Flawed asset
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A word about credit risk mitigation
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Flawed asset
/flɔːd ˈæsɛt/ (n.)
A “flawed asset” provision allows the “innocent” party to a financial transaction to suspend performance of its own obligations if its counterparty suffers certain default events without finally terminating or closing out the transaction. Should the defaulting side cure the default scenario, the transaction resumes and the suspending party must perform all its obligations including the suspended ones. For so long as it not cured, the innocent party may close the Master Agreement out at any time, but is not obliged to.
Rationale: avoiding a cleft stick
Why would a party ever want to not close out a defaulting counterparty? It all comes down to moneyness.
The “bilaterality” of most derivatives arrangements means that either party may, net, be “out of the money” — that is, across all outstanding transactions, it would have to pay a net sum of money if all transactions were terminated. This is a notional debt that only becomes “due” as such if you designate an Early Termination Date under the Master Agreement. So an out-of-the-money Non-defaulting Party has a good reason therefore not to close out the ISDA. Why should it have to pay out just because a Defaulting Party has failed to perform its end of the bargain? On the other hand, if it forebears from terminating against a bankrupt counterparty the Non-defaulting Party doesn’t want to have to continue stoically paying good money away to a bankrupt counterparty who isn’t reciprocating.
An out-of-the-money Non-defaulting Party seems, therefore, to be in a bit of a cleft stick.
Section 2(a)(iii) allows the 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, and thereby not thereby crystallising the 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 its rights don’t apply for so long as the conditions precedent to payment are not fulfilled.
Conceivably you could invoke a flawed asset provision even if you were in-the-money, but you would be mad to.
Which events?
Exactly which default events can trigger a flawed asset clause will depend on the contract. Under the ISDA Master Agreement it Events of Default and even Potential Events of Default do, but Termination Events and Additional Termination Events do not. Termination Events are softer, “hey look, it’s no-one’s fault, it’s just one of those things” kind of close outs, so that makes some sense — but on the other hand this is not really true of Additional Termination Events, which tend to be credit-driven and with more “culpability” and “event-of-defaulty-ness” about them. This is, a bit dissonant, but there are far greater dissonances, so we park this one and carry on.
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 a fantastical sight. It was therefore reasonably likely that a Non-defaulting Party might be nursing a large unfunded mark-to-market liability which it would not want to have to pay out on just because the clot at the other end of the contract had driven his fund into a ditch. A large uncollateralised position is a less likely scenario in these days of mandatory regulatory margin in which counterparties generally cash-collateralise their net market positions to, or near, zero each day.
Nor, we think, did it occur to dealers, who typically insisted on the flawed assets clause, that they might be on the wrong end of it. The events of September 2018 were, therefore, quite the chastening experience.
The ISDA’s Section 2(a)(iii)
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.
When first introduced, in 1987, they hadn’t even invented the 1995 CSA. Even once they had, it would be common for a muscular swap dealer 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, Balance-sheet levered prudentially regulated financial institution, am not paying you any margin.”
Query the utility these days
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, sometime 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 margined 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 to do in these enlightened, margined times.
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’.”
Flawed assets clauses in master trading agreements
ISDA
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.
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.
GMRA
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.
Prime brokerage agreements
Even though they are financing arrangements, prime brokerage agreements are often based on ISDA technology. They may have flawed asset clause — let’s fact it, it is the sort of thing credit will insist on it — but it doesn’t need one, as prime brokers are fully margined, so there is no circumstance in which a prime broker would owe a client anything (other than account equity) on termination.
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 the most litigationey clause in the ISDA Master Agreement, Section 2(a)(iii). They consider 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