Template:M intro isda bankruptcy phase transition: Difference between revisions

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Here is a scenario:
==== A want of certainty about the ultimate certainty ====
{{quote|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.}}
{{dialogue|
{{dkt autumnal humours}}
:—{{otto}}, {{dkt}}
}}
What even ''is'' bankruptcy? Is it different from insolvency? How come it is so hard? I mean — it’s ''bankruptcy'', right? Is there anything, other than rice pudding and income tax, more certain about our ultimately entwin’d fates?  How can our corporate end-time be such a problem?


What to do?
Well: it turns out a want of certainty is exactly the problem.  
====The phase transition of bankruptcy====
{{drop|N|ow. In the}} jurisprudence of company law, formal insolvency is a “phase transition”: a company’s whole “legal context” ''changes'' upon its bankruptcy. Erstwhile [[certainty|certainties]] of [[contract]] vanish; in their place arise uncontrollable ''vagaries''. An insolvency administrator is invested with wide, nightmarish ''[[discretion]]s'' to do as she pleases, within reason, to ensure the right thing is done by the bankrupt’s creditors — one of whom is you — and its customers, employees and, if there is anything left, shareholders.  


Creditors must fall upon her [[discretion|mercy]]. Outcomes are, thereby, ''[[uncertain]]''. (You may recall from your first law lecture that legal systems don’t ''like'' [[doubt|not knowing what will happen]]. Financial services types have a particular aversion.)<ref>Which, yes, is ''highly'' ironic, seeing as the financial markets ''depend for their existence'' on [[Doubt|uncertainty]].</ref>
With that introduction, we teach you: the phase transition of bankruptcy.


The administrator won’t care. She will quietly do what she can — and given her discretions, that is a lot — to stop precipitate creditors jumping her gun and swiping valuable assets. Hence, there is much fevered talk among [[legal eagles]] of [[voidable preference]]s and like [[magic]]al notions.
{{qd|Phase transition|/feɪz trænˈzɪʃᵊn/|n|(''[[Lexophysics]]''): An abrupt, discontinuous change in the properties of a system.}}
====Insolvency vs. bankruptcy====
{{drop|A|quick primer}} on the difference between ''[[insolvency]]'' and ''[[bankruptcy]]'': {{insolvency v bankruptcy capsule}}
====The phase transition of bankruptcy====
{{quote|
Here is a familiar scenario:


The ''game'' is what demands certainty. The law recognises that when it is ''up'', that imperative falls away. We are in exception territory: being too prescriptive is futile: it is best to let the administrator apply common sense.
''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.''


In some jurisdictions, bankruptcy will operate to suspend creditor rights or stay the execution of legal processes. One may lose the right to call in a loan or close out Transactions, for example.  
What to do?}}
{{drop|I|n the jurisprudence}} of company law, formal bankruptcy (but not mere insolvency) is a “phase transition”: the whole “legal context” surrounding a company ''changes''. Erstwhile [[certainty|certainties]] vanish: normal rules of [[contract]], [[debt]] and [[Credit risk|credit]] are suspended; in their place arise uncontrollable ''vagaries''. The court appoints an [[insolvency administrator]] and invests her with wide, nightmarish ''[[discretion]]s'' 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 ''[[discretion|mercy]]''.  


====Bankers: meh====
You may recall from your first law lecture that legal systems don’t much ''like'' [[doubt|not knowing what will happen]]. Financial services types have a particular aversion — which, yes, ''is'' ironic, given how the financial markets ''depend for their existence'' on [[Doubt|uncertainty]].  
{{drop|F|or a lender}}, this is not quite as drastic as it sounds. There are many ways of falling into [[Bankruptcy - ISDA Provision|bankruptcy]] – ''eight'' at least, by [[Bankruptcy - ISDA Provision|ISDA’s reckoning]] — but to a lender it doesn’t much matter which of them applies: the bank’s position is more or less the same: ''[[munted]]''.  


Its 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.
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 preference]]s, [[safe harbor]]s and like [[magic]]al 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.


====Derivatives counterparties: not so fast====
How does this play out for the big beasts who roam the savannas of our capital markets? Quite differently, as it turns out: this explains why a banker, though of course fearful, is ''sanguine'' about the vicissitudes of formal [[bankruptcy]] while a swap dealer is ''paralysed with terror'' about them.
{{drop|B|ankruptcy 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.

Latest revision as of 09:41, 15 September 2024

A want of certainty about the ultimate certainty

Queen: (Wildly waving a sheaf) Black news! Black news!
The Mercantile Anserine Trading Co, Pty Ltd.
Who purveys our favourite geese —

Ingrazio: What of it, Ma’am? ’Tis assuredly
A most heartily-endow’d incorporation:
Well-skilled in varied means of gandery.
Its full-filled trouser does no little filip to our ends:
We have, a-desk, a fecund inventory
Of its juridical indentures, and besides
A client ledger swole with hedgèd bets
A skein, ahem, of aleatory contingencies
By which the saucy gand’rers recompense us.

Nuncle: (Regarding the sheaf) ’Tis too bad, then, dear Ingrazio:
Herewith, grim tidings.

Ingrazio: Oh?

Nuncle: It seems thy favourite flockery
Hath turn’d its webbèd toes askance the sky.

Ingrazio: (Shocked) You what? How so? How so! What is ’t?

Nuncle: A creditors’ petition to sequestrate the goosers’ plant.

Queen: Black news! Oho!

