The ISDA Master Agreement – Part II: Negotiated Provisions By GuyLaine Charles Introduction

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The ISDA Master Agreement – Part II:
Negotiated Provisions
By GuyLaine Charles
Introduction
GuyLaine Charles is a partner at TeiglandHunt LLP. She represents institutional
investors, hedge-funds, financial institutions and corporate clients located in the
United States, Europe and Canada in the
negotiation and documentation of their
trading agreements including physical and
financial over-the-counter derivative and
commodities transactions through ISDA
Master Agreements and other industry
standard forms, prime brokerage, securities
lending, repurchase, futures and options,
and clearing agreements. GuyLaine also negotiates lending agreements and represents
investors in private equity funds.
Part I of this article, which was published in the January-February 2012
issue of this publication,1 described the origins of the ISDA Master
Agreements and how these agreements have evolved into the industry
standard with respect to the documentation of over-the-counter (OTC)
derivative trades. Part I also discussed some of the considerations that
risk and compliance professionals should take into account prior to
entering into, and during the course of, an OTC trading relationship
documented under an ISDA Master Agreement (referred to herein as
the “ISDA” or the “Agreement”). This Part II will deepen our analysis
of the ISDA Master Agreement.
A typical negotiation will be initiated by one party sending the other
its standard form of ISDA Master Agreement, which will consist of a
Schedule to a pre-printed 1992 ISDA or 2002 ISDA (the “Schedule”).
If the parties intend to collateralize their obligations under the Credit
Support Annex to the Schedule (the “CSA”), a “Paragraph 13” to the
CSA2 will also be provided. As discussed in greater detail in Part I,
the Schedule to the ISDA Master Agreement contains modifications
and additions to the pre-printed ISDA, and likewise, Paragraph 13
of the CSA contains modifications and additions to the pre-printed
Credit Support Annex. This Part II will introduce the central differences between the 1992 and 2002 ISDA Master Agreements (referred
to herein as the “1992 ISDA” and the “2002 ISDA”, respectively)
and then discuss the most commonly negotiated provisions of ISDA
Master Agreements.
1992 ISDA Master Agreement or
2002 ISDA Master Agreement?
Even before the negotiations begin, the threshold issue to be agreed
on by the parties will be the form of ISDA Master Agreement into
which they will enter. There are several differences between the two
©
2012, Guy-Laine Charles
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The ISDA Master Agreement – Part II: Negotiated Provisions
pre-printed forms that may make one form more
suitable than the other. The main differences can
be categorized as follows:
differences in the Payments Upon Early Termination,
differences in the Events of Default and Termination Events, and
addition of Set-off to the 2002 ISDA.
Payments Upon Early Termination
Perhaps the most significant amendment in the
2002 ISDA is the inclusion of “Close-out Amount”,
a provision that sets out a single measure of damages
where trades are being terminated as a result of an
“Event or Default” or a “Termination Event”3. In
the 1992 ISDA, the parties may elect between two
different measures of damages, “Market Quotation”
or “Loss”. “Close-out Amount” was developed to
offer greater flexibility to the party determining the
amount due upon termination of their trades under
an ISDA and to address some of the perceived weaknesses of Market Quotation that were highlighted
during periods of market stress in the late 1990s.
Close-out Amount is often described as a hybrid
of Market Quotation and Loss.
Market Quotation
Market Quotation is a payment measure determined on the basis of quotations obtained from
leading dealers in the relevant market selected by
the party terminating the trades (unless a Termination Event has occurred in which there are two
affected parties, for example a Tax Event (as defined
in the ISDA), in which case both parties make the
relevant determinations). The dealer quotations
will be for the replacement cost of the relevant
terminated transactions. If three or more quotations are provided, the Market Quotation will be
the arithmetic mean of those quotations, without
reference to the highest and lowest quotations. If
only three quotations are provided, the highest
and lowest quotations will be disregarded and the
remaining one will be the Market Quotation. If less
than three quotations are provided (i.e., a Market
Quotation cannot be determined), or if the party
making the determination does not reasonably
believe that Market Quotation would produce
a commercially reasonable result, then Loss will
apply. Typically entities that believe they are more
likely to be the party subject to an Event of Default
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or a Termination Event will negotiate for the applicability of Market Quotation in a 1992 ISDA
in order to gain transparency in the calculation of
the settlement amount.
