Mastering the storm

The succession of credit events in September and October revealed that many investors did not know what to do in the event of a default of a counterparty. What recourse do parties have under the Isda master agreement? By Joshua Cohn and Jillian Ashley


The long, upwards float of the credit bubble means it has been years since the last spate of crisis close-outs in the capital markets. A whole generation of market personnel now finds itself facing the current crisis without direct experience of terminating transactions in disturbed market conditions. Many have been gaining experience in this previously unfamiliar realm through the lens of the various editions of International Swaps and Derivatives Association master agreements. In this article, we sort through some of the important aspects of the most commonly used of the Isda master agreements, the 1992 Isda Master Agreement (Multicurrency - Cross Border), to distil a few basic lessons learned (or refreshed) in 2008.

The phone rings and...

News arrives that Party X is shaky, very shaky. What are the first steps to take? First, know the facts, identify your exposures (including all those that may yield set-offs) and understand your agreements (including those governing credit support). This typically requires an interdepartmental effort to determine the precise situation of Party X, the key agreement provisions that may relate to X's situation, and what may be owed to and from X. This is not a moment for guessing - more than your own institution's relationship with X may be on the line, and a wrong move may disable X under circumstances that create a liability for your institution. Of course, a failure to move may bring your institution late to the table, having forfeited an early mover's advantage.

In reviewing your contracts, do not rest on assumptions that standard form agreements are always the same. Read carefully for variations from standard industry or institutional terms. Parties that have abstracted their documents or rendered them electronically searchable prior to a crisis have an advantage. Even these parties, however, should execute a complete review of each relevant document before charting a course of dealing with Party X.

Find the trigger

Shakiness alone is not typically an agreed basis to terminate a relationship. You will need to review your agreement's events of default and termination events, whether they be those in the standard form Isda agreement or those the parties may have agreed to in the schedule to the Isda agreement, to see if the poor health of X merits a termination. Your institution may also have rights under common law, although there will be a question as to which common law rights survive agreement to contractual remedies.

Events of default are usually reserved for the most serious circumstances and bear tough consequences. Termination events, viewed as less 'blameworthy' circumstances, may still enable termination - although the precise terms of close-out may be more favourable, however modestly, to the closed-out party. Certain circumstances may constitute both an event of default and a termination event. It is important to determine whether the relevant agreement establishes a priority in such a situation.

Under the Isda agreement, a good range of standard form events may apply to Party X. In reviewing the possibilities, be aware of timing and notice conditions. A section 5(a)(i) failure to pay event of default, for example, bears a three-business-day-from-notice grace period. A failure to transfer collateral under an Isda 1994 Credit Support Annex (Isda Agreements Subject to New York Law Only) (New York CSA) will produce a section 5(a)(iii) credit support default under the Isda agreement with a two-business-day-from-notice grace period, imported from the New York CSA itself. Section 5(a)(ii), breach of agreement, carries a 30-calendar-day-from-notice grace period, making the provision used less often than others.

A misrepresentation event of default under section 5(a)(iv) offers no grace period (reflecting the fact a prior misrepresentation cannot be later cured). Section 5(a)(v), default under specified transaction, and section 5(a)(vi), the elective cross default, offer a mix of primary deference to grace periods under the relevant cross-referenced agreements and embedded fallback grace periods. Finally, the bankruptcy event of default encompasses a series of events, some of which are subject to grace periods and others not.

The events of default under the Isda agreement are nuanced in many respects and must be read with care to establish if they genuinely apply to Party X's situation. For example, events of default may apply to parties, their credit support providers and their specified entities, according to the choices made by the parties when initially coming to terms. The occurrence of an event of default of a credit support provider or a specified entity is an event of default with respect to the related party.

Section 5(a)(v) and section 5(a)(vi) of the Isda agreement are commonly confused. Section 5(a)(v) is a cross-acceleration and a final-payment default of certain sorts of transactions under other agreements or the Isda agreement itself. It is also a repudiation default. Actual acceleration is required to trigger the cross-acceleration leg of section 5(a)(v).

Section 5(a)(vi), however, is a debt cross-default, requiring only that acceleration be permitted under debt instruments having an aggregate value in excess of a threshold amount previously agreed by the parties, or that final payments under such instruments in aggregate shall not have been made in excess of the threshold amount.

