The ISDA – A Hedger’s Minefield
This long, and to many people, incomprehensible document has just been delivered electronically by your friendly banker because you are about to execute a derivative or are contemplating one. Okay, it’s time to take a deep breath and not sign that document until you fully understand what it means to you. While your banker may tell you that the ISDA Master Agreement is “non-negotiable,” the Schedule to the ISDA can be negotiated and it is important to make sure that the Schedule to the ISDA Master Agreement is negotiated and documented to protect your interests. For example, what happens if you want to transfer the swap to another bank or the banks credit rating is downgraded?
What is the ISDA and why should I care?
We won’t bore anyone with the history of the ISDA, just to say that the industry trade association, International Swaps and Derivatives Association, Inc., was formed in early 1985. The ISDA has gone through several iterations. Currently, the industry is either using the 1992 or 2002 version.
According to the trade group, “the ISDA ‘s primary purpose is to encourage the prudent and efficient development of the privately negotiated (or “over-the-counter” (OTC)) derivatives business.” They go on about promoting efficient conduct of the business and sound risk management practices.
What, then, is it you’re signing? – In some ways it is similar to signing a loan agreement, but instead of being unilateral it is bilateral. An interest rate swap, as most of you know, can have a positive market value or negative market value.
One of the parties will either be holding a negative or positive position. In simple terms, the ISDA documentation provides for the “road map” on how to close-out the derivative and collect if one party defaults, or is subject to a termination event.
The Master Agreement and Schedule to the Master Agreement
The Master Agreement contains general terms and conditions and is a pre-printed boilerplate document that is never changed or negotiated. However, modifications or amendments can be negotiated and documented through the Schedule to the Master Agreement, and it is important to make sure that the Schedule be coordinated with the terms of your loan agreement and collateral documents.
Often times we find inconsistencies in how the Schedule was drafted versus the loan agreement. Most banks’ documentation group have a standard just fill-in-the-blanks schedule. The hope is that most ISDA schedules will not be negotiated by the customer. The schedule is therefore, generally weighted in the bank’s favor. What you may have negotiated in the loan agreement could be undermined because the same language is not reflected in the schedule to the ISDA.
We recently negotiated an ISDA with a bank. In this particular case, we wanted to protect the hedger in the event the borrower transferred the loan to another bank or the bank sold the loan under the Additional Termination Event (“ATE”) section. Basically, if the bank is no longer a party to the credit agreement, the hedge contract can be terminated under this provision. With the current credit and volatile market environment, it becomes even more critical to ensure that the hedger is protected under the terms of the ISDA, and in the examples above to make sure that the hedger would have some protections to make sure the swap is not terminated in the event the bank is no longer a party to the underlying loan.
We wanted to end this brief ISDA discussion by pointing out that the schedule has a “Non Reliance” clause. It stipulates that the hedger is acting for its own account and has made its own independent decision. The hedger is not relying on any communication (written or oral) of the other party as investment advice or as a recommendation to enter into a transaction.
Furthermore, it states that the hedger is capable of evaluating and understanding (on its own behalf or through independent professional advice) the pro’s and con’s. It is capable of assuming, and assumes, the risks of the transaction. This means that even if the counter-party to a hedge transaction recommends a certain hedge product or structure, that counter-party has no obligation to advise in the professional sense (i.e., provide complete, unbiased information).
This is an important section to point out, and something to consider and keep in the back of your mind as you contemplate a transaction and weigh the advice you receive.