Payments on Early Termination - ISDA Provision

From The Jolly Contrarian
Jump to navigation Jump to search

2002 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 Section 6(f)).

6(e)(i) Events of Default. On an Early Termination Date following an Event of Default, the Non-defaulting Party will determine Early Termination Amount in the Termination Currency as the sum of:
(a) the Close-out Amounts for each Terminated Transaction plus
(b) Unpaid Amounts due to the Non-defaulting Party; minus
(c) Unpaid Amounts due to the Defaulting Party.
If the Early Termination Amount is positive, 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.
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 Early Termination Amount will be determined as if they were Events of Default under Section 6(e)(i) (but subject to the Mid-Market Events rider below).
(2) Two Affected Parties. If there are two Affected Parties, each party will determine the Termination Currency Equivalent of the Close-out Amounts for all Terminated Transaction and the Early Termination Amount will be:
(A) the sum of
(I) half of the difference between the higher amount (determined by party “X”) and the lower amount (determined by party “Y”) and
(II) the Termination Currency Equivalent of the Unpaid Amounts owing to X minus
(B) the Termination Currency Equivalent of the Unpaid Amounts owing to Y.
If the Early Termination Amount is a positive number, Y will pay it to X; if negative , X will pay its absolute value to Y.
(3) Mid-Market Events. In either case where the Termination Event is an Illegality or a Force Majeure Event, when determining a Close-out Amount the Determining Party will use mid-market valuations that do not take the Determining Party’s own creditworthiness into account.
6(e)(iii) Adjustment for Bankruptcy. If an “Automatic Early Termination” happens, one can adjust the Early Termination Amount to reflect payments or deliveries actually made between the automatic Early Termination Date and the payment date determined under Section 6(d)(ii).
6(e)(iv) Adjustment for Illegality or Force Majeure Event. The failure by a party or its Credit Support Provider to pay an Early Termination Amount when due will not be a Failure to Pay or Deliver or a Credit Support Default if caused by an Illegality or a Force Majeure Event. The unpaid amount will:
(1) be treated as an Unpaid Amount for a subsequent Early Termination Date resulting from an Event of Default, a Credit Event Upon Merger or an Additional Termination Event affecting all outstanding Transactions; and
(2) otherwise accrue interest in accordance with Section 9(h)(ii)(2).
6(e)(v) Pre-Estimate. The parties acknowledge that:
(a) Each Early Termination Amount is a reasonable pre-estimate of loss and not a penalty; and
(b) neither party may recover any additional damages as a consequence of terminating Terminated Transactions.

view template

Section 6(e) in full

6(e) Payments on Early Termination. If an Early Termination Date occurs, the amount, if any, payable in respect of that Early Termination Date (the “Early Termination Amount”) will be determined pursuant to this Section 6(e) and will be subject to Section 6(f).

6(e)(i) Events of Default. If the Early Termination Date results from an Event of Default, the Early Termination Amount will be an amount equal to (1) the sum of (A) the Termination Currency Equivalent of the Close-out Amount or Close-out Amounts (whether positive or negative) determined by the Non-defaulting Party for each Terminated Transaction or group of Terminated Transactions, as the case may be, and (B) the Termination Currency Equivalent of the Unpaid Amounts owing to the Non-defaulting Party less (2) the Termination Currency Equivalent of the Unpaid Amounts owing to the Defaulting Party. If the Early Termination 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 the Early Termination Amount to the Defaulting Party.
6(e)(ii) Termination Events. If the Early Termination Date results from a Termination Event:―
(1) One Affected Party. Subject to clause (3) below, if there is one Affected Party, the Early Termination Amount will be determined in accordance with Section 6(e)(i), except that references to the Defaulting Party and to the Non-defaulting Party will be deemed to be references to the Affected Party and to the Non-affected Party, respectively.
(2) Two Affected Parties. Subject to clause (3) below, if there are two Affected Parties, each party will determine an amount equal to the Termination Currency Equivalent of the sum of the Close-out Amount or Close-out Amounts (whether positive or negative) for each Terminated Transaction or group of Terminated Transactions, as the case may be, and the Early Termination Amount will be an amount equal to (A) the sum of (I) one-half of the difference between the higher amount so determined (by party “X”) and the lower amount so determined (by party “Y”) and (II) the Termination Currency Equivalent of the Unpaid Amounts owing to X less (B) the Termination Currency Equivalent of the Unpaid Amounts owing to Y. If the Early Termination Amount is a positive number, Y will pay it to X; if it is a negative number, X will pay the absolute value of the Early Termination Amount to Y.
(3) Mid-Market Events. If that Termination Event is an Illegality or a Force Majeure Event, then the Early Termination Amount will be determined in accordance with clause (1) or (2) above, as appropriate, except that, for the purpose of determining a Close-out Amount or Close-out Amounts, the Determining Party will:―
(A) if obtaining quotations from one or more third parties (or from any of the Determining Party’s Affiliates), ask each third party or Affiliate (I) not to take account of the current creditworthiness of the Determining Party or any existing Credit Support Document and (II) to provide mid-market quotations; and
(B) in any other case, use mid-market values without regard to the creditworthiness of the Determining Party.
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 Early Termination Amount will be subject to such adjustments as are appropriate and permitted by applicable 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) Adjustment for Illegality or Force Majeure Event. The failure by a party or any Credit Support Provider of such party to pay, when due, any Early Termination Amount will not constitute an Event of Default under Section 5(a)(i) or 5(a)(iii)(1) if such failure is due to the occurrence of an event or circumstance which would, if it occurred with respect to payment, delivery or compliance related to a Transaction, constitute or give rise to an Illegality or a Force Majeure Event. Such amount will (1) accrue interest and otherwise be treated as an Unpaid Amount owing to the other party if subsequently an Early Termination Date results from an Event of Default, a Credit Event Upon Merger or an Additional Termination Event in respect of which all outstanding Transactions are Affected Transactions and (2) otherwise accrue interest in accordance with Section 9(h)(ii)(2).
6(e)(v) Pre-Estimate. The parties agree that 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 the termination of the Terminated Transactions.

