Definition of Termination Event
A termination event is an occurrence that will cause all or part of a swap agreement to be ended early. 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 "tax event upon merger"), or a reduction in one counterparty's creditworthiness ("credit event").
A termination even can also relate to business agreements between multiple parties. If one of the members takes a course of action which is deemed inappropriate, that could serve as a termination event for the partnership.
Breaking Down Termination Event
As part of the swap arrangement, the counterparties agree to notify each other if a termination event takes place. If a swap is terminated early, both parties will cease to make the agreed-upon payments, and the counterparty who is responsible for the termination event may be required to pay damages to the other counterparty. Default events such as failure to pay or declaration of bankruptcy can also cause a swap contract to end early.
Example of a Termination Event
For example, Jack and Ernie are counterparties in a swap agreement. Bert is the sole partner in his company which has just declared bankruptcy, reducing Bert's creditworthiness and eliminating his ability to make the payments stated under the swap agreement. This is a credit event and would be considered a termination event for the swap partnership.