Template:M intro isda qualities of a good ISDA

So, what makes for a good ISDA? What makes any commercial contract good?

Bear in mind that a contract fulfils different purposes for different constituents during its life. For Sales, it is a tool of persuasion. For Credit, a long-range defensive strategy. For Operations, a manual. For the Legal Eagles, a crust.

Crystalline legal exactitude is but one quality and, in most cases an oddly insignificant one in that, once a contract is signed, the overwhelming likelihood is that no-one will ever look at it again. Not even Ops, once they have punched the collateral eligibility criteria into their systems.

The ISDA Master Agreement being what it is — a stone tablet hewn, by conventional wisdom, from holy granite so as to avoid controversy — it goes without saying “the sacred fourteen” are already immaculate: we mean, of course, “what makes a good ISDA Schedule”. For it will be toiling over that grubby mortal appendix — a crazed shadow thrown by guttering light across Plato’s craggy cave —that a negotiator will live out her days.

It should have five basic qualities: fairness, confidence, clarity, consistency and simplicity. These qualities interact with and, in large part, depend on each other.

Fair agreements must be clear for customers to realise they are fair.

Clear agreements will inspire confidence, in your own staff, thus distracting them from the temptations of Casanova’s principle and toward fairness.

Clarity and fairness lend themselves also to consistency since, armed with it, you will be able to treat your customers the same way — with equanimity — and they will find less cause to object.

Clarity, fairness, confidence and consistency make for simplicity: a simple record that is easy to create, maintain, roll out and, heaven forfend, enforce.

Fairness

“There could be no negotiating with terrorists.”

—Attributed to Richard Nixon

Fairness as an abstract quality seems like one of those lip-servicey, all-very-well-in-theory ideas that got you good grades in alternative dispute resolution class but will ship a haymaker to the jaw on first contact with reality. We are taught to treat legal negotiation as a kind of trench warfare: as if we are facing a mortal foe and not a valued customer. It is true that customers tend to be similarly disposed, so fairness never gets a chance to break out.

This is, in theory, odd. After all, between good-faith traders in the marketplace, commercial negotiation is no single round prisoner’s dilemma. To show fairness is not to show weakness, but strength.

So why the hostility? Puzzles like this often boil down to variations of the agency problem. They can usually be untangled by asking, cui bono? Usually, we will find a well-meaning professional adviser “making herself useful” by “avoiding doubt”. This is no exception.

JC is, by lifelong experience, a sell-side guy: his clients are providers of financial services who contract with people who want them. Merchant and customer are, here as in any marketplace, generally aligned: at the limit, their interests conflict, but gently: the merchant wants a big commission, the customer wants to pay a little one, but beyond that, each wishes earnestly for the other’s continued prosperity.

Things can get chewy at the extremes when large sums of money are involved — but most dealers and most customers never get near a chewy extreme.

We occasionally engage directly with ostensible hostiles — competitors, for example — but even then, we do so under an unspoken pact of good faith for the limited ends which have brought us together. We must, at some level, trust those with whom we contract, even if they are rivals. We must have some common interest. If we did not, we would not contract at all. No-one enters a contract she expects her counterparty to break.

Sidenote: the late David Graeber made a fascinating point when discussing the non-origin of money from barter: barter is an arm’s length trade of equivalent goods between parties who are dispositionally rivals and not partners. Once the exchange happens, nothing is left on the table; there is no presumption of goodwill, no expectation of further business, no obligations are undischarged. This is a delivery-versus-payment exchange between untrusting aliens. This is not needed within a community of trust. Where there is trust we need not extract a pound of flesh: there is a give and take; we let obligations lie undischarged on faith they will be performed later. Our gestures acquire a moral quality. These are the ties that bind — the imperative becomes to avoid fully discharging our dues to each other and thereby undoing those ties.

This is the relationship we should aspire to with our customers. We trust them to pay later — we extend credit. We do them favours, they appreciate it, and reward us with social, not economic, capital in the shape of more business. Hence, says Graeber, money emerged not from barter with strangers, but to memorialise mutual debts among friends. You don’t extend credit to your enemies.

So, we presume good faith in any negotiation: some level of trust. We don’t negotiate with terrorists. If you can’t trust your counterparts, you fall into the “traitor’s dilemma”. This makes for good TV, but bad business.

The “merchant-to-customer” contract is, by a landslide, the most common kind. Once signed, these are filed somewhere and never again reviewed — it is bad form to pay too much attention to the letter of a deal, even should there later be an argument.

Inhouse counsel with experience of bona fide, non-existential, customer disputes know one thing: if there is any doubt — and frequently, even when there isn’t — the business will roll over. No-one takes a point with a solvent client.