Loss
Loss is a payment measure based on the principles
of general indemnification. The party terminating
the ISDA will reasonably determine in good faith
its total losses and gains in connection with the terminated transactions. The terminating party’s Loss
may, but need not, be based on quotations obtained
from leading dealers in the relevant markets. Typically entities that believe they are less likely to be
the party subject to an Event of Default or a Termination Event will negotiate for the applicability
of Loss in a 1992 ISDA in order to gain flexibility
in the calculation of the settlement amount.
A Hybrid Approach - Close-Out Amount
As mentioned earlier, the weaknesses of Market
Quotation became apparent during the market
crises in late 1998 and early 1999, when many
parties trying to determine payment upon early
termination of their trades due to their counterparty default encountered difficulty in obtaining
the required quotations from dealers because of
the increase in market volatility. Even in instances
where four quotations could be obtained, in an
illiquid market, those quotations could be widely
divergent. Close-out Amount balances the need for
increased flexibility (lacking in Market Quotation)
while incorporating certain objectivity and transparency requirements (lacking in Loss).
In determining the Close-out Amount, the party
terminating the transactions may consider, without limitation, one or more of the following three
categories of information: (i) quotations, either
firm or indicative, from third parties (which may
include dealers, end-users, information vendors and
other sources), (ii) relevant market data (e.g., yields,
yield curves, volatilities, spreads and correlations),
and (iii) information from internal sources of the
type described in clauses (i) and (ii), provided the
internal information is of the same type used by
the determining party in the regular course of its
business for the valuation of similar transactions.
The definition of Close-out Amount clarifies that
the determining party will consider quotations
and market data provided by third parties unless
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The ISDA Master Agreement – Part II: Negotiated Provisions
it reasonably believes in good faith that such
quotations or relevant market data are not readily
available or would not produce a commercially
reasonable result. When markets are functioning
in a normal manner, the expectation is that thirdparty (as opposed to internal) sources should be
considered in calculating the Close-out Amount.4
Events of Default and Termination Events
Section 5 of the ISDA addresses Events of Defaults
and Termination Events and the 2002 ISDA introduced various changes into this section. The most
noteworthy of these changes are (i) a reduction in
the applicable grace or cure periods, (ii) an expansion of the definition of “Specified Transaction”,
and (iii) the addition of Force Majeure as a Termination Event.
Reduction of Cure Periods
In the 1992 ISDA more lenient cure periods are
provided than in the 2002 ISDA. Under the 1992
ISDA, a failure to pay or make a delivery under
a transaction only crystallizes into an Event of
Default if such failure is not cured within three
Local Business Days5 after notice of such failure
has been given by the non-defaulting party. Under
the 2002 ISDA, the cure period is one Local Business Day (or one Local Delivery Day6 in the case
of delivery failures). Similarly, where a “Specified
Transaction” (discussed below) is not subject to a
cure period under the terms that govern it directly,
a cure period is granted through the ISDA. That
period is three Local Business Days under the 1992
ISDA and one Local Business Day under the 2002
ISDA. Additionally, involuntary insolvency filings
and enforcement actions are subject to a 30-day
cure period under the 1992 ISDA, but only fifteen
days in the 2002 ISDA. The chart below compares
the cure periods applicable in the 1992 ISDA and
2002 ISDA.
In drafting the 2002 ISDA, the ISDA working
group reduced the cure period for payment failures
because its members believed three Local Business
Days was too long a period of inaction during times
of market stress and uncertainty. The reduction of
the cure periods for involuntary insolvency and
enforcement actions was not the result of members
believing that a bankruptcy filing could be dismissed or stayed in fifteen days, but rather that it
was sufficient time for the parties to communicate
with each other to determine whether the filing
or proceeding was frivolous or whether there were
serious credit problems.
