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===No notice of suspension required===
{{quote|
Leaving for a few moments the question of ''when'' one would ever need, let alone want to invoke Section {{{{{1}}}|2(a)(iii)}} other than in the strangest of days, let’s consider the mechanics.
{{Script|Herculio}}: I have a thought. This meagre tract: not ninety words <br>
Wrapp’d about with preliminal nicety and <br>
Stamp’d as for affixation to a [[boilerplate|servic’d boiler]] —<br>
Conceals a clever trick. <br>
{{script|Ser Jaramey}}: What kind of onion’d witchery is this? <br>
:—{{otto}}, {{br|Ser Jaramey Slizzard}}}}
=== Assets, and flawed assets ===
What is the big deal about this, then? Well, it turns your ISDA into a “flawed asset”.
{{quote|{{d|Flawed asset|/flɔːd ˈæsɛt/|n|}}


Notice there are ''none''.  
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.}}


Section {{{{{1}}}|2(a)(iii)}} just ''sits'' there, and has effect, without anyone’s particular by-or-leave. No notice is required: no-one need look out for envelopes being delivered to the physical address the firm occupied seventeen years ago when someone filled out Part IV of the schedule. Section {{{{{1}}}|2(a)(iii)}} doesn’t even say an {{{{{1}}}|Innocent Party}} is ''entitled'' to withhold payment: rather the conditions are not met and ''payment is not therefore due''. The effect of Section {{{{{1}}}|2(a)(iii)}} just ''happens'' if an EOD or PEOD exists. Now some EODs are determinative; some less so {{isdaprov|Misrepresentation}}s, for example and some may be entirely beyond the ken of the {{isdaprov|Innocent Party}} whose payment obligations 2(a)(iii) suspends, such as an undeclared {{isdaprov|Cross Default}}.
{{drop|I|n 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 [[Bitcoin|decentralised cryptographic tokens representing abstract capital]].


Section {{isdaprov|2(a)(iii)}} might apply, that is to say, without anyone ''realising'' it. This poses some rather intriguing questions.
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.


First, a ''conceptual'' one: at what point do we know when even do ''I'' know  whether I have “suspended” my payment and not just simply ''failed'' on it? Is there a difference? The payment arrangements under a modern {{isdama}} are a blizzard of electronic impulses, across multiple booking systems, product silos and other arrangements. The good people of FX ops will know everything there is to know about the currency pairs, but will have not the first notion about the rates portfolio, let alone the weirdos in structured credit — and sometimes payments fail for explainable reasons. So what happens if, for some reason {{{{{1}}}|2(a)(iii)}} applies — did a trader in a weak moment repudiate a contract during a collateral dispute? — and the conditions precedent to my payment do not exist, but I make my payment anyway? Is that a mistaken payment? Is it supported by [[consideration]]? Is there a potential claim for [[money had and received]]?
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 [[Insolvency|''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.


What, for the purpose of close-out valuations, is the status of payments that ''were'' made, but that were not ''required'' to be made? Are these some kind of negative energy in the close-out spacetime; dark matter, a kind of inverted {{isdaprov|Unpaid Amount}}?<ref>Okay I am having a bit of fun with you here I confess.</ref>
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.


Secondly, a ''practical'' one: in times of market dislocation ''all kinds of things do go wrong''. People suddenly resort to manual processes where things have been automated till now. They start frisking all money payments on their way out the door. For all you know ''your correspondent banks and agents may be doing the same thing without your knowledge''. Payments you ''thought'' you had made may not have got to your counterparty.<ref>This is not nearly as unlikely as it seems: in a widespread market dislocation, for example, where sanctions are involved (hello Ukraine conflict!) expect ''everyone'' to be terrified of getting anything wrong. ''Everything'' will slow down.</ref>  Counterparties make oral arrangements to check payments in before sending anything out — expect all kinds of paranoia, fear & loathing. It’s great. Sometimes payments going in either direction — can get hung up, stuck, blocked, sanctioned, or — who knows? — waived, or suspended by mutual consent, or even suspended by ''implication'': the parties may agree (or ''think'' they have agreed) to net settle payments usually made gross. If there is a misunderstanding —
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”.  


