|A word about credit risk mitigation
You’ll be most likely wanting to see the discussion on this wonderfully baffling subject under Section 2(a)(iii) of the ISDA Master Agreement. But see also the extended liens case, which discusses “rare cases in which security rights fall wholly outside the recognised categories of lien, pledge, mortgage or charge, and into a residual, purely contractual, category sometimes categorised as turning the grantor’s property into a form of “flawed asset”.”
Following an event of default, 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 hte contract altogether, rather than paying out its mark-to-market loss.
That was then; 1987; they hadn’t even invented the 1995 English Law 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 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.
Master trading agreements
- ISDA Master Agreement: You can find it all, in gruesome detail, in the article on Section 2(a)(iii). The ISDA provision has generated some case law, including Metavante and Firth Rixson, which the truly insatiable amongst you may care to read.
- 2010 GMSLA: As far as I can see there is no direct 2(a)(iii) equivalent in the GMSLA, but Section 8.6, which allows you to suspend payment if you suspect your counterparty’s creditworthiness, is the closest, but it isn't a flawed asset clause. Nor would you expect one. It makes little sense in a master agreement for transactions that generally have zero or short tenors, and are inherently margined daily as a matter of course – i.e., there is no “uncollateralised, large, out-of-the-money exposures” an innocent stock lender would want to protect such a flawed asset provision.
- Global Master Repurchase Agreement: Now here’s the funny thing. Even though the GMRA is comparable to the GMSLA in most meaningful ways, it does have a flawed asset provision. I don’t understand it, but that is true about much of the world of international finance.
Section 2(a)(iii) litigation
There is a (generous) handful of important authorities on the effect under English law or New York law of the suspension of obligations under Section 2(a)(iii) of the ISDA Master Agreement, and whether flawed asset provision amounts to an “ipso facto clause” under the US Bankruptcy Code or violates the “anti-deprivation” principle under English law. Those cases are:
- Lomas v Firth Rixson
- Marine Trade v Pioneer
- Pioneer v Cosco
- Pioneer v TMT
- Enron v TXU
- Metavante v Lehman
- Amazing in hindsight, really, isn’t it.