Template:M intro isda bankruptcy phase transition

Here is a scenario:

You are a credit officer in the commercial division of your local bank. It transpires your customer, who recently drew a £100 million fixed-rate term loan from you, is on the point of bankruptcy.

What to do?

The phase transition of bankruptcy

Now. In the jurisprudence of company law, formal insolvency is a “phase transition”: the whole “legal context” surrounding a company changes upon its bankruptcy. Erstwhile certainties vanish: normal rules of contract, debt and credit are suspended; in their place arise uncontrollable vagaries. The court appoints an insolvency administrator and invests her with wide, nightmarish discretions to do as she pleases, within reason, to sort out who gets what while ensuring the right thing is done by all the bankrupt’s creditors, customers, employees and, if there is anything left, shareholders. All, therefore, must fall upon her mercy.

You may recall from your first law lecture that legal systems don’t like not knowing what will happen. Financial services types have a particular aversion. Which, yes, is highly ironic, seeing as the financial markets depend for their existence on uncertainty. Anyhow.

The administrator won’t care. She will quietly do what she can — and given her discretion, that is a lot — to stop major creditors jumping her gun and swiping valuable assets. Hence all the learned talk among legal eagles of voidable preferences, safe harbors and like magical notions. In some jurisdictions, contractual rights may be suspended and legal action stayed. Creditors may lose their rights to call in loans or close out transactions.

Bankers: meh

For most creditors, this is not quite as drastic as it sounds. The damage is already done. There are many ways of falling into bankruptcy – eight at least, by ISDA’s reckoning — but to one owed money by a bankrupt it doesn’t much matter which one applies.

Your goose is already cooked. suspending its right to claim from a borrower money that it does not in any case have is no great loss. Indeed, none of these discretions make much difference: the bank is owed 100 million pounds; it will get back significantly less than that. There is not much that an insolvency administrator can do to make that worse.

Derivatives counterparties: not so fast

Bankruptcy might not make much odds to a lender, but a derivatives counterparty is in a very different boat. How it manages its rights under the Transactions, and what exactly it is or is not allowed to do under the Master Agreement, makes an enormous difference.