This is no more than commercial common sense: you stand to gain far more by preserving your relationship, even where that means excusing a customer the occasional gaffe, and trading on it than you do by taking a literal stance on technical indiscretions. That is barter behaviour.

This instinct amongst business people to “just let it go” is so pronounced, indeed, as to unnerve regulators and compliance departments, who have contrived ways to stop it, for fear it “induces” — a fancy way of saying “bribes” — clients to continue giving business.

In any case, the commercial imperative is so overwhelming that there is little point in asking for, let alone achieving, terms in contracts that go beyond “fair”. You will never use them. Seeing as, all other things being equal, you will conclude a fair contract faster than an unfair one — the ideal negotiation is no negotiation — it behoves you to have a fair template.

Make your templates fair.

Confidence

Your form should also inspire confidence, and not fear, in your own negotiating team. It is a fact of life that the average negotiator these days has less combat experience or expertise than was once the case. To do a good, job a negotiator must be comfortable with her tools, not scared of them. She should understand her templates and the products they govern. She should go beyond the contract’s formal articulation to grasp the underlying commercial drivers of the business relationship.

If she groks this, she can resolve most contractual points from first principles, and help improve the form, identifying and fixing the parts that cause the most friction.

The idea that negotiators might have insight borders on heretical among management consultants, who regard them as fungible rule-following automatons whose chief point of differentiation is unit cost. This is, of course, absurd, even on total quality management terms.

To put it in terms management consultants might understand, this is jidoka: “automation with a human touch”.

A negotiator who fears her material will hide behind the formal rules she is given to manage it. She won’t be drawn to discuss anything live — if she doesn’t understand the form, why would she put her vulnerability on show? — so will hide behind her keyboard, contributing to the familiar experience of electronic trench warfare: she will lob long, bulleted lists over no-man’s-land and into the enemy’s advanced positions, or escalate that way internally to risk departments. When they land, her missiles — missives? — will hiss and sputter, being passed about for days, before eventually being lobbed back, appended with yet more bullets and annotated in BLOCK CAPITALS, ITALICS and fetching interjections in fuchsia and lilac.

This impasse can last, as it did in Ypres, for years. You could write war peotry about it.

“. . . I am the NAV trigger you pulled, my friend. You waived it not.
In fog of war your unbending risk approach you would not flout
Look, I missed a little margin call, by just a bit: you closed me out.
I risk-reduced as best I could; when all is told
My lucky streak ran out;
My credit line went cold.
Let us sleep now. . . .”

(carries on for 94 pages)

Reverence to and intimidation by your own contractual form is madness, of course. While we should not be surprised, in our high modernist times, that our overlords fetishise the form over substance, deference to a contractual form that is plainly difficult or confusing is no cause for celebration. A confident negotiating team engages with the form rather than deferring to it.

Make sure your team has confidence in your forms.

Clarity

Of the many purposes of the ISDA, most deal with the present — desired capital treatment; the availability of close-out netting, margin obligations — and the past —representations and warranties, and conditions precedent to transacting and continuing to perform — but only one deals with the future. The close-out terms: the circumstance in which one can break the glass, sound the alarm and head for the lifeboats.

Close-out terms only come into serious contemplation at times of extreme stress: the market’s, your management’s and, therefore, yours. The more the firm stands to lose, the more extreme those stressy circumstances are likely to be. Management will become hysterical and lose any sense of perspective, make no bones about that, but so will the rest of the market. All manner of carefully concealed character flaws will be suddenly laid bare. Pay attention to this: this is where you really get to what people are like.

Defaulting customers will be absent without official leave, responding to no communication channels at all. Bank chief executives won’t take each other’s calls. Prime Ministers will be ordering overseas embassies to max out their credit cards just to have cash on hand to meet the government’s obligations. Central bankers will be ordering the banks they regulate to lowball LIBOR. It will be chaos.

When they crafted its close-out mechanics, the ’squad did not have in mind the wider general ambiance in which the ISDA’s last-resort rights would be exercised. They can’t have. They can only have pictured the close-out urge coming upon the responsible credit officer, in isolation, at a time of beatific placidity: that there would be time and space to consider and quietly contemplate what must be done, perhaps with a frisson of regret for the poor customer whom one is letting down.

It will not be like that.

There will be multiple counterparty failures at once. All kinds of things will be stretching your attention, and your management’s. There will be allegations — unproven, unverifiable, and likely false but at the time you won’t know it — of fraud, of dastardly dealing, of internecine conflicts within the client, of side-conversations with your CEO who is allegedly related to the chief investment officer by marriage, of predatory competitors beating you to the close-out punch and eating your lunch. Some of this may be true. Much will be nonsense. You will have no means of telling. All of this is the fog of war.

