pale in comparison to the principal sum owed.
So a swap counterparty who terminates might be out of the money, and disinclined to terminate just now, hoping that a more benign market environment might be just around the corner to dig it out of its hole so that when it does pull its trigger, the Close-Out Amount will be favourable. This is still taking quite the market punt on a bust counterparty — by means of a European option[17] — of course, and not the sort of thing a prudent risk manager would do,[18] but I don’t suppose banking folk can be expected to have understood this in 1986.
Actually, even that makes little sense, since such a counterparty wouldn’t be obliged to close out at all, but could just suspend its obligations under Section 2(a)(iii) — something which it can (or could, at any rate, when the notice period was devised, in 1987) do indefinitely. To be sure, a 2(a)(iii) suspension is just that — a suspension; should one come eventually to terminate the Transaction, those as-yet unperformed obligations will come back to haunt you as Unpaid Amounts, but at least here you retain control of the process and timing of close-out: it is an American option, not a European one. If you see the market moving against you, you can cash in your chips. So, ask yourself which is a bigger punt: that, the mark-to-market value you determine in 20 days — in a market that is likely to be a flaming wreck, by the way — better suits your book than the one you can actually trade on today, or on any day between now and that distant Early Termination Date?
So we get back to an alternative, disappointing explanation: It is just flannel.
Template
See also
References
- ↑ Yes, it’s true: in ISDA’s alternative universe, e-mail and electronic messaging systems are different things.
- ↑ 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.
- ↑ 3.0 3.1 See discussion on at Section 6(a) about the silliness of that time limit.
- ↑ By a striking oversight, not actually so named in the 1992 ISDA.
- ↑ 5.0 5.1 Or their equivalents under the 1992 ISDA, of course.
- ↑ 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.
- ↑ 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”.
- ↑ I know, I know — or women, but that spoils the Game of Thrones reference, you know?
- ↑ See footnote 1 and/or get a life.
- ↑ And we have done our due diligence, you know: in coming to this conclusion the JC has consulted Magic circle law firm partners, managing directors, inhouse GCs and even a former general counsel of ISDA, all of whom swore me to secrecy but were as nonplussed as, let’s face it, you are about this baffling clause.
- ↑ In this essay, as elsewhere, I use “Close-out Amount” as a generic term to refer to the amount determined to be payable under a terminated Transaction, whether documented under a 2002 ISDA or a 1992 ISDA. I know there is no such thing as a “Close-out Amount” under a 1992 ISDA. Just go with me on this, ok?
- ↑ This is in the definition of Close-out Amount (2002 ISDA) and Loss (1992 ISDA). Curiously, Market Quotation in the 1992 ISDA does it slightly differently, saying “The party making the determination (or its agent) will request each Reference Market-maker to provide its quotation to the extent reasonably practicable as of the same day and time (without regard to different time zones) on or as soon as reasonably practicable after the relevant Early Termination Date.” We guess that gives a bit of flexibility, but is not quite so clear-cut. We suppose the point is that the Non-Affected Party can presumably hit the prices offered by the Reference Market Makers — making the enormous assumption any will actually provide a price — and so isn’t subject to any market risk; which is good. But on the other hand, block-trading a huge portfolio on an arbitrary day you had to set because of the random requirement for “not more than 20 days” is hardly calculated to help the Defaulting Party. You would like to think common-sense would prevail for those dinosaurs still on the 1992 ISDA, who are using the Market Quotation concept. Then again, the fact that they are still on a 1992 ISDA twenty years after it was superseded suggests somewhat that common sense may be lacking somewhere in the relationship.
- ↑ Arguably unless you’re on a 1992 ISDA and using Market Quotation — see the footnote above.
- ↑ Hence, a Cross Default clause in the ISDA Master Agreement. Well — can you think of another reason for it?
- ↑ Such as the sort you could have if it were 1987 and the credit support annex hadn’t been invented.
- ↑ But are there such things in this day and age? Serious question.
- ↑ A correspondent writes pointing out — quite correctly — that, once an Event of Default has happened, the option to send a 6(a) Notice is American. So it is — thanks to Section 2(a)(iii), a potentially open ended one — until you convert it into something like a European option by sending the notice and specifying a date in the future on which it takes place.
- ↑ The silly FT book is right about this, to be fair.