Derivatives

Derivatives/Structured Products
Financial Institution Bankruptcy:
Points to consider in affected derivatives
and structured products
Contents
Page

What to do if a financial institution counterparty defaults

as a result of bankruptcy? 1

1. ISDA Master Agreements 1

2. Structured Notes 4

3. CDOs and Other Securitisation Transactions 5

4. CDS Transactions 5

5. Repos 6

Talk to us 7
What to do if a financial institution
counterparty defaults as a result of
bankruptcy?
Recent events have left many analysing their derivatives and structured products
exposure to financial institution bankruptcy. This alert sets out some of the practical
steps to take and matters to consider under:

(a) ISDA’s 1992 and 2002 Master Agreements

(b) Structured Notes

(c) CDOs and Other Securitisation Transactions

(d) CDS Transactions; and

(e) Repos

1. ISDA Master Agreements

Potential Events of Default and Relevant Cure Periods
The bankruptcy of a financial institution counterparty, credit support provider, or
specified entity under an ISDA Master Agreement (whether the 1992 or 2002 ISDA
Master Agreement) may be an event of default.

As the Non-Defaulting party several events of default may potentially be available, and
some of these may be subject to specified cure periods.

LIKELY EVENTS OF DEFAULT AND RELEVANT CURE PERIODS

Failure to Pay Non-defaulting Party must serve notice and allow the Defaulting
Party 3 Local Business Days (or 1 Local Business Day under a
2002 ISDA Master Agreement) to remedy this payment.

Breach of Non-defaulting Party must serve notice and allow a 30 Day cure
Agreement period before termination.

Credit Support The applicable cure period in the relevant Credit Support
Default Document applies.

Default Under The applicable cure period for the Specified Transaction applies,
Specified if no cure period is stated then the Non-defaulting Party must
Transactions serve notice and allow 30 Days to remedy this default.

Cross Default This is an event of default with immediate effect, no cure period.

Bankruptcy Clause 5(a)(vii) lists several grounds for Bankruptcy. There is a

30 day cure period for situations where insolvency proceedings
are instituted or where a secured party takes possession of assets.
For other grounds such as where a party is dissolved or becomes
insolvent there is no cure period.

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2
How do you terminate an ISDA Master Agreement?
How do you terminate an ISDA Master Agreement?
Where
Where aanon-defaulting party
non-defaulting triggers
party an Event
triggers of Default
an Event by delivering
of Default by delivering the counterparty,
a notice atonotice all transactions
to the counterparty, under the ISDA
all transactions Master
under the Agreement will be
ISDA Master
terminated.
Agreement will be terminated.
Event of Default
Event of Default
01/01 02/01 Applicable cure period 22/01

(if any)

Event of Serve notice under 6(a)

Default providing a max of 20 days End of cure Can designate an Early End of 20 day max notice
from date of notice until the period (if Termination Date period prior to Early
Early Termination Date applicable) during this period * Termination Date

What is in the notice?

Notice
What isis
in to notice?
thebe given under 6(a) and it must specify the relevant Event of Default.
Notice is to be given under 6(a) and it must specify the relevant Event of Default.
Designate a day not earlier than the day such notice is effective as Early Termination Date in respect of all outstanding Transactions. However,
ifDesignate
Automatic not earlier
a day Early than the day such
Termination notice is effective
is applicable the as
Early
Early Termination in respect
Termination DateDate all outstanding
willofhappen Transactions.
immediately uponHowever, if Automatic Early
the occurrence Termination
of that event. is applicable the
Early Termination Date will happen immediately upon the occurrence of that event.

The notice
The notice must be addressed
must correctly and
be addressed correctly writing,
must be inand must Notices
N.B.be given by e-mail
in writing, N.B. (or Notices
in the case given ISDA
of a 1992by e-mail Agreement
Master(or fax) will
in thebycase ofnot
a be
1992 in the absence
valid ISDA Masterof a
specific amendment
Agreement by fax) to the ISDA
will notMaster Agreement.
be valid in the absence of a specific amendment to the ISDA Master Agreement.
** If
Ifthere cure
thereisisnono period,
cure period, non-defaulting
the the non-defaulting may designate
party party may designate Termination
an Earlyan Early Termination
Date from Date of notice
servicefrom under
service of 6(a).
notice under 6(a).
 Calculating Settlement Amounts

Under ISDA’s 1992 Master Agreement these methods are, (i) First Method Market Quotation, (ii)
First Method and Loss, (iii) Second Method and Market Quotation and (iv) Second Method and
Loss. As a practical matter, First Method is almost never applicable.

Second Method and Market Quotation:

The Unpaid Amount due is the net amount (gain or loss to a party) resulting from the termination of
the transaction calculated on the basis of quotations obtained from Reference Market-makers for the
terminated transactions. The Defaulting as well as the Non-defaulting party is required to indemnify
the losses suffered.

