Section 2(a)(iii) - ISDA Provision
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.
- The JC’s famous Nutshell™ summary of this clause
- How and when 2(a)(iii) is or, more to the point not, triggered.
- The confusion, fear and loathing that can arising from no-one knowing whether 2(a)(iii) applies.
- The confusion arising from not knowing when the condition precedent is meant to apply.
- The JC’s idiosyncratic theory about why anyone thought 2(a)(iii) was a good idea in the first place.
- The JC’s impassioned argument that, even if once upon a time it was, Section 2(a)(iii) is no longer fit for purpose.
- How Section 2(a)(iii) held up during the sanctions extravaganza when Russia invaded Ukraine (hint: it didn’t help!)
- How Section 2(a)(iii) operates in the case of non-payment-or-delivery defaults.
- How corporate buyers of fully paid options might feel about 2(a)(iii) (hint: not happy!) and the sorts of amendments they might think about making if they want to feel happier
- Why regulators don’t like 2(a)(iii)
- What the courts think of 2(a)(iii) — in a nutshell, they are confused — plus a table comparing the six major decisions on the clause
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.