Approaching the ISDA Agreement丨Handling Process of Default and Termination Events (2)

Editor's note: For a long time, the mainland has formed three major market systems: the interbank OTC derivatives market with NAFMII as the main agreement, the securities and futures OTC derivatives market with SAC as the main agreement, and the over-the-counter market for foreign institutions with ISDA as the main agreement. Among them, the ISDA Master Agreement is an international agreement document issued by the International Swaps and Derivatives Association ("ISDA") to provide certain legal and credit protection mechanisms for parties involved in OTC derivatives transactions. In order to help you understand the functions and characteristics of the ISDA protocol, the CSI Investment Education Base has launched a column entitled "Approaching the ISDA Agreement" to share a comprehensive understanding of the ISDA protocol with all readers.

Cooperative institution: Guotai Junan Risk Management Co., Ltd

*因篇幅所限，本文仅对2002年ISDA协议部分重点条款进行分析思考。 为方便理解，请同时对照参阅ISDA发布的Chinese Translation of the 2002 ISDA Master Agreement-For Educational Purposes Only - Simplified Chinese。

条款标题：(a) Right to Terminate Following Event of Default.违约事件发生后的终止权利

Consider: In the event of an Event of Default, the non-defaulting party shall have the right (but not the obligation) to terminate all surviving transactions under this Agreement, provided that the defaulting party shall be notified of its intention to terminate the transactions no more than 20 days in advance of the specified date of the early termination date. The notice must describe the event of default, with an early termination date usually preceding 20 days after the notice is given. For certain bankruptcy events (as described in clause 5(a)(vii)), where "early automatic termination" applies, it will terminate automatically when such event is triggered, rather than by notice.

条款标题：(b) Right to Terminate Following Termination Event.终止事件后的终止权利(i) Notice.通知(ii) Transfer to Avoid Termination Event.为避免终止事件而转让

Consider: Section 6(b) deals with termination rights after a termination event as follows:

(1) Notice. In the event of a termination event for a non-force majeure event, the affected party shall immediately notify the other party of the termination event and its nature, each affected transaction, and any other information that the non-affected party may require. However, in the event of a Force Majeure Event, it is the responsibility of each party to use all reasonable efforts to notify the other party of the nature of the Force Majeure Event and to provide the other party with such additional information as may be required. Notification of a force majeure event requires only "reasonable efforts" because the nature of the event (e.g., a natural disaster) may make notification impossible.

(2) Assignment to avoid termination events. The principle of transfer to avoid certain termination events is that in the event of a "no-fault" termination event, it is preferable to proceed with the transaction over the termination of the transaction. In the 2002 ISDA Master Agreement, there was no longer a need to attempt to transfer transactions affected by illegal acts, as market participants found it difficult to do so in practice. In the event of a tax event (with only one affected party) or a tax event resulting from a merger (the burdened party being the affected party), the affected party shall have the right to elect an early termination date, provided that it must use all reasonable efforts to attempt to transfer all rights and obligations of the affected transaction to its other office or affiliate within 20 days of giving notice to the non-affected party pursuant to Section 6(b)(i) for the purpose of eliminating the termination event. The affected party in the tax event or the burdened party in the post-merger tax event is not liable for the loss, but is expected to pay a small fee for it. If the affected party is unable to make the transfer, the non-affected party must be notified within the 20-day notice period, and the latter may attempt to make the transfer within 30 days from the original notice date. Therefore, if an unsuccessful attempt by an affected party to transfer on the 20th day is followed by notifying the non-affected party, the non-affected party has only 10 days remaining to make the transfer. The prior written consent of the other party is required to make this transfer, but the other party may not unreasonably withhold, in particular if the policy of the non-affected party allows it to transact in the ordinary course of business with the affected party's proposed replacement office or affiliate.

条款标题：(iii)Two Affected Parties.两个受影响方

Consider: If a tax event under Section 5(b)(iii) occurs and there are two affected parties, the parties must use all reasonable efforts to agree on actions to avoid the relevant termination event within 30 days of receiving the notice.

