Section 2(a)(iii) - ISDA Provision: Difference between revisions

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===Chris Allen's note===
{{nman|isda|2002|2(a)(iii)}}
{{doc|Draft ISDA 2a3 protocol.doc|Draft ISDA 2(a)(iii) Protocol}}
{{nlp}}
 
These amendments are being led by [[ISDA]] and are likely to take effect by Protocol. These changes are separate to the ones being contemplated under DFA. I have spoken to ISDA's GC about trying to merge the docs so as to reduce client repapering. Current proposal is nonetheless to keep the activities separate.
 
====Intent of drafting====
The revised text looks to address 4 concerns (each arising from English case law):
 
#'''Time Limit''': Will now be triggered by the {{isdaprov|Defaulting Party}}serving notice on the {{isdaprov|Non-defaulting Party}}. Makes sense I think. Bank of England, FSA and Fed all keen for the period to be short (UK had suggested 1 month).
#'''Gross/Net issue''': (per [[Lomas v Firth Rixson (Case Note)|Firth Rixson]] and [[Marine Trade (Case Note)|Marine Trade]])
#'''Due Date Expiry issue''': (per [[Marine Trade]])
#'''Extinguishment issue''': (Firth Rixson) and the "Terminated Transaction" issue (per [[Pioneer v Cosco (Case Note)|Cosco]]).
 
====Outstanding Issues====
The revised language raises a few concerns.
 
#'''Incurable {{isdaprov|Events of Default}}''': ISDA was looking to apply the time restriction only in respect of "incurable" {{isdaprov|Events of Default}}". Not actually sure the list was sufficiently comprehensive to achieve that. Others have suggested to limit to {{isdaprov|Bankruptcy}}. Anyway, does not matter because none of that works under English law for capital reasons and so [[ISDA]] will be changing to apply the language to all {{isdaprov|Events of Default}} ([[FSA]] will require this).
#The language is problematic where, for example, a {{isdaprov|Defaulting Party}} informs the {{isdaprov|Non-defaulting Party}} of a {{isdaprov|Misrepresentation}}. Non-defaulting Party waives the misrep and then the "defaulter" experiences a {{isdaprov|Default Under Specified Transaction}}. Would leave a gap on the CP. I have mentioned this to ISDA.
----
 
==Original Text of Section 2(a)(iii)==
(iii) Each obligation of each party under Section 2(a)(i) is subject to (1) the condition precedent
that no Event of Default or Potential Event of Default with respect to the other party has occurred
and is continuing, (2) the condition precedent that no Early Termination Date in respect of the
relevant Transaction has occurred or been effectively designated and (3) each other applicable
condition precedent specified in this Agreement.
 
Innocuous looking, isn't it. But then the Protocol of the Elders of ISDA had a go at fixing [[Metavante]] concerns. Now look what they've done:
 
==Modified Text as per ISDA draft protocol==
===Section 2(a)(iii)===
(iii) Each obligation of each party under Section 2(a)(i) is subject to (1) the condition precedent
that no Event of Default or Potential Event of Default with respect to the other party has occurred
and is continuing, (2) the condition precedent that no Early Termination Date in respect of the
relevant Transaction has occurred or been effectively designated and (3) each other applicable
condition precedent specified in this Agreement. '''The condition precedent in Section 2(a)(iii)(1) will
'''cease to be a condition precedent to each obligation of the Non-defaulting Party on the Condition End Date,'''
'''if any.'''
'''(vi) For the avoidance of doubt, Section 2(a)(iii) applies to each obligation of each party under'''
'''Section 2(a)(i), after the application of Section 2(c)''' ''[i.e. {{isdaprov|Netting}}].''
'''(vi) For the avoidance of doubt, if the condition precedent in Section 2(a)(iii)(1) is not satisfied'''
'''with respect to a party (“X”) when an obligation of the other party (“Y”) would (but for such condition'''
'''precedent) become payable or deliverable to X under Section 2(a)(i), then the obligation of Y will become'''
'''payable or deliverable on the first to occur of (A) the date on which all applicable conditions precedent'''
'''to such obligation under Section 2(a)(iii) are satisfied, (B) the Condition End Date or (C) the date on'''
'''which all applicable conditions precedent cease to apply under any other provision of this Agreement.'''
===Restatement of Section 9(c) {{isdaprov|Survival of Obligations}} in entirety:===
'''''Survival of Obligations''.  Without prejudice to Sections 2(a)(iii) and 6(c)(ii), the obligations of the'''
'''parties under this Agreement will survive the termination of any {{isdaprov|Transaction}}.  For the avoidance of doubt,'''
'''notwithstanding the occurrence of the last scheduled due date for performance by a party under a Transaction,'''
'''any obligation of a party that would have become due under that Transaction but for Section 2(a)(iii) will:'''
 
