Background

The governing agreements for a wide range of transactions, from the most basic financing arrangements to the most complex derivatives trading relationships, frequently include a “cross-default” event of default. This type of a default is triggered under one agreement when a party defaults in respect of indebtedness incurred under another agreement (i.e., “other indebtedness”)—hence the name, “cross-default.”

A cross-default provision often includes a monetary threshold that must be exceeded before a default will occur. For example, an event of default will occur if a payment is missed and either the amount of the missed payment, alone or in combination with the principal amount of the other indebtedness, exceeds a specific level.

Cross-Default under the 2002 ISDA Master Agreement

Section 5(a)(vi) of the published form of 2002 ISDA Master Agreement is the cross-default event of default that is most common to derivatives trading relationships. Counterparties to master trading agreements that do not contain a cross-default event of default often incorporate a provision into those agreements that mirrors Section 5(a)(vi) of the ISDA Master Agreement.

An event of default will occur under Section 5(a)(vi) of the ISDA Master Agreement when a counterparty—or its credit support provider (e.g., a guarantor of any obligations under the ISDA Master Agreement) or any identified party (typically, an affiliate)—defaults under an agreement or instrument relating to “Specified Indebtedness,” which the ISDA Master Agreement defines as “any obligation in respect of borrowed money.” Section 5(a)(vi) provides for two different default scenarios: the first scenario applies to any default while the second scenario applies only to a payment default.

In the first default scenario, an event of default will occur if two conditions are met. First, the sum of the principal amount of the Specified Indebtedness and any missed payments under that indebtedness must exceed an agreed-upon level referred to as the “Threshold Amount,” which can be a stated dollar amount or determined as a percentage of a counterparty’s shareholders’ equity. Second, the default must result in the Specified Indebtedness becoming due and payable, or becoming capable at the time of being declared due and payable, before it would have otherwise been due and payable. As such, the first default scenario represents a cross-default provision and a cross-acceleration provision, though for certain types of derivatives transactions it is common for the parties to modify it so that it is solely a cross-acceleration provision.

In the second default scenario, an event of default will occur if there is a default in making one or more payments due under the Specified Indebtedness in an aggregate amount—when considered alone or together with the principal amount of that indebtedness—that equals or exceeds the Threshold Amount. As such, the second default scenario represents a cross-default provision and this is rarely modified by counterparties.

Expanding Cross-Default to Cover Specified Transactions with Other Counterparties

Counterparties sometimes expand the cross-default event of default so that it applies to not only payments due in respect of Specified Indebtedness, but also to payments due in respect of over-the-counter derivatives and other financial transactions entered into by the defaulting party with other, unrelated counterparties. This practice became more common after the failure of Lehman Brothers in September 2008, as market participants began to evaluate various counterparty risk management-oriented provisions in their trading agreements. One perceived benefit of expanding cross-default to cover third-party Specified Transactions is to provide a non-defaulting party with an “early warning” mechanism that allows it to terminate its open positions prior to the defaulting party’s insolvency filing.

By way of context, the 2002 ISDA Master Agreement has a separate event of default in Section 5(a)(v) that is triggered by a default with respect to derivatives and other financial transactions, defined under the agreement as “Specified Transactions,” a term that is defined as over-the-counter derivatives and other financial transactions, like repurchase and reverse repurchase agreements, entered into between the two counterparties to the agreement or, to the extent agreed to by the counterparties, any identified credit support provider or other party (typically, an affiliate). By expanding the cross-default provision to apply to “third-party” Specified Transactions, the counterparties are creating what can be described as a “compound” event of default that combines concepts in Section 5(a)(v) and (vi) of the 2002 ISDA Master Agreement.

Market participants’ views about an expanded cross-default provision are mixed. In our experience, whether such a provision is viewed favorably or unfavorably does not necessarily split evenly along the lines of buyside and dealer firms.

On the one hand, some buyside firms view the expanded cross-default event as providing them with increased counterparty risk management benefits, largely on the basis that the dealer has a larger and more complex portfolio of Specified Transactions making the dealer’s default more likely to present counterparty risks to the buyside firm.

On the other hand, some dealers prefer to expand cross-default to capture Specified Transactions, since it presents the obvious benefit of having “another lever to pull” in the case of the buyside firm’s failure. The benefits to a dealer of the expanded cross-default provision may be more pronounced if the dealer’s security interests in collateral are junior to other derivative counterparties or if the dealer believes that the other counterparty (i.e., Party B) has a complex portfolio of Specified Transactions with other dealers or otherwise has a more complex risk profile.

Drafting Considerations in Respect of an Expanded Cross-Default Provision

When considering the expansion of cross-default to cover third-party Specified Transactions, market participants should give specific attention to several items.

First, the counterparties should consider whether to limit the types of Specified Transactions that will be covered by the expanded cross-default provision.

Second, the counterparties should determine the means by which the Threshold Amount will be measured in respect of any such third-party Specified Transactions. The cross-default provision was intended to apply to funded indebtedness rather than derivatives transactions, so measuring the Threshold Amount based on the “aggregate principal amount” of Specified Indebtedness as required in the first default scenario described above does not work well for a derivatives transaction. Accordingly, for purposes of the first default scenario, an expanded cross-default provision should instead measure the Threshold Amount for derivatives transactions by examining the amount that becomes, or would become, payable as a result of the liquidation or termination of the applicable derivatives transaction.

Third, and perhaps most fundamentally, market participants should consider whether the benefits of the expanded cross-default provision outweigh its potential burdens, since every event of default has the potential to be both a shield that protects a counterparty and a sword that can be used against it depending upon the facts and circumstances surrounding any particular default scenario.