Section 2(a)(iii) - ISDA Provision
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2002 ISDA Master Agreement
From our machine overlords
Full text of Section 2(a)(iii)
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Section 2(a)(iii) is the world-famous, notorious, much-feared “flawed asset” provision in the ISDA Master Agreement. The text is unchanged between the 1992 ISDA and the 2002 ISDA. However there was a change from the 1987 ISDA which did not have the middle condition precedent that “no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated”. As to what this achieved, we speculate below.
Summary
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.
The problem with bilateral agreements
Triago: Forsooth: it wears the colours of a fight.
A word-scape stain’d with tightly kernèd face
And girded round with fontish weaponry.
Herculio (inspecting the document): Verily, convenantry this dark
Speaks of litiginous untrust.
As we have remarked before, most financing contracts are decidedly one-sided. One party — the dealer, broker, bank: we lump these various financial service providers together as The Man — provides services, lends money, manufactures risk outcomes; the other — the customer — consumes them.
Generally, the customer presents risks to The Man, and not vice versa. All the “fontish weaponry” is, therefore pointed in one direction: the customer’s. It goes without saying that should the customer “run out of road”, The Man stands to lose something. What is to be done should The Man run out of road is left undetermined but implicitly it is unlikely, and not expected to change anything for the customer. Whatever you owe, you will continue to owe; just to someone else.
Even though the ISDA is also, in practice, a “risk creation contract” and has these same characteristics, it is not, in theory, designed like one.
To see the “dealer" and the “customer” in their traditional roles of “The Man” and “punter”, therefore, one must absorb a rather bigger picture. In the small picture — the ISDA agreement proper — either party can be out-of-the-money, and either party can blow up. The fontish weaponry points both ways.
This presented the First Men with an unusual scenario when they were designing the ISDA Master Agreement: what happens if you blow up when I owe you money? I might not want to crystallise my contract: since that will involve me paying you a mark-to-market replacement cost I hadn’t budgeted for paying out just now. (This is less true in these days of mandatory variation margin — that is one of JC’s main objections — but the ISDA Master Agreement was forged well before this modern era).
The answer the First Men came up with was the “flawed asset” provision of Section 2(a)(iii). This allows an innocent, but out-of-the-money, party faced with its counterparty’s default, to not close out the ISDA, but just freeze its own obligations until the default situation is resolved.
There is an argument the flawed asset clause wasn’t a good idea even then, but a better one that it is a bad idea now, but like so many parts of this sacred, blessed form it is there and, for hundreds and thousands of ISDA trading arrangements, we are stuck with it.
Ask a chary credit officer what she thinks of Section 2(a)(iii) and her eyes are sure to glister as she regales you with the countless times it's got her out of a scrape at the first sign of Potential Event of Default. Regulators are less enamoured, especially after the global financial crisis, and took some steps to impose at least as “use it or lose it” drop-dead point, but institutional inertia and the brick wall of reality has long since arrested that drift.
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, without formal action by the non-Defaulting Party 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, until the Transaction has been formally terminated, at which point it really ought to go without saying.
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 in the round 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 does 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 Early Termination Date ... has occurred”...
New in the 1992 ISDA was the second condition precedent, that “...no Early Termination Date in respect of the relevant Transaction has occurred or been effectively designated”.
This is tidy-up material to bring triggered Termination Events into scope. There is a period between notice of termination and when the Early Termination Date is actually designated to happen — and in a busy ISDA it could be a pretty long period — during which time the Transaction is still on foot and going, albeit headed inexorably at a brick wall.
General discussion
See also
- Clause 8.6 of the 2010 GMSLA
- Clause 6(j) of the Global Master Repurchase Agreement
References