Bankruptcy as a phase transition

After a few weeks in the criminal law we're back to the financial markets: this week: why are ISDA ninjas so afraid about bankruptcy? What happens at the bewitching hour?

Queen: Must the rigid struts of precedent
That fix our covenantry as stars
To the very velvet firmament
So dissolve, upon one distemper’d prayer?
Must our claim, short days ago as bankable
To visor’d men who tabulate exposures
As a helm to sconce in battle —
Now so meekly dissipate, as tissue i’ the rain?

Nuncle: If wettened claims were but thy problem.

Queen: What mean you, fool?

Nuncle: Thy claims make bitter pennies
Of what once were sweetened pounds, ’tis so
But less so thy extant liabilities. They yet stand
And keep their stout and craggy shape.

Ingrazio: Pish! Doth one not cancel t’other
By the golden sorcery of offset?

Nuncle: Alack: that happy magic is abruptly stayed:
Th’administrstor’s deeper conjury sees to ’t:
The fundamental order of the world’s abeyed.
And yet the woe is more: the curvèd shape
Of lexical geometry conspires to hold us dangled:
Alive, yet unempower’d, while all about
The tempest runs unchecked this next rude fortnight.

JC has been composing epic sagas about the famous Automatic Early Termination provision of the ISDA Master Agreement — they are coming, never fear! — but on the way he got himself side-tracked with this question: what is it that so freaks out the derivatives community about bankruptcy?

A want of certainty about the ultimate certainty

What even is bankruptcy? Is it different from insolvency? How come it is so hard? I mean — it’s bankruptcy, right? Is there anything more ultimately certain about our fates, other than rice pudding and income tax? How can this be a problem?

Well: it turns out a want of certainty is exactly the problem.

Phase transition

/feɪz trænˈzɪʃᵊn/ (n.)

(Lexophysics): An abrupt, discontinuous change in the properties of a system.

Insolvency vs. bankruptcy

“Insolvency” is an oddly nebulous financial state: essentially, that one cannot meet one’s debts as they fall due (cashflow insolvency), or that one’s liabilities exceed one’s assets (balance-sheet insolvency).

“Bankruptcy” is a more determinate legal state: definitive formal steps have been taken to put a legal entity into administration, or to wind it up, usually on account of its insolvency.

Insolvency is usually, but not necessarily,¹ a precondition for bankruptcy.

An insolvent entity may file for bankruptcy (or its creditors may petition for it). But it need not. Technically, insolvent entities can limp around indefinitely without ever entering formal bankruptcy. GameStop was insolvent for much of 2019, and look at that sweet unicorn now.

The water is further muddied because many finance contracts — notably the ISDA Master Agreement, conflate the concepts of insolvency and bankruptcy.

ISDA’s crack drafting squad™ defines “Bankruptcy” to include measures of formal legal bankruptcy,² and measures of financial insolvency³ and some that are a bit of both.⁴

But, bottom line: insolvency is an accounting concept; bankruptcy a legal one.

An awkward moment in the commercial lending division

Here is a familiar scenario:

You are a credit officer in the commercial division of your local bank. It transpires your customer, who recently drew a £100 million fixed-rate term loan from you, is on the point of bankruptcy.

What to do?

In the jurisprudence of company law, formal bankruptcy (but not mere insolvency) is a “phase transition”: the whole “legal context” surrounding a company changes. Erstwhile certainties vanish: normal rules of contract, debt and credit are suspended; in their place arise uncontrollable vagaries. The court appoints an insolvency administrator and invests her with wide, nightmarish discretions to do as she pleases, within reason, to sort out who gets what while ensuring the right thing is done by all the bankrupt’s creditors, customers, employees and, if there is anything left, shareholders. All, therefore, must fall upon her mercy.

You may recall from your first law lecture that legal systems don’t much like not knowing what will happen. Financial services types have a particular aversion — which, yes, is ironic, given how the financial markets depend for their existence on uncertainty.

Anyhow: the administrator won’t care. She will quietly do what she can — and given her discretion, that is a lot — to stop major creditors jumping her gun and swiping valuable assets. Hence all the learned talk among legal eagles of voidable preferences, safe harbors and like magical notions. In some jurisdictions, contractual rights may be suspended and legal action stayed. Creditors may lose their rights to call in loans or close out transactions.

How does this play out for the big beasts who roam the savannas of our capital markets? Quite differently, as it turns out: this explains why a banker, though of course fearful, is sanguine about the vicissitudes of formal bankruptcy while a swap dealer is paralysed with terror about them.

Below the line:

• Why bankers might be sanguine about all this

• Why derivatives counterparties should not be

• A sidebar for equity swap ninjas

• Spinning roulette wheels

This leads us to the topic of Automatic Early Termination, for which there is a whole separate article. It is such a beast we may need to break it into parts. It is coming next time.