Template:Isda 2(a)(iii) summ

Flawed Assets

Flawed asset
/flɔːd ˈæsɛt/ (n.)
A financial asset that looks good, but thanks to a carefully buried conditions precedent, is not there when you, and more importantly, your insolvency administrator, wants it.

In the language of financial obligations, one’s rights to future payments under a contract are an asset. You own them and, all other things being equal, can deal with themcthat is, sell or raise money against them — the same way you can sell or mortgage a house, car, a portfolio of equities, or some decentralised cryptographic tokens representing abstract capital.

“Assets” have a few “ontological” properties, one of which is continuity, in time and space. They might rust, depreciate, go out of fashion or stop working properly but they are nevertheless, existentially, still there, at least until you do sell them. They therefore have some value to you, however parlous the state of your affairs might otherwise be.

This makes accounting for assets possible, albeit difficult.

Flawed Assets

Flawed asset

/flɔːd ˈæsɛt/ (n.)

A financial asset that looks good, but thanks to a carefully buried conditions precedent, is not there when you, and more importantly, your insolvency administrator, wants it.

In the language of financial obligations, one’s rights to future payments under a contract are an asset. You own them and, all other things being equal, can therefore deal with them — that is, sell or raise money against them — the same way you can sell or mortgage a house, car, a portfolio of equities, or some decentralised cryptographic tokens representing abstract capital. [Really? — Ed.]

“Assets” have a few “ontological” properties, one of which is continuity, in time and space. Assets might rust, depreciate, go out of fashion or stop working properly but they are nevertheless, existentially, still there, at least until you do sell them. They therefore have some value to you, however parlous the state of your affairs might otherwise be.

This makes accounting for assets possible, albeit difficult. Should your fates line up so that some official comes to be drawing up a closing account of your earthly financial existence — should you become bankrupt, heaven forfend — your assets can reliability be popped onto the “plus” side of the ledger. The difficulty subsists in working out what they are worth, but at least they are there.

This continuity is important to the administration of failing enterprises wherever they are based, and so many countries have rules preventing company managers hurriedly disposing of their assets as impending disaster looms. Managers can’t therefore grant unfair preferences, by selling or giving away assets at an undervalue. And they can’t enter contracts, even in times of fair weather, which might have the effect of giving some creditors and counterparties unfair preferences over others, should the clouds roll in.

Section {{{{{1}}}|2(a)(iii)}} has exactly that effect on a {{{{{1}}}|Defaulting Party}}’s claims under an ISDA. Just when it goes insolvent or fails materially to perform, its “asset” represented by the {{{{{1}}}|Transaction}}, perhaps temporarily, vanishes. It allows a {{{{{1}}}|Non-defaulting Party}} to indefinitely suspend its performance of its obligations under a {{{{{1}}}|Transaction}} without terminating the {{{{{1}}}|Transaction}}. Should the {{{{{1}}}|Defaulting Party}} cure the default, the {{{{{1}}}|Transaction}} resumes and the {{{{{1}}}|Non-defaulting Party}} must resume all its obligations, including the suspended ones. But for so long as the default is not cured, the {{{{{1}}}|Non-defaulting Party}} does not have to do anything but keeps the option to terminate (thereby crystallising the loss at any time.

So an asset that doesn’t have that quality of continuity: that suddenly isn’t there, or that has the unnerving quality of winking in and out of existence at inopportune moments — especially at times of its owner’s existence fitfulness — is somehow imperfect: “flawed”. 

Insolvency regimes: not fans.

In the United States, there is a provision in the Bankruptcy Code rendering unenforceable any contract terms providing for termination or modification that are triggered by the simple fact of insolvency proceedings. These are known as “ipso facto” clauses, because the simple fact of bankruptcy “in itself” triggers the clause. If Section 2(a)(iii) were an ipso facto clause, it would not be enforceable.

Whether Section 2(a)(iii) is an ipso facto clause is a subject of vigorous but tiresome debate. For our purposes, the fact that people don’t easily agree about it is all you need to know: this makes a silly contractual provision even more cavalier.

