Today, many parties to derivatives transactions are grappling with how to manage their exposure to counterparties in financial difficulties, poring over the terms of the contracts in place between them. Parties may have more choices than they first think. In particular, they should not forget the common law rights that sit alongside written contractual rights.
This briefing considers the most important rights under the 1992 and 2002 ISDA Master Agreements (ISDA MAs) and briefly rights at common law. Section references apply to both the 1992 ISDA Master Agreement (multicurrency – cross border) and the 2002 ISDA MA. We do not consider other OTC trading agreements, although many of the same issues will arise. Neither do we consider exchange-traded derivatives where the applicable exchange and clearing default regime may also be relevant.
Events of Default – do they apply?
The ISDA MA “Events of Default” are specified in Section 5 and include a range of insolvency-related events. These include when the party or its Credit Support Provider “institutes or has instituted against it a proceeding seeking a judgment of insolvency or bankruptcy or any other relief under any bankruptcy of insolvency law” (Section 5(a)(vii) (4) of the 1992 ISDA MAs and Section 5(a)(vii)(4)(A) of the 2002 ISDA MA) or “becomes subject to the appointment of an administrator” (Section 5(a)(vii)(6)).
There is a waiting period that applies to the Section 5(a)(vii)(4) Event of Default, but this would not apply to proceedings which are instituted by the counterparty itself. Accordingly companies in administration in the UK will be subject to an Event of Default for these purposes. Similarly, the filing by a party or its Credit Support Provider (that is, any entity specified as such in the related ISDA Master Agreement) of a Voluntary Petition under Chapter 11 of the U.S. Bankruptcy Code would also give rise to an Event of Default.
Section 2(a)(iii) – conditions precedent
Where a party becomes subject to an “Event of Default” under the ISDA MA, the Non-Defaulting Party can choose to suspend scheduled payments and deliveries under the Transactions entered into under that ISDA MA. Under Section 2(a)(iii) of the ISDA MA, the duty to pay or deliver under a Transaction is subject to various conditions precedent. One of these is that no “Event of Default” or “Potential Event of Default” with respect to the other party has occurred and is continuing, and that no “Early Termination Date” has been effectively designated. The same provision also applies to the English law ISDA Credit Support Annex. Accordingly a Non-Defaulting Party is contractually entitled to suspend deliveries and redeliveries of credit support to a defaulting counterparty for so long as an Event of Default or Potential Event of Default is continuing. However one point to bear in mind is that there is no English case law on the operation of Section 2(a)(iii) in an insolvency situation. Accordingly, a Non-Defaulting Party should consider the possibility (and consequences) of any challenge by an insolvency official to the operation of these suspension rights.
Contractual close-out under ISDA MA: Section 6
Where a party becomes subject to an Event of Default, the Non-Defaulting party will usually also have the right to exercise (or not exercise) its rights under Section 6 the ISDA MA to serve a notice and close-out all Transactions entered into with the counterparty under that ISDA MA. However if:
- the Schedule to the ISDA MA applies “Automatic Early Termination” to the counterparty; and
- if the Event of Default is one of those insolvency-related events that falls within the scope of Automatic Early Termination,
then all Transactions under the ISDA Master Agreement will have automatically terminated. The ISDA MA will not support any continuing performance of these Transactions. Therefore when considering their rights, parties should consider whether or not “Automatic Early Termination” has been applied.
A contractual close-out (whether under automatic termination or termination by notice) under Section 6 of the ISDA MA will almost invariably result in a “two-way payment” valuation. This will capture:
- accrued sums due and payable from one party to the other;
- sums due from one party to the other that would have become due before the early termination date but for the failure of a condition precedent; and
- a calculation (whether on a “Market Quotation”, “Loss” or “Close-out Amount” basis) that goes to assessing the net present value of future obligations of each of the parties under the terminated Transactions.
Both parties get value for these amounts. The close-out values of the transactions are netted and, in the case of a 1992 ISDA MA under which “Second Method” has been specified and in all cases under a 2002 ISDA MA, the ISDA MA obliges the out-of-the-money party to pay the net balance to the in-the-money party. There is no walk away: even if the non-defaulting party is out-of-the-money on a net basis it still must pay.
Discharge of a contract at common law
In certain circumstances, parties may also have common law close-out rights. This is because (except where automatic termination applies), a party does not have to exercise its close-out remedies under the written contract terms. In addition, Section 9(d) of the ISDA MA makes clear that remedies are cumulative and not exclusive. However, whether or not these rights can be exercised, and their potential ramifications, will require careful analysis.
What to do?
Where a party has the choice whether to close-out under Section 6 of the ISDA MA, it may face a difficult decision. Various circumstances may come into play, including whether the party is in-the-money or out-of-the-money on the trades, and the maturity and volatility of the portfolio of transactions as well as their collateralization and the ability to obtain a valuation given market liquidity. Often, counterparties will close-out derivative transactions to crystallise the market risk in those transactions (and in collateral supporting them). This is particularly so where the party is out-of-the-money and there is enough liquidity for it to close-out its hedges to leave it flat. Fear of market risk will often prompt close-out if the party is in-the-money and adequately collateralized by the counterparty. In those circumstances the non-defaulting party may worry that market movements will leave a collateral shortfall.
However, if the party is not hedged or collateralized, there may be disadvantages to closing out. Waiting instead for grounds for other termination rights or the exercise rights under Section 2(a)(iii) to suspend performance may be preferable. However, there are risks in adopting such an approach, especially where a counterparty is insolvent. The party seeking to exercise its rights must take care not to waive them. In addition, it must not act too soon. An invalid termination at common law might entitle the other party to close-out under Section 6 of the ISDA MA (for example in the 2002 ISDA MA as a “repudiation” under Section 5(a)(ii) (2)). In short, you should carefully consider what is the best course of action available to you.