Section 2(a)(iii) - 1992 ISDA Provision
1992 ISDA Master Agreement
Section 2(a)(iii) in a Nutshell™
Use at your own risk, campers!
Full text of Section 2(a)(iii)
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Content and comparisons
Section 2(a)(iii) is the world-famous, notorious, much-feared flawed asset provision in the ISDA Master Agreement. Fertile hunting grounds for fee-hungry barristers in the Re Lehman Brothers International and Re Spectrum Plus litigations.
Flawed assets generally
Following certain default events, 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 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.
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 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. 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 basically 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 do 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 notice of suspension required
Leaving for a few moments the question of when one would ever need, let alone want to invoke Section 2(a)(iii) other than in the strangest of days, let’s consider the mechanics.
Notice there are none.
Section 2(a)(iii) just sits there, and has effect, without anyone’s particular by-or-leave. No notice is required: no-one need look out for envelopes being delivered to the physical address the firm occupied seventeen years ago when someone filled out Part IV of the schedule. Section 2(a)(iii) doesn’t even say an Innocent Party is entitled to withhold payment: rather the conditions are not met and payment is not therefore due. The effect of Section 2(a)(iii) just happens if an EOD or PEOD exists. Now some EODs are determinative; some less so — Misrepresentations, for example and some may be entirely beyond the ken of the Innocent Party whose payment obligations 2(a)(iii) suspends, such as an undeclared Cross Default.
Section 2(a)(iii) might apply, that is to say, without anyone realising it. This poses some rather intriguing questions.
First, a conceptual one: at what point do we know — when even do I know — whether I have “suspended” my payment and not just simply failed on it? Is there a difference? The payment arrangements under a modern ISDA Master Agreement are a blizzard of electronic impulses, across multiple booking systems, product silos and other arrangements. The good people of FX ops will know everything there is to know about the currency pairs, but will have not the first notion about the rates portfolio, let alone the weirdos in structured credit — and sometimes payments fail for explainable reasons. So what happens if, for some reason 2(a)(iii) applies — did a trader in a weak moment repudiate a contract during a collateral dispute? — and the conditions precedent to my payment do not exist, but I make my payment anyway? Is that a mistaken payment? Is it supported by consideration? Is there a potential claim for money had and received?
What, for the purpose of close-out valuations, is the status of payments that were made, but that were not required to be made? Are these some kind of negative energy in the close-out spacetime; dark matter, a kind of inverted Unpaid Amount?
Secondly, a practical one: in times of market dislocation all kinds of things do go wrong. People suddenly resort to manual processes where things have been automated till now. They start frisking all money payments on their way out the door. For all you know your correspondent banks and agents may be doing the same thing without your knowledge. Payments you thought you had made may not have got to your counterparty. Counterparties make oral arrangements to check payments in before sending anything out — expect all kinds of paranoia, fear & loathing. It’s great. Sometimes payments — going in either direction — can get hung up, stuck, blocked, sanctioned, or — who knows? — waived, or suspended by mutual consent, or even suspended by implication: the parties may agree (or think they have agreed) to net settle payments usually made gross. If there is a misunderstanding —
In short, it is not always certain whether payments have, in fact, been made, or missed. You would think this sort of thing would be determinate, but it isn’t. And this kind of uncertainty is more likely exactly at a time of stress.
This can lead to some unfortunate surprises: the counterparty who, faced with a massive counterparty failure, and diligently files its notice of Failure to Pay or Deliver, only to find that, last week some clot in Collateral Ops mis-keyed a small yen payment or just effected a net settlement that the counterparty didn’t match, meaning that none of the “failing payments” were actually due in the first place. Expect a race back in time to see who committed the earliest unremedied non-payment.
When does it apply
Note also that the ’squad neglected to prescribe the precise point in time at which the condition precedent must apply. Common sense surely requires it be measured as at close of business on the Business Day on which the payment or delivery is originally scheduled to be performed. But it doesn’t take the trouble to say that. So what if, some time after the due date for payment, but, say, before the grace period for a Failure to Pay or Deliver has expired, the hitherto non-Defaulting Party falls into, say, technical insolvency (perhaps as a result of the putatively Defaulting Party’s failure? Is the miscreant original defaulter saved from the jaws of oblivion by such a jammy hap? We think not — surely, it should not, though one could no doubt construct the intellectual justification why it might — but uncharacteristic slackness with words from ISDA’s crack drafting squad™ makes the situation less clear than it could be.
Our read, for all that is worth: a party is only entitled to suspend payments under 2(a)(iii) if the conditions to payment were unfulfilled on the due date for payment or delivery. That is was when it was bound to pay: that its counterparty’s credit position deteriorated after the due date, but before you have got round to paying it, does not matter. You still gots to pay.