In short, it is not always certain whether payments have, in fact, been made, or missed. You would think this sort of thing would be determinate, but it isn’t. And this kind of uncertainty is more likely ''exactly at a time of stress''.  
Section {{{{{1}}}|2(a)(iii)}} seems to have that effect on a {{{{{1}}}|Defaulting Party}}’s claims under an ISDA  —  its asset. Just when the {{{{{1}}}|Defaulting Party}} goes insolvent or fails to perform, the {{{{{1}}}|Non-defaulting Party}} is entitled to suspend the performance of its obligations without terminating the {{{{{1}}}|Transaction}}. Not entitled, even — as we will see, it just happens.


This can lead to some unfortunate surprises: the counterparty who, faced with a massive counterparty failure, and diligently files its notice of {{{{{1}}}|Failure to Pay or Deliver}}, only to find that, last week some clot in Collateral Ops mis-keyed a small yen payment or just effected a net settlement that the counterparty didn’t match, meaning that none of the “failing payments” were actually due in the first place. Expect a race back in time to see who committed the earliest unremedied non-payment.
Should the {{{{{1}}}|Defaulting Party}} then cure the default, the {{{{{1}}}|Transaction}} resumes and the {{{{{1}}}|Non-defaulting Party}} must resume all its obligations, including the suspended ones. But for so long as the default is not cured, the {{{{{1}}}|Non-defaulting Party}} does not have to do anything. The {{{{{1}}}|Defaulting Party}} is left hanging there, with this “flawed asset”.


===Speaking of strange days===
=== Insolvency regimes: not keen. ===
None of this you will enjoy when, as it will, it happens just as the world has lost its head and is blaming it on you. The [[JC]] has a theory — well, the JC has ''lots'' of theories, but this one in particular — that the [[master agreement]]s of the world are a product of ''detente'': that post-Communist, End of History delusion that gripped the world in the roaring nineties, that we had solved the problem of illiberalism, that wars were a thing of the past, and that the range of calamities that the market needed to defend against all involved the failure of commercial enterprise.  
{{drop|T|he 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 the pandemic didn’t do the job, the Russia/Ukraine war of 2022 has rudely disabused us of the notion. We are left with master agreements that do not, terribly well, deal with the illogicalities of disease, pestilence, war, sanctions, and the sudden, indeterminate interruption of cross-border commercial relations. Nowhere is this better illustrated than Section {{{{{1}}}|2(a)(iii)}} — which per the below, was increasingly an irrelevance anyway — which speaks to a world in which the worst thing one could do was repudiate a contract. It ''really'' doesn’t work when the fog of war descends and it isn’t clear whether one should, or is allowed to, or must, make payments — opposing governments may have diametrically opposed rules on the topic — and there is a clash of sanctions as well as civilisations.
If Section {{{{{1}}}|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.


===Even normal days, ''these'' days?===
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:{{quote|
Even setting aside the successive calumnies the modern world seems intent on lurching between, the idea of a [[flawed asset]] provision seems well and truly out of date. The overriding mischief that it addresses arises when a solvent swap counterparty with a long-dated [[out-of-the-money]] portfolio, finds its counterparty has, against the run of play, gone bust. If I am in the hole to you to the tune of $50 million, but that liability isn’t due to mature for ten years, in which time it might well come right and even go positive, I don’t want to crystallise it now, at the darkest point, just because ''you'' sir have gone tits-up.  
“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.


Answer: insert a flawed asset provision. This lets me suspend my performance on your default, ''without'' closing you out, until you have got your house in order and paid all the transaction flows you owe me. So the portfolio goes into suspended animation. Like Han Solo in ''The Empire Strikes Back''.  
It seems, at any rate, that Section {{{{{1}}}|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.


