Set-off - ISDA Provision
2002 ISDA Master Agreement
Section 6(f) in a Nutshell™
Full text of Section 6(f)
Related agreements and comparisons
Content and comparisons
ISDA published a suggested set-off provision in the Users Guide but no-one liked it, and several bespoke versions developed and percolated around the market. These often provided for the inclusion of Affiliates in relation to the Non-defaulting Party or Non-affected Party.
ISDA’s crack drafting squad™ got the hint and implemented a fully-fledged set-off provision based on this language into the 2002 ISDA — but not without a little boo-boo. You can read all about it, and the boo-boo, and what people have done to fix it, at our article about that Section 6(f) Set-off provision.
One does not exercise a set-off right willy nilly. Unless one is, mutually, settlement netting (where on a given day I owe you a sum, you owe me a sum, and we agree to settle by one of us paying the other the difference) set-off is a drastic remedy which will be seen as enemy action. You would not do it, without agreement, to any client you expected to keep. So, generally, use set-off as a remedy it only arises following an event of default.
A bit of a bish in the 2002 ISDA
Set-off in the 2002 ISDA borrows from the text used to build it into the 1992 ISDA (see below) but still contains a rather elementary fluff. It imagines a world where the Early Termination Amount is payable one way, while all Other Amounts are only payable the other. Life, as any fule kno, is not always quite that convenient.
- Payer owes Payee an Early Termination Amount of 10
- Payer owes Payee Other Amounts of 40
- Payee owes Payer Other Amounts of 50
Not ideal. But fixable if you’re prepared to add some dramatically anal language:
- 6(f) Set-Off. Any Early Termination Amount (or any other amounts, whether or not arising under this Agreement, matured, contingent and irrespective of the currency, place of payment of booking of the obligation)” payable to one party (the “Payee”) by the other party (the “Payer”), ...
Red letter day for ISDA’s crack drafting squad™
Whatever else you might have to say about ISDA’s set off provision — and as this page demonstrates, there’s quite a bit to say — one thing that stands out is how appallingly drafted it is.
The expression, “in circumstances where there is a Defaulting Party or where there is one Affected Party in the case where either a Credit Event Upon Merger has occurred or any other Termination Event in respect of which all outstanding Transactions are Affected Transactions has occurred” will make your head spin, but it is meant to strike two contingencies: All Transactions are being terminated, and one Party is at fault.
The ’squad’s own pedantic approach to drafting, which separates Events of Default from Termination Events, and labels the perpetrators differently (“Defaulting Party” for the former; “Affected Party” for the latter, is to blame here.
In any case one would only impose Section 6(f) set off where your counterparty has gone fully tetas arriba and you have terminated all Transactions. In any other cases you would effect set-offs by mutually-agreed-at-the-time payment netting, which does not require any pre-existing legal right.
The 2002 ISDA’s Set-off provision refers to a “Payer” and “Payee”. Since either the “Payer” or the “Payee” could be the Innocent Party, including Affiliates into the 2002 definition becomes problematic and cumbersome.
Generally, market practice is therefore to do the following:
- Where Affiliates are required: to use bespoke wording.
- Where Affiliates are not required: use the 2002 ISDA standard set-off wording above.
But cross affiliate set-off is a pretty rum affair in any case. Generally, set-off requires mutuality of payment, currency, time and counterparty, so setting off between affiliates is liable to challenge anyway (unless you have cross-guarantee arrangements). And in these modern days of bank recovery and resolution, conjoining claims between entities which are supposed to be siloed and independent isn’t really the thing.
Scope of Set-off
The 2002 ISDA set-off wording allows set-off following an Event of Default, CEUM, or any other Termination Event where there is one Affected Party and all outstanding transactions are Affected Transactions.
Often brokers will also want to set-off where there is an Illegality or ATE. There is no specific reference to all Transactions being Affected Transactions but this is implied in any set-off provision by its nature:
- If only some transactions are Affected Transactions and so only a portion of outstanding Transactions are being terminated then there is an on-going relationship and unilateral set-off is not appropriate.
- i.e., if you weren’t terminating all Transactions, it would be drastic and counterproductive to a relationship to use a set-off.
- As such, the Tax Event and Tax Event Upon Merger provisions (those not caught by your wording) are more likely to only affect certain transactions and not all Transactions and therefore set-off is not likely to be relevant in such instances.
- Force Majeure: The 1992 ISDA contains no Force Majeure provision. Commercially, it is not likely that an ISDA Master Agreement would be closed-out as a result of a Termination Event as these are generally viewed as non-fault and set-off would generally not be relevant.
- Illegality does allow either party to terminate but this is limited to all Affected Transactions which may not result in a close-out of the entire ISDA Master Agreement. In fact, the definition used of Affected Transactions makes it clear that in the cases of Illegality, Tax Event Upon Merger or Tax Event then it will only be transactions affected by the Termination Event that are closed-out. In relation to ATEs and CEUM this will be all Transactions and so set-off is relevant.
For details freaks
Bespoke wording to capture affiliate set-off
If you are the “live-dangerously” sort who wants to capture cross-affiliate set off, try amending the first line of Section 6(f) to read as follows:
6(f) Set-Off. Any
Early Termination Amountamounts, whether or not arising under this Agreement, matured, contingent and irrespective of their currency, place of payment or booking payable to one party or its Affiliates, if it is the Non-defaulting Party or Non-affected Party (the “Payee”) by the other party or its Affiliates, if it is the Non-defaulting Party or Non-affected Party (the “Payer”), in circumstances where there is a Defaulting Party or where there is one Affected Party in the case where either a Credit Event Upon Merger has occurred or any other Termination Event in respect of which all outstanding Transactions are Affected Transactions has occurred, will, at the option of the Non-defaulting Party or the Non-affected Party, as the case may be (“X”) (and without prior notice to the Defaulting Party or the Affected Party, as the case may be), be reduced by its set-off against any other amounts (“Other Amounts”) payable by the Payee to the Payer (whether or not arising under this Agreement, matured or contingent and irrespective of the currency, place of payment or place of booking of the obligation).
From the prose stylist’s point of view this is quite the monstrous contraption. But the “ISDA way” leads us to this outcome.
So what are we trying to say here, and is there a better way of saying it?
Firstly, we are talking only about situations where there is a catastrophic, credit-induced close-out of the whole ISDA — one that precipitates the total breakdown of the relationship between the parties. In any other case neither party would use a mandatory set-off.
Secondly, the Innocent Party — the JC made this term up, by the way, but it is useful — is the one who is bringing its own Affiliate rights and liabilities into the frame for set-off. It cares not one whit for the Guilty Party, which is presently smoking hulk straddling the median strip, remember, much less any of its Affiliates (who are most likely similarly indisposed).
So how might we say this, given a fresh piece of paper?
6(f) Set-off: Following the designation of an Early Termination Date for all Transactions where there is one Innocent Party, that party may, by notice, set-off any Payables it owes against any Payables the other party owes the Innocent Party, converting currencies if necessary and estimating unascertained obligations in good faith, but accounting for any difference between its estimate and the amount when it is finally ascertained. In this clause:
“Innocent Party” means a Non-defaulting Party or a Non-affected Party, as the case may be and, when determining any Payables owed by or to such a party, includes its Affiliates.
“Payable” means any amount owed by the party in question, whether or not arising under this Agreement, matured or contingent and irrespective of its currency, place of payment or booking.