view template

Related agreements and comparisons

Related Agreements
Click here for the text of Section 6(e) in the 1992 ISDA
Comparisons
Template:Isdadiff 6(e)

Resources and navigation

Resources Wikitext | Nutshell wikitext | 1992 ISDA wikitext | 2002 vs 1992 Showdown | 2006 ISDA Definitions | 2008 ISDA | JC’s ISDA code project
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) Force Majeure Event5(b)(iii) Tax Event5(b)(iv) Tax Event Upon Merger5(b)(v) Credit Event Upon Merger5(b)(vi) Additional Termination Event

Index — Click ᐅ to expand:

Get in touch
Comments? Questions? Suggestions? Requests? Sign up for our newsletter? Questions? We’d love to hear from you.
BREAKING: Get the new weekly newsletter here Old editions here

Content and comparisons

6(e) Payments on Early Termination

6(e)(i) Events of Default (Early Termination Payments)
6(e)(ii) Termination Events (Early Termination Payments)
6(e)(iii) Adjustment for Bankruptcy (Early Termination Payments)
6(e)(iv) Adjustment for Illegality or Force Majeure Event
6(e)(v) Pre-Estimate (Early Termination Payments)

Early Termination Amount is not actually defined in the 1992 ISDA, but is referred to obliquely in Section 6(e) as:

...The amount, if any, payable in respect of an Early Termination Date and determined pursuant to this Section ...

Correctly, it is best referred to as a “Section 6(e) Amount” under the 1992 ISDA, although of course everyone does call it the Early Termination Amount. This inevitability was recognised in the 2002 ISDA, where it is defined in Section 6(e) as follows:

... the amount, if any, payable in respect of that Early Termination Date.

But the 2002 ISDA also has a “Close-out Amount”, so you may want to know what the difference between the Early Termination Amount and the Close-out Amount, you know, is. Yes?
Template

Summary

On the difference between an “Early Termination Amount” and a “Close-out Amount

The 1992 ISDA features neither an Early Termination Amount or a Close-out Amount, which many would see as a regrettable oversight. The 2002 ISDA has both, which looks like rather an indulgence, until you realise that they do different things.[1]

A Close-out Amount is the termination value for a single Transaction, or a related group of Transactions that a Non-Defaulting Party or Non-Affected Party calculates while closing out an 2002 ISDA, but it is not the final, overall sum due under the ISDA Master Agreement itself. Each of the determined Close-out Amounts summed with the various Unpaid Amounts to arrive at the Early Termination Amount, which is the total net sum due under the ISDA Master Agreement at the conclusion of the close-out process. (See Section 6(e)(i) for more on that).

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.[2]

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. [3]

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[4] to designate an Early Termination Date for all outstanding Transactions.

So, at some point in the next twenty days[4] there will be a final reckoning and one Party will pay the other the Early Termination Amount.[5]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[6]

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.[7]

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,[6] and assembled all the values into an Early Termination Amount[8] 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:

Template

General discussion

Section 6(e)(i) Events of Default (Early Termination Payments)

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.[9]

...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 (Early Termination Payments)

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 (Early Termination Payments)

Template:Isda 6(e)(iii) summ

Section 6(e)(iv) Adjustment for Illegality or Force Majeure Event

Template:Isda 6(e)(iv) summ

Section 6(e)(v) Pre-Estimate (Early Termination Payments)

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.
Template

See also

Template

References

  1. This is not to say it isn’t hugely over-engineered, all the same: regular readers will know that the JC would never not say that about the output of ISDA’s crack drafting squad™.
  2. Yes, it’s true: in ISDA’s alternative universe, e-mail and electronic messaging systems are different things.
  3. 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.
  4. 4.0 4.1 See discussion on at Section 6(a) about the silliness of that time limit.
  5. By a striking oversight, not actually so named in the 1992 ISDA.
  6. 6.0 6.1 Or their equivalents under the 1992 ISDA, of course.
  7. 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.
  8. 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”.
  9. 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.