Expansion of the Definition of
“Specified Transaction”
Section 5(a)(v) of the ISDA, sometimes described
as a limited cross-default provision, provides that an
Event of Default will occur if a party to the ISDA
defaults under a “Specified Transaction” with the
other party (subject to any cure periods provided for
under such Specified Transaction). Under the 1992
ISDA, “Specified Transaction” is defined as a derivative transaction entered into between the parties to
the ISDA that is a rate swap, basis swap, forward
rate, commodity swap/option, equity or equity
index swap/option, bond option, interest rate option, foreign exchange transaction, cap transaction,
floor transaction, collar transaction, currency swap
transaction, cross-currency rate swap transaction,
currency option or any other similar transaction or
any combination of these transactions.7
The 2002 ISDA expands the definition of
Specified Transactions to include the following
transactions: swap option, credit protection transaction, credit swap, credit default swap/option, total
return swap, credit spread transaction, repurchase
transaction, reverse repurchase transaction, buy/
sell back transaction, securities lending transaction,
weather index transaction or forward purchase or
Event of Default
1992 ISDA Master Agreement
2002 ISDA Master Agreement
Failure to pay [§5(a)(i)]
3 Local Business Days from date of notice 1 Local Business Day from date of notice
Failure to deliver [§5(a)(i)]
3 Local Business Days from date of notice 1 Local Delivery Day from date of notice
Breach of agreement (generally) [§5(a)(ii)]
30 days from date of notice
30 days from date of notice
Default under Specified Transaction [§5(a)(v)]
3 Local Business Days
1 Local Business Day
Involuntary insolvency filing [§5(a)(vii)(4)]
30 days
15 days
Enforcement action by a secured party [§5(a)(vii)(7)]
30 days
15 days
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sale of a security, commodity or other financial instrument or interest. Moreover, the definition in the
2002 ISDA includes any transaction that is similar
to the specifically enumerated transactions “that
is currently, or in the future becomes, recurrently
entered into in the financial markets and which is a
forward, swap, future, option or other derivative on
one or more rates, currencies, commodities, equity
securities or other equity instruments, debt securities or other debt instruments, economic indices
or measures of economic risk or value, or other
benchmarks against which payments or deliveries
are to be made”.8
The expansion of the definition of Specified
Transaction effectively brings within the scope of
this limited cross-default provision the parties’ repurchase (repos), securities lending, and securities
forward transactions. In adding repos, securities
lending and securities forward transactions as potential triggers for an Event of Default under the
ISDA, the 2002 ISDA also addresses delivery failures which as a practical matter, may occur due to
administrative errors, settlement system problems
or scarcity of the underlying security. Section 5(a)
(v) of the 2002 ISDA clarifies that where repos,
securities lending and securities forward transactions are subject to a master agreement,9 a failure
to deliver a security under such agreement will only
trigger an Event of Default under the ISDA if all
transactions under the relevant master agreement
are accelerated or terminated.
Force Majeure
The 2002 ISDA introduces the Force Majeure (or
impossibility) Termination Event in Section 5(b)
(ii), which may be triggered if by reason of a force
majeure event or act of state that is beyond the
control of a party (or its credit support provider) (i)
the office through which a party (or its credit support provider) is acting is prevented from making or
receiving payments or deliveries or complying with
any other material obligation under the ISDA or a
credit support document or it becomes impossible
or impracticable for that office to make or receive
payments or deliveries or comply with any other
material obligation under the ISDA or a credit support document, (ii) such party (or credit support
provider) could not overcome the force majeure
event using reasonable efforts, and (iii) a waiting
period of eight business days has elapsed (unless the
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force majeure event affects a payment or delivery or
the ability to comply under a credit support document, in which case there is no waiting period).
The Force Majeure provision is rarely negotiated
but there are a few points to note about the provision. There is no definition of “force majeure”,
other than that it is a force majeure or act of state
that prevents or makes it impossible to make or
receive payments or deliveries or comply with
obligations under the ISDA or credit support
document. Additionally, although a party (or its
credit support provider) is required to attempt to
overcome the force majeure event using reasonable
efforts, such party need not incur a loss in doing so.
Finally, only the party affected by the Force Majeure
event is the “Affected Party,” and therefore, it is the
party that determines the Close-out Amount (based
on mid-market values).
Set-off
The 2002 ISDA standardized set-off language that
prior to 2002 was often incorporated by participants in the Schedule to the 1992 ISDA is based
on language suggested in the User’s Guide to the
1992 ISDA. Specifically, Section 6(f ) permits
the non-defaulting party, upon the termination
of all transactions due to the occurrence of an
Event of Default or a Termination Event where all
outstanding transactions are terminated, to offset
any amount owed under the ISDA against other
amounts owed under other agreements between
the parties (whether mature or contingent). Often
market participants seek to expand the set-off right
to include amounts owed under agreements with
affiliates. However, a recent decision has ascertained
that cross-affiliate set-off is not enforceable in insolvency proceedings for lack of mutuality.10
Frequently Negotiated Provisions
After agreeing on a 1992 ISDA or 2002 ISDA, the
negotiation of the Schedule and Paragraph 13 will
usually focus on credit, risk, and legal provisions,
some of which we have touched on above and in
Part I of this article. Other frequently negotiated
provisions are summarized below.