'''(1) prior to the occurrence or effective designation of an {{isdaprov|Early Termination Date}} in respect of such'''
'''Transaction become due (together with interest in accordance with Section [9(h)(i)(3)(A)]  [2(e)] ) on'''
'''the first to occur of (A) the date on which all applicable conditions precedent to such obligation under'''
'''Section 2(a)(iii) are satisfied, (B) the Condition End Date or (C) the date on which all applicable conditions'''
'''precedent cease to apply under any other provision of this Agreement, and'''
'''(2) following the occurrence or effective designation of an {{isdaprov|Early Termination Date}} in respect of such'''
'''Transaction be taken into account in determining the amount payable in respect of such'''
'''{{isdaprov|Early Termination}} Date pursuant to Section 6(e).'''
 
===Amendment to Section 2(e) of the [[1992 ISDA Master]] Agreement only ===
NB there isn't a Section 2(e) in [[2002 ISDA Master]] - this amendment is purely to bring  the {{1992isda}}it in line with the 2002 provision on {{isdaprov|Interest and Compensation}}:''
'''Default Interest; Other Amounts'''. Prior to the occurrence or effective designation of an Early
Termination Date in respect of the relevant Transaction, a party that defaults in the performance of any
payment obligation will, to the extent permitted by law and subject to Section 6(c), be required to pay interest
(before as well as after judgment) on the overdue amount to the other party on demand in the same currency
as such overdue amount, for the period from (and including) the original due date for payment to (but
excluding) the date of actual payment, at the Default Rate. Such interest will be calculated on the basis of
daily compounding and the actual number of days elapsed. If, prior to the occurrence or effective designation
of an Early Termination Date in respect of the relevant Transaction, a party defaults in the performance of
any obligation required to be settled by delivery, it will compensate the other party on demand if and to the
extent provided for in the relevant Confirmation or elsewhere in this Agreement. '''If a party does not pay '''
'''any amount that, but for Section 2(a)(iii), would have been payable, it will, to the extent permitted by'''
'''applicable law and subject to Section 6(c), pay interest (before as well as after judgment) on that'''
'''amount to the other party on demand (after such amount becomes payable) in the same currency as the amount,'''
'''for the period from (and including) the date the amount would, but for Section 2(a)(iii), have been payable'''
'''to (but excluding) the date the amount actually becomes payable, at the rate  certified by the payer to be a'''
'''rate offered to the payer by a major bank in a relevant interbank market for overnight deposits in the'''
'''applicable currency, such bank to be selected in good faith by the payer for the purpose of obtaining'''
'''a representative rate that will reasonably reflect conditions prevailing at the time in that relevant market.'''
 
===Additional {{isdaprov|Definitions}} in Section 14===
"'''Terminated Transactions'''" means, with respect to any {{isdaprov|Early Termination Date}}, (a) if resulting from an Illegality or
a {{isdaprov|Force Majeure Event}}, all {{isdaprov|Affected Transaction}}s specified in the notice given pursuant to Section 6(b)(iv), (b) if
resulting from any other {{isdaprov|Termination Event}}, all {{isdaprov|Affected Transaction}}s and (c) if resulting from an {{isdaprov|Event of Default}},
all Transactions''', in each case under which a party has or may have any obligation, including, without limitation,'''
'''an obligation to pay an amount that became payable (or would have become payable but for Section 2(a)(iii) or due'''
'''but for Section 5(d)) to the other party under Section 2(a)(i) or 2(d)(i)(4) on or prior to that Early Termination Date'''
'''and which remains unpaid as at such Early Termination Date.'''
'''"Condition End Date" means the first Local Business Day after the date falling [  ] days after notice'''
'''is given by the Defaulting Party to the Non-defaulting Party that an Event of Default [specified in Section'''
'''5(a)(iv), 5(a)(v), 5(a)(vi) or 5(a)(vii)] or[, in the case of Section 5(a)(vii)(4),] Potential Event of Default'''
'''has occurred with respect to the Defaulting Party.'''
 
==Commentary==
In a nutshell, what this does is:
*Allows the {{isdaprov|Defaulting Party}} to notify of an {{isdaprov|Event of Default}} or {{isdaprov|Potential Event of Default}}.
*That in turn starts the clock running on a period (to be agreed by the parties but (see Chris' note - likely to be no more than a month) in which the {{isdaprov|Non-defaulting Party}} has to decide what to do. During that period the Non-Defaulting retains its traditional right under 2(a)(iii) to suspend payments under the {{isdama}}.
*upon expiry of that period the {{isdaprov|Event of Default}} no longer qualifies as a [[condition precedent]] to payment under the Section 2(a)(iii), so if the Non-Defaulting Party has not exercised its right to terminate, it must resume performance of the transaction.
 
