Template:M summ 2002 ISDA 6

No general “no-fault” termination right under the ISDA

Unlike the 2010 GMSLA and many other — ahh, less sophisticated master agreements — the ISDA Master Agreement doesn’t have a general termination right of this sort at all. It is like one of those fancy fixie pushbikes that cost seven grand and don’t even have brakes. You can only terminate Transactions, not the master agreement construct which sits around them. The empty vessel of a closed-out ISDA thus remains for all eternity as an immortal, ineffectual husk. This is to do with paranoid fears about the efficacy of the ISDA’s sainted close-out netting terms if you do terminate the agreement — meh; maybe — but I like to think it is because, before he was cast out from heaven, the Dark Lord made plans to unleash his retributive fury upon the world through a sleeping army of wight-walker zombie ISDAs, doomed to roam the earth until the day of judgment, apropos nothing but there, not alive, but un-dead, ready to reanimate and rally to the Dark Lord’s banner and rain apocalyptic hell on we errant descendants of the Good Man, who did not heed His warnings of financial weapons of mass destruction.

How the close-out mechanism works

It’s optional ...: An Event of Default gives the “Non-defaulting Party” a right (but not an obligation) to designate an Early Termination Date with respect to all outstanding Transactions on not more than 20 days’ notice.

... Unless AET applies: Where Automatic Early Termination applies to a party (being jurisdiction-dependent, it often will only apply to one party) the Non-defaulting Party loses its optionality should the Event of Default be Bankruptcy: all Transactions automatically terminate whehter you want them to or not, and whether you realise it or not. This is plainly sub-optimal from a Non-defaulting Party's perspective. You should therefore only switch on AET if you are sure you need it (e.g. for counterparties in jurisdictions where close-out netting may fail in an insolvency, but not before). Being sure generally means “having a netting opinion telling you netting does not work without it.” In other words, AET is one provision you should not insist on just because the other party insists upon it against you).

Not triggering an Event of Default can be controversial: For what this optionality not to terminate means, and how controversial it can be, see the commentary to Section 2(a)(iii).

Once all Transactions are terminated, you move to Section 6(e) which directs how to value the Transactions (it depends on who is the Defaulting Party, and whether you have elected Loss or Market Quotation, and First Method or Second Method. Under the 2002 ISDA it is much easier.

Section 6(a)

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 on fire, your normally affable counterparty is suddenly diffident, evasive, or strangely just not picking up the phone, and your online master agreement database has crashed because everyone in the firm is interrogating it at once. The sense of dreary quietude in which your Master Agreement was negotiated will certainly not prevail. Bear this in mind when negotiating. For example, the elaborate steps your counterparty insists on for your sending close-out notices, to fifteen different addresses, in five different formats and with magic words in the heading, will really trip your gears, especially if some of those methods are no longer possible. There is an argument that some buy-side counterparties complicate the formal process of closing out specifically to buy time and deter their dealers from pulling the trigger. It is a pretty neat trick, if so: you can expect the dealer’s credit department to puke all over a margin lockup, but a bit of fiddling around the edges of a Notices section? Sure, whatever.

Bear in mind, too: this is one time the commercial imperative will count for nothing. This is it: literally, the end game. If you close out there is no business: you are terminating your trading relationship altogether with extreme prejudice. The normal iterated game of prisoner’s dilemma has turned into a single round game. Game theorists will realise at once that the calculus is 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.

Section 6(b)

There is a difference between Termination Events that are non-catastrophic, and usually Transaction-specific, and those that are catastrophic, which are usually counterparty specific.

Non-catastrophic ones affecting just a subset of Transactions might be caused by, say, a Tax Event or a local Illegality, but in any weather do not concern the solvency, creditworthiness or basic mendacity of your counterparty. They generally won’t have much, directly, to do with your counterparty at all beyond the jurisdictions it inhabits and the laws it is subject to. These are generally the Termination Events, but not Additional Termination Events.