Even among those who had them in the first place, senses of humour will be in short supply. Many, many people, pursuing their own buttocractic agendas, will want short, clipped and above all good answers to conflicting questions they are all shouting at you at once — questions to which there are no answers, let alone good ones. If you even understand the question, the last thing anyone wants to hear by way of answer is, “ahhh, it’s complicated” or, God forbid, “the contract is not clear.”

And unless your organisation is deeply committed to fairness, clarity and simplicity in its contractual relationships, its contracts will not be clear.

This, counsels, we think — and we are obliged to say the JC seems to be on his own about this one — a discipline in times of fair weather and fecund trading conditions, to be prepared for typhoons. While there is time and capacity to do so, spend time ensuring your contracts have short, clear, plain, consistent and blunt termination language, with simple-to-follow events addressing only generally catastrophic circumstances. The day you need to enforce your rights will be an omnishambles enough without a baffling contract making it it hard to figure out what those rights are.

Now: most of the weapons you need are embedded in the pre-printed form of the ISDA Master Agreement itself. Do not mess around with these. Try to resist the temptation to augment them, and have ready-at-hand a simple step-by-step guide to how to get through them without screwing anything up. Like this one.

Make your forms clear and easy to follow in moments of existential crisis.

Consistency

It helps with clarity if, in a scrape, you know what your ISDA will say where it matters without having to actually go and read it. This actually happened:

SCENE: A COBRA committee meeting at a large investment bank in the teeth of the global financial crisis.
Head of Trading: I need to know our close-out rights against these fifteen Lehman entities.
General counsel (Looking pleased with himself): Certainly! We have a crack squad of our best lawyers on it. You will have an answer within forty-eight hours.
Head of Trading (Going white): What? Forty-eight hours? I want it in forty-eight seconds.

At the point where you need your close-out rights, it is too late to start reading contracts. Have you ever tried to read an ISDA Schedule in a hurry, even when the world is not apparently on the brink of rapture?

You might not need to read it at a time of crisis if you control quality where it matters. If all your contracts are the same, and you know what they say, you would be in a dramatically better place.

“This is all very well, JC, but how are we supposed to force a counterparty to take our credit terms? It is a competitive market! No-one in their right mind would do that! We must negotiate every time! And, plus, we can’t stop our counterparties from insisting on their own bespoke terms, you know: this is a client service business! We cannot dictate!”

Quite so: and to get you through the live-long day we commend Serenity’s Prayer to you.

Lord, grant me:
The serenity to accept the things I cannot change
The courage to change the things I can, and
The wisdom to know the difference.

You cannot control everything, it is true. But there are some things you can: the starting point for your own docs, for one thing — and some things you certainly cannot, such as customer’s pet peeves.

But pet peeves have the general quality of being correct: few customers get “peeved” at Failure to Pay or Bankruptcy Events of Default.

Take these peeves seriously. Therefore. If you configure your human system be on the look out for them so you can constantly sand off rough edges when you encounter them — see “jidoka” above — then these pet peeves can serve as a kind of carborundum.

It is a curious fact that template augmentations — scar tissue from previous wounds — tend to stick, whereas template simplifications do not. This is a cultural matter: no-one likes removing things they presume were put there for a good reason. This assumption is often wrong. It is in your gift to change it. You just need to take hearts and minds with you.

A useful rhetorical, seldom posed, is:

If someone presented this term to me, would I accept it?

If you start with something you know to be offensive do not be surprised when customers do not accept it and you have to change it.

Rebase your documents to be acceptable to the person on the Clapham omnibus, at least in concept, from the off. Legal advisors are already incentivised to seek changes as a means of demonstrating their value. Why start with a form with which any sane advisor would have to take issue?

“Platinum plating”

Pareto tells us a few special, “platinum” customers will generate outsized revenues, and the large majority will generate an acceptable, but unremarkable returns. A common gambit here is a sort of “quality triage” where the firm offers “platinum” customers more favourable terms than everyone else. Some firms even “tier” their customers, offering softer starting points for platinum customers.

This is madness. It implies that tedious legal wrangling is a kind of punishment for mediocrity. This is to put things precisely backward: platinum customers generate that colossal revenue by taking more risks with more of the bank’s money. If they blow up they will leave a much bigger crater. They are precisely the customers with whom your legal agreements should be strongest.

The converse is this: if your platinum client documentation is fit for managing the big risk-takers, then it is fit for everyone else too. You don’t need need to tier your clients: just offer them all the better terms. The purpose of legal documentation is sometimes opaque but it is not ritualistic punishment. Offering “platinum terms” to regular customers will also reduce how much time you spend — waste — haggling with customers who present risk, and generate less revenue, in the first place. Why aggravate the onboarding process for low-risk clients?

