Template:Isda 2(a)(iii) summ

Does not apply to {{{{{1}}}|Termination Events}}

Since most ISDA Master Agreements that reach the life support machine in an ICU get there by dint of a {{{{{1}}}|Failure to Pay}} or {{{{{1}}}|Bankruptcy}} this does not, in point of fact, amount to much, but it is worth noting that while {{{{{1}}}|Event of Default}}s — and even events that are not yet but with the passing of time might become {{{{{1}}}|Events of Default}} — can trigger a {{{{{1}}}|2(a)(iii)}} suspension, a mere Section {{{{{1}}}|5(b)}} {{{{{1}}}|Termination Event}} — even a catastrophic one like an {{{{{1}}}|Additional Termination Event}} (such as a NAV trigger, key person event or some such) — cannot. This might rile and unnerve credit officers, by nature an easily perturbed lot, but given our arguments below for what a train-wreck the whole {{{{{1}}}|2(a)(iii)}} thing is, those of stabler personalities will consider this basically a good thing.

Nevertheless the JC has seen valiant efforts to insert {{{{{1}}}|Additional Termination Events}} to section {{{{{1}}}|2(a)(iii)}}, and — quel horreur — Potential Additional Termination Events, a class of things that do not exist outside the laboratory, and must therefore be defined. All this for the joy of invoking a clause that doesn’t make any sense in the first place.

“Some things are better left unsaid,” said no ISDA lawyer ever.

No notice of suspension required

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.

Notice there are none.

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 — Misrepresentations, for example and some may be entirely beyond the ken of the Innocent Party whose payment obligations 2(a)(iii) suspends, such as an undeclared Cross Default.

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

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 ISDA Master Agreement 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?

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 Unpaid Amount?

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. 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 —

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.

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.

When does it apply

Note also that the ’squad neglected to prescribe the precise point in time at which the condition precedent must apply. Common sense surely requires it be measured as at close of business on the {{{{{1}}}|Business Day}} on which the payment or delivery is originally scheduled to be performed. But it doesn’t take the trouble to say that. So what if, some time after the due date for payment, but, say, before the grace period for a Failure to Pay or Deliver has expired, the hitherto {{{{{1}}}|non-Defaulting Party}} falls into, say, technical insolvency (perhaps as a result of the putatively {{{{{1}}}|Defaulting Party}}’s failure? Is the miscreant original defaulter saved from the jaws of oblivion by such a jammy hap? We think not — surely, it should not, though one could no doubt construct the intellectual justification why it might — but uncharacteristic slackness with words from ISDA’s crack drafting squad™ makes the situation less clear than it could be.

Our read, for all that is worth: a party is only entitled to suspend payments under {{{{{1}}}|2(a)(iii)}} if the conditions to payment were unfulfilled on the due date for payment or delivery. That is was when it was bound to pay: that its counterparty’s credit position deteriorated after the due date, but before you have got round to paying it, does not matter. You still gots to pay.

Speaking of strange days

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 agreements 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.

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.

Even normal days, these days?

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.

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.

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.

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 eagles 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.

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 ISDA Master Agreements 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.

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.

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.

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?

Flawed assets generally

Flawed asset
/flɔːd ˈæsɛt/ (n.)
A “flawed asset” provision allows the “innocent” party to a financial transaction to suspend performance of its own obligations if its counterparty suffers certain default events without finally terminating or closing out the transaction. Should the defaulting side cure the default scenario, the transaction resumes and the suspending party must perform all its obligations including the suspended ones. For so long as it not cured, the innocent party may close the Master Agreement out at any time, but is not obliged to.

Rationale: avoiding a cleft stick

Why would a party ever want to not close out a defaulting counterparty? It all comes down to moneyness.

The “bilaterality” of most derivatives arrangements means that either party may, net, be “out of the money” — that is, across all outstanding transactions, it would have to pay a net sum of money if all transactions were terminated. This is a notional debt that only becomes “due” as such if you designate an {{{{{1}}}|Early Termination Date}} under the Master Agreement. So an out-of-the-money {{{{{1}}}|Non-defaulting Party}} has a good reason therefore not to close out the ISDA. Why should it have to pay out just because a {{{{{1}}}|Defaulting Party}} has failed to perform its end of the bargain? On the other hand, if it forebears from terminating against a bankrupt counterparty the {{{{{1}}}|Non-defaulting Party}} doesn’t want to have to continue stoically paying good money away to a bankrupt counterparty who isn’t reciprocating.

An out-of-the-money, {{{{{1}}}|Non-defaulting Party}} seems to be, therefore, in a bit of a cleft stick.

Section {{{{{1}}}|2(a)(iii)}} allows the {{{{{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 and thereby not thereby crystallise the mark-to-market loss implied by its out-of-the-money position.

The {{{{{1}}}|Defaulting Party}}’s “asset” — its right to be paid, or delivered to under the {{{{{1}}}|Transaction}} — is “flawed” in the sense that its rights don’t apply for so long as the conditions precedent to payment are not fulfilled.

Conceivably you could invoke a flawed asset provision even if you were in-the-money, but you would be mad to.

Which events?

Exactly which default events can trigger a flawed asset clause will depend on the contract. Under the ISDA, {{{{{1}}}|Events of Default}} and even Potential {{{{{1}}}|Events of Default}} do, but {{{{{1}}}|Termination Event}}s and {{{{{1}}}|Additional Termination Event}}s do not.

This is because most Termination Events are softer, “hey look, it’s no-one’s fault, it’s just one of those things” kind of closeouts — but this is not really true of {{{{{1}}}|Additional Termination Event}}s, which tend to be credit-driven and girded with more “culpability” and “event-of-defaulty-ness”.

This is, a bit dissonant, but there are far greater dissonances, so we park this one and carry on.

2(a)(iii) in a time of Credit Support

Flawed assets entered the argot in a simpler, more (less?) peaceable time when two-way, zero-threshold, daily-margined collateral arrangements were an unusual sight. Nor, in those times, were dealers often of the view that they might be on the wrong end of a flawed assets clause. They presumed if anyone was going bust, it would be their client. Because — the house always wins, right? The events of September 2018 were, therefore, quite the chastening experience.

In any case without collateral, a {{{{{1}}}|Non-defaulting Party}} could, be nursing a large, unfunded mark-to-market liability which it would not want to pay out just because the clot at the other end of the contract had driven his fund into a ditch.

That was then: in these days of mandatory regulatory margin, counterparties generally cash-collateralise their net market positions to, or near, zero each day, so a large uncollateralised position is a much less likely scenario. So most people will be happy enough just closing out: the optionality not to is not very valuable.