条款标题：(iv) Right to Terminate.终止的权利

Consider: (1) Circumstances requiring the exercise of the right of early termination after assignment: In the circumstances of Sections 6(b)(ii) and 6(b)(iii) above, if the parties are unable to agree, transfer, or otherwise avoid the relevant termination event within 30 days of giving notice, an early termination date may be declared in accordance with Section 6(b)(iv) of this Agreement.

(2) Circumstances in which the right of early termination may be exercised directly: In the event of a credit event arising from the merger, other termination events, or tax events arising from the merger in which the encumbered party is the unaffected party, the early termination date may be declared in accordance with Section 6(b)(iv) of this Agreement.

If the termination event continues, the terminator may give notice to the other party of all affected transactions for a period of up to 20 days (usually less), electing an early termination date (no earlier than the effective date of the original notice).

(3) Circumstances under which the right of early termination may be exercised after the expiration of the waiting period: If an illegal or force majeure event occurs and persists and the waiting period (3 local business days for the illegal event and 8 local business days for the force majeure event) has passed, the following early termination rights will arise: Either party may terminate all or part of the affected transaction by giving no more than 20 days' notice to the other party and electing to terminate the early termination date no earlier than the effective date of the notice. Termination of some of the affected transactions provides some flexibility in the event that it is not in the best interests of all parties to terminate all affected transactions. If the terminator elects to terminate part of the affected transactions, the termination date shall not be earlier than 2 local business days after the effective date of the notice to allow time for the other party to decide whether to terminate the other affected transactions. Because of the risk of "discretionary performance" in the process, the other party may issue a counter-notice stating that any or all other affected transactions will be terminated on the same day as the early termination date not specified by the affected party.

This Agreement provides that in the event of an illegal or force majeure event, the non-affected party shall initially have the right to terminate the transaction because the non-affected party is affected by the failure of the affected party credit support provider to perform its credit support documents. An affected party may give notice to terminate some or all of the remaining affected transactions only if the counterparty terminates only part of the affected transactions. The rationale for this procedure is that ISDA members believe that the credit support provider of the affected party cannot provide performance guarantees and that the affected party should not have a unilateral right to terminate the affected transaction.

条款标题：(c) Effect of Designation.指定的效力

Consider: If notice of an early termination date is given in respect of an event of default or a termination event, the early termination date will occur on the selected date, regardless of whether the event of default or termination event is still ongoing at the time.

When an early termination date occurs or is elected, either party will no longer be required to make normal payments or deliveries for its own termination transaction pursuant to Section 2(a)(i) or 9(h)(i) of this Agreement. This Agreement itself will not terminate by giving notice of early termination, only the termination of the parties' payment or delivery obligations. Please note that other provisions of this Agreement, such as the obligation to make lump sum payments (Section 2(d)(i)), the obligation to make termination payments under Section 6(e), the obligation to convert currency (Section 8), and the obligation to pay execution fees (Section 11), will continue to be valid due to Section 9(c), "Survival of Obligations". Amounts that would have been paid or delivered after the notice of termination had taken effect but on or before the date of early termination, or any obligation that could not have been paid or delivered due to failure to satisfy all conditions precedent, are included in the definition of unpaid.

条款标题：(d) Calculations；Payment Date计算；付款日期

Consider: On or shortly thereafter the date of early termination, each party shall, to the extent practicable, provide the other party with a reasonably detailed report of the calculation of the early termination payment and advise the account to which any termination payment is due. The report should disclose not only the details of any quotes, but also the market data used in the calculations or information from internal sources. If the non-defaulting party or the party without fault is unable to obtain written confirmation as to the source of the market quote or market data, the record of the party obtaining the quote or market data shall be conclusive evidence of the existence of such quote or market data. If there are two affected parties, the report will not specify the net closing amount payable, as the two affected parties will calculate separately and the difference calculated by both parties will be split equally.

