Termination Clause: What it is, How it Works, Example

What Is a Termination Clause?

A termination clause is a section of a swap contract that describes the procedures and remedies for one of the counterparties if the other counterparty defaults or otherwise ends the contract. This includes, but is not necessarily limited to, the payment of damages to the injured counterparty. When a swap terminates early, both parties will cease making the contractually agreed-upon payments.

A termination clause may also be included in an employment contract. It defines the employee's rights in terms of receiving notice of termination, severence, or pay in lieu of notice.

Understanding Termination Clause

Counterparties using the International Swaps and Derivatives Association's (ISDA) master swap agreement can take advantage of the termination clause that is already written into that agreement. Possible termination events include legal or regulatory changes that prevent one or both parties from fulfilling the contract terms (illegality), the placement of a withholding tax on the transaction (tax event), or a reduction in one counterparty's creditworthiness (credit event). The failure to pay or a declaration of bankruptcy by either party are examples of default events.

A termination clause contains language that could lead to an early end to the swap contract if either party experiences specific, predetermined events or changes in its financial status, or if other specific events outside the party's control will change its ability to legally maintain the contract.

The agreement value method, formula method, or indemnification method can be used to calculate these damages, called "termination payments."

While a clear default of the swap contract immediately releases the non-defaulting, or injured, party from further obligations to make payments, it does not address potential relief from the risks and benefits of future payments not yet due, or the risks associated with replacing the injured party's contract at similar terms. Therefore, the termination clause contains provisions that can speed up the counterparty's obligations (acceleration) and other procedures to compensate the injured party for the loss of the swap contract.

Master Swap Agreement

The master swap agreement is a basic, standardized swap contract created by the International Swaps and Derivatives Association in the late 1980s. It identifies the two parties entering the transaction and describes the terms of the arrangement, such as payment, and events of default and termination. It also lays out all other legalities of the deal, including early termination.

The agreement simplifies the process because it establishes the basic legal terms so that only the specific financial terms, such as rate and maturity, need be discussed. Signing a master swap agreement also makes it easier for the same parties to engage in additional transactions in the future because they can conform to the initial agreement.

Termination Clause for Employees

Termination clauses, also sometimes called severance clauses, are written into employment contracts. The clause provides a pre-set agreement on what will happen when the employee is terminated in terms of how much notice they get and/or what sort of payment they will receive.

If there is no termination clause, then standard employee regulations, laws, and standards are enforced.

Employees can negotiate a termination clause in their favor. If they are let go, for example, they could ask for a large severance package. Typically, employers will try to limit the employee's rights within the termination clause in order to reduce the cost of terminating an employee.

Employee Termination Clause Example

Corporate executives typically have favorable termination clauses written into their employment contracts. When a company wants someone, it is more likely to negotiate or offer the executive what they want to come aboard.

A struggling company, for example, may believe that a particular chief executive officer (CEO) could save the company and get it on the right path. They need to entice the potential CEO, and one way to do it is through pay as well as the termination clause. The company could offer the CEO $1 million per year, for example, and $20 million in severance pay if the board of directors (B of D) fires the CEO. If the CEO likes the proposal, they may join the company, or they may counteroffer, asking for higher pay and/or higher severance pay.

While this may be agreed to by the CEO, it also caps how much the company will need to pay should it decide to get rid of the CEO for underperformance.