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2002 ISDA Master Agreement
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Crosscheck: 2(a)(iii) in a Nutshell™
Original text
See ISDA Comparison for a comparison between the 1992 ISDA and the 2002 ISDA.
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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 was mostly unchanged between the 1992 ISDA and the 2002 ISDA, bar a single clarification in Section 2(a)(iii)(3). 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 all this means, or achieved, we speculate below.
Basics
Herculio: I have a thought. This meagre tract: not ninety words
Wrapp’d about with preliminal nicety and
Stamp’d as for affixation to a servic’d boiler —
Conceals a clever trick.
Ser Jaramey: What kind of onion’d witchery is this?
Assets, and flawed assets
What is the big deal about this, then? Well, it turns your ISDA into a “flawed asset”.
Flawed asset
/flɔːd ˈæsɛt/ (n.)
A financial asset that looks good, but thanks to a carefully buried conditions precedent, is not there when you, and more importantly, your insolvency administrator, most wants it.
In the language of financial obligations, the right to future payments under a contract is an asset. The creditor owns that right and, all other things being equal, can deal with it — that is, sell or raise money against it — the same way it can sell or mortgage a house, car, a portfolio of equities, or some decentralised cryptographic tokens representing abstract capital.
Assets have certain “ontological” properties, such as continuity in time and space. They might rust, depreciate, go out of fashion or stop working properly but they are nevertheless, existentially, still there. While you own them they therefore have some value to you, however parlous the state of your affairs might otherwise be.
Should your stars line up so that some official comes to be drawing up a closing account of your earthly financial existence — should you become bankrupt, heaven forfend — your assets can reliably be popped onto the “plus” side of the ledger. The difficulty subsists in working out what they are worth, but at least they are there.
This continuity is important to the administration of failing enterprises wherever they are based. It is a rude shock to find the assets you thought were there have without good explanation, gone. Many countries have rules preventing company managers from selling or giving away assets at an undervalue or otherwise granting unfair preferences as impending disaster looms. And nor can they enter contracts, even in times of fair weather, which would have the effect of granting unfair preferences, or depriving other creditors, should the clouds roll in.
An asset that doesn’t have that quality of continuity: that suddenly isn’t there, or that has the unnerving quality of winking in and out of sight at inopportune moments — is thus somehow imperfect: “flawed”.
Section 2(a)(iii) seems to have that effect on a Defaulting Party’s claims under an ISDA — its asset. Just when the Defaulting Party goes insolvent or fails to perform, the Non-defaulting Party is entitled to suspend the performance of its obligations without terminating the Transaction. Not entitled, even — as we will see, it just happens.
Should the Defaulting Party then cure the default, the Transaction resumes and the Non-defaulting Party must resume all its obligations, including the suspended ones. But for so long as the default is not cured, the Non-defaulting Party does not have to do anything. The Defaulting Party is left hanging there, with this “flawed asset”.
Insolvency regimes: not keen.
The United States Bankruptcy Code renders unenforceable terms terminating or modifying a contract that are triggered by the simple fact of insolvency proceedings. These are known as “ipso facto” clauses, because the simple fact of bankruptcy “in itself” triggers the clause.
If Section 2(a)(iii) were an ipso facto clause, it would not be enforceable. Whether it is an ipso facto clause is a subject of vigorous but tiresome debate. For our purposes, that people don’t easily agree about it is all you need to know.
The UK has no statutory equivalent of America’s ipso facto rule, but hundreds of years ago resourceful common law judges “discovered” an “anti‑deprivation” rule to the effect that, in the honeyed words of Sir William Page Wood V.C., in Whitmore v Mason (1861) 2J&H 204:
“no person possessed of property can reserve that property to himself until he shall become bankrupt, and then provide that, in the event of his becoming bankrupt, it shall pass to another and not his creditors”.
This required some wilfulness on the bankrupt’s part and not just inadvertence or lucky hap, but still: if you set out to defeat the standing bankruptcy laws do not expect easily to get away with it.
It seems, at any rate, that Section 2(a)(iii), might resemble some kind of intended deprivation; merely crystallising one’s existing position and stopping it from going further down the Swanee, as one might do by closing out altogether, seems less likely to.
Anyway: be aware: Section 2(a)(iii) attracts insolvency lawyers.
Rationale: avoiding a cleft stick
We can have a fine time rabbiting away about the ontology of assets, but isn’t there a more basic question: why would a Non-defaulting Party, presented with a counterparty in default, ever not want to just close out?
It all comes down to moneyness.
The “bilaterality” of a swap transaction means that either party may, net, be “out of the money” — that is, it would have to pay a net sum of money were the Transaction terminated — at any time. Unless something dramatic happens, this “moneyness” is only a “notional” debt: it only becomes “due” if an Early Termination Date is designated under the Master Agreement.