Nor does lowering your starting bid weaken your negotiating position. Brokerage is not a zero-sum game. There are no points for securing stronger risk terms than you need — that does not translate to less risk, just more negotiation — and your walk-away point remains your walk-away point however close you start to it. The sooner you get to agreement, or your walkaway point, the better.

And if you are diligent, consistent and rigorous in this approach, your customers and their advisors will figure this out. They will tire of banging their heads against a brick wall for the sake of improving what is already a reasonable position.

Simplicity

All else being equal, make it simple. This, of course, depends on your counterpart: you can’t clap one-handed, and a dogged pettifogger who takes pride in convolution — there are many of these — will not be assuaged by your best efforts to be brief, however noble.

But Serenity’s Prayer is your friend, all the same. Sure; there are things you cannot change — bear them with good grace and a joyful heart — but just as many yet that you can: you may have to live with whatever pedantry is flung back to you but do not court it by needlessly complicating what you send out.

Convolution causes confusion. Confusion causes fear and requires explanation. Explanation leads — perhaps, eventually — to resolution, but takes time, burns resources, and comes at the cost of variance from your ideal. All this mucking around invites pedantry, should your counterparty’s advisers be given to pedantry. Lawyers, by nature, are given to pedantry.

In essence: having to explain something that could have been clear in the first place, without loss of emphasis is, at least, wasted energy.

Use plain language. Short sentences, modern language. Use “you must ~” rather than “Party B shall be obligated to ~”. Use “we may ~” rather than “Party A shall be entitled but, for the avoidance of doubt, not obliged to ~”.

Write agreeably. You have choices in how your institution expresses itself: these can influence the critical path of your negotiation. Don’t poke your customer with a sharpened stick. Take lessons from Dale Carnegie: try to win friends and influence people. There are polite, agreeable and damnable ways of saying the same thing.

Compare:

“Customer shall be obliged forthwith upon demand and from time to time unconditionally to indemnify and hold the Bank harmless, without set-off, limitation or counterclaim, in the event the Bank or any one or more of its affiliates, agents, nominees or sub-custodians, howsoever described, suffers or incurs, or determines in its absolute discretion that it is or may be likely to suffer or incur, any custom, duty, excise, taxation, stamp or withholding, levy, deduction or charge of whatsoever nature, including penalties, costs, charges and legal expenses incurred in respect thereof, with regard to or in respect of any of Customer’s assets held by or in the name of or in the custody network of the Bank in connection with this Agreement or otherwise.”

with:

“If we incur any tax while we look after your assets for you, you must reimburse us upon request.”

Simplicity aids comprehension when things are going to hell.

Almost all the tools you need are in the pre-printed Master Agreement. It bears repeating that, in these days of daily variation margin, it will be a rare day when your only option to close out a loss-making ISDA will be a NAV trigger or a key person clause.

What you can do about it

“This is all very well, JC, but come on. What hope have I, a mere subject matter expert, of influencing an organisation’s sacred forms? Hell will surely first freeze over.”

It is only a truism that nothing is more immutable than policy if — because — no-one ever challenges it.

Who should bell the cat?

Who better than she who must suffer under its yoke?

Pray, forgive JC’s mixed-metaphor rabble-rousing — but is not that challenge the very thing you have to offer? Is it not your calling? Your destiny? Your superpower?

Within your gift, if only you would give it, lies the fresh air to heal the wounds and scars of historical misadventure to which those templates bear gruesome witness. And if you won’t speak up, why not? What does that then say about your life’s work? That you are but a painted ship upon a painted ocean?

Try it! Go on! Offer to fix your doughty verbiage! What have you got to lose? Did anyone get fired at your firm for asking reasonable questions? If they did, why are you still working there?

Of course your counterparty’s negotiators will be just as institutionalised. They, too, will expect a certain form. They will fear, just as you do, stepping away from What Is Written; for departure from that which can be done without fear of blame. The buttocractic oath is a strong incentive. But overcome it!

Rise up, subject matter experts! Slip your surly bonds!

A word from Mr Nietzsche:

“For believe me! — the secret for harvesting from existence the greatest fruitfulness and the greatest enjoyment is: to live dangerously! Build your cities on the slopes of Vesuvius! Send your ships into uncharted seas! Live at war with your peers and yourselves! Be robbers and conquerors as long as you cannot be rulers and possessors, you seekers of knowledge! Soon the age will be past when you could be content to live hidden in forests like shy deer!”

JC’s anecdotal evidence is that suspicion of simpler forms quickly gives way to relief. If you get your design right, your customers will quickly see the advantage. Negotiators have enough of a job thrashing through everyone else’s ghastly forms: they will be glad of the relief you offer with an easy one.

If you don’t ask, you won’t get.