Recent events in the financial markets have highlighted the importance of parties to a 1992 Master Agreement1 understanding the termination mechanics following an event of default. It is now more vital than ever for the Non-defaulting Party to have a clear and effective close-out mechanism to replace the terminated derivative transaction as quickly as possible.2 In contrast to a Termination Event, which may be triggered without the fault of either party and is designed to close out a Transaction following an event that substantially alters the Transaction's economic profile, an Event of Default arises where the fault of a party triggers termination. The purpose of this article is to briefly examine the consequences of an Event of Default and the subsequent process by which the Non-defaulting Party can terminate an Agreement.
Events of Default
Generally, Section 5(a) of the Agreement provides that an Event of Default will be triggered upon the occurrence of any of the following events:
- Failure to make payments when due;
- Failure to comply with the terms of the Agreement;
- Failure to comply with any collateral obligations pursuant to a Credit Support Document;
- The making of any material misrepresentation;
- Default under any derivative transaction between the Non-defaulting Party and (i) the other party or (ii) any Credit Support Provider or Specified Entity of the other party;
- A default under any agreement relating to borrowed money between a third party and (i) a party or (ii) its Credit Support Provider or any Specified Entity;
- The occurrence of a merger where the rights and obligations of the merging party are not assumed by the merged entity; and
- A bankruptcy filing or other insolvency event with respect to (i) a party or (ii) its Credit Support Provider or a Specified Entity.
Designating an Early Termination Date
Upon the occurrence of an Event of Default, no further performance is required by either party and the Non-defaulting Party can designate a date (the "Early Termination Date") for termination of all outstanding Transactions under the Agreement by providing notice to the Defaulting Party pursuant to Section 6(a) of the Agreement. 3, 4 Such notice must specify the relevant Event of Default and designate an Early Termination Date, which cannot be a date (i) earlier than the effective date of the notice or (ii) later than 20 days following such effective date. Once notice of the designation of an Early Termination Date becomes effective, outstanding derivatives are terminated regardless of whether the Defaulting Party is still in default. The effective date of the notice is established by the form of its delivery.5
Statement of Amounts Payable
"On or as soon as reasonably practicable following the occurrence of an Early Termination Date" each party shall provide to the other party a statement of amounts payable under the Agreement and calculations showing how such amounts were determined.6 The payment calculation will be a function of the parties' choice of (i) two methods of payment and (ii) two methods of valuation, each of which are elected at the outset of the Agreement. With respect to payment, parties may either opt for the "First Method" in which payments, if any, are only made to the Non-defaulting Party, regardless of whether the Defaulting Party would otherwise be entitled to any payments, or the much more popular "Second Method" in which payments are made to whichever party would otherwise be entitled to receive such payments (in which case it is possible for the Defaulting Party to receive payments upon termination).
Market Quotation and Loss
The parties either opt for "Market Quotation," a regime in which the amount of any payments is equal to the future replacement value of the Terminated Transactions, as determined by the Non-defaulting Party, or "Loss," in which case the amount of any payments to a party is equal to the amount of loss suffered by such party as a result of the Agreement and its termination.
Where Market Quotation is selected, the value of any payments due is calculated by reference to Market Quotations solicited from so-called "Reference Market-makers" in the relevant market. As soon as practicable allowing the Early Termination Date, each solicited Reference Market-Maker provides its quotation of the value of payments that would be made to the Non-defaulting Party (which amounts may be negative) had the Event of Default not occurred. If more than three quotations are received, the Market Quotation will be the arithmetic average after disregarding the highest and lowest quotations. If three quotations are received, the highest and lowest quotations will be disregarded and the Market Quotation will equal the remaining quotation. If fewer than three quotations are received, the parties will calculate the value of any payments based on the Loss regime.
For Agreements where market quotation has been selected, any amounts that had become payable to either party on or prior to the early termination date but remain unpaid as of such date (such amounts, "Unpaid Amounts") are included in the determination of the Market Quotation only to the extent that all conditions precedent to the payment of such amounts were satisfied as of the relevant Early Termination Date.