条款标题：(ii) Payment Date.付款日

Consider: The amount of early termination of the event of default should be paid on the effective date of the payment advice. The amount of early termination of the termination event shall be payable on the second local business day after the effective date of the payment advice. If there are two affected parties, the agreed early termination amount shall be paid on the second local business day after the report provided by the second party becomes effective. The amount shall be payable, together with the accrued interest calculated in accordance with Section 9(h)(ii)(2), in the termination currency as agreed in Part 1(f) of the Annex.

条款标题：(e) Payments on Early Termination.提前终止的付款

Reflections: The method of calculating the early termination amount has changed substantially in the 2002 ISDA Master Agreement, and the elements of the market quotation method and the loss method calculation have been modified to the new alternative transaction method, respecting the principle that the calculation agency makes all calculations in accordance with Article 6(e). A computing agency may be a non-defaulting party, an unaffected party, or both affected parties and must act in good faith and use commercially reasonable procedures to obtain commercially reasonable results. The alternative transaction method is the calculation of the replacement loss, cost or gain of the termination transaction by the calculation agency to protect the calculation agency from the economic equivalent of the relevant factors such as direct cash flow and pricing of the termination transaction or any options attached thereto. For normal (i.e., Article 2(a)(i)) payments and deliveries due after the early termination date (assuming all conditions precedent to Article 2(a)(iii) are satisfied), the early termination amount shall be calculated on a net present value basis. The amount of early termination will be calculated on the date of early termination or, if it is contrary to commercial reasonableness, the next commercially reasonable date. Unpaid amounts and Article 11 fees are not included in the calculation of the early termination amount and are treated separately after the calculation of the early termination amount has been completed.

Computing agencies may consider any relevant information, such as the following:

(1) a definitive or indicative quote from a third party (i.e. another dealer), taking into account the creditworthiness of the calculation institution and any credit supporting documents between the parties (it is not required to obtain four quotations as in the case of the market quotation method);

(2) relevant market data, such as interest rates, prices, yield curves, and volatility provided by third parties in the relevant market;

and (3) is obtained by the Computing Institution or its affiliates from its own internal sources, provided that such information is of the same type as the information used by the Computing Institution or its affiliates in the ordinary course of business to conduct similar transaction valuations with other counterparties.

The Calculator will use the above information to calculate the Early Termination Amount, unless it reasonably believes in good faith that such quotations or market data are not readily available or that the use of such quotations or market data will not yield commercially reasonable results, in which case the Calculator will not have to insist on obtaining such information from third parties. Quote and information providers can include dealers, end-users, brokers, information vendors and providers, which is broader than the traditional market quote method that only refers to market makers. Funding costs may be taken into account in the calculations of the calculation agency, provided that the above costs have not been included in the information or quotation. The last provision of the definition re-emphasizes the need to use commercially reasonable procedures by adding the hedging closing costs associated with the termination transaction to the early termination payment, as well as deducting any hedging gains, provided that there is no double counting.

This explains why a calculator needs to use third-party or internal data to value a termination transaction, in the same way as similar transactions made by unrelated third parties, and the methodology must be consistent. However, depending on the type, size, complexity or volume of the terminated transaction, different valuation methods may be commercially reasonable. Any termination amount due to an illegal or force majeure event, if terminated at the mid-market price, cannot be considered for the credit qualification of the computing institution, because the event is beyond the control of the computing institution, and it is unreasonable to consider the credit qualification at this time.

条款标题：(i) Events of Default.违约事件

Consideration: The amount of early termination is calculated in accordance with clause 6(e) and may be set off in accordance with the set-off clause which is now incorporated into the body of the agreement as clause 6(f). All transactions are terminated under the Event of Default. According to the agreement, the early termination amount consists of the following three components:

(1) the payment of the future replacement value of the termination transaction calculated when the calculation institution derives the termination amount;

(2) payment or delivery obligations under the Agreement (i.e., amounts due but outstanding by the Early Termination Date pursuant to Section 2(a)(i) ("Outstanding Payments");

and (3) sums that would have been paid or goods delivered prior to the date of early termination if all conditions precedent were met (e.g., no event of default has occurred) or an early termination date has not been declared. The amount due under Section 2(a)(iii) is also referred to as the "Outstanding Amount".

