Section 2(a)(iii) - ISDA Provision
Overview
Section 2(a)(iii) is the world-famous, notorious, much-feared “flawed asset” provision in the ISDA Master Agreement. The text is unchanged between the 1992 ISDA and the 2002 ISDA. However there was a change from the 1987 ISDA which did not have the middle condition precedent that “no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated”. As to what this achieved, we speculate below.
Summary
The problem with bilateral agreements
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, creates risk outcomes; the other — the customer — consumes them. Generally, the customer presents risks to The Man and not vice versa. All the weaponry is therefore pointed in one direction: the customer’s. It almost goes without saying that should the customer “run out of road”, the Man stands to lose something.
Even though the ISDA is also, in practice, a “risk creation contract” having these same characteristics, it is not, in theory, designed like one. Seeing the dealer and the customer for what they are involves seeing a rather bigger picture. In the small picture — the ISDA agreement proper — either party can be out of the money, and either party can blow up. The weaponry points both ways.
This presented the First Men with an unusual scenario when they were designing the ISDA Master Agreement: what happens if you blow up when I owe money to you? Here I might not want to crystalise my contract: since it will involve me paying you a mark-to-market amount I hadn’t budgeted for I might not even be able to. (This is less of a concern in these days of mandatory bilateral variation margin, but the ISDA Master Agreement was forged well before this modern era).
The answer the First Men came up with was the “flawed asset” provision of Section 2(a)(iii). This allows an innocent, but out-of-the-money, party faced with its counterparty’s default not to close out the ISDA, but to just freeze its obligations, and do nothing until the situation is resolved.
There is an argument it wasn’t a good idea then; there is a better argument it isn’t a good idea now, but like so many parts of this sacred form it is there and, for hundreds and thousands of ISDA trading arrangements, we are stuck with it.
Flawed assets generally
Following certain default events,[1] a “flawed asset” provision allows an innocent, but out-of-the-money counterparty to a derivative or securities finance transaction to suspend performance of its obligations without terminating the transaction and thereby crystallising a mark-to-market loss implied by its out-of-the-money position.
The defaulting party’s asset – its right to be paid, or delivered to under the transaction – is “flawed” in the sense that it doesn’t apply for so long as the conditions precedent to payment are not fulfilled.
The most famous flawed asset clause is Section 2(a)(iii) of the ISDA Master Agreement. It entered the argot in a simpler, more peaceable time, when two-way, zero-threshold, daily margined CSAs were a rather fantastical sight, and it was reasonably likely that a counterparty might be nursing a large unfunded mark-to-market liability which it would not want to have to fund just because the clot at the other end of the contract had gone belly-up. Closing out the contract would crystallise that liability, so the flawed asset provision allowed that innocent fellow to just stop performing the contract altogether, rather than paying out its mark-to-market loss.
That was then; 1987; they hadn’t even invented the 1995 CSA. Even once they had, it would be common for a muscular broker/dealers to insist on one-way margining: “You, no-name pipsqueak highly levered hedge fund type, are paying me variation margin and initial margin; I, highly-capitalised, prudentially regulated, balance-sheet levered[2] financial institution, am not paying you any margin.”
Well, those days are gone, and bilateral zero-threshold margin arrangements are more or less obligatory nowadays, so it’s hard to see the justification for a flawed asset provision. But we still have one, and modish post-crisis threats by regulators worldwide to stamp them out seem, some time in 2014, to have come to a juddering halt.
One can level many criticisms at the flawed assets concept these days, and the JC does. Not only is it often triggered by vague, indeterminate things, there are many cases where its technical application makes absolutely no sense. Really, if a counterparty doesn’t like the position it is in when a counterparty defaults, its remedy is simple. Close out. Just saying “talk to the hand” really ought not do in these enlightened, margined times.
Does not apply to Termination Events
Since most ISDA Master Agreements that reach the life support machine in an ICU get there by dint of a Failure to Pay or Bankruptcy this does not, in point of fact, amount to much, but it is worth noting that while Event of Defaults — and even events that are not yet but with the passing of time might become Events of Default — can, without formal action by the non-Defaulting Party trigger a 2(a)(iii) suspension, a mere Section 5(b) Termination Event — even a catastrophic one like an Additional Termination Event (such as a NAV trigger, key person event or some such) — cannot, until the 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 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 Additional Termination Events to section 2(a)(iii), and — quel horreur — Potential Additional Termination Events, 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.
“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 Termination Events into scope. There is a period between notice of termination and when the Early Termination Date is actually designated to happen — and in a busy ISDA it could be a pretty long period — during which time the Transaction is still on foot and going, albeit headed inexorably at a brick wall.
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- The JC’s famous Nutshell™ summary of this clause
- Mechanics:
- How and when 2(a)(iii) is or, more to the point not, triggered.
- The confusion arising from no-one knowing whether 2(a)(iii) applies.
- The confusion arising from not knowing when it applies.
- The JC’s theory about why anyone thought 2(a)(iii) was a good idea in the first place.
- The JC’s view that, even if once upon a time it was, Section 2(a)(iii) is no longer fit for purpose.
- How Section 2(a)(iii) held up during the sanctions extravaganza when Russia invaded Ukraine (hint: it didn’t help!)
- Regulatorry issues
- Why regulators don’t like 2(a)(iii)
- What the courts think of 2(a)(iii) — in a nutshell, they are confused
- A table comparing the six major decisions on the clause
- Practical issues:
- How Section 2(a)(iii) operates in the case of non-payment-or-delivery defaults.
- How corporate buyers of fully paid options might feel about 2(a)(iii) (hint: not happy!)
- Amendments corporates might think about making if they want to feel happier
See also
- Clause 8.6 of the 2010 GMSLA
- Clause 6(j) of the Global Master Repurchase Agreement
References
- ↑ Exactly which defaults will depend on the contract: under an ISDA Master Agreement it will include Events of Default and Potential Events of Default, but not Termination Events or Additional Termination Events — which, given the “culpability” of ATEs, is something of a dissonance in itself.
- ↑ Amazing in hindsight, really, isn’t it.