Speaking of strange days
None of this you will enjoy when, as it will, it happens just as the world has lost its head and is blaming it on you. The JC has a theory — well, the JC has lots of theories, but this one in particular — that the master agreements of the world are a product of detente: that post-Communist, End of History delusion that gripped the world in the roaring nineties, that we had solved the problem of illiberalism, that wars were a thing of the past, and that the range of calamities that the market needed to defend against all involved the failure of commercial enterprise.
If the pandemic didn’t do the job, the Russia/Ukraine war of 2022 has rudely disabused us of the notion. We are left with master agreements that do not, terribly well, deal with the illogicalities of disease, pestilence, war, sanctions, and the sudden, indeterminate interruption of cross-border commercial relations. Nowhere is this better illustrated than Section 2(a)(iii) — which per the below, was increasingly an irrelevance anyway — which speaks to a world in which the worst thing one could do was repudiate a contract. It really doesn’t work when the fog of war descends and it isn’t clear whether one should, or is allowed to, or must, make payments — opposing governments may have diametrically opposed rules on the topic — and there is a clash of sanctions as well as civilisations.
Even normal days, these days?
Even setting aside the successive calumnies the modern world seems intent on lurching between, the idea of a flawed asset provision seems well and truly out of date. The overriding mischief that it addresses arises when a solvent swap counterparty with a long-dated out-of-the-money portfolio, finds its counterparty has, against the run of play, gone bust. If I am in the hole to you to the tune of $50 million, but that liability isn’t due to mature for ten years, in which time it might well come right and even go positive, I don’t want to crystallise it now, at the darkest point, just because you sir have gone tits-up.
Answer: insert a flawed asset provision. This lets me suspend my performance on your default, without closing you out, until you have got your house in order and paid all the transaction flows you owe me. So the portfolio goes into suspended animation. Like Han Solo in The Empire Strikes Back.
Now if, heaven forfend, you can’t thereafter get your house in order — if what was once your house is presently a smoking crater —then the game is up anyway, isn’t it? You will be wandering around outside your building in a daze clutching an Iron Mountain box cycling hurriedly through the stages of grief, wondering where it all went so wrong, wishing you had pursued that music career after all, but in any case casting scant thoughts for your firm’s unrealising mark-to-market position on that derivative portfolio with me.
This seems cavalier in these enlightened times, but in the old days people did think like this. But, with the gruesome goings-on of 2008, those are largely bygone days, though older legal eagles may wistfully look into the middle distance and reminiscing about these kinder, happier times. Those who didn’t wind up desperately rekindling their music careers in 2009, anyway.
In the aftermath of the Lehman collapse regulators showed some interest in curtailing the flawed asset provision. The Bank of England suggested a “use it or lose it” exercise period of 30 days. Ideas like this foundered on the practical problem that repapering tens of thousands of ISDA Master Agreements was not wildly practical, especially without a clear consensus on what the necessary amendment might look like. So the initiative withered on the vine somewhat.
In the meantime, other regulatory reform initiatives overtook the debate. These days flawed asset provision is largely irrelevant, seeing as brokers don’t tend to take massive uncollateralised directional bets. Compulsory variation margin means for the most part they can’t, even if the Volcker rule allowed them to.
Since all swap counterparties now must pay the cash value of their negative mark-to-market exposures every day, the very thing the flawed asset seeks to avoid — paying out negative positions — has happened, there is a lot more to be said for immediately closing out an ISDA, whether or not it is out-of-the-money.
For synthetic prime brokerage fiends, there is another reason to be unbothered by Section 2(a)(iii): you shouldn’t have a losing position, since you are meant to be perfectly delta-hedged. Right?
For details freaks
Non-payment delivery defaults
Say you’re a corporate in the habit of buying OTC calls or puts from your swap dealer under an ISDA Master Agreement. This is all quite ordinary, unglamorous business: it is what prudent treasury functions do to hedge their various rates and currency risks.
The basic structure, as for any option, is:
- If option is in-the-money, dealer pays customer market price minus strike price.
- If option is out-of-the-money, dealer pays customer bupkis.
And that’s it.
That is, the customer pays everything it will ever have to pay on the trade date, has no further obligations actual or contingent and should own an unconditional right to be paid out by its dealer if it’s in-the-money on the exercise date.
Now: imagine you have bought such an option. You settled all premium up front and the option turns out to be a wildly profitable (of course it does! You’re great at your job!) but — before you can exercise it and book that PNL, you commit an unrelated Event of Default or Potential Event of Default under your ISDA Master Agreement.
This sounds bad, sure, but as we rehearse elsewhere, some Events of Default are oddly nebulous, indeterminate things: Cross Default, Misrepresentation and Bankruptcy in particular. And others are trivial: any technical Breach of Agreement, regardless of materiality, if uncured after 30 days counts, at that point, as an Event of Default and as a Potential Event of Default from the instant it is committed, since the full-blown EOD depends only on “the giving of notice or the lapse of time or both”.