While the UK has no statutory equivalent of America’s ipso facto rule, hundreds of years ago resourceful common law judges “discovered” an “anti‑deprivation” rule that, in the honeyed words of Sir William Page Wood V.C., in Whitmore v Mason (1861) 2J&H 204:

“no person possessed of property can reserve that property to himself until he shall become bankrupt, and then provide that, in the event of his becoming bankrupt, it shall pass to another and not his creditors”.

This required some wilfulness on the bankrupt’s part and not just inadvertence or lucky hap, but still: if you set out to defeat the standing bankruptcy laws do not expect easily to get away with it.

It seems, at any rate, that Section {{{{{1}}}|2(a)(iii)}}, might resemble some kind of intended deprivation; merely crystallising one’s existing position and stopping it from going further down the Swanee, as one might do by closing out altogether, seems less so.

Anyway: be aware: Talk of Section 2(a)(iii) attracts insolvency lawyers. That ought to be reason enough to keep schtum about it.

On avoiding a cleft stick

Ww can have a fine time rabbiting away about the ontology of assets for sure, but isn’t there a more basic question: why would a Non-defaulting Party, presented with a counterparty in default, ever not want to just close out?

It all comes down to moneyness. The “bilaterality” of a swap {{{{{1}}}|Transaction}} means that either party may, net, be “out of the money” — that is, it would have to pay a net sum of money if the {{{{{1}}}|Transaction}} were terminated — at any time. Unless something dramatic happens, this “moneyness” is only a “notional” debt: it only becomes “due” if an {{{{{1}}}|Early Termination Date}} is designated under the Master Agreement.

So an out-of-the-money, {{{{{1}}}|Non-defaulting Party}} has a good reason not to close out the ISDA. Doing so would oblige it to crystallise and pay out a mark-to-market loss. Why should it have to do that just because a {{{{{1}}}|Defaulting Party}} has failed to perform its end of the bargain?

On the other hand, the {{{{{1}}}|Defaulting Party}} is, er, ipso facto, not holding up its end of the bargain. Just as our innocent {{{{{1}}}|Non-defaulting Party}} does not wish to realise a loss by terminating, nor does it want to have to stoically pay good money away to a {{{{{1}}}|Defaulting Party}} who isn’t paying anything back.

A cleft stick.

Section {{{{{1}}}|2(a)(iii)}} allows our {{{{{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 — thereby neither crystallising its ugly mark-to-market position nor pouring perfectly good money away (which is a form of drip-feeding away that mark-to-market position, if you think about it).

So much so good for the {{{{{1}}}|Non-defaulting Party}}. 

But the {{{{{1}}}|Defaulting Party}}’s “asset” — its contingent claim for its in-the-money position against the {{{{{1}}}|Non-defaulting Party}} — is compromised. This, for an insolvency administrator and all the {{{{{1}}}|Defaulting Party}}’s other creditors, is a bummer. It deprives them of the “asset” represented by the {{{{{1}}}|Transaction}}.

Which events?

Exactly which default events can trigger the suspension? Under the ISDA, {{{{{1}}}|Events of Default}} and even Potential {{{{{1}}}|Events of Default}} do, but {{{{{1}}}|Termination Events}} and {{{{{1}}}|Additional Termination Events}} do not. This is because most {{{{{1}}}|Termination Events}} are softer, “Hey look, it’s no one’s fault, it’s just one of those things” kind of events. This is not usually true of Additional Termination Events, though: they tend to be credit-driven, and girded with more “culpability” and “event-of-defaulty-ness”. So this is a bit dissonant, but there are far greater dissonances, so we park this one and carry on.

We have seen valiant efforts to insert Additional Termination Events to section 2(a)(iii), and “Potential Additional Termination Events”, a class of things that does not exist outside the laboratory, so must therefore be defined. All this for the joy of invoking a clause that makes little sense in the first place.

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.

The problem with bilateral agreements

Triago: Forsooth: it wears the colours of a fight.
A word-scape stain’d with tightly kernèd face
And girded round with fontish weaponry.
Herculio (inspecting the document): Verily, convenantry this dark
Speaks of litiginous untrust.

