Events of Default - ISDA Provision
2002 ISDA Master Agreement
Section 5(a) in a Nutshell™
Full text of Section 5(a)
Related agreements and comparisons
Content and comparisons
- 5(a)(i) Failure to Pay or Deliver
- 5(a)(ii) Breach of Agreement
- 5(a)(iii) Credit Support Default
- 5(a)(iv) Misrepresentation
- 5(a)(v) Default Under Specified Transaction
- 5(a)(vi) Cross Default
- 5(a)(vii) Bankruptcy
- 5(a)(viii) Merger without Assumption
Types of Events of Default
Some Events of Default you can independently verify without counterparty's confirmation, for example:
- Direct breaches: direct breaches of the Agreement (eg Failure to Pay; Breach of Agreement);
- Public events: Events which are necessarily public (most of the Bankruptcy limbs; Merger Without Assumption
Not independently verifiable
Some require the counterparty to tell you as they depend on facts which you could not know are not public knowledge, are not breaches of a direct obligation to the counterparty and would not otherwise come to the firm's attention: Particularly:
- Cross Default
- other limbs of Bankruptcy (eg "has a secured party take possession of all or substantially all its assets".
“Hard” Events of Default
Hard events where some positive action has actually been taken representing a default - such as a Failure to Pay
“Soft” or “Passive” Events of Default
Where a state of affairs has arisen permitting a hard Event of Default to be called, but it has not been designated it happened, such as Cross Default, where person owning the actual "hard" default right against your counterparty may not have triggered (or have any intention of triggering) it.
That said, and for the same reason, such “not independently verifiable” termination/default events are effectively soft anyway, even where we have such an obligation from counterparty to notify us of their occurrence, because we have no means of policing whether or not the Counterparty has in fact notified us, and therefore no practical remedy anyway if it does not. It is a self certification, after all, and all we can rely on is its moral force and the party's competence to monitor its own position and be sufficiently organised to tell us.
Additionally, the obligation on a counterparty to monitor "passive" Events of Default like Cross Default (as opposed to cross acceleration where QED a defaulting party will be notified about the occurrence) is a pretty onerous one particularly for a large entity, and even more so where (as they often are for funds) derivatives are included in definition of Specified Indebtedness.
Given that cross defaults may have artificially low Threshold Amounts (as do some of ours) and are set at levels where actual counterparties owning those rights directly are most unlikely to exercise them, it should not be a surprise to find parties resistant to notifying us about these.
This becomes a credit call but a practical recommendation would be:
- Impose notification requirement only on "active" termination/default events which are non-public and CP has no excuse for not having monitored them and counterparty has actually exercised; and
- If that doesn't work, agree to drop the provision altogether, as in my view its practical utility is limited to "moral" at best (as there is no effective sanction for counterparty breach anyway)
Illegality trumps Event of Default. Be careful where, for example, a Failure to Pay is occasioned by a mandatory change in law by a government having jurisdiction over one or other counterparty — see Illegality. Good example: Greek capital controls of June 2015.
Events of Default vs. Termination Events: Showdown
Puzzled ISDA ingénues may wonder why there are Events of Default and Termination Events under the, er, eye-ess-dee-aye. In any weather, there seem to be rather a lot of them. And there is a third, hidden category: Additional Termination Events that the parties crowbar into the Schedule.
Do we really need all these, and what is the difference?
- Events of Default tend to imply fault, turpitude, moral outrage, and are comprehensive — some would say overcomprehensive — Failure to Pay; Breach; Credit Support Default; Misrepresentation; Bankruptcy and — here we’re well and truly in over-comprehensive territory — Cross Default.
- Termination Events tend to be unwanted vicissitudes of commercial life which neither party could anticipate, and are often Transaction-specific — Illegality, Force Majeure; Tax Events.
- Just in case you are worried ISDA’s crack drafting squad™, with the collective weight of the whole derivatives industry urging it on, might have forgotten something important over 30 years of the ISDA Master Agreement you can make up your own ones. These are the “Additional Termination Events”: they are treated like Termination Events, but tend to be more (in terms of moral outrage) like Events of Default. You will spend many years of your life arguing about these, but they will never get used.
So, with feeling:
- Naughtiness: Imply a degree of turpitude on the part of the TRANSGRESSOR. Termination Events are sort of gentler and fluffier (although ATEs are often quite turpitudinous);
- All or none: Exercising an Event of Default necessitates terminating all outstandingTransactions; invoking a Termination Event may only affect specific “Affected Transactions” (but again, ATEs are often both turpitudinous and (for that very reason) impact necessarily on all outstanding Transactions;
- Calculations: The Non-Defaulting Party always makes the termination calculations; in a Termination Event (if both parties are affected) they share it and split the difference;
- Default interest: The interest accrual rate for your Close-Out Amount is different (i.e., higher) following an Event of Default than following a Termination Event. Because — turpitude, right?
- Notice: oblige the Affected Party to fess up about them — a fair expectation, since the Affected Party hasn’t been actively turpitudinous in the Termination Event coming about and can be still expected to act in good faith; Events of Default generally don’t, for the same reason: Dude has materially breached your contract. What skin is it off dude’s nose to further breach it, by not owning up?
- Some Termination Events only arise only once the Affected Party has failed to transfer obligations away to a party who wouldn’t be an Affected Party.
- Potential number of Affected Parties: Most Termination Events, at least in theory, can be suffered by both parties simultaneously. Credit Event Upon Merger is the exception — well I guess both parties could contemporaneously merge with materially crappier credits: who knows? — and the stentorian in me feels that — it being plainly credit-related, if it were necessary to include at all — it would not have hurt to put Credit Event Upon Merger and Additional Termination Events — which are typically all credit-related — in the Events of Default bucket.
- The sorts of people who are interested in learning about sw-æps under an eye-ess-dee-aye. Come on, you were one once.
- Controversial view: No, except to protect the livelihoods of an entire cottage industry of sheeple.
- You will never guess who.
- Please write to me, at firstname.lastname@example.org, if you ever encounter a close-out — a real, actually-gone-through-with-it, Section 6, whole-ISDA close out based purely on an Additional Termination Event (or, actually, any event other than a Failure to Pay or Deliver or a Bankruptcy) You will be my Black Swan.
- I mean the Defaulting Party.
- Though this won’t stop excitable credit officers seeking to add that obligation in the negotiation.
- by no means clear: has ever anyone seen a live example of a credit event upon merger?