Enter Triago, ignorant of the foregoing

Triago: Why, Majesty! Let not thy dread a-weight the regal brow
More brusquely than thy splendoured diadem!
O, Queen! Let not autumnal humours bring thee low.
Pray, Madam: allow my song.

Triago produces a piccolino from his cloak and begins to play.

Queen: (Sotto voce) By Homer’s stick! Who let him in?

Ingrazio: ’Tis not the season that rends the royal jams, dear Trig:
But the harvest that it brings. Put away thy tiny fiddle, sir
’Ere her majesty so commands.

Nuncle: Or brains you with ’t.

Ingrazio: Bankrupt? The goosers? It cannot be!

Queen: Must the rigid struts of precedent
That fix our covenantry as stars
To the very velvet firmament
So dissolve, upon one distemper’d prayer?
Must our claim, short days ago as bankable
To visor’d men who tabulate exposures
As a helm to sconce in battle —
Now so meekly dissipate, as tissue i’ the rain?

Nuncle: If wettened claims were but thy problem.

Queen: What mean you, fool?

Nuncle: Thy claims make bitter pennies
Of what once were sweetened pounds, ’tis so
But less so thy extant liabilities. They yet stand
And keep their stout and craggy shape.

Ingrazio: Pish! Doth one not cancel t’other
By the golden sorcery of offset?

Nuncle: Alack: that happy magic is abruptly stayed:
Th’administrstor’s deeper conjury sees to ’t:
The fundamental order of the world’s abeyed.
And yet the woe is more: the curvèd shape
Of lexical geometry conspires to hold us dangled:
Alive, yet unempower’d, while all about
The tempest runs unchecked this next rude fortnight.

Ingrazio: Cans’t thou make it simpler, boy?

Nuncle: As simple as ’t may be made, not simpler:
The petition may be put aside, or resiled
It may yet expire: we knoweth not for half-a-month.
If “yea”, we carry on, with hopeful heart —
’Twas but a freighted dream, unspun upon the waking.
If “nay”, the spectral wraith outlives the night:
We are alive wi’ it. We are a-loss, not now, but then:
As at the beat said prayer was laid — nay, one beat prior.
The body’s dead and two-week stiff,
O’er raked by public hands
Afore we lodge our deposition.

Queen: Mark our wither’d arm, boy:
Lest our allotted time
Along these salted strands, and
Beneath the teeming feathered roils
That drench this sad allotment
Taper down.

Triago: We are dying, French Guyana, dying!

Nuncle: Let us not be too dramatic.

—Otto Büchstein, Talentdämmerung

What even is bankruptcy? Is it different from insolvency? How come it is so hard? I mean — it’s bankruptcy, right? Is there anything, other than rice pudding and income tax, more certain about our ultimately entwin’d fates? How can our corporate end-time be such a problem?

Well: it turns out a want of certainty is exactly the problem.

With that introduction, we teach you: the phase transition of bankruptcy.

Phase transition
/feɪz trænˈzɪʃᵊn/ (n.)

(Lexophysics): An abrupt, discontinuous change in the properties of a system.

Insolvency vs. bankruptcy

Aquick primer on the difference between insolvency and bankruptcy: “Insolvency” is an oddly nebulous financial state: essentially, that one cannot meet one’s debts as they fall due (cashflow insolvency), or that one’s liabilities exceed one’s assets (balance-sheet insolvency); while “bankruptcy” is a more determinate legal state: definitive formal steps have been taken to put a legal entity into administration, or to wind it up, usually on account of its insolvency.

An insolvent entity may file for bankruptcy or its creditors may petition for it. But it need not. Technically, insolvent entities can limp around indefinitely without ever entering formal bankruptcy. GameStop was arguably insolvent for much of 2019, and look at that sweet unicorn now.

Insolvency is usually, but not necessarily,[1] a precondition for bankruptcy.

The water is further muddied because many finance contracts, and notably the ISDA Master Agreement, conflate the concepts of insolvency and bankruptcy. ISDA’s crack drafting squad™ defines “Bankruptcy” to include measures of formal legal bankruptcy,[2] and measures of financial insolvency[3] and some that are a bit of both.[4]

But, bottom line: insolvency is an accounting concept; bankruptcy a legal one.

The phase transition of bankruptcy

Here is a familiar 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?

In the jurisprudence of company law, formal bankruptcy (but not mere insolvency) is a “phase transition”: the whole “legal context” surrounding a company changes. 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 much like not knowing what will happen. Financial services types have a particular aversion — which, yes, is ironic, given how 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.

How does this play out for the big beasts who roam the savannas of our capital markets? Quite differently, as it turns out: this explains why a banker, though of course fearful, is sanguine about the vicissitudes of formal bankruptcy while a swap dealer is paralysed with terror about them.

  1. ↑ Nothing’s easy, is it? It is not unheard of for a solvent entity to file for a “strategic bankruptcy”. But let us not get distracted.
  2. ↑ You really want to do this? Okay: True bankruptcy events: Section 5(a)(vii) limbs (1) (Dissolution), (4) (Institution of bankruptcy proceedings), (5) (Winding-up resolution), (6) (Appointment of administrator) and parts of (8) (Analogous events)
  3. ↑ Practical insolvency events: Section 5(a)(vii) limbs (2)(Cashflow insolvency and arguably balance sheet insolvency too) (3) (Composition with creditors)
  4. ↑ Hybrid events: Section 5(a)(vii)(7) (Enforcement of security)
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