—Otto Büchstein, Die Schweizer Heulsuse

As we have remarked before, most financing contracts are decidedly one-sided. One party — the dealer, broker, bank: we lump these various financial service providers together as The Man — provides services, lends money and manufactures risk outcomes; the other — the customer — consumes them.

Generally, the customer presents risks to The Man, and not vice versa. In a loan, all the “fontish weaponry” is pointed in the same direction: the customer’s. It goes without saying that should the customer “run out of road”, The Man stands to lose something. What is to be done should The Man run out of road is left undetermined but implicitly it is unlikely, and not expected to change anything for the customer. Whatever you owe, you will continue to owe; just to someone else.

Though the ISDA is also, in practice, a “risk creation contract” and has these same characteristics, it is not, in theory, designed like one. Either party can be out-of-the-money, and either party can blow up. The ISDA’s fontish weaponry points both ways.

This presented dealers with an unusual scenario: what happens if you blow up when I owe you money? I might not want to crystallise my contract: that will involve me paying you a mark-to-market replacement cost I hadn’t budgeted for paying out just now. (This is less true in these days of mandatory variation margin — that is one of JC’s main objections — but the ISDA Master Agreement was forged well before this modern era).

The ISDA answers this with the “flawed asset” provision of Section {{{{{1}}}|2(a)(iii)}}. This allows an innocent, but out-of-the-money, party faced with its counterparty’s default, to not close out the ISDA, but just freeze its own obligations until the default situation is resolved.

There is an argument the flawed asset clause wasn’t a good idea even then, but a better one that it is a bad idea now, but like so many parts of this sacred, blessed form it is there and, for hundreds and thousands of ISDA trading arrangements, we are stuck with it.

Ask a chary credit officer what she thinks of Section {{{{{1}}}|2(a)(iii)}} and her eyes are sure to glister as she regales you with the countless times it's got her out of a scrape at the first sign of {{{{{1}}}|Potential Event of Default}}. Regulators are less enamoured, especially after the global financial crisis, and took some steps to impose at least as “use it or lose it” drop-dead point, but institutional inertia and the brick wall of reality has long since arrested that drift.

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, without formal action by the {{{{{1}}}|non-Defaulting Party}} 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, until the {{{{{1}}}|Transaction}} has been formally terminated, at which point it really ought to go without saying.

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 in the round 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 {{{{{1}}}|Additional Termination Event}}s, a class of things that does 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 ninja ever.

Developments between editions

“...a condition precedent for the purpose of this Section 2(a)(iii) ...”

The 2002 ISDA trims back the third limb of Section 2(a)(iii) from “all other conditions precedent” to just those that specifically say they mean to be caught by Section 2(a)(iii). This a sensible restriction in scope as far as it goes (but JC would go further and remove Section 2(a)(iii) altogether).

We have heard the argument advanced — apparently on the authority of that FT book about derivatives — that this restricted third limb somehow conditions the other conditions precedent in the clause (i.e., that there is no ongoing PEOD or EOD and that the Transaction has not already been terminated):

Section 2(a)(iii)(3) makes clear that if people want to stipulate any condition precedent other than the standard ones in Section 2(a)(iii)(1) and (2) they must clearly add the wording that the relevant condition will be “a condition precedent for the purposes of Section 2(a)(iii)”. ... Effectively this narrows the scope of the corresponding provision of the 1992 Agreement where no such statement was necessary.

It plainly does not, and nor do we see how you could read the FT book as making that argument. The extreme looseness of {{{{{1}}}|2(a)(iii)}} imported by any notified breach of the agreement, however technical, being a Potential Event of Default, remains.

“No Early Termination Date ... has occurred”...

New in the 1992 ISDA was the second condition precedent, that “...no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated”.

This is tidy-up material to bring triggered {{{{{1}}}|Termination Event}}s into scope. There is a period between notice of termination and when the {{{{{1}}}|Early Termination Date}} is actually designated to happen — and in a busy ISDA it could be a pretty long period — during which time the {{{{{1}}}|Transaction}} is still on foot and going, albeit headed inexorably at a brick wall.