Second Method and Loss:

Loss here refers to the total losses under the ISDA Master Agreement. This includes loss of bargain,
cost of funding, any unpaid amounts but not legal fees and other out of pocket expenses. The
Defaulting party will pay the loss suffered by the Non-defaulting party and the Non-defaulting party
will pay the loss suffered by the Defaulting party.

Under ISDA’s 2002 Master Agreement, the settlement method is the Close-out Amount which is:

A more flexible method of calculation which combines both the Market Quotation and Loss Methods.
The Close-out Amount will include losses or gains to the Determining Party in order to replace the
transaction with its economic equivalent. The amount will be determined by the Determining Party,
which will act in good faith and use commercially reasonable procedures in order to produce a
commercially reasonable result.

CLOSE-OUT CHECKLIST- Event of Default

1. You become aware of potential Event of Default.

2. Appoint the necessary personnel to review the ISDA documents, including establishing
the following:

(a) Is it a 1992 or 2002 ISDA?

(b) If it is a 1992 ISDA, what is the payment measure and payment method?

3. If it is an Event of Default, take steps to find out:

(a) Is there a cure period?

(i) If yes - wait till the cure period runs out and then serve notice under clause 6(a)
designating an Early Termination Date.

(ii) If no – serve notice under clause 6(a) designating an Early Termination Date.

4. Early Termination Date

(a) Calculations Statement: On or as soon as possible after the Early Termination Date,
each party must calculate the amount payable (if any) and provide the counterparty
a statement with the calculations, together with details of the account to which the
amount is payable.

(b) Calculations:

(i) If it is ISDA 1992 – follow the methods specified.

nn If it is Market Quotation:

– Request Reference Market-makers to provide quotations on or as soon as possible

after the Early Termination Date.

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 – If more than three quotations are received Market Quotation will be the arithmetic
mean of the quotations, disregarding the quotations having the highest and the
lowest value.

– If three quotations are received the Market Quotation will be the quotation which
remains after disregarding the quotations with highest and lowest value.

– If less than three quotations are received then it is deemed that the Market
Quotation in respect of such transaction cannot be determined.

nn If it is Loss:

– On Early Termination Date or as soon as possible afterwards, the party must

reasonably determine in good faith the total loss and costs. The party may use
market quotations as reference when determining the loss.

(ii) If it is ISDA 2002 – The Determining Party must calculate the Close-out Amount
acting in good faith and using commercially reasonable procedures in order to
produce a commercially reasonable result.

This may include considering information from third parties and internal sources on:

nn quotations for replacement transactions; and

nn information of the relevant market including, rates, prices, yields, yield curves,
volatilities, spreads, correlations etc.

6. Payment

For Events of Default – the payments must be made on the day that notice of the amount
payable is effective. N.B Amounts payable in respect of an Early Termination Date
will be subject to set-off.

2. Structured Notes
It is likely that the bankruptcy of a financial institution in a structured note will trigger
event of default and termination provisions in the underlying documentation.

The financial institution could be acting in a number of pivotal capacities either

as arranger, guarantor, liquidity provider, cash manager or in relation to any swap
documentation (amongst others). A thorough review of all documentation involving
the financial institution is recommended not just to identify whether its bankruptcy has
triggered a redemption or termination of notes (directly or indirectly) but also from a
mechanical, administrative and ratings perspective. Such effects should be identified
immediately and addressed where possible.

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3. CDOs and Other Securitisation Transactions
A financial institution may perform some of the following roles in a structured finance
transaction: swap counterparty; liquidity provider; repo and put agreement counterparty;
and cash account provider.

A bankrupt financial institution which fulfils one of these roles in a CDO transaction
therefore is likely to be affected by the trigger downgrade provisions in the underlying
CDO and securitisation documentation generally insisted upon by the rating agencies.

Following bankruptcy the bankrupt counterparty will generally be required to:

(a) find an eligible replacement counterparty;

(b) find a guarantor to guarantee its obligations; or

(c) any other action which is satisfactory to the relevant rating agencies.

Alternatively, the parties can unwind the transaction in accordance with the mandatory
redemption event provisions.

Each rating agency has different criteria and it may depend on the type of structured
finance transaction in question. In each instance you will need to carefully review
the terms of the transaction documents, swap agreement or credit support annex to
ascertain the downgrade language to ensure compliance with the requirements of the
relevant rating agency. 

4. CDS Transactions
Closing down one CDS following a credit event is one matter, but closing down many
CDS transactions at once will, if not handled efficiently mean that potential losses may
occur. The Bankruptcy Credit Event will be the most likely Credit Event to be triggered
under the 2003 Credit Derivatives Definitions.

We advise having in place a Credit Event Strategy to minimise loss when dealing with
a major credit event like that of the bankruptcy of a major financial institution by
implementing the following:

1) documentation that will help your employees target rapidly the vital information
required to effect the credit event process and settlement process when facing a
major credit event; and

2) personnel who work in committees supervising the above mentioned documentation

ensuring all parties have all the information they need to deal with a major credit
event at short notice.

