Template:M intro isda bankruptcy phase transition

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 (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.