When a counterparty's credit comes into doubt, the first question is which events give grounds to end the trades early. The answer is in the master agreement.

Why the events exist

A master agreement such as the ISDA Master Agreement (a form published by the International Swaps and Derivatives Association (ISDA)) sets up a mechanism for close-out netting: when certain events that harm a counterparty's credit occur, the claims and obligations under the trades as of that time are settled together. Contractual events, such as an event of default, are what set this mechanism in motion. The settlement can be automatic or can happen at the other party's request, and the details are set by the master agreement1. Early termination here means that trades end before their scheduled date because of an event set out in the contract. It is different from mid-term cancellation, where a client ends a trade for its own reasons. The structure of master agreements is covered in The ISDA Master Agreement and Schedule.

Events need to be defined clearly and precisely. The examination manual of the US Federal Reserve Board (Section 2070.1, September 2002) says that special attention should be paid to the definition of the events (trigger events) that give the other party the right to end the trades. In Russia's 1998 debt moratorium, some contracts did not include a sovereign debt moratorium or restructuring among the events2.

Types of events

The events that appear in the sources fall into the following types. Which of them are treated as events depends on the contract.

Type Examples Examples in the sources
Insolvency Petition for bankruptcy, civil rehabilitation, or corporate reorganization; a Chapter 11 filing under the US Bankruptcy Code Petitions for bankruptcy, civil rehabilitation, or corporate reorganization are close-out netting events under Japan's Close-out Netting Act3. In the 2013 Tokyo High Court case, trades ended on a credit support provider's Chapter 11 filing4
Failure to pay or deliver Not paying on a settlement date In the 1997 Tokyo High Court case, a settlement amount went unpaid and the other party terminated the contract5. The examination manual also gives it as an example6
Deterioration in credit standing A rating downgrade, a worsening of financial condition, a merger The examination manual describes provisions that give rights to change terms or terminate on predetermined credit events6
Events affecting parties related to the counterparty Insolvency proceedings of a credit support provider or an affiliate The 2013 Tokyo High Court case (see the row above). The content of the US rule is covered below, in "Cross-default and affiliate set-off"

Events of deteriorating credit standing are also used as conditions for requiring collateral or tightening collateral terms, not only for the right to end the trades6. The mechanics of collateral are set in the Credit Support Annex (CSA).

From the event to the early termination date

After an event occurs, the process follows one of two forms, depending on the contract: a form in which the other party requests termination, and a form in which the trades terminate automatically when the event occurs, without any request. The date on which the trades end is called the early termination date1. In the case decided by the Supreme Court in 2016, the counterparty's US parent company filed for insolvency proceedings, and under the terms of the contract the individual trades terminated early on the same day7. The March 2018 report of the Financial Law Study Group (a study group of the Japanese Bankers Association) says that the Japan branch of ISDA recommends automatic close-out rather than close-out on request1.

Party hit by the eventOther partyRequest requiredAutomaticAn event such asinsolvency occursRequest terminationof the tradesTrades terminateautomatically whenthe event occursTrades end and thetermination amountis calculated
Figure 1From the event to the calculation of the termination amount
Figure description

When an event such as insolvency occurs on one side, the other party requests termination if the contract requires a request, and the trades end. If the contract does not require a request, the trades terminate automatically when the event occurs. Either way, the termination amount is calculated after the trades end.

Even after an event occurs, the trades cannot always be ended immediately. A contract may provide a grace period. If the trades reach their maturity before the grace period ends, and the contract does not clearly provide for the situation, the other party can lose the protection of the contract. The same applies if the maturity comes before a debt restructuring is completed. In some cases the contract procedures take time, and settlement is delayed significantly2.

The report explains that Section 2(a)(iii) of the ISDA Master Agreement form is a provision that allows the other party to wait without requesting termination. There is a US bankruptcy court decision holding that this provision runs against the purpose of the bankruptcy law, and in 2014 a revision was finalized that limits the waiting period to a fixed length of time8.

Cross-default and affiliate set-off

Contracts include devices that widen the events and the scope of settlement. A cross-default clause is a clause that makes an event under one contract also lead to the termination of other contracts. The examination manual says that the contract should make clear whether this clause "permits" or "requires" the termination of other contracts between the parties10. The US rule also says that a termination right based on a failure to pay or deliver under another contract between the same parties may be included in a covered contract11.

An affiliate set-off clause is a clause that includes, in the set-off at close-out, what the party owes to the counterparty's affiliates and what the affiliates owe to it. In one case, the contract had a clause under which, when an early termination date was designated for one party, the other party could use its own claims and those of its affiliates in the set-off. In that case, the other party was in civil rehabilitation proceedings. The Supreme Court judgment of July 8, 2016 did not recognize the effect of a set-off based on this clause7. Even when a contract widens the events and the scope of settlement, its effect can be denied because of the rules of insolvency law.

How insolvency law and resolution regimes affect the contract

A termination provided for in the contract is not always recognized as it stands in insolvency or resolution. Japan's Close-out Netting Act covers specified financial transactions entered into by financial institutions. Suppose the parties have agreed to close-out netting in a master agreement. When a petition for bankruptcy, rehabilitation, or reorganization is filed, the net amount of the trades' valuations becomes a single claim or obligation. This happens regardless of the parties' intentions3.

