Payments on Early Termination - 1992 ISDA Provision
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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
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Content and comparisons
Compare with Close-out Amount under the 2002 ISDA
The 1992 ISDA close-out methodology is hideous. They overhauled whole process of closing out an ISDA, soup to nuts, in the 2002 ISDA, and is now much more straightforward — as far as you could ever say that about ISDA’s crack drafting squad™’s output. But a large part of the fanbase — that part west of Cabo da Roca — sticks with the 1992 ISDA. Odd.
Differences, in very brief:
The 1992 ISDA has the infamous Market Quotation and Loss measures of value, and the perennially-ignored First Method and the more sensible Second Method means of evaluating the termination value of terminated Transactions. The 2002 ISDA has just the Close-out Amount to cover everything. So while the 1992 ISDA is far more elaborate and over-engineered, this is not to deny that the 2002 ISDA is elaborate or over-engineeered.
The 2002 ISDA has a new Section 6(e)(iv) dealing with Adjustment for Illegality or Force Majeure Event. This wasn’t needed in the 1992 ISDA, which didn’t have Force Majeure Event at all, and a less sophisticated Illegality.
Summary
Section 6(e)(i)
One thing to say: this is one of the main places where the 1992 ISDA and the 2002 ISDA are very different. The 2002 Master Agreement dramatically simplifies and, after 20 odd years of curmudgeonly refusal to accept this, even the Americans now seem to acknowledge, improves the process of closing out an ISDA.
Anyway. You chose the 1992, so here we are. (Changed your mind? Flee to safety here).
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.
- 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,[1] 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.[2]
General discussion
Section 6(e)(i) Events of Default
One thing to say: this is one of the main places where the 1992 ISDA and the 2002 ISDA are very different. The 2002 Master Agreement dramatically simplifies and, after 20 odd years of curmudgeonly refusal to accept this, even the Americans now seem to acknowledge, improves the process of closing out an ISDA.
Anyway. You chose the 1992, so here we are. (Changed your mind? Flee to safety here).
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.
- 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,[3] 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.[4]
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.
See also
References
- ↑ They won’t.
- ↑ The 2002 ISDA and its Close-out Amount recognises that.
- ↑ They won’t.
- ↑ The 2002 ISDA and its Close-out Amount recognises that.