{{isdaanatomy}}

Latest revision as of 15:12, 26 May 2024

2002 ISDA Master Agreement

A Jolly Contrarian owner’s manual™

2(a)(iii) in a Nutshell

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Original text

2(a)(iii) Each obligation of each party under Section 2(a)(i) is subject to (1) the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing, (2) the condition precedent that no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated and (3) each other condition specified in this Agreement to be a condition precedent for the purpose of this Section 2(a)(iii).
See ISDA Comparison for a comparison between the 1992 ISDA and the 2002 ISDA.
The Varieties of ISDA Experience
Subject 2002 (wikitext) 1992 (wikitext) 1987 (wikitext)
Preamble Pre Pre Pre
Interpretation 1 1 1
Obligns/Payment 2 2 2
Representations 3 3 3
Agreements 4 4 4
EODs & Term Events 5 Events of Default: FTPDBreachCSDMisrepDUSTCross DefaultBankruptcyMWA Termination Events: IllegalityFMTax EventTEUMCEUMATE 5 Events of Default: FTPDBreachCSDMisrepDUSTCross DefaultBankruptcyMWA Termination Events: IllegalityTax EventTEUMCEUMATE 5 Events of Default: FTPDBreachCSDMisrepDUSSCross DefaultBankruptcyMWA Termination Events: IllegalityTax EventTEUMCEUM
Early Termination 6 Early Termination: ET right on EODET right on TEEffect of DesignationCalculations; Payment DatePayments on ETSet-off 6 Early Termination: ET right on EODET right on TEEffect of DesignationCalculationsPayments on ETSet-off 6 Early Termination: ET right on EODET right on TEEffect of DesignationCalculationsPayments on ET
Transfer 7 7 7
Contractual Currency 8 8 8
Miscellaneous 9 9 9
Offices; Multibranch Parties 10 10 10
Expenses 11 11 11
Notices 12 12 12
Governing Law 13 13 13
Definitions 14 14 14
Schedule Schedule Schedule Schedule
Termination Provisions Part 1 Part 1 Part 1
Tax Representations Part 2 Part 2 Part 2
Documents for Delivery Part 3 Part 3 Part 3
Miscellaneous Part 4 Part 4 Part 4
Other Provisions Part 5 Part 5 Part 5

Resources and Navigation

Index: Click to expand:

Comparisons

Section 2(a)(iii) is the world-famous, notorious, much-feared “flawed asset” provision in the ISDA Master Agreement. The text was mostly unchanged between the 1992 ISDA and the 2002 ISDA, bar a single clarification in Section 2(a)(iii)(3). There was a change from the 1987 ISDA which did not have the middle condition precedent that “no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated”. As to what all this means, or achieved, we speculate below.

Basics

Herculio: I have a thought. This meagre tract: not ninety words
Wrapp’d about with preliminal nicety and
Stamp’d as for affixation to a servic’d boiler
Conceals a clever trick.
Ser Jaramey: What kind of onion’d witchery is this?

Otto Büchstein, Ser Jaramey Slizzard

Assets, and flawed assets

What is the big deal about this, then? Well, it turns your ISDA into a “flawed asset”.

Flawed asset
/flɔːd ˈæsɛt/ (n.)

A financial asset that looks good, but thanks to a carefully buried conditions precedent, is not there when you, and more importantly, your insolvency administrator, most wants it.

In the language of financial obligations, the right to future payments under a contract is an asset. The creditor owns that right and, all other things being equal, can deal with it — that is, sell or raise money against it — the same way it can sell or mortgage a house, car, a portfolio of equities, or some decentralised cryptographic tokens representing abstract capital.

Assets have certain “ontological” properties, such as continuity in time and space. They might rust, depreciate, go out of fashion or stop working properly but they are nevertheless, existentially, still there. While you own them they therefore have some value to you, however parlous the state of your affairs might otherwise be.

Should your stars line up so that some official comes to be drawing up a closing account of your earthly financial existence — should you become bankrupt, heaven forfend — your assets can reliably be popped onto the “plus” side of the ledger. The difficulty subsists in working out what they are worth, but at least they are there.

This continuity is important to the administration of failing enterprises wherever they are based. It is a rude shock to find the assets you thought were there have without good explanation, gone. Many countries have rules preventing company managers from selling or giving away assets at an undervalue or otherwise granting unfair preferences as impending disaster looms. And nor can they enter contracts, even in times of fair weather, which would have the effect of granting unfair preferences, or depriving other creditors, should the clouds roll in.

