Right to Terminate Following Event of Default - ISDA Provision

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2002 ISDA Master Agreement
A Jolly Contrarian owner’s manual

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

6(a) Right to Terminate following Event of Default. If one party (“Defaulting Party”) suffers an Event of Default, the other (the “Non-defaulting Party”) may, by not more than 20 days’ notice, designate an Early Termination Date for all outstanding Transactions. If Automatic Early Termination applies to the Defaulting Party and the Event of Default it is qualifying Bankruptcy event, the Early Termination Date will occur:

(i) upon the Bankruptcy event, if under 5(a)(vii)(1), (3), (5) or (6) or if analogous, (8); and
(ii) immediately before institution of the relevant proceeding, if under 5(a)(vii)(4) or if analogous, (8).

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Section 6(a) in full

6(a) Right to Terminate Following Event of Default. If at any time an Event of Default with respect to a party (the “Defaulting Party”) has occurred and is then continuing, the other party (the “Non-defaulting Party”) may, by not more than 20 days notice to the Defaulting Party specifying the relevant Event of Default, designate a day not earlier than the day such notice is effective as an Early Termination Date in respect of all outstanding Transactions. If, however, “Automatic Early Termination” is specified in the Schedule as applying to a party, then an Early Termination Date in respect of all outstanding Transactions will occur immediately upon the occurrence with respect to such party of an Event of Default specified in Section 5(a)(vii)(1), (3), (5), (6) or, to the extent analogous thereto, (8), and as of the time immediately preceding the institution of the relevant proceeding or the presentation of the relevant petition upon the occurrence with respect to such party of an Event of Default specified in Section 5(a)(vii)(4) or, to the extent analogous thereto, (8).
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Related agreements and comparisons

Related Agreements
Click here for the text of Section 6(a) in the 1992 ISDA
Comparisons
Click to compare this section in the 1992 ISDA and 2002 ISDA.

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:
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Content and comparisons

+++ COVID-19 UPDATE +++ COVID-19 UPDATE +++ COVID-19 UPDATE +++ See section 12 for what this all means in a time of global pandemic lockdown

See also the separate article all about Automatic Early Termination, which features in the last sentence of this Section, but deserves a page all of its own.

No change in the Early Termination Date definition from 1992 ISDA to 2002 ISDA (no real surprise there) but the close out methodology between the two versions, by which one works out what must be paid and by whom on an Early Termination Date, and which you are encouraged to follow in all its gory detail starting at Section 6(a), is really quite different, and notwithstanding the fact that the 2002 ISDA version was meant to address the many and varied complaints levelled by market practitioners at the 1992 ISDA we still find the 1992 version in use in the occasional market centred in unsophisticated rural backwaters like, oooh, I don’t know, New York.

Those with a keen eye will notice that, but for the title, Section 6(a) of the 2002 ISDA is the same as Section 6(a) of the 1992 ISDA and, really, not a million miles away from the svelte form of Section 6(a) in the 1987 ISDA — look on that as the Broadcaster to the 1992’s Telecaster.
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Summary

Everyone’s hair will be on fire

This is likely to be a time where the market is dislocated, your credit officer is running around with her hair is on fire, your normally affable counterparty is suddenly diffident or evasive, and your online docs database has crashed because everyone in the firm is interrogating it at once.

This is also one time the commercial imperative will count for little, since you are terminating your trading relationship altogether and with extreme prejudice. Your normally iterated game of prisoner’s dilemma has turned into a single round game. Game theorists among you will know immediately that the calculus is therefore very different, and much, much less appealing.

So: good luck keeping your head while all around you are losing theirs.

Close-out sequence

Once you have designated an Early Termination Date for your ISDA Master Agreement, proceed to 6(c) to understand the Effect of Designation. Or learn about it in one place with the NC.’s handy cribsheet, “closing out an ISDA”.

The Notices provisions in Section 12 are relevant to how you may serve this notice. In a nutshell, in writing, by hand. Don’t email it, fax it, telex it, or send it by any kind of pony express or carrier pigeon unless your pigeon/pony is willing to provide an affidavit of service.
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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, you will need:

(i) a Failure by the Defaulting Party to make a payment or delivery when due;
(ii) a notice by the Non-Defaulting Party under Section 6(a) to the Defaulting Party that the failure has happened and designating an Early Termination Date, no more than twenty days in the future.
(i) The standard grace periods are set out in Section 5(a)(i). Be careful here: 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.
(ii) 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).
(iii) At the expiry of this grace period, you finally have a fully operational Event of Default. Now Section 6(a) gives you the right, by not more than 20 days’ notice[2] to designate an Early Termination Date for all outstanding Transactions. So, at some point in the next twenty days.
(iv) For this we go 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. For it not to be (i.e., 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.