The catastrophic ones are by their nature affect — that is, “Affect” — all Transactions. These generally are the bespoke Additional Termination Events your credit department insisted on — or theirs did; they will have something to do with the naughtiness of lack of fibre of your counterparty (or you!), and these function for most respects a lot more like Events of Default.

Thus, in the drafting of ISDA Schedules, CSAs and so on, you will often find laboured reference to Events of Default and/or Termination Events which lead to Early Termination Dates with respect to all outstanding Transactions as some kind of special, hyper-exciting, class of Termination Event.

Lucky premium content subscribers get a lot more discussion about the practical implications of all the above and a table comparing the events.

Section 6(c)

Once you have designated your Early Termination Date under Section 6(a), proceed directly to Section 6(e) to determine the Close-out Amount (if you are under a 2002 ISDA, or “tiresomely unlabelled amount payable upon early termination of the ISDA Master Agreement” if you a labouring under a 1992 ISDA).

The key thing to observe here is that, suddenly, all Transactions vanish, and all payments and deliveries due under them are suspended, to be replaced by the single Close-out Amount per Transaction, which is then subsumed into the Early Termination Amount for the whole agreement. Note the Close-out Amount does not have an independent existence as a payable amount owed by any party at any point: it is simply a calculation one makes, by reference to a now extinguished Transaction, on the way to determining the whole-agreement Early Termination Amount. This is why a Transaction-specific guarantee is a flawed type of Credit Support Document — at the very point you call upon it, the Transaction will vanish.

Section 6(d)

Section 6(d) is to do with working out the termination value of Transactions for which you’ve just designated an Early Termination Date (or, in the 1992 ISDA, the thing you wished they’d defined as an Early Termination Date).

Under the ’92 one uses Loss and Market Quotation, and all that Second Method malarkey, and in the 2002 ISDA the much neater and tidier Close-out Amount concept.

Generally, this is good fat-tail paranoia material, so once upon a time parties used to negotiate it heavily. General SME-drain from the negotiation talent pool over the years due to vigorous down-skilling means people are less fussed about it now.

A popular parlour game among those pedants who still insist on using the 1992 ISDA — or, in fairness, are forced to by some other pedant further up their chain, or a general institutional disposition towards pedantry — is to laboriously upgrade every inconsistent provision in the 1992 ISDA to the 2002 ISDA standard except the one provision of the 1992 ISDA they always liked — if the pedant is in question is from the Treasury department, that will be the longer grace period in the Failure to Pay; if she is from Credit, it absolutely won’t be.

You might well ask why anyone would be so bloody-minded, but then you might well ask why anybody watches films from the Fast and Furious franchise. Because they can.

Or, possibly, to preserve the slightly more generous grace periods for Failure to Pay (three days in the 1992 ISDA versus one in the 2002 ISDA) and Bankruptcy (thirty days in the 1992 ISDA versus 15 in the 2002 ISDA) in which case, you’d retrofit longer grace periods into the new version, wouldn’t you? But no).

Section 6(e)

For our step-by-step guide to closing out an ISDA Master Agreement see Section 6(a).

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.

(Want to see how awful the 1992 is? Go here).

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.

...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.

That would be a bummer. Further commentary on the Guarantee page.

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

Regrettably, the 1992 ISDA features neither an Early Termination Amount nor a Close-out Amount. The 2002 ISDA has both, which looks like rather an indulgence until you realise that they do different things.

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 Transaction 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 after the close-out process. (See Section 6(e)(i) for more on that).

Section 6(f)

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 but still contains a rather elementary fluff-up: it imagines a world like our own, but 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.

For example:

Payer owes Payee an Early Termination Amount of 10 Payee owes Payer Other Amounts of 50 Net: Payee owes Payer 40.

But what if there are Other Amounts payable the same way as the Early Termination Amount?

Payer owes Payee an Early Termination Amount of 10 Payer owes Payee Other Amounts of 40 Payee owes Payer Other Amounts of 50 Net: Payee owes Payer 40. Whoops: Payee is still owed 40 by Payer so is an unsecured creditor '

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”), ...