An asset that doesn’t have that quality of continuity: that suddenly isn’t there, or that has the unnerving quality of winking in and out of sight at inopportune moments — is thus somehow imperfect: “flawed”.

Section 2(a)(iii) seems to have that effect on a Defaulting Party’s claims under an ISDA — its asset. Just when the Defaulting Party goes insolvent or fails to perform, the Non-defaulting Party is entitled to suspend the performance of its obligations without terminating the Transaction. Not entitled, even — as we will see, it just happens.

Should the Defaulting Party then cure the default, the Transaction resumes and the Non-defaulting Party must resume all its obligations, including the suspended ones. But for so long as the default is not cured, the Non-defaulting Party does not have to do anything. The Defaulting Party is left hanging there, with this “flawed asset”.

Insolvency regimes: not keen.

The United States Bankruptcy Code renders unenforceable terms terminating or modifying a contract that are triggered by the simple fact of insolvency proceedings. These are known as “ipso facto” clauses, because the simple fact of bankruptcy “in itself” triggers the clause.

If Section 2(a)(iii) were an ipso facto clause, it would not be enforceable. Whether it is an ipso facto clause is a subject of vigorous but tiresome debate. For our purposes, that people don’t easily agree about it is all you need to know.

The UK has no statutory equivalent of America’s ipso facto rule, but hundreds of years ago resourceful common law judges “discovered” an “anti‑deprivation” rule to the effect that, in the honeyed words of Sir William Page Wood V.C., in Whitmore v Mason (1861) 2J&H 204:

“no person possessed of property can reserve that property to himself until he shall become bankrupt, and then provide that, in the event of his becoming bankrupt, it shall pass to another and not his creditors”.

This required some wilfulness on the bankrupt’s part and not just inadvertence or lucky hap, but still: if you set out to defeat the standing bankruptcy laws do not expect easily to get away with it.

It seems, at any rate, that Section 2(a)(iii), might resemble some kind of intended deprivation; merely crystallising one’s existing position and stopping it from going further down the Swanee, as one might do by closing out altogether, seems less likely to.

Anyway: be aware: Section 2(a)(iii) attracts insolvency lawyers.

Rationale: avoiding a cleft stick

We can have a fine time rabbiting away about the ontology of assets, but isn’t there a more basic question: why would a Non-defaulting Party, presented with a counterparty in default, ever not want to just close out?

It all comes down to moneyness.

The “bilaterality” of a swap transaction means that either party may, net, be “out of the money” — that is, it would have to pay a net sum of money were the Transaction terminated — at any time. Unless something dramatic happens, this “moneyness” is only a “notional” debt: it only becomes “due” if an Early Termination Date is designated under the Master Agreement.

So an out-of-the-money, Non-defaulting Party has a good reason not to close out the ISDA. Doing so would oblige it to crystallise and pay out a mark-to-market loss. Why should it have to do that just because a Defaulting Party has failed to perform its end of the bargain?

On the other hand, the Defaulting Party is, er, ipso facto, not holding up its end of the bargain. Just as our innocent Non-defaulting Party does not wish to realise a loss by terminating, nor does it want to have to stoically pay good money away to a Defaulting Party who isn’t paying anything back.

A cleft stick, therefore.

Section 2(a)(iii) allows our Non-defaulting Party the best of both worlds. The conditions precedent to payment not being satisfied, it can just stop performing and sit on its hands — thereby neither crystallising its ugly mark-to-market position nor pouring perfectly good money away (which is a form of drip-feeding away that mark-to-market position, if you think about it).

So much so good for the Non-defaulting Party.

But the Defaulting Party’s “asset” — its contingent claim for its in-the-money position against the Non-defaulting Party — is compromised. This, for an insolvency administrator and all the Defaulting Party’s other creditors, is a bummer. It deprives them of the “asset” represented by the Transaction.

Which events?

Exactly which default events can trigger the suspension? Under the ISDA, Events of Default and even Potential Events of Default do, but Termination Events and Additional Termination Event do not. This is because most Termination Events are softer, “Hey look, it’s no one’s fault, it’s just one of those things” kind of events. This is not usually true of Additional Termination Events, though: they tend to be credit-driven, and girded with more “culpability” and “event-of-defaulty-ness”. So this is a bit dissonant, but there are far greater dissonances, so we park this one and carry on.

JC has seen valiant efforts to insert Additional Termination Events to section 2(a)(iii), and Potential Additional Termination Event, a class of things that does not exist outside the laboratory, and must therefore be defined. All this for the joy of invoking a clause that is highly unlikely to ever come into play, and which makes little sense in the first place.

