Template:M gen 2002 ISDA 2(a)(iii)
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[1] 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.
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 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[2].
Enron v TXU upheld the validity of Section 2(a)(iii)[3] Metavante v Lehman considered Section 2(a)(iii) of the ISDA Master Agreement and reached more or less the opposite conclusion.
Also of interest in the back issues of the Jolly Contrarian’s Law Reports are:
- ↑ 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.