Credit
Some of the most significant negotiating points
relate to a party’s ability to declare an Event of
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Default or Termination Event resulting in the right
to terminate all transactions under the ISDA and
potentially triggering defaults under other agreements that the defaulting party has in place. The
party that is viewed as the more creditworthy counterparty, usually the sell-side participant (although
post-Lehman that assumption can be challenged),
will seek to broaden the Events of Default and to
shorten the cure periods under the ISDA form to
maximize its ability to terminate the trades under
the Agreement promptly. Conversely, the party that
is viewed as the less creditworthy counterparty will
seek to limit the Events of Default and maintain
the lengthier cure periods. These points arise most
frequently in the negotiation of the Cross-Default
provision, Default under Specified Transaction and
Additional Termination Events.
Cross-Default
Section 5(a)(vi) of the ISDA provides that an Event
of Default will occur if a party defaults on a thirdparty obligation and the default or the obligation
is in excess of a specified threshold amount. The
third-party obligation must be an obligation in
respect of borrowed money (whether present or future, contingent or otherwise, as principal or surety
or otherwise) and is referred to as “Specified Indebtedness”. The negotiation of the Cross-Default
provision typically revolves around the following
three points:
amendment of the provision to provide for
cross-acceleration and the addition of an administrative error carve-out;
expansion of the definition of Specified Indebtedness; and
agreement on a threshold amount.
Cross Acceleration and
Administrative Error Carve-Out
Corporate and buy-side participants often seek to
delay or eliminate the application of the CrossDefault provision. With respect to the first prong
of the Cross-Default provision (clause (1)), which
addresses any type of default having occurred under
the Specified Indebtedness, they seek to require
that in order to trigger an Event of Default under
the ISDA not only must the default have occurred
under the Specified Indebtedness, but the creditor
must have also chosen to demand payment of the
obligation (“cross acceleration”). Under the sec-
ond prong of the Cross-Default provision (clause
(2)), which addresses payment defaults under the
Specified Indebtedness, they seek to require that a
payment default will not trigger an Event of Default
if the failure to pay was due to an administrative or
Even before the negotiations begin, the
threshold issue to be agreed on by the
parties will be the form of ISDA Master
Agreement into which they will enter.
operational error, the party had the funds necessary
to make the payment and the payment is cured
within a certain period of time, usually between
one and three Local Business Days (“administrative
error carve-out”).
Expanding the Definition of Specified
Indebtedness
Sell-side participants sometimes seek to expand
the definition of Specified Indebtedness to include
Specified Transactions (and to expand the definition
of Specified Transactions to include transactions
with third parties). Participants are most likely to
request this change from counterparties that have
little in the way of “borrowed money” (mainly
loans). This way, if a counterparty defaults on an
obligation under a derivative or securities transaction with a third-party in excess of the threshold
amount (and where cross-acceleration applies such
obligation is accelerated), the other party may declare an Event of Default.11
Threshold Amount
A party to an ISDA will attempt to negotiate a sizeable threshold amount for itself to prevent an Event
of Default from being triggered by a default on a de
minimis loan obligation or payment. On the other
hand, parties will want to keep their counterparties’
threshold amount as low as possible in order to allow for greater opportunities to declare an Event
of Default. Parties often agree to asymmetrical
threshold amounts which are fair to each party as
they are set at either (i) a percentage of an entity’s
shareholders’ equity or members’ capital, for corporations or limited liability companies, or net asset
value, for investment funds (three percent is not
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an atypical percentage), (ii) a fixed dollar amount
which makes sense for each party based on their
borrowed money, or (iii) the lesser of (i) and (ii).
Default Under Specified Transaction
As discussed above, certain parties will prefer the
2002 ISDA because of its expanded definition
of “Specified Transaction,” which affords more
opportunities to declare an Event of Default. It
is not uncommon for parties negotiating a 1992
Negotiation of the Schedule and
Paragraph 13 will usually focus on
credit, risk, and legal provisions….
ISDA to incorporate the 2002 ISDA definition
of “Specified Transaction.” Some parties will push
for an even broader definition of Specified Transaction, to pull in the parties’ obligations under their
prime brokerage agreements. While such a request
is appropriate where the prime brokerage client has
agreed to portfolio margining (or netting collateral
across prime brokerage and OTC trades), it is less
appropriate where no such arrangement is in place.
Additional Termination Events
Section 5(b)(v) of the ISDA provides for either or
both parties to specify any “Additional Termination
Events” or “ATEs” applicable to a party (the “Affected Party”), which will entitle the other party (also
referred to as the non-affected party) to terminate
the transactions under the ISDA. ATEs are intended
to be leading indicators of the deteriorating credit
condition of the Affected Party. They provide the
non-affected party an opportunity to get out of its
trades before the counterparty’s problems lead it to
default under the ISDA or worse, become insolvent.