So an out-of-the-money, Non-defaulting Party has a good reason not to close out the ISDA. Doing so would oblige it to crystallise and pay out a mark-to-market loss. Why should it have to do that just because a Defaulting Party has failed to perform its end of the bargain?
On the other hand, the Defaulting Party is, er, ipso facto, not holding up its end of the bargain. Just as our innocent Non-defaulting Party does not wish to realise a loss by terminating, nor does it want to have to stoically pay good money away to a Defaulting Party who isn’t paying anything back.
A cleft stick, therefore.
Section 2(a)(iii) allows our Non-defaulting Party the best of both worlds. The conditions precedent to payment not being satisfied, it can just stop performing and sit on its hands — thereby neither crystallising its ugly mark-to-market position nor pouring perfectly good money away (which is a form of drip-feeding away that mark-to-market position, if you think about it).
So much so good for the Non-defaulting Party.
But the Defaulting Party’s “asset” — its contingent claim for its in-the-money position against the Non-defaulting Party — is compromised. This, for an insolvency administrator and all the Defaulting Party’s other creditors, is a bummer. It deprives them of the “asset” represented by the Transaction.
Which events?
Exactly which default events can trigger the suspension? Under the ISDA, Events of Default and even Potential Events of Default do, but Termination Events and Additional Termination Event do not. This is because most Termination Events are softer, “Hey look, it’s no one’s fault, it’s just one of those things” kind of events. This is not usually true of Additional Termination Events, though: they tend to be credit-driven, and girded with more “culpability” and “event-of-defaulty-ness”. So this is a bit dissonant, but there are far greater dissonances, so we park this one and carry on.
JC has seen valiant efforts to insert Additional Termination Events to section 2(a)(iii), and Potential Additional Termination Event, 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 is highly unlikely to ever come into play, and which makes little sense in the first place.
Why the ISDA?
Herculio: All well-meant, good Triago. Be not sour —
These are not grapes.
Triago: Indeed not sir: rather, scrapes.
And scars and knocks — the job-lot doggedly sustained.
Herculio: (Aside) Some more than others. The odd one feigned.
But come, Sir Tig: what unrests you here?
Triago (waving paper): A tract from a brother clerk in America.
Herculio: Cripes abroad. Grim tidings?
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.
—Otto Büchstein, Die Schweizer Heulsuse
Why, then, is this flawed assets business special to ISDA? Is it special to ISDA?
Normal financing contracts are, by nature, one-sided. Loans, for example. One party — the dealer, broker, bank: we lump these various financial service providers together as The Man — provides services, lends money and “manufactures” risk outcomes; the other — the customer — consumes them.
So, generally, the customer presents risks to The Man, and not vice versa. If the customer fails, it can’t repay its loan. All the “fontish weaponry” is therefore pointed at the customer.
Though the ISDA is also a “risk creation contract” with these same characteristics, it is not designed like one. Either party can be out of the money, and either party can blow up. The fontish weaponry points both ways.
This presented dealers with an unusual scenario: what happens if you blow up when I owe you money? That could not happen in a loan. It is less likely to happen under a swap these days, too, thanks to the arrival of mandatory variation margin — that is one of JC’s main objections — but the ISDA Master Agreement was forged well before this modern era.
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.
Developments between editions
“...a condition precedent for the purpose of this Section 2(a)(iii) ...”
The 2002 ISDA trims back the third limb of Section 2(a)(iii) from “all other conditions precedent” to just those that specifically say they mean to be caught by Section 2(a)(iii). This a sensible restriction in scope as far as it goes (but JC would go further and remove Section 2(a)(iii) altogether).
We have heard the argument advanced — apparently on the authority of that FT book about derivatives — that this restricted third limb somehow conditions the other conditions precedent in the clause (i.e., that there is no ongoing PEOD or EOD and that the Transaction has not already been terminated):
Section 2(a)(iii)(3) makes clear that if people want to stipulate any condition precedent other than the standard ones in Section 2(a)(iii)(1) and (2) they must clearly add the wording that the relevant condition will be “a condition precedent for the purposes of Section 2(a)(iii)”. ... Effectively this narrows the scope of the corresponding provision of the 1992 Agreement where no such statement was necessary.
It plainly does not, and nor do we see how you could read the FT book as making that argument. The extreme looseness of 2(a)(iii) imported by any notified breach of the agreement, however technical, being a Potential Event of Default, remains.
“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.
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See also
- Clause 8.6 of the 2010 GMSLA
- Clause 6(j) of the Global Master Repurchase Agreement