Section 2(a)(iii) - 1992 ISDA Provision
1992 ISDA Master Agreement
Section 2(a)(iii) in full
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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.
The overriding mischief that a flawed asset provision 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?
Flawed assets generally
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.
The asset – a right to payment under the transaction – is “flawed” in the sense that it only become payable if the conditions precedent to payment are 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.
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.
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.
Also of interest in the back issues of the Jolly Contrarian’s Law Reports are:
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.
- Amazing in hindsight, really, isn’t it.
- 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.