Quiz: Termination and Netting

This is a draft, shown for review before publication.

6 questions to check your understanding of the chapter “Termination and Netting”. Choose an answer and select “Check answer” to see the answer and explanation. You can also open “Answer and explanation” to see the answer first.

1. Question 1

   Which of the following is correct about how things proceed after an early termination event set out in a master agreement has occurred?

   1. A.Once an event occurs, the trades terminate automatically under any contract
   2. B.Even under a contract with a grace period, the trades end on the day the event occurs
   3. C.Whether the trades end at a request or automatically, the termination amount is calculated after they end
   4. D.In the form that requires a request, the party on which the event occurred makes the request and ends the trades
   Answer and explanation

   Answer: C

   After an event occurs, there are two forms, depending on the contract. In one, the other party requests termination and the trades end. In the other, the trades terminate automatically when the event occurs, without waiting for a request. In either form, the termination amount under close-out netting is calculated after the trades end. The party that makes the request is the other party, not the party on which the event occurred.

   Under a contract that provides a grace period, the trades do not necessarily end on the day the event occurs. In some cases the contract procedures take time and settlement is delayed significantly.

   Learn more: Events of Default and Termination Events

2. Question 2

   What is a cross-default clause in a master agreement?

   1. A.A clause that makes an event under one contract also lead to the termination of other contracts
   2. B.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
   3. C.A clause that allows the other party to wait without requesting termination
   4. D.A clause that treats a moratorium on, or restructuring of, the debt of the counterparty's country as an event
   Answer and explanation

   Answer: A

   A cross-default clause makes an event under one contract also lead to the termination of other contracts. It is one of the devices that widen the events and the scope of close-out.

   A clause that includes affiliates' debts and claims in the set-off is an affiliate set-off clause. A clause that allows the other party to wait without requesting termination is the one in Section 2(a)(iii) of the ISDA Master Agreement form. Whether to include a sovereign debt moratorium or restructuring is a question of how the events are defined, and it is separate from a clause that sets how far an event reaches into other contracts.

   Learn more: Events of Default and Termination Events

3. Question 3

   As a hypothetical example, a company and its counterparty have three transactions under one master agreement. At the time a close-out netting event occurs at the counterparty, the values are +1,000 million yen for transaction 1, −600 million yen for transaction 2, and −200 million yen for transaction 3, from the company's side. Positive is an amount the company receives, and negative is an amount it pays. What remains between the company and the counterparty after close-out netting?

   1. A.A claim of 1,000 million yen that the company holds against the counterparty
   2. B.A claim of 200 million yen that the company holds against the counterparty
   3. C.An obligation of 800 million yen that the company owes to the counterparty
   4. D.A claim of 1,000 million yen that the company holds against the counterparty, and an obligation of 800 million yen that it owes to the counterparty
   Answer and explanation

   Answer: B

   Close-out netting adds up the values of all transactions under the master agreement and turns the net amount into a single claim or a single obligation. Adding +1,000 million, −600 million, and −200 million yen gives +200 million yen. The net is positive, so what remains is a claim of 200 million yen that the company holds against the counterparty.

   The 1,000 million yen claim looks only at the value of transaction 1. The 800 million yen is the total of transactions 2 and 3, where the company pays, without deducting transaction 1, where it receives. A result with both a claim and an obligation is the view in which the payments and receipts of the individual transactions remain. In close-out netting, they are replaced by a single claim or a single obligation. If transaction 1 were +200 million yen instead, the sum would be −600 million yen, and what remains would be an obligation of 600 million yen that the company owes.

   Learn more: Close-Out Netting

4. Question 4

   Which of the following is correct about the contractual rights that the US Bankruptcy Code gives to parties to swap agreements?

   1. A.The parties can liquidate or terminate only after the trustee has chosen to assume or reject the contract
   2. B.The parties can liquidate or terminate, but offset is allowed only after the court approves it
   3. C.All parties to the contract have the same rights, not only swap participants or financial participants
   4. D.Liquidation, termination, and offset because of a bankruptcy filing are not stayed or limited by the Code's provisions
   Answer and explanation

   Answer: D

   The Code gives a party that is a swap participant or a financial participant the right to liquidate, terminate, or accelerate a swap agreement because of a bankruptcy filing or the like, and to offset (net) termination values or payment amounts. The exercise of these rights is not stayed, avoided, or limited by any provision of the Code or by any order of a court or administrative agency. Offset is treated the same way as liquidation and termination.

   The trustee's choice to assume or reject executory contracts with the court's approval is a different provision. Separately from that provision, the contractual rights of parties to swap agreements are protected. As for the automatic stay triggered by a bankruptcy filing, the exercise of rights of setoff and of rights over collateral relating to swap agreements and similar contracts is also excluded from the stay.

   Learn more: Close-Out Netting

5. Question 5

   As a hypothetical example, a bank and Company Y have several transactions under one master agreement that provides for close-out netting. A petition for the commencement of bankruptcy proceedings is filed against Company Y, and the commencement order is issued afterward. Under Japan's close-out netting act, the values at which point in time are added up to fix the single claim or obligation between the bank and Company Y?

   1. A.The time of the petition for the commencement of bankruptcy proceedings
   2. B.The time of the commencement order for the bankruptcy proceedings
   3. C.The time the bank requests termination of the transactions under the master agreement
   4. D.The time the amount of the claim is fixed within the bankruptcy proceedings
   Answer and explanation

   Answer: A

   Under the close-out netting act, the net total of the values of all transactions at the time a close-out netting event occurs becomes a single claim or a single obligation between the parties. The close-out netting event is the filing of the petition for the commencement of bankruptcy proceedings, so the amount is fixed by adding up the values at the time of the petition. Once the commencement order is issued, this result is recognized within the bankruptcy proceedings.

   The commencement order concerns the stage at which the result is recognized within the proceedings, not the point at which the amount is fixed. The same goes for the time the amount is confirmed within the proceedings. Close-out netting operates regardless of the parties' intentions, so the amount is not fixed by waiting for the bank's request.

   Learn more: Japan's Close-Out Netting Act

6. Question 6

   As a hypothetical example, a Japanese bank trades with the head office of Company W, which is incorporated in Country R. Company W also has a branch in Country S, but the bank does not trade with the branch. The individual transactions and the master agreement are governed by Japanese law. When the bank confirms the validity of close-out netting with a legal opinion as a precondition for using the effect of netting, the laws of which jurisdictions must it check?

   1. A.One: Country R
   2. B.Two: Country R and Japan
   3. C.Three: Country R, Country S, and Japan
   4. D.Two: Country S and Japan
   Answer and explanation

   Answer: B

   The laws to check are a combination of four. The first is the law of the country that granted the counterparty its license to be established. The second is the law of the country where the counterparty's overseas branch is located, when the branch is included. The third is the law governing the individual transactions to be netted. The fourth is the law governing the contracts needed to carry out the netting. In this example, the country of incorporation is Country R, the country whose law governs the individual transactions and the master agreement is Japan, and the branch is not included in the trades, so there are two jurisdictions.

   Country R alone leaves out the law governing the transactions and the contract. Country S is added when the branch is included in the trades, and it is outside the scope in this example. Country S and Japan alone leave out the country of incorporation. If the contract is governed by the law of yet another country, the jurisdictions to check increase.

   Learn more: Netting Enforceability and Legal Opinions