The bankruptcy default is a collection of nine clauses, listing specific events (in some cases subject to specific detailed conditions) and also extending to events of "analogous effect" and actions "in furtherance of, or indicating (a party's) consent" to a specified event. The specific events within the bankruptcy default comprise a list of bankruptcy events across various jurisdictions. The list was developed to facilitate multi-jurisdictional use of the Isda agreement. As a result, listed events may overlap, and an event constituting a default under a given clause in one jurisdiction may classify as a default under that clause or under a different clause in another jurisdiction. Certain terms used in relation to insolvency-related events are prone to have different meanings in different jurisdictions. For example, in New York alone there are multiple legal definitions of 'insolvent' that could be relevant depending on context.

Finally, credit support default is a common triggering event - although it is one that often requires a degree of management by the non-defaulting party (NDP). Shaky parties have a tendency to face ever-increasing margin calls. They tend to wish to keep their diminishing assets fully engaged in their businesses, rather than resting in a counterparty's account. Testing and potentially disputing collateral calls may become a vital Party X activity as it attempts to keep its lights on. Markets in crisis may provide extremely fertile ground for collateral disputes.

The New York CSA's dispute resolution mechanism is often criticised, but not easily surpassed. The principal issue attached to the provision is the time-consuming nature of the multiple steps required to respond to a dispute. An additional concern is that the provision becomes more difficult to use in disturbed markets. Nonetheless, passage through the provision may be required to establish that a failure to post collateral is simply that - a failure, and not a fair response to an unfair request. Like the events of default themselves, the CSA dispute resolution provision needs to be mapped with care to ensure procedures are followed.

In considering triggers, note that the identity of the trigger, possibly in combination with other factors, may determine features of the mechanics of the close-out described in section 6 of the Isda agreement. Certain bankruptcy defaults, for instance, may produce an automatic early termination if the parties have so agreed. The choice to activate automatic early termination (reflected in the schedule to the Isda agreement) is made largely on the basis of the parties' assessment of relevant bankruptcy laws, including risks of stays and cherry-picking under those laws.

Know the law

You do not want to close out without knowing the rules of the road. The Isda agreement is used between parties in many jurisdictions - although it was designed with a choice of New York or English law in mind. However, in practice, parties sometimes select the laws of other jurisdictions. Still other bodies of law, beyond that chosen in the Isda agreement, may apply in important ways to the close-out. Choices of bankruptcy law, procedural law, set-off law and rules governing access to collateral, for example, may all emerge from factors other than contractual choice of law. Internal choice of law and extrinsic choices may be outcome-determinative, as Lehman Brothers itself learned in its multi-year set-off spat with Thailand's Financial One Public Company. Although the decision was ultimately reversed on appeal, Lehman was initially found to have wrongly applied one jurisdiction's set-off rules when another jurisdiction's conventions applied. The default interest penalty initially assessed against Lehman would have been staggering.

Planning the close-out

NDPs should work carefully through agreement provisions detailing the mechanics of close-out. It is helpful to outline steps that need to be taken and timing provisions that need to be observed. Under the Isda agreement, for example, an actionable event of default must be ongoing at the time a close-out is initiated. Under section 6, the NDP may "by not more than 20 days' notice ... designate a day not earlier than the day such notice is effective" as the date of termination. The date of termination will be the presumptive 'as of' date for calculation of a close-out value. The close-out value must be paid on the date the notice of that close-out value is given to Party X, or interest will begin to accrue at a default rate. To the extent the close-out value must be converted into a termination currency, that conversion must be at the rate equal to the spot exchange rate "on such date as would be customary for the determination of such a rate ... for value on the relevant early termination date".

Obviously, notice mechanics must be considered in planning the close-out. Although the Isda agreement offers a standard notice provision, be alert to modifications in the schedule to the agreement. Take into account requirements for multiple notices and limitations upon notice methodology under specific circumstances. It is not unheard of to find that Party X has unplugged relevant electronics, bolted the door and connected the telephone to a direct feed from a 24-hour talk-radio station. It is also not unusual for NDPs to have outdated or inaccurate notice information in their files. Give notice to as many agreement-designated recipients and by as many means as may be appropriate under the circumstances to make sure the deed is done - or at least to convince a reviewing court you have done your best to fulfil your notice obligations, detailed in section 6 and section 12.