Now if, heaven forfend, you ''can’t'' thereafter get your house in order — if what was once your house is presently a smoking crater —then the game is up anyway, isn’t it? You will be wandering around outside your building in a daze clutching an [[Iron Mountain]] box cycling hurriedly through the stages of grief, wondering where it all went so wrong, wishing you had pursued that music career after all, but in any case casting scant thoughts for your firm’s unrealising mark-to-market position on that derivative portfolio with me.  
Anyway: be aware: Section {{{{{1}}}|2(a)(iii)}} attracts insolvency lawyers.


This seems cavalier in these enlightened times, but in the old days people did think like this. But, with the gruesome goings-on of 2008, those are largely bygone days, though older [[legal eagle]]s may wistfully look into the middle distance and reminiscing about these kinder, happier times. Those who didn’t wind up desperately rekindling their music careers in 2009, anyway.
=== Rationale: avoiding a cleft stick ===
{{drop|W|e can have}} a fine time rabbiting away about the ontology of assets, but isn’t there a more basic question: why would a {{{{{1}}}|Non-defaulting Party}}, presented with a counterparty in default, ever ''not'' want to just close out?


In the aftermath of the [[Lehman]] collapse regulators showed some interest in curtailing the [[flawed asset]] provision. The Bank of England suggested a “use it or lose it” exercise period of 30 days. Ideas like this foundered on the practical problem that repapering tens of thousands of {{isdama}}s was not wildly practical, especially without a clear consensus on what the necessary amendment might look like. So the initiative withered on the vine somewhat.  
It all comes down to [[Moneyness|''moneyness'']].


In the meantime, other regulatory reform initiatives overtook the debate. These days flawed asset provision is largely irrelevant, seeing as brokers don’t tend to take massive uncollateralised directional bets. Compulsory [[variation margin]] means for the most part they ''can’t'', even if the Volcker rule allowed them to.  
The “[[The bilaterality, or not, of the ISDA|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 {{{{{1}}}|Early Termination Date}} is designated under the Master Agreement.  


Since all swap counterparties now must pay the cash value of their negative [[mark-to-market]] exposures every day, the very thing the flawed asset seeks to avoid — paying out negative positions — has happened, there is a lot more to be said for immediately closing out an {{isda}}, whether or not it is [[out-of-the-money]].
So an [[out-of-the-money]], {{{{{1}}}|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 {{{{{1}}}|Defaulting Party}} has failed to perform its end of the bargain?


For [[synthetic prime brokerage]] fiends, there is another reason to be unbothered by Section 2(a)(iii): you shouldn’t ''have'' a losing position, since you are meant to be perfectly delta-hedged. Right?
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.


===Flawed assets generally===
A cleft stick, therefore.
{{Flawed asset capsule}}
 
Section {{{{{1}}}|2(a)(iii)}} allows our {{{{{1}}}|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 {{{{{1}}}|Non-defaulting Party}}.
 
But the {{{{{1}}}|Defaulting Party}}’s “asset” — its contingent claim for its in-the-money position against the {{{{{1}}}|Non-defaulting Party}} — is compromised. This, for an insolvency administrator and all the {{{{{1}}}|Defaulting Party}}’s other creditors, is a bummer. It deprives them of the “asset” represented by the {{{{{1}}}|Transaction}}.
 
