Bankruptcy as a phase transition

ISDA Anatomy™ →Go uptown →intro →prem →sa 💥🆕💥 Audio version of this article 🎧 Listen to this podcast — on Spotify — on Substack Index: Click ᐅ to expand: Audio Essays A bankruptcy phase transition yesterday. Index: Click ᐅ to expand: ISDA Navigation 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: FTPD • Breach • CSD • Misrep • DUST • Cross Default • Bankruptcy • MWA Termination Events: Illegality • FM • Tax Event • TEUM • CEUM • ATE 5 Events of Default: FTPD • Breach • CSD • Misrep • DUST • Cross Default • Bankruptcy • MWA Termination Events: Illegality • Tax Event • TEUM • CEUM • ATE 5 Events of Default: FTPD • Breach • CSD • Misrep • DUSS • Cross Default • Bankruptcy • MWA Termination Events: Illegality • Tax Event • TEUM • CEUM Early Termination 6 Early Termination: ET right on EOD • ET right on TE • Effect of Designation • Calculations; Payment Date • Payments on ET • Set-off 6 Early Termination: ET right on EOD • ET right on TE • Effect of Designation • Calculations • Payments on ET • Set-off 6 Early Termination: ET right on EOD • ET right on TE • Effect of Designation • Calculations • Payments 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 Tell me more Sign up for our newsletter — or just get in touch: for ½ a weekly 🍺 you get to consult JC. Ask about it here.

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, 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, and measures of financial insolvency and some that are a bit of both.

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 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.

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See also

• Bankruptcy
• Automatic Early Termination
• Netting