The credit event process involves a mine field of administrative tasks. Some of these
tasks may seem simple e.g. the delivering of notices but such tasks need to be tackled
in a coherent manner. We advise that compiling a universal spreadsheet with vital
information like identification of parties, transaction type, settlement method, credit
events, notification details and forms and valuation provisions will put you in good stead
to invoke a robust credit event strategy should the time come to face a major credit
event.

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 We would be happy to come to talk you and give bespoke advice on how to create
an effective Credit Event Strategy through the setting up of documentation to help
you concentrate on this aspect of your risk management and deal with the legal and
administrative hurdles you must jump in order to settle your CDS transactions.

5. Repos
As stated in item (3) above a financial institution is likely to enter into repo transactions
as part of its structured finance activities.

A bankrupt financial institution under a repo is therefore likely to trigger an event of

default under the relevant repurchase transaction.

LIKELY EVENTS OF DEFAULT POSSIBLE UNDER PARAGRAPH 10(a) OF

GMRA 2000 WHERE BUYER OR SELLER IS BANKRUPT
10(a) EVENTS OF DEFAULT

(i) Buyer fails to pay the Purchase Price upon the applicable Purchase Date or Seller fails to
pay the Repurchase Price upon the applicable Repurchase Date, and the non-Defaulting
Party serves a Default Notice on the Defaulting Party.

(ii) If the parties have specified in Annex I that this sub-paragraph shall apply, Seller fails to
deliver Purchased Securities on the Purchase Date or Buyer fails to deliver Equivalent
Securities on the Repurchase Date, and the non-Defaulting Party serves a Default Notice
on the Defaulting Party.

(iii) Seller or Buyer fails to pay when due any sum payable under sub-paragraph (g) (Failure to
deliver Purchased Securities) or (h) (Failure to deliver Equivalent Securities), and the non-
Defaulting Party serves a Default Notice on the Defaulting Party.

(iv) Seller or Buyer fails to comply with paragraph 4 (Margin Maintenance) and the non-
Defaulting Party serves a Default Notice on the Defaulting Party;

(v) Seller or Buyer fails to comply with paragraph 5 (Income Payments) and the non-
Defaulting Party serves a Default Notice on the Defaulting Party.

(vi) An Act of Insolvency occurs with respect to Seller or Buyer and (except in the case of an
Act of Insolvency which is the presentation of a petition for winding-up or any analogous
proceeding or the appointment of a liquidator or analogous officer of the Defaulting Party
in which case no such notice shall be required) the non-Defaulting Party serves a Default
Notice on the Defaulting Party.

(viii) Seller or Buyer admits to the other that it is unable to, or intends not to, perform any of its
obligations hereunder and/or in respect of any Transaction and the non-Defaulting Party
serves a Default Notice on the Defaulting Party;

(ix) Seller or Buyer is suspended or expelled from membership of or participation in any

securities exchange or association or other self regulating organisation, or suspended from
dealing in securities by any government agency, or any of the assets of either Seller or
Buyer or the assets of investors held by, or to the order of, Seller or Buyer are transferred or
ordered to be transferred to a trustee by a regulatory authority pursuant to any securities
regulating legislation and the non-Defaulting Party serves a Default Notice on the
Defaulting Party;

(x) Seller or Buyer fails to perform any other of its obligations hereunder and does not remedy
such failure within 30 days after notice is given by the non-Defaulting Party requiring it to
do so, and the non-Defaulting Party serves a Default Notice on the Defaulting Party;

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In the case of bankruptcy, it is most likely 10(a)(vi) will apply. In any event, we advise
that, to minimise further loss and maximise recoveries, there be systems in place to
assess exposure to a bankrupt counterparty under a repo as soon as possible. Except
in certain circumstances, notices will be required to be delivered in order to pursue an
event of default. Whilst a repo with a bankrupt counterparty may require no notice to
be served, an event of default under such repo could have a knock on event of default
effect on “another” repo, and so we advise that a non defaulting party be well prepared to
undertake a review of the event of default of provisions across all its repos on all possible
events of default at any time.

Parties should also be mindful of any insolvency issues raised by triggering an event of
default and instances in which contractual set off provisions could be set aside in favour
of mandatory set off provisions under the Insolvency Rules 1986.

In any event, where an event of default has been triggered we advise the non defaulting
party to thoroughly assess what impact insolvency of the counterparty will have on its
own financial arrangements and what modifications are appropriate to counter them.

Talk to us
Ed Parker, Head of Derivatives
Partner , London
T +44 (0)20 7782 8922
F +44 (0)20 7782 8774
E eparker@mayerbrown.com

Dominic Griffiths, Head of Securitisation

Partner , London
T +44 (0)20 7782 8292
F +44 (0)20 7782 8774
E dgriffiths@mayerbrown.com

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0164fin
September 2008