===Which events?===
{{drop|E|xactly ''which'' default}} events can trigger the suspension? Under the [[ISDA Master Agreement|ISDA]], {{{{{1}}}|Events of Default}} and even ''Potential'' Events of Default do, but {{{{{1}}}|Termination Events}} and {{{{{1}}}|Additional Termination Event}} do not. This is because ''most'' {{{{{1}}}|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 {{{{{1}}}|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 {{{{{1}}}|Additional Termination Events}} to section {{{{{1}}}|2(a)(iii)}}, and ''Potential'' {{{{{1}}}|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?===
{{quote|
{{script|Herculio}}: All well-meant, good [[Triago]]. Be not sour —<br>These are not grapes.<br>
{{script|Triago}}: Indeed not sir: rather, scrapes.<br>And scars and knocks — the job-lot doggedly sustained.<br>
{{script|Herculio}}: (''Aside'') Some more than others. The odd one feigned.<br>
But come, Sir Tig: what unrests you here?<br>
{{script|Triago}} (''waving paper''): A tract from a brother clerk in America.<br>
{{script|Herculio}}: Cripes abroad. Grim tidings?<br>
{{script|Triago}}: Forsooth: it wears the colours of a fight.<br>
A word-scape stain’d with tightly kernèd face<br>
And girded round with fontish weaponry.<br>
{{script|Herculio}} (''inspecting the document''): Verily, convenantry this dark<br>
Speaks of litiginous untrust.<br>
—[[Otto Büchstein]], [[Die Schweizer Heulsuse|''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 {{2002ma}} trims back the third limb of Section {{{{{1}}}|2(a)(iii)}} from “all other conditions precedent” to just those that specifically say they mean to be caught by Section {{{{{1}}}|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):
{{quote|
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 {{{{{1}}}|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 {{1992ma}} 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'' {{{{{1}}}|Termination Event}}s into scope. There is a period between notice of termination and when the {{{{{1}}}|Early Termination Date}} is actually designated to happen — and in a busy ISDA it could be a pretty long period — during which time the {{{{{1}}}|Transaction}} is still on foot and going, albeit headed inexorably at a brick wall.

Latest revision as of 10:31, 17 May 2024

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 {{{{{1}}}|2(a)(iii)}} seems to have that effect on a {{{{{1}}}|Defaulting Party}}’s claims under an ISDA — its asset. Just when the {{{{{1}}}|Defaulting Party}} goes insolvent or fails to perform, the {{{{{1}}}|Non-defaulting Party}} is entitled to suspend the performance of its obligations without terminating the {{{{{1}}}|Transaction}}. Not entitled, even — as we will see, it just happens.

Should the {{{{{1}}}|Defaulting Party}} then cure the default, the {{{{{1}}}|Transaction}} resumes and the {{{{{1}}}|Non-defaulting Party}} must resume all its obligations, including the suspended ones. But for so long as the default is not cured, the {{{{{1}}}|Non-defaulting Party}} does not have to do anything. The {{{{{1}}}|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 {{{{{1}}}|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 {{{{{1}}}|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 {{{{{1}}}|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 {{{{{1}}}|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 {{{{{1}}}|Early Termination Date}} is designated under the Master Agreement.

So an out-of-the-money, {{{{{1}}}|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 {{{{{1}}}|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 {{{{{1}}}|2(a)(iii)}} allows our {{{{{1}}}|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 {{{{{1}}}|Non-defaulting Party}}.

But the {{{{{1}}}|Defaulting Party}}’s “asset” — its contingent claim for its in-the-money position against the {{{{{1}}}|Non-defaulting Party}} — is compromised. This, for an insolvency administrator and all the {{{{{1}}}|Defaulting Party}}’s other creditors, is a bummer. It deprives them of the “asset” represented by the {{{{{1}}}|Transaction}}.

Which events?

Exactly which default events can trigger the suspension? Under the ISDA, {{{{{1}}}|Events of Default}} and even Potential Events of Default do, but {{{{{1}}}|Termination Events}} and {{{{{1}}}|Additional Termination Event}} do not. This is because most {{{{{1}}}|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 {{{{{1}}}|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 {{{{{1}}}|Additional Termination Events}} to section {{{{{1}}}|2(a)(iii)}}, and Potential {{{{{1}}}|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 {{{{{1}}}|2(a)(iii)}} from “all other conditions precedent” to just those that specifically say they mean to be caught by Section {{{{{1}}}|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 {{{{{1}}}|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 {{{{{1}}}|Termination Event}}s into scope. There is a period between notice of termination and when the {{{{{1}}}|Early Termination Date}} is actually designated to happen — and in a busy ISDA it could be a pretty long period — during which time the {{{{{1}}}|Transaction}} is still on foot and going, albeit headed inexorably at a brick wall.