As the termination trading portfolio may use different currencies, they will be converted to a single base currency (termination currency equivalent), selected in Part 1(f) of the Appendix. If no election is made, and the agreement is governed by the laws of the State of New York, the fallback currency is the U.S. dollar; If the agreement is governed by English law, the fallback currency is the Euro. Therefore, in Clause 6(e)(i), if an Early Termination Date is specified for an Event of Default, the Early Termination amount will be:

(1) the net closing currency equivalent of the termination amount calculated by the non-defaulting party for all termination transactions, plus (2) the closing currency equivalent of the outstanding amounts owed by the defaulting party to the non-defaulting party; Less (3) the termination currency equivalent of the outstanding amounts owed by the non-defaulting party to the defaulting party. If the net amount of early termination is positive, the defaulting party pays the non-defaulting party. If it is negative, the non-defaulting party pays the defaulting party.

Pursuant to the terms defined in Section 14, the outstanding amount (as of the Early Termination Date) includes the following:

(1) the fair value of the amounts due but not paid and the physical goods due but not delivered;

(2) the fair value of unpaid sums and undelivered physical goods due to failure to satisfy conditions precedent;

(3) the fair value of unpaid sums and undelivered physical objects due to illegal or force majeure events;

(4) If a termination event occurs before all transactions are terminated early due to an event of default, a credit event due to merger, or other termination event that affects only part of the transactions, the early termination amount arising from the early termination of such affected transactions shall be the amount that should have been paid by the payer but has not yet been paid.

条款标题：(ii) Termination Events.终止事件

Consider: (1) In a termination event, if there is only one affected party, the amount of early termination will be calculated in accordance with Section 6(e)(i). The difference is that in relation to 6(e)(i) the "defaulting party" is deemed to be an affected party and the "non-defaulting party" is deemed to be an unaffected party.

(2) In addition to an Extraordinary or Force Majeure Event, if a "no-fault" termination event involves two Affected Parties, each Affected Party shall calculate the net termination currency equivalent of the Early Termination Payment of the Affected Transaction and divide the difference equally. On this basis, the termination currency equivalent is added and deducted from the outstanding amount owed to each other. If the net early termination amount ("Net Amount") is positive, the party calculating the lower termination amount pays the net amount to the other party. If it is negative, the party that calculates the higher termination amount will pay its counterparty the absolute value of that amount.

(3) In the event of illegality and force majeure, the calculation of the amount of early termination shall be carried out in accordance with (1) or (2) above, as appropriate. However, when calculating the termination amount, the Calculation Institution or the third party or affiliate of the Quotation does not consider the Calculation Agency's current credit credentials or any credit supporting documents, and provides a mid-market quotation. This is because the illegal or force majeure event is not within the control of the computing agency, and its credit qualification is not a relevant factor in obtaining a quote. The approach emphasizes the "no-fault" nature of termination events, and ISDA members believe that in illegal and force majeure events, it is unfair to value the transaction from one side of the market or average the results of the calculations of the two affected parties. In the above case, if internal or other market data is used to value a terminated transaction, the calculator should use the mid-market price and ignore its credit qualifications.

条款标题：(iii)Adjustment for Bankruptcy.破产调整

Consider: Section 6(e)(iii) deals with adjustments to the amount of early termination due to the application of automatic early termination. This provision is intended to protect non-defaulting parties who have made payments to insolvent counterparties but are unaware that their counterparty has been automatically terminated early. In such a case, the amount payable for early termination may be adjusted appropriately and the non-defaulting party will not lose the amount paid.