Under the Isda agreement, the parties determine at signing certain fundamental characteristics of close-out. Most choose 'second method', which mandates the in-the-money party receives the mark-to-market value upon close out, even if that party is in default. The parties will also have made a choice between market quotation and loss as the measure of the liquidation value. If market quotation has been chosen, loss will still be available as a fallback - although the precise circumstances that permit a fallback to loss will vary from situation to situation. In what little case law there is on the issue, courts have mandated fallback to loss (sometimes counter to the industry's customary reading of the Isda agreement) where quotations are not obtained in good faith or where the market quotation result differs so greatly from the result under loss as to be commercially unreasonable. Certainly, in the recent Lehman Brothers failure, many market participants endured sufficient difficulty in using market quotation to stimulate falling back to loss.

Market quotation is intended to be a strict methodology for collecting third-party market values. Loss is intended to be a general indemnification provision allowing a good deal of freedom to the non-defaulting party to choose how it wishes to calculate its losses. Certainly, in the troubled markets of late, many NDPs have found it difficult or impossible to get reliable quotes from dealers. Perhaps an equal number of NDPs, however, has struggled to manage the freedom that loss offers. In a distorted market, finding an accurate means of calculating damages may be difficult.

Some NDPs in the Lehman event found themselves applying the close-out amount measure of liquidation value that is standard in the 2002 Isda Master Agreement. Close-out amount was designed after the financial crisis of 1997/98 to soften the methodology of market quotation and provide some guiding structure to the challenging freedom of loss. Use of close-out amount was recommended by the Credit Risk Management Policy Group III10, and came to apply to many interdealer contracts as a result of recent amendment of Isda agreements. Perhaps the story is apocryphal, but we are told Lehman was the last of the roughly 30 dealers to sign up to a standard close-out amount amendment circulated in the dealer community shortly before its collapse.

In any event, close-out amount has proven helpful in its own right. It also offers something of a guide as to how one might use loss and, actually, how one might gain perspective on a decision to fall back from market quotation to loss. Close-out amount, in essence, requires a party to act in good faith and use commercially reasonable procedures to reach a commercially reasonable result. Like relevant New York case law, close-out amount favours reference to neutral third-party indicators of value, such as market prices. Close-out amount prescribes flexibility in methodology, to the extent that rigidity of methodology would forfeit reasonableness in the process. In considering how (and when) to calculate damages, an NDP also must consider (in New York) its duty to mitigate damages. An NDP is not required to stop a bullet for Party X, but an NDP may need to accept some degree of inconvenience or incidental cost if to do so would diminish the cost to X of the liquidation.

Working through choices in liquidation valuation and designing a process to collect valuations are substantial tasks. Careful reading of agreements and examination of exposures, as well as process planning, are necessary to get the best result possible. Many undertake the process knowing their effort may be reviewed with critical hindsight by a court or possibly an insolvency official eager to recover for the benefit of Party X's creditors at large. An NDP may be forced to disclose its own valuation methodologies and explain any mismatches between those methodologies and the techniques used in the close-out, or to explain differences between book and close-out values.

While you are thinking ...

The Isda agreement contains a conditions precedent section, section 2(a)(iii), that permits a party to withhold its performance if its counterparty is suffering an event of default, potential event of default or if an early termination date has been designated. This provision may allow a party to avoid paying or delivering into a situation where compensatory performance may not be forthcoming.

In the Lehman Brothers insolvency, a number of out-of-the-money counterparties have exercised their section 2(a)(iii) rights to suspend performance, but then have not closed out their defaulted counterparty. In other words, these NDPs have stopped paying Lehman in the ordinary course of business, but have not exercised their option to close-out because their second method Isda agreements would require payment of the liquidation value to Lehman.

This strategy, upheld in Australia in Enron Australia versus TXU Electricity,11 has been met with a motion on behalf of Lehman to permit the assignment of these frozen agreements to other parties. Regardless of the outcome with respect to this motion, section 2(a)(iii) will remain an important source of protection to an NDP facing a failing counterparty, while the NDP considers options and outcomes.


Close-outs in crisis markets are challenging in many ways. Certainly, applying the terms of the documents governing the transactions being closed out may require a substantial effort in troubled markets. Crisis market close-outs frequently indicate ways in which these documents might be improved. It will be interesting to see, when the credit crunch recedes, what (if any) changes to industry standards our latest experiences produce.

Joshua Cohn is a partner and Jillian Ashley is an associate at Allen & Overy in New York. Email:,

Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.

To access these options, along with all other subscription benefits, please contact or view our subscription options here:

You are currently unable to copy this content. Please contact to find out more.

Most read articles loading...

You need to sign in to use this feature. If you don’t have a account, please register for a trial.

Sign in
You are currently on corporate access.

To use this feature you will need an individual account. If you have one already please sign in.

Sign in.

Alternatively you can request an individual account here