ATEs are specifically tailored to the type of entities
involved. Discussed below are ATEs applicable to
each of (i) an investment fund, (ii) a private corporation, and (iii) a rated entity.
Net Asset Value Triggers – Investment Funds
In order to track a trading counterparty’s overall
financial health, each party will ask for financial
information in the form of annual or quarterly financial statements. It is common for a party facing
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an investment fund to also request monthly financial statements that set forth the fund’s Net Asset
Value (or “NAV”), which is calculated as total assets
minus total liabilities. This statement of Net Asset
Value, or “NAV Statement,” provides a snapshot of
the fund’s performance for the month, and typically
documents the redemptions or subscriptions made
in the relevant month.
A sell-side participant facing an investment fund
will seek to include Additional Termination Events
based on the fund’s NAV Statements. These events,
commonly known as “NAV triggers”, will be triggered by a decline in the fund’s NAV in any given
month, 3-month and/or 12-month period. For
instance, it may be an ATE if a fund’s NAV declines
by 20% or more in a given month, 30% or more
in any three-month period, or 40% or more in any
twelve-month period. Often investment funds will
request that the monthly and quarterly triggers be
solely performance based and therefore exclude
redemptions and subscriptions. However, sell-side
counterparties tend to consider redemptions that
cause a decline in excess of the agreed percentage
indicators of an impending problem and therefore
want to be entitled to act in light of such a decline.
Another common NAV trigger is the “NAV floor,”
which would entitle the non-affected party to
terminate the trades under the Agreement if the
fund’s NAV falls below a baseline amount. When
negotiating these ATEs, investment funds should
ensure that the agreed declines are not easily triggered and sell-side participants should ensure that
they are adequately protected when there has been
a considerable loss of assets.
Maintenance of Ownership –
Private Corporation
When entering into an ISDA with a subsidiary of a
customer (e.g., a bank entering into a swap with a
subsidiary of its debtor) a sell-side participant will
want to ensure that the subsidiary’s ownership, if
its credit relationship is really with the parent, does
not change. For instance it may provide that an
ATE occurs if the parent entity fails to own either
directly or indirectly more than 51% of the voting
securities of its counterparty.
Credit-Rating Downgrade – Rated Entity
A credit rating downgrade ATE is often requested
from a counterparty that is a rated entity or that
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is guaranteed by a rated entity. The ATE can be
drafted in numerous different ways but the upshot
is that should such rated entity, or its guarantor
suffer a downgrade in its credit-rating (e.g., below
investment grade or higher), the other party will be
entitled to terminate all the outstanding transactions under the ISDA. The utility of a credit-rating
downgrade ATE hinges on the accuracy of the
ratings published by the rating agencies. The
fall of Lehman Brothers Holdings Inc. exposed
the weakness of this lagging indicator. However,
the Securities and Exchange Commission, mandated by the Dodd-Frank Wall Street Reform
and Consumer Protection Act,12 has proposed
tougher regulations for credit rating firms that are
intended to strengthen the integrity and improve
the transparency of credit ratings,13 which will
hopefully lend greater effectiveness to the credit
rating downgrade ATE.
Cure Periods
Under the 1992 ISDA, the most commonly negotiated cure period is failure to pay or deliver. If
the parties agree to reduce the cure period for this
Event of Default from three Local Business Days to
one, they will also likely amend the corollary Event
of Default in the Credit Support Annex (failure to
deliver margin14) and reduce the cure period specified there from two Local Business Days down to
one Local Business Day. As discussed above, the
standard 2002 ISDA provides for cure periods of
one day for failure to pay or deliver.
Risk
In order to mitigate counterparty credit risk, parties will enter into a CSA. The CSA provides a
contractual framework for the posting of collateral
to secure a party’s “Exposure.” For any given day,
Exposure is the net amount that one party would
pay to the other based on the mid-market replacement value of all transactions between the parties,
as if they were to be terminated on that day. The
form CSA provides that:
on every valuation day (defined in Paragraph
13 – usually every business day) the party that is
in-the-money (the “Secured Party”) may make
a demand for collateral (a “collateral call”) to
the other party (the “Pledgor”), who will have
to transfer collateral (“variation margin”) within
the amount of time specified in the agreement;
if the market moves in favor of the Pledgor
and the Secured Party is over-collateralized,
the Pledgor may make a collateral call and
the Secured Party will return collateral to the
Pledgor15; and
either party can be the Pledgor or the Secured
Party depending on which party is in-themoney.
