Payments on Early Termination - 1992 ISDA Provision
1992 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
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.
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.
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.
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?
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.
- Market Quotation requires at least three arm’s length quotations to value the Transactions to be terminated. Since the Reference Market-makers won’t know anything about the state of your Transactions — and you are hardly likely to tell them — they can hardly be expected to factor your specific Unpaid Amounts into their quotations, so their quotations, if they even give you one, will be to replace the remainder of the Transaction in the abstract, assuming all past payments have been made, and there are no Unpaid Amounts. Therefore, later on in your close-out calculation process, you will have to factor in those Unpaid Amounts yourself.
- Loss allows the Non-defaulting Party to figure out (in "good faith") its losses and costs (minus its gains) replacing Terminated Transactions. While the NDP can to this by reference to dealer quotations, it doesn’t have to. Seeing as, unlike a Reference Market-maker, the NDP itself absolutely does know what the Unpaid Amounts are, ISDA’s crack drafting squad™ thought it easier for the Loss calculation method to factor the Unpaid Amounts in right away, rather than doing that as a separate second step, as per Market Quotation. But this really just confuses things, when it could have all been simple.
Section 6(e)(i) Events of Default
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
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
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) Pre-Estimate
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.
- ↑ They won’t.
- ↑ The 2002 ISDA and its Close-out Amount recognises that.
- ↑ 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.