Under the Loss regime, each party makes a good faith determination of its total losses and costs (which may be negative) incurred in connection with the Terminated Transaction(s). This determination includes loss of bargain, cost of funding, losses and costs incurred in respect of any payment or delivery required to have been made on or before the relevant Early Termination Date, and, at the election of the parties, may also include losses or costs incurred as a result of termination of the Transaction(s), including liquidation and hedging costs. Loss does not include legal fees and out-of-pocket expenses. The Agreement provides that a party should determine its Loss as of the Early Termination Date, or if not reasonably practicable, as soon as reasonably practicable thereafter. Finally, a party may, but is not required to, calculate the amount of such loss by reference to quotations provided by one or more dealers.
The amount due will become due and payable as of the date notice of such amount is deemed effective pursuant to Section 12(a) and interest will accrue on any such amount from the Early Termination Date to (but excluding) the date such amount is paid. Such interest is compounded daily and will be calculated based on the Applicable Rate.7
A Hypothetical Example
The following hypothetical example of an option transaction based on the Assumptions provided illustrates the vast differences that might result from the application of a Market Quotation or Loss regime following a termination.
If Market Quotation applied, the $90 average of the quotations provided
by Reference Market-Makers (excluding the highest and lowest quotation) would be the basis for the amount due to the Non-defaulting Party and the $25 unpaid amount could be added. If Loss was applicable, the Non-defaulting Party could base its calculation on the total losses and costs incurred in connection with the Transaction, including the cost of unwinding the hedge ($10), the valuation of the Transaction ($120), the lost value of funding remaining to maturity ($10) and the Unpaid Amount ($25). The difference between the $115 available under the Market Quotation regime and the $165 resulting from the application of the Loss determination highlights the fact that the amount payable following a termination could vary significantly depending upon the elections of the parties.
Set-Off Provisions
Often parties include a Set-off clause in their Agreement for payments following a default. Payments due in respect of an Early Termination Date will be subject to Set-off against (i) amounts payable under certain other transactions between the parties and (ii) collateral held or posted under the agreement.8 These provisions may be subject to differing treatment in different jurisdictions and may be adjusted pursuant to any applicable bankruptcy or insolvency law. Moreover, a proper calculation of Set-off may have the effect of delaying the process of delivering Section 6(e) statements as a fair amount of calculations and analysis are required by the party seeking to enforce its Set-off rights. As a result, these provisions and their application should be carefully reviewed by counsel.
Conclusion
All told, the mechanics of termination following an Event of Default should become an even more important part of ISDA related transactions in the coming months. As such, ISDA counterparties and their advisors should carefully review their existing ISDA infrastructure and the mechanics of the ISDA Master Agreement to be better prepared to effectively handle terminations following Events of Default.
1 This article concerns itself with the terms of the 1992 Master Agreement as published by the International Swaps and Derivatives Association, Inc. Capitalized terms used and not defined herein will have the meaning ascribed to them in the 1992 Master Agreement. The authors note that the 2002 version differs substantially with respect to the mechanics of close-outs following Events of Default. The provisions of the 2002 Master Agreement will not be described in this article.
2 See generally, Paul C. Harding, MASTERING THE ISDA MASTER AGREEMENT, (Prentice Hall 2002) at 77.
3 Termination is not the exclusive remedy available following an Event of Default. Section 9(d) of the Master Agreement presumably allows an innocent party to sue for damages, including specific performance.
4 Once an Early Termination Date is designated, it can only be cancelled with the consent of both parties.
5 Section 12(a) of the Agreement details the effectiveness of notice for various forms of delivery.
6 See generally, Section 6(d) of the Master Agreement.
7 The "Applicable Rate" is a function of whether the obligation is payable or deliverable by the Defaulting Party or the Non-defaulting Party on the one hand, and the timing of when such payments or deliveries are due on the other.
8 As the User's Guide to the 1992 Master Agreement makes clear, without an effective Set-off clause, the Non-defaulting Party may not have any "realistic expectation of receiving payments owed to it by the Defaulting Party (and its Affiliates) under other agreements." This concern must be weighed, however, against the possibility that a broad Set-off right might be relied upon by a counterparty withholding payment pending settlement of an unrelated dispute with one of its Affiliates. See User's Guide to the 1992 Master Agreement (International Swaps and Derivatives Association, Inc., 1993 ed.) at 54.
Assumptions:
Unpaid Amount due to the Non-defaulting Party: $25
Cost of unwinding hedge: $10
Non-defaulting Party valuation of Transaction: $120
Value of funding remaining to maturity: $10
Average of four quotations from Reference Market-makers: $100
Average of two quotations (excluding high and low): $90
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