Segregation of Independent Amounts
If parties choose to collateralize their obligations
under the CSA, one party may be required to
post an “Independent Amount.” The Independent
Amount,16 or initial margin, has historically been an
amount required by sell-side participants to guard
against credit exposure that may arise between the
demand for and the delivery of variation margin
including movements in value occurring between
the time a party defaults and the time the nondefaulting party designates a termination date. The
Independent Amount is posted in addition to the
daily variation margin requirements in the CSA.
A dealer may hold a significant amount of assets
as Independent Amounts for a single trading counterparty depending on the size of its OTC trading
portfolio. When the dealer becomes a credit-risk
and enters insolvency proceedings, as was the case
with Lehman, the counterparty’s claim for a return
of its Independent Amounts becomes a general
unsecured claim. Since Lehman’s insolvency an
increasing number of buy-side participants have
requested that their Independent Amounts be held
with a third-party custodian in order to ensure that
the collateral posted to cover their Independent
Amount is held with a bankruptcy-remote entity
from which it is more readily recoverable.17 Segregation of Independent Amounts can be a costly
proposition, both in terms of the upfront legal and
other fees required to set-up the relationship as well
as the ongoing fees to the custodian.
Eligible Collateral
In Paragraph 13 of the CSA, the parties will
specify the forms of “Eligible Collateral” that
may be delivered as collateral. The most common forms of Eligible Collateral are U.S. dollars
and U.S. treasuries (or U.S. dollars and letters
of credit with respect to commodity counterparties). In some instances a party will have access
to a specific class of assets, such as municipal or
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foreign governmental bonds, that it would like
to be able to post as collateral. The parties will
then agree on the class and maturities of the assets that would be considered Eligible Collateral,
as well as the discount that would apply to the
valuation of the assets in determining how much
collateral has been posted. The parties may also
have to negotiate terms that address enforcement
issues that may arise in connection with foreign
domiciled assets.
Transfer Timing
The term “transfer timing” refers to the period
within which collateral called for under the CSA
must be transferred. A failure to transfer within
that period will give rise to a Potential Event of
Default.18 The standard CSA provides that if a
collateral call is made before the notification time
(a time agreed by the parties), then the collateral
must be transferred by close of business on the next
Local Business Day. If the collateral call is made
after the notification time, then the collateral must
be transferred by close of business on the second
Local Business Day.
Current market practice calls for collateral demands to be satisfied within one business day.
Therefore, parties will often seek to reduce the
transfer timing such that if a call is made before
the notification time, then the collateral must be
transferred by close of business on the same day,
otherwise the transfer must be made by close of
business on the next Local Business Day. Whether
this timeframe is operationally feasible for a trading entity often depends on the notification time.
An early notification time (e.g., 10:00 a.m.) will
give a pledgor most of the day to satisfy the call. A
later notification time (e.g., 1:00 p.m.) may make
same-day transfers operationally challenging. This
is pretty straightforward when the parties are in
the same geographical location. Parties that are
located in different time zones will have to agree
to a time that works for each party with respect to
both making a collateral call and receiving one.
Parties should also take into account the agreed
grace period for margin failures in negotiating
transfer-timing terms.
Miscellaneous
Other frequently negotiated terms deal with a
party’s rights upon the occurrence and continuance
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of an Event of Default, and any limitation on, or
waiver of, such rights.
Limitation on Reliance on Section 2(a)(iii)
Section 2(a)(iii)(1) of the ISDA provides that
each obligation of a party to make each payment
or delivery specified in a confirmation is subject
to the condition precedent that no Event of Default or Potential Event of Default with respect
to the other party has occurred and is continuing.
Accordingly, if an Event of Default or Potential
Event of Default has occurred with respect to a
party (the defaulting party), the other party (the
non-defaulting party) at its option may either (i)
designate an Early Termination Date under the
agreement, or (ii) cease making any payment or
delivery obligations to the non-defaulting party
in reliance on Section 2(a)(iii)(1). Paragraph 4(a)
(i) of the CSA provides the non-defaulting party
a corresponding right to cease transferring collateral upon the occurrence and continuance of
an Event of Default, Potential Event of Default or
Specified Condition.19 The non-defaulting party
may choose not to terminate its trades under the
ISDA, perhaps because it is net out-of-the-money
on all trades, and yet may cease performing in
reliance on these provisions. In the meantime, the
defaulting party is still required to make timely
payments, deliveries and margin transfers to the
non-defaulting party.