Why the ISDA?

Herculio: All well-meant, good Triago. Be not sour —
These are not grapes.
Triago: Indeed not sir: rather, scrapes.
And scars and knocks — the job-lot doggedly sustained.
Herculio: (Aside) Some more than others. The odd one feigned.
But come, Sir Tig: what unrests you here?
Triago (waving paper): A tract from a brother clerk in America.
Herculio: Cripes abroad. Grim tidings?
Triago: Forsooth: it wears the colours of a fight.
A word-scape stain’d with tightly kernèd face
And girded round with fontish weaponry.
Herculio (inspecting the document): Verily, convenantry this dark
Speaks of litiginous untrust.
Otto Büchstein, Die Schweizer Heulsuse

Why, then, is this flawed assets business special to ISDA? Is it special to ISDA?

Normal financing contracts are, by nature, one-sided. Loans, for example. One party — the dealer, broker, bank: we lump these various financial service providers together as The Man — provides services, lends money and “manufactures” risk outcomes; the other — the customer — consumes them.

So, generally, the customer presents risks to The Man, and not vice versa. If the customer fails, it can’t repay its loan. All the “fontish weaponry” is therefore pointed at the customer.

Though the ISDA is also a “risk creation contract” with these same characteristics, it is not designed like one. Either party can be out of the money, and either party can blow up. The fontish weaponry points both ways.

This presented dealers with an unusual scenario: what happens if you blow up when I owe you money? That could not happen in a loan. It is less likely to happen under a swap these days, too, thanks to the arrival of mandatory variation margin — that is one of JC’s main objections — but the ISDA Master Agreement was forged well before this modern era.

There is an argument the flawed asset clause wasn’t a good idea even then, but a better one that it is a bad idea now, but like so many parts of this sacred, blessed form it is there and, for hundreds and thousands of ISDA trading arrangements, we are stuck with it.

Developments between editions

“...a condition precedent for the purpose of this Section 2(a)(iii) ...”

The 2002 ISDA trims back the third limb of Section 2(a)(iii) from “all other conditions precedent” to just those that specifically say they mean to be caught by Section 2(a)(iii). This a sensible restriction in scope as far as it goes (but JC would go further and remove Section 2(a)(iii) altogether).

We have heard the argument advanced — apparently on the authority of that FT book about derivatives — that this restricted third limb somehow conditions the other conditions precedent in the clause (i.e., that there is no ongoing PEOD or EOD and that the Transaction has not already been terminated):

Section 2(a)(iii)(3) makes clear that if people want to stipulate any condition precedent other than the standard ones in Section 2(a)(iii)(1) and (2) they must clearly add the wording that the relevant condition will be “a condition precedent for the purposes of Section 2(a)(iii)”. ... Effectively this narrows the scope of the corresponding provision of the 1992 Agreement where no such statement was necessary.

It plainly does not, and nor do we see how you could read the FT book as making that argument. The extreme looseness of 2(a)(iii) imported by any notified breach of the agreement, however technical, being a Potential Event of Default, remains.

“No Early Termination Date ... has occurred”...

New in the 1992 ISDA was the second condition precedent, that “...no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated”.

This is tidy-up material to bring triggered Termination Events into scope. There is a period between notice of termination and when the Early Termination Date is actually designated to happen — and in a busy ISDA it could be a pretty long period — during which time the Transaction is still on foot and going, albeit headed inexorably at a brick wall.

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  • JC’s “nutshell” summary of the clause
  • Background reading and long-form essays
    • Mechanics:
    • How and when 2(a)(iii) is or, more to the point not, triggered.
    • The confusion arising from no-one knowing whether 2(a)(iii) applies.
    • The confusion arising from not knowing when it applies.
    • The JC’s theory about why anyone thought 2(a)(iii) was a good idea in the first place.
    • The JC’s view that even if once upon a time it was, Section 2(a)(iii) is no longer fit for purpose.
    • How Section 2(a)(iii) held up during the sanctions extravaganza when Russia invaded Ukraine (TL;DR: it didn’t help!)
    • Regulatory issues
    • Why regulators don’t like 2(a)(iii).
    • What the courts think of 2(a)(iii) — in a nutshell, they are confused about it.
    • A table comparing the six major decisions on the clause.
    • Practical issues:
    • How Section 2(a)(iii) operates in the case of non-payment-or-delivery defaults.
    • How corporate buyers of fully paid options might feel about 2(a)(iii) (hint: not happy!)
    • Amendments those corporates might think about making if they want to feel happier.

See also

References