Template:Failure to pay procedure
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 {{{{{1}}}|Failure to Pay or Deliver}} under Section {{{{{1}}}|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 {{{{{1}}}|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 “{{{{{1}}}|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 {{{{{1}}}|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 {{{{{1}}}|5(a)(i)}}
A {{{{{1}}}|Failure to Pay or Deliver}}, by the {{{{{1}}}|Defaulting Party}} to make a payment or delivery when due on day T. This is not, yet, an {{{{{1}}}|Event of Default}} under Section {{{{{1}}}|5(a)(i)}}. But we are on the way.
2. You must give notice of the failure under Section {{{{{1}}}|5(a)(i)}}
The {{{{{1}}}|Non-defaulting Party}} must give the {{{{{1}}}|Defaulting Party}} notice of the failure. This is not a Section {{{{{1}}}|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 {{{{{1}}}|12}} cautions that it may not be by e-mail or {{{{{1}}}|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.[1]
Since payments and deliveries are generally due at close of business on a given day, Q.E.D., a Section {{{{{1}}}|5(a)(i)}} notice of {{{{{1}}}|Failure to Pay or Deliver}} can usually only be given after close of business on the due date.
Thanks to Section {{{{{1}}}|12(a)}} ({{{{{1}}}|Notices}}), the Section {{{{{1}}}|5(a)(i)}} notice will only be effective on the following {{{{{1}}}|Local Business Day}}: i.e., T+1. [2]
3. You must allow the grace period under Section {{{{{1}}}|5(a)(i)}} to expire
At this point you have a {{{{{1}}}|Potential Event of Default}}, but not an actual one.
Once your Section {{{{{1}}}|5(a)(i)}} notice of {{{{{1}}}|Failure to Pay or Deliver}} is effective, the {{{{{1}}}|Defaulting Party}} has a “grace period” in which it sort itself out and make the payment or delivey and head off an Event of Default.
The standard grace periods are set out in Section {{{{{1}}}|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 {{{{{1}}}|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 {{{{{1}}}|LBD}}s, for example.
So: once you have a clear, notified {{{{{1}}}|Failure to Pay or Deliver}}, you have to wait at least one and possibly three or more {{{{{1}}}|Local Business Day}}s before doing anything about it. Therefore you are on tenterhooks until the close of business T+2 {{{{{1}}}|LBD}}s (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 {{{{{1}}}|6(a)}} notice designating an {{{{{1}}}|Early Termination Date}}
At the expiry of the Section {{{{{1}}}|5(a)(i)}} grace period, you finally have a fully operational {{{{{1}}}|Event of Default}}. Now Section {{{{{1}}}|6(a)}} allows you, by not more than 20 days’ notice[3] to designate an {{{{{1}}}|Early Termination Date}} for all outstanding Transactions.
So, at some point in the next twenty days[3] there will be a final reckoning and one Party will pay the other the Early Termination Amount.[4]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 {{{{{1}}}|Transactions}}.
5. Determine {{{{{1}}}|Close-out Amount}}s[5]
One must now ascertain termination values for the {{{{{1}}}|Terminated Transaction}}s as of the Early Termination Date per the methodology set out in Section {{{{{1}}}|6(e)(i)}}.
Now armed with our crystalised {{{{{1}}}|Failure to Pay or Deliver}} {{{{{1}}}|Event of Default}} and with an {{{{{1}}}|Early Termination Date}} to target, we go directly to Section {{{{{1}}}|6(e)}}, noting as we fly over it, that Section {{{{{1}}}|6(c)}} reminds us for the avoidance of doubt that even if the {{{{{1}}}|Event of Default}} which triggers the {{{{{1}}}|Early Termination Date}} evaporates in the meantime — these things happen, okay? — yon {{{{{1}}}|Defaulting Party}}’s goose is still irretrievably cooked.[6]
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 {{{{{1}}}|Transaction}}s. Once they have done that you are ready for your Section {{{{{1}}}|6(e)}} notice.
6. Pay your {{{{{1}}}|Early Termination Amount}} on the {{{{{1}}}|Early Termination Date}}
Your in-house metaphysicians having calculated your Close-out Amounts,[5] you must assemble all the values into an Early Termination Amount.[7] This must be paid on that day you selected way back in step 4, when you designated an {{{{{1}}}|Early Termination Date}}.
- ↑ Yes, it’s true: in ISDA’s alternative universe, e-mail and electronic messaging systems are different things.
- ↑ 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.
- ↑ 3.0 3.1 See discussion on at Section 6(a) about the silliness of that time limit.
- ↑ By a striking oversight, not actually so named in the 1992 ISDA.
- ↑ 5.0 5.1 Or their equivalents under the 1992 ISDA, of course.
- ↑ 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.
- ↑ 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”.