Template:M intro isda qualities of a good ISDA

In which JC ventures forth, uninvited, onto the topic of what makes a good ISDA. The same things, we rather think that make any good commercial contract, but ISDA is what we know so we should go with that.

The pre-printed master agreement is what it is — it was drafted, so conventional wisdom has it, to avoid controversy — so when we talk about the “qualities of a good ISDA” we mean of course its Schedule. That is where all the skirmishes are.

A scan of the subheads will reveal five basic qualities: fairness, clarity, consistency, simplicity and aptness to instil confidence. These qualities interact and 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 Casanova principle and toward fairness. Clarity and fairness lends itself to consistency, since your customers will find less cause to negotiate. Clarity, fairness, confidence and consistency make for simplicity a simple record that is easy to maintain, roll out and, heaven forfend, enforce.

Fair

“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 that alternative dispute resolution module but is sure to ship a haymaker to the jaw on first contact with the real commercial world. We are enculturated to treat a negotiation as some kind of trench warfare: as if we are facing a mortal enemy and not our customer. It is true that our customers tend to be similarly disposed — fairness never gets a chance to break out.

But this is no single round prisoner’s dilemma. To show fairness is not to show weakness, but strength.

JC is, by lifelong experience, a sell-side guy: he comes at this from the perspective of a merchant contracting with its customers. Hip types call these “B2C” deals, but the JC is not a one of those. Merchant and customer are, generally, on the same side: their interests conflict, but gently: the merchant wants a commission or a mark-up, the customer wants a good price, but beyond that each wishes earnestly for the other’s continued prosperity.

Things can get chewy at the extremes — but most customers never get near a chewy extreme.

Now, we sell-siders may occasionally engage with ostensible hostiles — competitors, for example — but when we do, we abide by an unspoken pact of good faith for the limited ends which have brought our warring sides together. We must, at some level, trust one other, or have a common interest, or we would not contract at all.

So a presumption of any negotiation is good faith. Some level of trust. We don’t negotiate with terrorists. If you can’t trust your counterparts, this happens: the traitor’s dilemma.

In any case, the “merchant-to-customer” contract is, by a landslide, the most common kind. Those with any in-house counsel experience of bona fide, non-existential, customer disputes know one thing: if there is any doubt — and frequently, when there isn’t — the business will roll over. No-one takes a point with a solvent client.

This is nothing more than common sense: you stand far more to gain in future revenue by preserving your relationship at the small cost of excusing a customer the occasional gaffe than taking a literal stance on technical errors.

The instinct to “let it go” is so pronounced that compliance teams have contrived means to prevent the business granting these concessions for fear they are seen as impermissible “inducements”.

In any case, the commercial imperative is so overwhelming a factor in ongoing business relationship that there is little point in asking for, let alone achieving, terms that go beyond “fair”. No-one will ever 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 — you should start with a fair template.

Confident

Your form should also inspire confidence, and not fear, in your own negotiating team. It is a fact of life that negotiators these days have less combat experience and expertise than they once had. To do a good job they must be comfortable with their tools. They should understand the templates and the products they govern. They should go beyond the contract’s formal articulation to grasp the underlying commercial drivers of the relationship. If they do, they can help you identify the parts of the contract that aren’t achieving what they seem to be.

By contrast, a negotiator who fears her material will hide behind the formal rules you give her to manage it. She won’t be drawn to discuss anything live — if she doesn’t understand the form and what it is trying to achieve, why would she put that vulnerability on show? — so will hide behind her keyboard, thereby contributing to the familiar experience of electronic trench warfare: she will lob long, bulleted issues lists over no-man’s-land and into the enemy’s advanced positions, or escalate that way internally to risk departments, where the missives will hiss and sputter, being passed about for days, before eventually being lobbed back, annotated in BLOCK CAPITALS, appended with yet more more bullets points. This impasse can go last, as it did in Ypres, for years. You could write war poetry about it.

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 we fetishise the form over the substance, deference to a contractual form that is plainly suboptimal is no cause for celebration. A confident negotiating team engages with the form rather than deferring to it. This is the negotiator’s version of “jidoka”: the human touch that makes the machine sing.

Clear

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.

Closeout terms will 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. Your management will be going mad — make no bones about that — but so will the market and, quite possibly, the geopolitical situation too. All kinds of people will be doing inexplicable things.

Your customers will be AWOL: the defaulting client certainly will. 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.

We do not imagine that, when they crafted its close-out mechanics, the ’squad had the wider general ambiance in which the ISDA’s s last-resort rights would be exercised. They can’t have. We imagine they 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. All of this is the fog of war.

