Today, many parties to derivatives contracts are grappling with how to manage their exposure to counterparties in financial difficulty. Parties may have more choices than they first think.
This note considers the most important rights under the 1992 and 2002 ISDA Master Agreements. Section references apply to both the 1992 ISDA MA (multicurrency – cross border) and the 2002 ISDA MA. We do not consider other OTC trading agreements, although many of the same issues will arise. Nor 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 includes a range of insolvency-related “Events of Default”. These include a situation where a 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 or insolvency law or becomes subject to the appointment of an administrator.
Accordingly, companies in administration in the UK will be subject to an Event of Default for these purposes. Similarly, a filing by a party or its credit support provider (that is, any entity specified as such in the related ISDA MA) 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) – condition precedent
Under Section 2(a)(iii) of the ISDA MA, the duty of a party to pay under a “Transaction” is subject to the condition that no “Event of Default” or “Potential Event of Default” with respect to the other party has occurred and is continuing. Accordingly a non-defaulting party is contractually entitled to suspend payments to a defaulting counterparty. It is equally entitled to suspend deliveries and redeliveries of credit support to the defaulting counterparty under an ISDA Credit Support Annex. However, there is no English case law on the operation of Section 2(a)(iii) in an insolvency situation. So, a nondefaulting 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 under Section 6 of the ISDA MA to serve a notice and close out all Transactions entered into under the ISDA MA. However if:
- the schedule to the ISDA MA applies “Automatic Early Termination” to the defaulting party; and
- the Event of Default is one of those insolvency-related events that fall within the scope of Automatic Early Termination,
then all Transactions under the ISDA MA will have automatically terminated on the occurrence of the Event of Default.
A contractual close-out (whether following automatic termination or termination by notice) under Section 6 of the ISDA MA will result in a payment valuation. This will capture:
- accrued sums due and payable (but unpaid) from one party to the other;
- sums that would have become due before the early termination date but for their suspension pursuant to Section 2(a)(iii); and
- a calculation (whether on a “Market Quotation”, “Loss” or “Close-out Amount” basis) that goes to assessing the net present value of the future obligations of each of the parties under the terminated Transactions.
The close-out values of all the terminated Transactions are netted. Where the parties:
- have used a 1992 ISDA MA and specified “Second Method”; or
- used 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. Even if the nondefaulting party is out-of-the-money on a net basis it still must pay.
What to do?
Where a party has the choice whether or not 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;
- the maturity and volatility of the portfolio of Transactions as well as their collateralisation; 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 the collateral supporting them) but in some circumstances this may not be the best course of action.
Another factor is that, if the Banking Bill, as currently drafted, becomes law, the resulting legislation may limit a party’s ability to exercise set-off rights against a bank in financial difficulty. To read an analysis of the Bill, click here