Payments on Early Termination - 1992 ISDA Provision

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1992 ISDA Master Agreement
A Jolly Contrarian owner’s manual

Section 6(e) in a Nutshell
Use at your own risk, campers!

6(e) Payments on Early Termination. If an Early Termination Date occurs, the “Early Termination Amount” will be determined as follows (subject to any Set-off).
6(e)(i) Events of Default. If the Early Termination Date follows an Event of Default: —

(1) If First Method and Market Quotation applies, the Defaulting Party must pay any positive excess of (A) the sum of Settlement Amount and the Termination Currency Equivalent of the Unpaid Amounts owing to the Non-defaulting Party over (B) the Termination Currency Equivalent of the Unpaid Amounts owing to the Defaulting Party.
(2) If First Method and Loss applies, the Defaulting Party must pay the Non-defaulting Party’s positive Loss (if it has suffered one).
(3) If Second Method and Market Quotation applies, the amount payable will be (A) the sum of the Settlement Amount for the Terminated Transactions and the Termination Currency Equivalent of the Unpaid Amounts owing to the Non-defaulting Party less (B) the Termination Currency Equivalent of the Unpaid Amounts owing to the Defaulting Party. If positive, the Defaulting Party will pay that amount to the Non-defaulting Party; if negative, the Non-defaulting Party will pay its absolute value to the Defaulting Party.
(4) If Second Method and Loss applies, the Non-defaulting Party’s Loss in respect of this Agreement will be payable. If it is positive number, the Defaulting Party will pay it to the Non-defaulting Party; if negative, the Non-defaulting Party will pay its absolute value to the Defaulting Party.

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Section 6(e) in full

6(e) Payments on Early Termination. If an Early Termination Date occurs, the following provisions shall apply based on the parties’ election in the Schedule of a payment measure, either “Market Quotation” or “Loss”, and a payment method, either the “First Method” or the “Second Method”. If the parties fail to designate a payment measure or payment method in the Schedule, it will be deemed that “Market Quotation” or the “Second Method”, as the case may be, shall apply. The amount, if any, payable in respect of an Early Termination Date and determined pursuant to this Section will be subject to any Set-off.
6(e)(i) Events of Default. If the Early Termination Date results from an Event of Default: —

(1) First Method and Market Quotation. If the First Method and Market Quotation apply, the Defaulting Party will pay to the Non-defaulting Party the excess, if a positive number, of (A) the sum of the Settlement Amount (determined by the Non-defaulting Party) in respect of the Terminated Transactions and the Termination Currency Equivalent of the Unpaid Amounts owing to the Non-defaulting Party over (B) the Termination Currency Equivalent of the Unpaid Amounts owing to the Defaulting Party.
(2) First Method and Loss. If the First Method and Loss apply, the Defaulting Party will pay to the Non-defaulting Party, if a positive number, the Non-defaulting Party’s Loss in respect of this Agreement.
(3) Second Method and Market Quotation. If the Second Method and Market Quotation apply, an amount will be payable equal to (A) the sum of the Settlement Amount (determined by the Non-defaulting Party) in respect of the Terminated Transactions and the Termination Currency Equivalent of the Unpaid Amounts owing to the Non-defaulting Party less (B) the Termination Currency Equivalent of the Unpaid Amounts owing to the Defaulting Party. If that amount is a positive number, the Defaulting Party will pay it to the Non-defaulting Party; if it is a negative number, the Non-defaulting Party will pay the absolute value of that amount to the Defaulting Party.
(4) Second Method and Loss. If the Second Method and Loss apply, an amount will be payable equal to the Non-defaulting Party’s Loss in respect of this Agreement. If that amount is a positive number, the Defaulting Party will pay it to the Non-defaulting Party; if it is a negative number, the Non-defaulting Party will pay the absolute value of that amount to the Defaulting Party.

6(e)(ii) Termination Events. If the Early Termination Date results from a Termination Event: —

(1) One Affected Party. If there is one Affected Party, the amount payable will be determined in accordance with Section 6(e)(i)(3), if Market Quotation applies, or Section 6(e)(i)(4), if Loss applies, except that, in either case, references to the Defaulting Party and to the Non-defaulting Party will be deemed to be references to the Affected Party and the party which is not the Affected Party, respectively, and, if Loss applies and fewer than all the Transactions are being terminated, Loss shall be calculated in respect of all Terminated Transactions.
(2) Two Affected Parties. If there are two Affected Parties: —
(A) if Market Quotation applies, each party will determine a Settlement Amount in respect of the Terminated Transactions, and an amount will be payable equal to (I) the sum of (a) one-half of the difference between the Settlement Amount of the party with the higher Settlement Amount (“X") and the Settlement Amount of the party with the lower Settlement Amount (“Y") and (b) the Termination Currency Equivalent of the Unpaid Amounts owing to X less (II) the Termination Currency Equivalent of the Unpaid Amounts owing to Y; and
(B) if Loss applies, each party will determine its Loss in respect of this Agreement (or, if fewer than all the Transactions are being terminated, in respect of all Terminated Transactions) and an amount will be payable equal to one-half of the difference between the Loss of the party with the higher Loss (“X”) and the Loss of the party with the lower Loss (“Y”).
If the amount payable is a positive number, Y will pay it to X; if it is a negative number, X will pay the absolute value of that amount to Y.