In the resolution of banks and similar institutions, the termination itself can be stopped. Article 137-3 of the Deposit Insurance Act allows the Prime Minister to make a decision after certain findings. Under that decision, provisions such as those allowing termination because measures have been taken against the financial institution have no effect for a set period. The provision implements the Financial Stability Board (FSB)'s "Key Attributes"12.

Section 560 of the US Bankruptcy Code provides that the right of a swap agreement participant to request liquidation or termination because of a condition such as the commencement of insolvency proceedings cannot be stayed or limited by other provisions of the Bankruptcy Code13. At the same time, the Federal Reserve Board's rule restricts covered large bank groups and similar firms from including, in their qualified financial contracts, termination rights based on the insolvency proceedings of an affiliate. Termination rights based on the counterparty's own insolvency or failure to pay may be included11.

Settlement after termination and credit events

When an event occurs and the trades end, the termination amount is determined. The mechanism of close-out netting, which adds up payments and receipts, is covered in Close-Out Netting.

A credit event in a credit default swap (CDS) is a different mechanism from the events on this page. In a CDS, events such as the insolvency of the reference entity or its failure to pay trigger payments under the contract14.

Notes

  1. 全国銀行協会 金融法務研究会 (financial law study group of the Japanese Bankers Association), "デリバティブ取引に係る諸問題と金融規制の在り方" (Issues in derivatives transactions and the approach to financial regulation) (March 2018), Chapter 2 (神田秀樹), "２　日本法における二者間ネッティングの取扱い" (2. Treatment of bilateral netting under Japanese law) (pages 23–24, PDF pages 30–31; in Japanese). Automatic close-out and close-out on request are on page 23, and the recommendation of the Japan branch of ISDA is on page 24. ↩ ↩2 ↩3

  2. Board of Governors of the Federal Reserve System, Trading and Capital-Markets Activities Manual (July 2011 edition), Section 2070.1 "Legal Risk" (September 2002), "Trigger Events" (page 2, PDF page 132). ↩ ↩2

  3. "金融機関等が行う特定金融取引の一括清算に関する法律" (Act on Close-out Netting of Specified Financial Transactions Conducted by Financial Institutions, etc., in Japanese), Article 2, paragraph 4 (close-out netting events) and paragraph 6 (close-out netting), and Article 3. ↩ ↩2

  4. 全国銀行協会 金融法務研究会, "デリバティブ取引に係る諸問題と金融規制の在り方" (March 2018), Chapter 2 (神田秀樹), "６　店頭デリバティブ取引におけるネッティング後の損害の額の算定（東京高判平成25年4月17日判例時報2250号14頁）" (6. Calculating the amount of loss after netting in OTC derivatives transactions (Tokyo High Court judgment of April 17, 2013, Hanrei Jiho No. 2250, page 14)), "(1) Summary of the facts" (page 32, PDF page 39; in Japanese). ↩

  5. The same report, Chapter 2, "４　スワップ契約の不履行と損害（東京高判平成9年5月28日判例タイムズ982号166頁）" (4. Non-performance of a swap contract and damages (Tokyo High Court judgment of May 28, 1997, Hanrei Times No. 982, page 166)), "(1) Summary of the facts" (page 25, PDF page 32; in Japanese). ↩

  6. The examination manual, Section 2020.1 "Counterparty Credit Risk and Presettlement Risk" (September 1999), "Material-change triggers" (page 6, PDF page 62) and "Other Credit Enhancements" (page 7, PDF page 63). ↩ ↩2 ↩3 ↩4

  7. 全国銀行協会 金融法務研究会, "デリバティブ取引に係る諸問題と金融規制の在り方" (March 2018), Chapter 1 (中田裕康), "３（３）", the section on the Supreme Court judgment (Supreme Court judgment of July 8, 2016), "b. Course of events" and "d. Judgment on appeal" (pages 13–15, PDF pages 20–22; in Japanese). ↩ ↩2

  8. The same report, Chapter 2, "３　ISDAのマスター契約書式" (3. The ISDA master agreement form) (page 25, PDF pages 31–32; in Japanese). ↩

  9. The same report, Chapter 2, "6" (Tokyo High Court judgment of April 17, 2013), "(2) Holding", the part on the reference date for calculating damages (pages 34–35, PDF pages 41–42; in Japanese). ↩

  10. The examination manual, Section 2070.1 "Legal Risk" (September 2002), "Trigger Events", the last paragraph (page 2, PDF page 132). ↩

  11. 12 CFR § 252.84(b)(1) (prohibition on termination rights based on the insolvency proceedings of an affiliate and similar events) and (d)(1) to (3) (termination rights based on the insolvency proceedings of the direct party, or on a failure to pay or deliver, including under another contract between the same parties, are permitted). The meaning of the terms is in the definition of "Default right" in § 252.81. ↩ ↩2

  12. The Financial Law Study Group report, Chapter 2, "２　日本法における二者間ネッティングの取扱い" (2. Treatment of bilateral netting under Japanese law), the section on Article 137-3 of the Deposit Insurance Act (page 24, PDF pages 31–32; in Japanese). ↩

  13. Title 11 of the United States Code, § 560, first sentence. The conditions that count as grounds are conditions of the kind in § 365(e)(1), which that section refers to. ↩

  14. The examination manual, Section 4350.1 "Credit Derivatives" (April 2003), pages 1–2 (PDF pages 632–633). ↩