And it wouldn’t be good were your dealer to invoke Section 2(a)(iii) and suspend its obligation to cash settle your options because, say, you were a day late sending over your audited annual financial statements, as you agreed in a weak moment in 2004 and have been obliged by the terms of your ISDA to do ever since, on pain of a Section 3(d) transgression. It would be outrageous, in fact — so outrageous it is hard to imagine any dealer with the brass neck to do it — but still, in legal theory, the plain implication of the flawed asset regime is that a dealer could do it. And the fact that no-one in their right mind would do it, in normal times, is of scant interest to a negotiation community whose livelihood depends on arguing the toss about exactly this kind of hypothetical. And, after all, experience tells us that wenn die Scheiße auf den Lüfter trifft as, from time to time, it does, credit officers tend to depart their right minds and do unexpected, weird and apparently brass-necked things. Such is the joy and terror of our calling.
At this point ISDA ninjas will wave their fingers and say, “aha, yes: but what about other bilateral swap transactions the customer might have traded under the same single agreement, and its daily variation margin obligations, and such things? It is not all about single option transactions, after all.”
But — and leaving aside the obvious fact that, even if present, these things really shouldn’t invalidate the exercise of prepaid options in any case — there is a customer type where none of these things will apply: exactly the one mentioned above: the treasury department of an non-financial counterparty that is out of scope for regulatory margin, who is only buying pre-paid options, and would never have a variation margin obligation, or any other future payment obligation following trade settlement, in any case. These counterparties often trade under truncated ISDAs or even long-form confirmations. These people have a reasonable expectation Section 2(a)(iii) will not interfere with their economic right to be paid out on their options.
There is a complicated way of dealing with this but, we submit an easy one is just to disapply section 2(a)(iii) from obligations under prepaid option transactions altogether. Frankly, disapplying Section 2(a)(iii) for the whole ISDA would not be a bad idea but, serenity’s prayer and all that.
Why the regulators don’t like Section 2(a)(iii)
While not concluding that 2(a)(iii) is necessarily a “walk-away clause” (or an “ipso facto” clause, as it is called in the US) UK regulators were concerned after the financial crisis that Section 2(a)(iii) could be used to that effect and wondered aloud whether such practices should be allowed to continue. Why? Because you are kicking a fellow when he is down, in essence.
An insolvent counterparty may be in a weakened moral state, but if it still made some good bets under its derivative trading arrangements, so it ought to be allowed to realise them. On the other hand, the contract has a fixed term; you wouldn’t be entitled to realise those gains early if you hadn’t gone insolvent so why should it be any different just because you’ve blown up? The answer to that is, put up or shut up: If you don’t like it that I can’t pay your margin, you are entitled to close out. If you don’t want to close out, then you can jolly well carry on performing. In any case, regulators also wonder: how long can this state of suspended animation last? Indefinitely? What is to stop a non-defaulting party monetising the gross obligations of a defaulting party not closing out, invoking 2(a)(iii), suspending its performance and then realising value by set-off?
On the other hand, suggesting a fundamental part of the close-out circuitry of an ISDA Master Agreement is a “walk-away” takes prudentially regulated counterparties to an uncomfortable place with regard to their risk-weighted assets methodology.
With the effluxion of time some of the heat seems to have gone out of the debate, and new policies, or market-led solutions, have taken hold.
What the courts think of Section 2(a)(iii)
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. These are amusing, as they are conducted in front of judges and between litigators none of whom has spent more than a fleeting morning in their professional careers considering the legal complications, let alone commercial implications, of derivative contracts. Thus, expect some random results.
Are there flawed asset clauses in other master agreements?
- 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 are no “uncollateralised, large, out-of-the-money exposures” an innocent stock lender would want to protect with 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.
- 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.
- Okay I am having a bit of fun with you here I confess.
- This is not nearly as unlikely as it seems: in a widespread market dislocation, for example, where sanctions are involved (hello Ukraine conflict!) expect everyone to be terrified of getting anything wrong. Everything will slow down.
- At the limit you could allow net settlement of the option against outstanding amounts owed, right?
- This is true in legal theory but in most cases not in practice: usually a swap dealer will offer you a price to close out your trade early — at its side of the market, naturally — and unless you are doing something dim-witted like selling tranched credit protection to broker-dealers under CDO Squareds they have put together themselves, you should be able to find another swap dealer to give you a price on an off-setting trade.
- For example, Greenclose v National Westminster Bank plc albeit not related to flawed assets.
- You wonder how much of that was influenced by what a bunch of odious jerks Enron were in their derivative trading history, mind you.