Section 2(a)(iii)(1) allows the non-defaulting
party to game the market by refusing to terminate
its transactions under the Agreement until it is beneficial for it to do so, or when the market swings in
its favor. It is unclear how long a party can rely on
2(a)(iii)(1) when facing an entity that is subject to
U.S. insolvency proceedings.20
The negative consequences to the defaulting
party can be significant. Excess collateral and settlement payments owed to the defaulting party may
be withheld by the non-defaulting party, thereby
creating or further deepening the defaulting party’s
credit problems. This lack of liquidity may cause the
defaulting party to default on its obligations with
other trading counterparties, triggering a wave of
defaults that leads to the defaulting party’s demise.
In order to prevent this result, parties will often negotiate a limitation on the right to rely on
Section 2(a)(iii)(1) in not making any payment
or delivery obligations, by providing that the
P R A C T I C A L C O M P L I A N C E & R I S K M A N A G E M E N T F O R T H E S E C U R I T I E S I N D U S T RY
The ISDA Master Agreement – Part II: Negotiated Provisions
non-defaulting party may only cease to perform
for a certain number of days after the occurrence
of the Event of Default that gave rise to such
right. Typically the parties agree to anywhere
between 30 and 90 days, the rationale being that
such number of days is sufficient time for the
non-defaulting party to decide if it will continue
performing to the defaulting party (thereby preserving the trading relationship), or terminate
the trades under the ISDA. Entities that are less
likely to be a defaulting party will resist the limitation or seek to extend the time period as much
as possible. Currently, an ISDA working group
(dubbed the “Section 2(a)(iii) Working Group”)
is considering potential amendments to Section
2(a)(iii) to address, amongst others, the issues
highlighted above.
“Fish or Cut Bait”
A related but different legal limitation is commonly
referred to as the “fish or cut bait” or “use it or lose
it” provision. This term provides that upon the occurrence and continuance of an Event of Default
or Termination Event, the non-defaulting party or
non-affected party will have to terminate its trades
under the ISDA within a certain number of days or
forever waive its right to terminate the trades based
on such event. The “fish or cut bait” is negotiated
principally to address the occurrence of misrepresentations, which do not have a cure period, as well
as ATEs that either cannot be cured or may take
some time to cure.
The concern is that a non-defaulting or nonaffected party will use the existence of an Event
of Default or Termination Event as an excuse to
terminate the trades under the ISDA, long after the
fact and after the parties have continued to perform.
In order to avoid this result, a party may request a
“fish or cut bait” provision pursuant to which the
non-defaulting or non-affected party waives its right
to terminate its transactions under the ISDA based
on an Event of Default or Termination Event within
a certain number of days following the occurrence
of the event.
Conclusion
In entering into an ISDA relationship parties must
first agree on the ISDA form they will use and then
negotiate certain provisions of the Agreement to
ensure that their economic and legal rights are
preserved. In addition, parties should be aware of
the changes to the ISDA documentation that the
International Swaps and Derivatives Association
is working on that reflect the current state of the
law and of the industry. While a number of these
modifications are meant to be adopted on an industry-wide basis (e.g., the suggested documentation
of the Section 2(a)(iii) Working Group), they can
sometimes take a long time to be finalized by the
ISDA working groups. Counterparties may want
to be proactive and bilaterally amend their agreements to reflect these changes either in the law or
in industry practice.
E N D N OT E S
1
2
The ISDA Master Agreement – Part I: Architecture, Risks and Compliance, Practical Compliance & Risk Management for the Securities
Industry, January-February 2012.
If the parties’ ISDA Master Agreement is
subject to New York law, they will enter into a
mark-to-market security arrangement under a
1994 ISDA Credit Support Annex (CSA). If the
parties’ ISDA Master Agreement is subject to
English Law, they may enter into either (1) a
1995 ISDA Credit Support Annex (Transfer –
English Law), which provides for transfer of title
of collateral (rather than creating a security
interest), or (2) a 1995 ISDA Credit Support
Deed (Security Interest – English Law), which
provides for the creation of a formal security
interest in the collateral. Parties that intend to
use assets located in Japan as credit support
would also likely enter into or incorporate into
their CSA the terms of the 2008 ISDA Credit
3
Support Annex (Loan/Japanese Pledge) in
order to minimize exposure to counterparties
through collateral arrangements in respect of
cash, deposit accounts, Japanese government
bonds or other marketable securities located
in Japan.