条款标题：(iv) Adjustment for Illegality or Force Majeure Event.就非法或不可抗力事件作出的调整。

Think: This new provision deals with situations where a party or credit support provider does not pay an early termination payment due to an illegal or force majeure event. In this case, non-payment will not be considered an Event of Default (i.e. failure to pay or deliver or default on credit support). provided, however, that amount will accrue interest, and if an early termination date is subsequently caused by an Event of Default, a credit event resulting from the merger, or other termination event affecting all subsequently terminated transactions, that amount will be deemed unpaid and interest will accrue in accordance with Section 9(h)(ii)(2).

条款标题：(v) Pre-Estimate.预先估计

Think: The clause states that the amount recovered through early termination payments reflects compensation for losses from the transaction and compensation for losses from protection against future risks, rather than penalties. This is emphasised because if the English court considers that the fine is excessive, it cannot be enforced. In addition, a party may not claim additional damages in excess of its actual losses, so claims for consequential losses are prohibited unless otherwise stated in the Annex, but this is less likely to occur. The prohibition of consequential loss claims is also common in many other master agreements (e.g., bond buybacks and securities lending).

条款标题：(f) Set-Off.抵销

Think: Set-off is limited to both parties to the agreement. In the 2002 ISDA Master Agreement, affiliates of non-defaulting parties were not included in the set-off clause, but affiliates may be added via an annex if the parties are satisfied that this is legally enforceable in the relevant jurisdiction. Set-offs can be triggered when there is an event of default, a credit event due to a merger, or any other termination event. A set-off can be against any debt of the defaulting party or the affected party, and the set-off is effective when the non-defaulting party has to pay the insolvent defaulting party an early termination amount without any realistic hope of receiving any amounts due to it by the defaulting party under other agreements. The legal effect of the set-off is that after such set-off, in terms of the part of the set-off, the creditor-debtor relationship between the two parties is extinguished, and one party only needs to pay the remaining part of the amount to the other party. Set-offs can be made without prior notice and have a wide range of set-offs. The main points of the exercise of set-off are:

(1) In the event of an Event of Default by one of the parties to the transaction, or in the event of a termination event, all outstanding transactions under such termination event constitute affected transactions and there is only one affected party.

(2) The non-breaching party or the non-affected party has the right to exercise the right of set-off, and the breaching party or the affected party shall not take the initiative to exercise the right of set-off.

(3) The scope of the set-off is any early termination amount payable by one party to the transaction to the other party and any other amount payable by the other party to the transaction. Any other amount herein refers to the monetary debt of the other party to the transaction for any reason, regardless of whether the currency is the same as the currency of the early termination payment, whether it is due, whether it is paid in the same place as the place in which it is credited, etc.

Set-off can involve currency exchange, provided that it is done in a commercially reasonable manner. Unidentified debts, i.e., debts that are difficult to value, can be estimated and set off, but must be finally settled when the value of that debt is subsequently calculated. The set-off does not constitute a security interest of any kind, which is a separate legal right in addition to the other rights listed in the last sentence of article 6 (f). Under English law, Rule 4.90 of the UK Insolvency Rules 1986 provides for mandatory rights of set-off, but as noted above, this set-off clause goes beyond that. When using a right of set-off, it is essential to establish reciprocity (i.e. both parties act as principal) because, like close-out netting, set-off only works on a principal-to-principal basis. If the term "non-agency" is chosen to apply to both parties, the relevant provisions for set-off purposes can be strongly strengthened.

Author: Liu Yan, the executive director of product design in the OTC derivatives department of Guotai Junan Risk Management Co., Ltd., and intern Wang Lishu assisted in the collection and translation of reference materials for this article.

Annotation:

[1] 篇幅所限，本文只对主协议重点条款进行分析思考；为方便理解，请对照ISDA发布的Chinese Translation of the 2002 ISDA Master Agreement-For Educational Purposes Only - Simplified Chinese进行阅读，该文版权属于ISDA。

Disclaimer: The information in this article is for investor education purposes only and does not constitute any investment advice to investors, and investors should not substitute their independent judgment or make decisions based solely on such information. The information in this article is intended to be accurate and reliable, but the accuracy or completeness of such information is not guaranteed, and no liability is accepted for any loss or damage that may arise from the use of such information.