Template:M intro isda qualities of a good ISDA

In which JC ventures forth, unbidden, onto the topic of what makes a good ISDA. Mainly the same things that make any good commercial contract, but ISDA is what we know so we will go with it.

The pre-printed Master Agreement being what it is — a stone tablet hewn, so conventional wisdom has it, from holy granite so as to avoid controversy — when we talk about the “qualities of a good ISDA” it goes without saying “the sacred fourteen” are already immaculate: we mean of course a good ISDA Schedule. It is toiling over that, grubby mortal appendix — a crazed shadow thrown by guttering light across the far wall of Plato's cave —that you will live out your days.

A scan of the sub-headings below will betray JCs view of it: an ISDA should have five basic qualities: fairness, clarity, consistency, simplicity and aptness to instil confidence.

These qualities interact with and, in large part, depend on each other. They are in symbiosis.

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’a principle and toward fairness. Clarity and fairness lend themselves also to consistency, since you will treat your customers the same way — with equanimity — and as such they will find less cause to negotiate. 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 that alternative dispute resolution module but is sure to ship a haymaker to the jaw on first contact with commercial reality. We treat a negotiation as some kind of trench warfare: as if we face a mortal enemy and not a 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.

Confidence

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.

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.

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.

Consistency

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.

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, is:

If someone presented this term to me, would I accept 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”

A common gambit here is a sort of “quality triage”: it is a truism that a few special, “platinum” customers will generate disproportionate revenues for the firm, and a large morass will be reliable but unremarkable. The thinking goes that one should therefore offer “platinum” customers better terms than regular ones, to the point where some firms even offer different starting points to different clients.

In its unstated assumption that tedious legal wrangling is a kind of punishment for mediocrity, this has things precisely backward: platinum customers generate that colossal revenue by taking the most risk with the bank’s money. They may be better run, with more powerful systems and heavier infrastructure, but that doesn’t mean they can’t blow up, and if they do they will leave a much bigger crater. These are precisely the clients with whom your legal agreements should be strongest.

The converse is this: if your platinum client documentation is fit for the big risk-takers, then it is fit for everyone else too. You don’t need better terms with smaller fry. 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 will present you less risk and generate less revenue.

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 — it does not necessarily translate to less risk — and your walk-away point remains your walk-away point however close you start to it. From a resourcing perspective, the sooner you get to agreement, or the 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 intentions, however noble. She will have her severability boilerplate, and that is that.

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 holding assets for you under this contract, you must reimburse us upon request.”

Simple, too, aids easy comprehension at a time when things are going to hell.

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 loss-making ISDA will be a NAV trigger or a key person clause.