Flawed asset

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You’ll be most likely wanting to see the discussion on this wonderfully baffling subject under Section 2(a)(iii) of the ISDA Master Agreement. But see also the extended liens case, which discusses “rare cases in which security rights fall wholly outside the recognised categories of lien, pledge, mortgage or charge, and into a residual, purely contractual, category sometimes categorised as turning the grantor’s property into a form of ‘flawed asset’.”

More generally, following an event of default, a flawed asset provision allows an innocent, but out-of-the-money party to a derivative or securities finance transaction to suspend performance of its obligations without terminating the transaction and thereby crystallising a mark-to-market loss.

The asset – a right to payment under the transaction – is “flawed” in the sense that it only become payable if the conditions precedent to payment are fulfilled.

Section 2(a)(iii) entered the argot in a simpler, more peaceable time, when zero threshold, daily margined CSAs were an uncommon, rather fantastical sight. They’re more or less obligatory now – indeed, once regulatory uncleared margin is a thing they will be obligatory – so it’s hard to see the justification for a flawed asset provision.

Master trading agreements

• ISDA Master Agreement: You can find it all, in gruesome detail, in the article on Section 2(a)(iii). The ISDA provision has generated some case law, including Metavante and Firth Rixson, which the truly insatiable amongst you may care to read.
• 2010 GMSLA: As far as I can see there is no direct 2(a)(iii) equivalent in the GMSLA, but Section 8.6, which allows you to suspend payment if you suspect your counterparty’s creditworthiness, is the closest, but it isn't a flawed asset clause. Nor would you expect one. It makes little sense in a master agreement for transactions that generally have zero or short tenors, and are inherently margined daily as a matter of course – i.e., there is no “uncollateralised, large, out-of-the-money exposures” an innocent stock lender would want to protect such a flawed asset provision.
• 2010 GMSLA: Now here’s the funny thing. Even though the GMRA is comparable to the GMSLA in most meaningful ways, it does have a flawed asset provision. I don’t understand it, but that is true about much of the world of international finance.

Section 2(a)(iii) litigation

There is a (generous) handful of important authorities on the effect under English law or New York law of the suspension of obligations under the most litigationey clause in the ISDA Master Agreement, Section 2(a)(iii). They consider whether flawed asset provision amounts to an “ipso facto clause” under the US Bankruptcy Code or violates the “anti-deprivation” principle under English law. Those cases are:

• Lomas v Firth Rixson
• Marine Trade v Pioneer
• Pioneer v Cosco
• Pioneer v TMT
• Enron v TXU
• Metavante v Lehman