Even among those who had them in the first place, patience and a sense of humour will be in short supply. People — many, many people — will want short, clipped answers to different questions they are all shouting at you at once — to which there are no short, clipped answers. 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 bet your bottom dollar, it 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 — short, clear, plain, blunt termination language, with simple-to-follow events addressing only generally catastrophic circumstances. The day is going to be an omnishambles, so make your job on that day as easy as it can possibly be.

The reality is that 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 unnecessarily 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.

Consistent

It helps with clarity if you have confidence, in a scrape, that you know what your ISDA is going to say where it matters. You can be sure of this if you are control quality where it matters. (Where it doesn’t — where the request is to acquiesce to a counterparty’s modern slavery policy — which it win’t disclose to you — or agreeing to the ethical treatment of the polar bears etc, you can afford to take a view.)

“This is all very well but how, JC, 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 insisting on bespoke terms, you know: this is a client service business! We cannot dictate!”

Quite so: and to get you through the livelong day we commend serenity’s prayer to you.

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

But pet peeves have the general quality of being correct: few people are peeved at a failure to pay clause.

If you configure your human system to constantly sand off rough edges when you encounter them then these pet peeves serve as a kind of carborundum.

It is a curious fact that augmentations to a template — scar tissue from previous wounds —have a habit of sticking to your legal forms, whereas simplifications do not. This is a cultural matter. It is in your gift to change it. You just need to take hearts and minds with you.

Your forms

if you start off with something you know to be offensive do not be surprised when they do not accept it.

A useful rhetorical, seldom posed us this:

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

Rebase your documents to executable, at least in concept, from the off.

Platinum plating

There is a false economy — at any rate a misalignment of risk and reward — in the widely held belief that “platinum” customers should be offered better terms then regular ones. Some firms even triage their starting point based on the size of the client.

This has things precisely backwards. Your platinum generate the most revenue by taking the most risk customers take greater risk and present greater catastrophe.. on a greater scale stop if you are prepared to run this risk with the premium customer then you should be prepared to run it with a smaller custom or two. This will also reduce the time you spend fruitlessly negotiating with customers who you know be generating less of your revenue.

Nor does de-escalating your starting position we can your hand in the negotiation. Your walk away remains your walk away Colin the sooner you get to it the better that it's does not take long tends to focus our customers mind even one a customed to long and rewarding negotiations.

Furthermore if you are diligent and consistent in your positioning, customers and their advisors will quickly tyre of banging their heads against a brick wall and will accept what is, after all, a reasonable position.

Customer pet peeves

It is true that you cannot change the negotiating position of a truculent customer, but by rebating your documents to something more agreeable you perhaps avoid painting the clients into a corner from which it will not then back down in the first place.

Simple

All else being equal, make it simple. This is somewhat conditional, by serenity's prayer, your counterparty night have a ten for its own convoluted terms, and it takes advanced Dale Carnegie diplomacy to persuade such a chap not to self-harm — but at the least do not be the progenitor of unnecessary complication. Convolution causes confusion, confusion leads to explanation, explanation leads eventually to resolution, but that resolution takes time, burns resources, and comes at the cost of formal or even substantive variance from your standard.

Having to explain something that should have been clear in the first place is, at the least wasted energy.

Use plain language. Short sentences, modern language. Write agreeably: “must” instead of “shall be obligated to —”; “may” instead of “shall be entitled but, for the avoidance of doubt, not obliged to —”.

But simple aids easy comprehension at the time when things are going to hell.

It is defiantly standard, to the point where some will amend the schedule by reference to the line numbers in the pre-printed standard. (Don't do this: there are reformatted versions floating around with different pagination and it makes for confusion when your ISDA is scanned as text into the Edgar database etc.). It has twenty one years of history, too, and is now so canonical it is hard to imagine ISDA publishing a new one.

Almost all the tools you need are in the master. 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 potentially loss making ISDA will be some bespoke Additional Termination Event like a NAV trigger or a key man provision. One more right will complete the set: a right to call for more margin. Most prime brokers have this. If you can, by close of day, engineer a failure to pay (or an infusion of cash) then your key person trigger, cross default rights, financial reports, representations and warranties are little use to you.

[Another argument against bilateral margin: the customer can always close out a trade: the dealer is not on risk, QED, and will always give a price to exit — the unwind price on its hedge. It is not generally a taxable event for the dealer. Dealers can’t unilaterally terminate customer positions, and even where they can — synthetic prime brokers generally have the right to — they generally won’t, without extreme provocation, because that would upset the customer.