6(e)(iii) Adjustment for Bankruptcy. In circumstances where an Early Termination Date occurs because “Automatic Early Termination” applies in respect of a party, the amount determined under this Section 6(e) will be subject to such adjustments as are appropriate and permitted by law to reflect any payments or deliveries made by one party to the other under this Agreement (and retained by such other party) during the period from the relevant Early Termination Date to the date for payment determined under Section 6(d)(ii).
6(e)(iv) Pre-Estimate. The parties agree that if Market Quotation applies an amount recoverable under this Section 6(e) is a reasonable pre-estimate of loss and not a penalty. Such amount is payable for the loss of bargain and the loss of protection against future risks and except as otherwise provided in this Agreement neither party will be entitled to recover any additional damages as a consequence of such losses.
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Related agreements and comparisons

Related Agreements
Click here for the text of Section 6(e) in the 2002 ISDA
Comparisons
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Resources and navigation

Resources Wikitext | Nutshell wikitext | 2002 ISDA wikitext | 2002 vs 1992 Showdown | 2006 ISDA Definitions | 2008 ISDA
Navigation Preamble | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | 11 | 12 | 13 | 14
Events of Default: 5(a)(i) Failure to Pay or Deliver5(a)(ii) Breach of Agreement5(a)(iii) Credit Support Default5(a)(iv) Misrepresentation5(a)(v) Default Under Specified Transaction5(a)(vi) Cross Default5(a)(vii) Bankruptcy5(a)(viii) Merger Without Assumption
Termination Events: 5(b)(i) Illegality5(b)(ii) Tax Event5(b)(iii) Tax Event Upon Merger5(b)(iv) Credit Event Upon Merger5(b)(v) Additional Termination Event

Index — Click ᐅ to expand:

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Content and comparisons

Section 6(e)(i)

Compare with Close-out Amount under the 2002 ISDA

The 1992 ISDA close out methodology is hideous. In a nutshell, what you need to know (if “it being hideous” really isn’t enough for you) is:

(i) Ignore First Method: No-one in their right mind would ever agree to the First Method, so you don’t need to worry about that. (It provides that on an Event of Default, the Defaulting Party never gets paid anything, even if the total mark-to-market value of its exposure under the 1992 ISDA is massively in its favour).
(ii) Market Quotation basically defaults to Loss: Market Quotation basically defaults to Loss anyway, seeing as if you can’t get at least three Reference Market-maker quotations, Market Quotation is deemed indeterminable and the Non-defaulting Party determines its Loss instead (only excluding Unpaid Amounts, since they are excluded from Market Quotation).
(iii) Market Quotation and Loss are needlessly inconsistent: As noted above, for reasons best known to 1992’s ISDA’s crack drafting squad™ (and look: it was a gentler, more naive time, when complexity for the sake of it was half the fun of derivatives practice) Market Quotation excludes Unpaid Amounts, where as Loss includes them, and Loss is calculated in the Termination Currency Equivalent, whereas Market Quotation is not.

The above nutshell in a nutshell: If you can’t see your way clear to using a 2002 ISDA — and some Americans cannot — select “Second Method and Loss” and have done with it.
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Summary

Section 6(e)(i)

Upon a Termination Event under the ISDA Master Agreement it is good to have your payment and calculation methods well-defined. The section Payments on Early Termination (ISDA Master Agreement Section 6(e) and Schedule 1(f)) covers this.

First Method

Fun fact: That terrible FT book about derivatives, and other like-minded sources, label the First Method a “limited two-way payments” clause, by which lights Long John Silver was a “limited two-legged pirate”. Less disingenuously also known as a “walkaway clause”, the First Method, which ensured that on close-out a Defaulting Party got paid nothing, regardless of how far in-the-money its Transactions were, was rarely used, even in the heady early 1990s, when derivatives seemed fun, new and mostly harmless.

Under the First Method, a payment is only ever made if the Settlement Amount is payable by the Defaulting Party to the Non-defaulting Party. This is, needless to say, a big fat free option against a Defaulting Party. The First Method is thus a back door to withhold payments that otherwise would due under the ISDA Master Agreement, it is hard to see why anyone in their right mind would give away this kind of optionality at the commencement of a derivative trading relationship, and, predictably, no one did.

Very, very rarely seen.

Second Method

The Second Method is a method of determining the Early Termination Amount due upon close out of an 1992 ISDA. Unlike the First Method, it requires a payment to be made equal to the net value of the Terminated Transactions to whom it is due, regardless whether it is the Defaulting Party or the Non-defaulting party. I.e., the Defaulting Party might get paid. Nice, huh?

Transaction Valuation

The 1992 ISDA provides alternative ways of arriving at a value for your portfolio of Terminated Transactions. This probably seemed like a good idea to ISDA’s crack drafting squad™ at the time — hey look: acid wash denim seemed a good idea at the time, to someone — but it leads to complexity, confusion, fear and loathing.

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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.[3]

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. [4]

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).

Let us imagine for a moment you 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[5] to designate an Early Termination Date for all outstanding Transactions.

So, at some point in the next twenty days[5] there will be a final reckoning and one Party will pay the other the Early Termination Amount.[6]But we have a ways to go before we even know what that amount will be. But observe: the payment date is now locked in. Time to get your skates on and start closing out Transactions.

5. Determine Close-out Amounts[7]

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.[8]

There is a bit of a chicken licken-and-egg situation here as 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.

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,[7] and assembled all the values into an Early Termination Amount[9] 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:

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See also

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References

  1. They won’t.
  2. The 2002 ISDA and its Close-out Amount recognises that.
  3. Yes, it’s true: in ISDA’s alternative universe, e-mail and electronic messaging systems are different things.
  4. 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.
  5. 5.0 5.1 See discussion on at Section 6(a) about the silliness of that time limit.
  6. By a striking oversight, not actually so named in the 1992 ISDA.
  7. 7.0 7.1 Or their equivalents under the 1992 ISDA, of course.
  8. 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.
  9. 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”.