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For details freaks

“by not more than 20 days’ notice

What is the significance of the maximum notice period of 20 days that one may use to close out the ISDA Master Agreement? Poor defaulted Counterparty is in pieces, on its knees, bleeding out, but really, as long as it gets some notice, does it really care how much? Surely, the longer the period, the more hope you have? While the agreement remains in termination but un-terminated, en route to that crater in the ground but not there yet — the chance remains, however remote, that things will come right; that you, its counterparty, will see sense, or unexpectedly discover the one compassionate bone in your body that, until now, has gone wholly unnoticed and, in a cloying bout of clemency, will change your mind and withdraw your notice of termination? Well, a little hedge fund can dream, can’t it? So why deprive it, and yourself, of that option?

Now, this is deep ISDA lore. It is of the First Men[6] — yea, even the Children of the Forest. As such — since they didn’t have a written tradition back in 1986 and legends were passed down orally from father to son[7] and much has been lost to vicissitude and contingency — it is not a subject on which there is much commentary: That dreadful FT book about derivatives sagely notes that, usually, much less notice is given than 20 days (I mean, you don’t say) but doesn’t give a reason for this curious outer bound, in the same way it doesn’t give a reason for much else in the ISDA Master Agreement despite costing a monkey and that being its express purpose. Nor, for that matter, does the official ISDA User’s Guide to the 2002 ISDA Master Agreement.

One is just expected to know. Yet, in point of fact, no-one seems to. And no-one wants to risk looking stupid by asking, right? Well, companions, just not knowing is not how we contrarians roll. We like looking stupid. Compared with plain old ignorance, it speaks to having at least put in some effort, even if wasted: noble but futile toil is flattering in some lights. So, in the absence of a credentialised, plausible reason,[8] let us speculate.

Remember the ISDA Master Agreement was invented by banking folk: people who who view the Cosmos chiefly through the prism of indebtedness[9]. A lender whose borrower has defaulted will not dilly dally: she will bang in a default notice and seize whatever assets she can get her hand in poste haste. I lend, you owe. I don’t muck about. Breakage costs on a loan are easy to calculate and they are not especially volatile. There is nothing to be gained by waiting around: The longer I take to terminate my exposure , the larger it is likely to be.

But, but, but. ISDAs are different. They are not, principally,[10] a contract of indebtedness, and while a large uncollateralised mark-to-market exposure[11] is economically the same as indebtedness, the contract is bilateral, and who is indebted at any time is dependent on the net exposure: it can and does swing around.

Also, the mark-to-market exposure on swap transaction is a wildly volatile thing: With a loan, less so: you know you have (a) principal, (b) accrued interest and (c) break costs — the last of which might be significant for a long term fixed rate loan[12], but generally will pale in comparison to the principal sum owed.

So a swap counterparty who terminates might be out of the money, and disinclined to terminate just now, hoping that a more benign market environment might be just around the corner to dig it out of its hole so that when it does pull its trigger, the Close-Out Amount will be favourable. This is still taking quite the market punt on a bust counterparty — by means of a European option[13] — of course, and not the sort of thing a prudent risk manager would do[14], but I don’t suppose banking folk can be expected to have understood this in 1986.

Actually, even that makes little sense, since such a counterparty wouldn't be obliged to close out at all, but could just suspend its obligations under Section 2(a)(iii) — something which it can (or could, at any rate, when the notice period was devised, in 1987) do indefinitely. To be sure, a 2(a)(iii) suspension is just that — a suspension; should one come eventually to terminate the Transaction, those as-yet unperformed obligations will come back to haunt you as Unpaid Amounts, but at least here you retain control of the process and timing of close-out: it is an American option, not a European one. If you see the market moving against you, you can cash in your chips. So, ask yourself which is a bigger punt: that, the mark-to-market value you determine in 20 days — in a market that is likely to be a flaming wreck, by the way — better suits your book than the one you can actually trade on today, or on any day between now and that distant Early Termination Date?

So we get back to an alternative, disappointing explanation: It is just flannel.
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See also

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References

  1. 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.
  2. See discussion on at Section 6(a) about the silliness of that time limit.
  3. Or their equivalents under the 1992 ISDA, of course.
  4. See previous footnote.
  5. 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”.
  6. I know, I know — or women, but that spoils the Game of Thrones reference, you know?
  7. See footnote 1 and/or get a life.
  8. And we have done our due diligence, you know: in coming to this conclusion the JC has consulted Magic circle law firm partners, managing directors, inhouse GCs and even a former general counsel of ISDA, all of whom swore me to secrecy but were as nonplussed as, let’s face it, you are about this baffling clause.
  9. Hence, a Cross Default clause in the ISDA Master Agreement. Well — can you think of another reason for it?
  10. This gag comes to you direct from our “here all week, folks!” store of corking one-liners.
  11. Such as the sort you could have if it were 1987 and the credit support annex hadn't been invented.
  12. But are there such things in this day and age? Serious question.
  13. A correspondent writes pointing out — quite correctly — that, once an Event of Default has happened, the option to send a 6(a) Notice is American. So it is — thanks to Section 2(a)(iii), a potentially open ended one — until you convert it into something like a European option by sending the notice and specifying a date in the future on which it takes place.
  14. The silly FT book is right about this, to be fair.