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 commercial contract good, but let’s not spoil a good story.

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.

A scan of the sub-headings below will betray JC’s view: it 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.

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. Why the hostility? 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.

Conundrums like this usually boil down to variations of the agency problem and can be untangled by asking, cui bono? Usually, it will be an agent such as like a professional adviser who is “making herself useful” by “avoiding doubt”. This is no exception.

JC is, by lifelong experience, a sell-side guy: he comes at this from the perspective of a provider of financial services contracting with people who want them. Merchant and customer are, her as in any marketplace, generally on the same side: at the limit, 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 when large sums of money are involved — but most dealers and most customers never get near a chewy extreme.

Sell-siders occasionally engage with ostensible hostiles — competitors, for example — but when we do, there is an unspoken pact of good faith for the limited ends which brought the warring factions together. We must, at some level, trust one those with whom we contract. Me 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: David Graeber makes a fascinating point when discussing the non-origin of currency out from barter: barter is an arm’s length trade of equivalent goods conducted between parties who are dispositionally rivals and not partners. Once the exchange happens, nothing is left on the table; there is no presumption of enduring goodwill, no expectation of further business, or any kind of obligation undischarged. A barter is a delivery-versus-payment exchange conducted between untrusting aliens. The contract ends upon exchange: no trust is needed. Inside your community, where there is trust, we are less compelled to extract a pound of flesh: there is a give and take; we let obligations lie undischarged on trust 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. 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 capital, not economic capital, in the shape of more business.

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.

In any case, the “merchant-to-customer” contract is, by a landslide, the most common kind. Once finalised, these are filed somewhere and never again reviewed — it is bad form to pay too much attention the letter of the deal, even should there later be an argument. Those with any inhouse 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 to gain far more in future revenue by preserving your relationship even where that means excusing a customer the occasional gaffe than you do by taking a literal stance on technical errors.

The instinct amongst business people to “just let it go” is so pronounced, indeed, that compliance teams have found ways to prevent this happening for fear it is seen as an impermissible “inducement”.

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.

Make your templates fair.

Confidence

Your form should also inspire confidence, 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, not scared of them. They should understand the templates they use 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.

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, 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 issues 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 more bullets and annotated in BLOCK CAPITALS or a fetching hot pink. This impasse can last, as it did in Ypres, for years. You could write war poetry 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 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.

Make sure your team have 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.

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.

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.

We do not imagine that, when they crafted its close-out mechanics, the ’squad had in mind 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 — questions 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 — a discipline in times of fine weather and fecund trading conditions, to make sure your contracts have short, clear, plain and blunt termination language, with simple-to-follow events addressing only generally catastrophic circumstances. The day when you need your contracts will be omnishambles enough without disastrous, baffling contracts making it worse.

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. You can be sure of this if you control quality where it matters. (Where it doesn’t — and with all the will in the world there are open tracts of most ISDA Schedules which will never have practical impact on anything, 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.

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. But who should bell the cat? Who better than she who must suffer under its yoke?

Pray, forgive JCs’ mixed-metaphor rabble-rousing — but is not that challenge the very thing your experience offers? 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 witness. And you won’t, why not? What does that then say about your life’s work? That you are but a painted ship upon a painted ocean?

We hope this is mere rhetorical conjecture. Try it! Go on! Offer to fix your doughty verbiage! What have you got to lose?

Did anyone get fired for asking good questions? (If they did — what are you doing working at such an organisation?)

Of course your counterparty’s negotiators will be no less institutionalised. They too will have expectations of 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.

Arise, 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.