Avoiding Common Pitfalls When Negotiating ISDA Master Agreements
By Kevin M. Masucci
Negotiating an ISDA Master Agreement can be a lengthy and often frustrating process as parties attempt to agree upon the many legal, business and credit terms that must be considered. In fact, the November 2006 member survey of the International Swaps and Derivatives Association, Inc. (ISDA), demonstrated that most members negotiating basic ISDA Master Agreements (e.g., those without a credit support annex or other credit support documentation) take anywhere from 30 to 150 days to complete such documentation.
However, all is not lost, as much can be done to improve the efficiency and effectiveness of negotiations. In that regard, below are a number of helpful tips to consider when negotiating ISDA documentation.
Complete ISDA Documentation Before Trading
While many counterparties will permit trading (at least to a limited extent) before the completion of ISDA documentation, such pre-completion trading can frustrate the ongoing negotiation process. At its heart, a derivatives transaction (e.g., an interest rate swap, foreign currency swap or credit default swap) is, at least from the counterparty’s perspective, fundamentally a means of generating trading revenue for its trading desk. Once a trade has been completed, the motivation to fully document such a transaction can wane as the proverbial “heat” will be off the counterparty, with final negotiations relegated to its legal and credit personnel. Accordingly, resolving any outstanding business or credit issues can become more complex without the motivation of a pending trade.
Additionally, trading without fully negotiated ISDA documentation is risky business, as the rights and obligations of the respective parties may be uncertain. In such situations, trade confirmations will often state that the parties will use their best efforts to enter into an ISDA Master Agreement, and during that time the transaction will be governed by a standard (and unmodified) ISDA Master Agreement, which is commonly referred to as a “vanilla” master agreement.
A vanilla master agreement, however, leaves open many important elections that would normally be made in the schedule to the ISDA Master Agreement. Some of these elections are: (i) designation of entities that could trigger cross-default provisions; (ii) designation of default thresholds; (iii) whether certain events of default or termination events will apply; (iv) specification of additional, customized termination events; (v) specification of tax representations; (vi) specification of elections; (vii) whether a party will provide credit support and/or a credit support provider; (viii) specification of law; and (ix) scope of payment netting.
Finally, use of a vanilla master agreement presents a serious issue if negotiations should become heated or, worse, deadlocked, since, depending on the specific situation, such an agreement would likely adversely affect the relative bargaining power of one or both parties.
Negotiate With the Proper Team
While negotiating an ISDA agreement can be a tricky proposition, a party that understands the complexity involved at the outset will be well-positioned to achieve a smooth and efficient conclusion to its negotiation with a counterparty. A party’s lawyers who have the support of its business personnel will be best-positioned to quickly escalate business and credit concerns to the proper decision makers, thereby avoiding unnecessary delays in negotiation. Also, an involved business person will be knowledgeable of delays and potential roadblocks early on, thereby helping the legal team prioritize the handling of such matters.
Many counterparties operate with a small and/or overburdened negotiation staff. Accordingly, delays in responses to legal and credit issues are not unusual. An involved businessperson will also be in an excellent position to alert the counterparty’s decision makers of any such delays and can request that negotiations be given priority. However, discretion should be used when demanding the immediate attention of an overburdened counterparty concerning multiple matters.
Overall, a negotiation team that is composed of legal and business staff working together will find that it is best-equipped to negotiate with a counterparty and to quickly address any issues as they arise.
Confirm Proper Authority to Enter Into ISDA Documentation
One area of ISDA documentation that may at times be overlooked is whether the party entering into the ISDA documentation with a counterparty has the proper authority to do so. While this issue is relevant to all types of entities, in the case of funds engaging in derivatives transactions, there are several distinct issues that should be considered.
A review of the fund’s prospectus and statement of additional information (or other offering documentation) should be undertaken to be sure that the types of derivatives transactions that are expected to be traded are permitted under the terms therein. Any particular limitations on derivatives trading should be identified, and the fund’s investment adviser(s) should be made aware of these limitations. If amendments to a fund’s disclosure documentation are required to permit trading of a particular type of derivative, such amendments should be completed before engaging in those transactions.
Furthermore, it is suggested that whenever possible, the fund itself (as opposed to the fund’s investment adviser acting as agent) enter into the ISDA documentation and related transaction confirmations. Doing so helps to avoid any implication that the counterparty is engaging in transactions with the investment adviser as principal (and thereby looking to the credit and/or assets of such adviser). Nevertheless, it is not uncommon for an adviser to sign ISDA documentation on a fund’s behalf, as agent and attorney-in-fact. If an investment adviser signs ISDA documentation in this manner, care should be taken to ensure that the underlying investment management agreement between the adviser and the fund grants to the adviser the proper authority to enter into such documentation and that the agreement contains a sufficiently broad power of attorney covering the types of transactions that will be traded with the counterparty.
Finally, in certain situations where an investment adviser will be executing transactions on a fund’s behalf, a counterparty may require that the adviser, in its individual capacity, make certain representations concerning those transactions. In this circumstance, the adviser will generally be personally liable to the counterparty for the accuracy of those representations. Consequently, such representations should be carefully limited in scope to adviser-specific matters, such as: (i) the due organization and good standing of the adviser; (ii) the authority of the adviser to engage in transactions on the fund’s behalf under the related investment management agreement; (iii) the adviser’s registration and/or qualification under applicable law; and (iv) other similarly narrow adviser-specific representations.
General statements relating to a fund’s authority to enter into transactions, ERISA representations, statements as to its compliance with securities and other laws, and other fund-specific representations are best left to the ISDA documentation entered into by the fund and should be omitted from any specific representations given by the adviser.
Consider Specific Regulatory Requirements
Whenever a fund seeks to enter into derivatives transactions, consideration should always be given to any particular regulatory requirements that may be applicable to the fund under the regulations of a specific jurisdiction. For example, funds subject to the Investment Company Act of 1940, as amended (1940 Act), must consider how this statute and the regulations thereunder affect each particular transaction being entered into with a counterparty. Under the 1940 Act, a fund generally is not permitted to post collateral supporting a transaction directly to a counterparty. Instead, any such collateral must be retained with the fund’s custodian (usually through a tri-party account control arrangement among the fund, the fund’s custodian and the counterparty). Such an arrangement is not part of the standard ISDA credit support documentation and must be specifically addressed during the negotiation process. Funds subject to other regulatory schemes (such as those in Canada, Ireland, Australia and Luxembourg) may also have special requirements requiring the inclusion of specific provisions in the ISDA documentation.
While the ISDA negotiation process requires consideration of an array of legal, credit and business concerns, by being aware of these complexities and putting in place the proper resources ahead of time, a party will find that it is well-positioned to negotiate its ISDA documentation effectively to achieve an efficient and effective result.