Events of Default are set forth in Section 5(a)
of the ISDA and entitle the party that is not the
defaulting party to terminate all transactions
between the parties. The Events of Default
under 5(a) are: (i) Failure to Pay or Deliver,
(ii) Breach of Agreement, (iii) Credit Support
Default, (iv) Misrepresentation, (v) Default
under Specified Transaction, (iv) Cross-Default,
(vii) Bankruptcy and (viii) Merger without Assumption. Termination Events are set forth in
Section 5(b) of the ISDA and entitle the party
that is not affected by the Termination Event
to terminate any transactions between the parties that are affected by such event (or typically
4
5
6
7
all the transactions in the case of an Additional
Termination Event). The Termination Events
under 5(b) are (i) Illegality, (ii) Tax Event, (iii)
Tax Event Upon Merger, (iv) Credit Event Upon
Merger, (v) Additional Termination Event, and
(vi) Force Majeure (under the 2002 ISDA only).
See INT’L SWAPS AND DERIVATIVES ASS’N, User’s
Guide to the ISDA 2002 Master Agreement, 26
(2003 ed.).
Generally, a day on which commercial banks
are open for business in the city of the defaulting party. See INT’L SWAPS AND DERIVATIVES
ASS’N, ISDA Master Agreement, §14 (1992)
(the “1992 ISDA”).
Generally, a day on which settlement systems
necessary to accomplish the relevant delivery
are generally open for business. See INT’L SWAPS
AND DERIVATIVES ASS’N, 2002 ISDA MASTER
AGREEMENT §14 (2002) (the “2002 ISDA”).
1992 ISDA §14.
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The ISDA Master Agreement – Part II: Negotiated Provisions
8
9
10
11
2002 ISDA §14.
For example, a Master Repurchase Agreement, Master Securities Lending Agreement,
and a Master Securities Forward Transaction
Agreement, or their global counterparts (for
non-trading in non-U.S. securities), as applicable.
In re Lehman Bros. Inc., 458 B.R. 134 (Bankr.
S.D.N.Y. 2011) (holding that there is no exception to the mutuality requirement of Section
553 of the U.S. Bankruptcy Code that would
permit cross-affiliate set-off even if the right
to set-off debts across affiliates was clearly
contemplated by a valid, prepetition contract).
It is unclear how a party may come to know of
a cross-default or cross-acceleration Event of
Default. If the default or acceleration is worthy
of media attention, the defaulting party has
likely already defaulted under one of the other
12
13
14
15
16
17
enumerated Events of Default (e.g. failure to
pay).
Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010, Pub. L. No. 111-203,
124 Stat. 1376 (2010).
Nationally Recognized Statistical Rating Organizations from the Securities and Exchange
Commission, Release No. 34-64514, Proposed
Rules for Nationally Recognized Statistical Rating Organizations, available at http://www.sec.
gov/rules/proposed/2011/34-64514.pdf.
CSA, at Par. 7(i).
Transfers will be subject to Minimum Transfer
Amounts and Rounding, See CSA, Paragraph 3.
Independent Amounts are specified in Paragraph 13(b)(iv)(A) of the CSA.
For an in-depth discussion on segregation of
Independent Amounts, see the Independent
Amounts White Paper, published by ISDA,
18
19
20
MFA and SIFMA, dated March 1, 2010, available at http://www.isda.org/c_and_a/pdf/
Independent-Amount-WhitePaper-Final.pdf
A Potential Event of Default means any event
which, with the giving of notice or the lapse
of time or both, would constitute an Event of
Default. See the1992 ISDA, §14.
The parties agree in Paragraph 13 which of the
Termination Events specified in the ISDA Master Agreement will be “Specified Conditions”
for the purposes of the CSA.
See In re Lehman Brothers© Holdings Inc., Case
No. 08-19555 (JPM) (Bankr. SDNY Sept. 15,
2009) (transcript of record) (ruling from the
bench that the U.S. Bankruptcy Code did not
permit a debtor (creditor in bankruptcy) to
rely on Section 2(a)(iii) in accordance with its
terms, approximately one year after the creditor’s (debtor in bankruptcy) insolvency filing).
This article is reprinted with permission from Practical Compliance and Risk Management for
the Securities Industry, a professional journal published by Wolters Kluwer Financial Services, Inc.
This article may not be further re-published without permission from Wolters Kluwer
Financial Services, Inc. For more information on this journal or to order a subscription to
Practical Compliance and Risk Management for the Securities Industry, go to
onlinestore.cch.com and search keywords “practical compliance”
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