Flawed asset
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A word about credit risk mitigation
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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”.”
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
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, net across all outstanding transactions, would owe money, if all transactions were terminated. This is a notional debt that is not “due” as such, so it is money a solvent counterparty might not want to have pay out just because its counterparty has failed to perform its end of the bargain. On the other hand, the innocent counterparty doesn’t want to have to continue stoically paying away to a bankrupt counterparty that isn’t reciprocating.
The flawed asset provision allows the innocent party the best of these both worlds. It can stop, and sit on its hands, 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 an ISDA Master Agreement it Events of Default and even Potential Events of Default, but not Termination Events or Additional Termination Events — which, given the “culpability” and “event-of-defaulty-ness” of ATEs, is something of dissonance in itself.
Collateral
Flawed assets entered the argot in a simpler, more peaceable time when two-way, zero-threshold, daily-margined collateral arrangements were a fantastical sight. 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 blown up. This is a lot less likely in these days of mandatory regulatory margin. Nor 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.
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 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