• Unsecured ISDA Based Swap Documents
  • June 20, 2007 | Author: Joshua P. Agrons
  • Law Firm: Fulbright & Jaworski L.L.P. - Houston Office
  • Many companies hedge interest rate risk, foreign exchange exposure or commodity prices, and the process frequently involves International Swaps and Derivatives Association (“ISDA”) based documentation. The document architecture is straight forward in principle, using an ISDA Master Agreement, which is signed as is, and attaching a Schedule to the Master Agreement, through which changes and elaborations are made. Each transaction is then evidenced by a deal-specific confirmation.  The most widely used form of ISDA master agreement is the 1992 Multi-currency Cross Border form.  Although other forms of Master Agreement exist, the common usage of the 1992 Master Agreement renders it the most suitable form for tips on key points to be negotiated in the related Schedule. Many clients struggle with swap documentation because the documents, including related user’s guides, are intricate. Nevertheless, a number of issues should be negotiated, and are worth the time and effort associated with seeking changes to the Master Agreement in the Schedule. This practice tip summarizes a few key points that a company should attempt to negotiate with its swap provider, and uses defined terms from the Master Agreement.

    The company must first determine the scope of the default provisions under Section 5 of the Master Agreement. This is important because the broader the definition of “Specified Entity”, the broader the scope of the events of default that may arise under the Master Agreement as a result of (i) the failure to perform a material transaction agreement (described as a Specified Transaction in Section 5(a)(v) of the Master Agreement), (ii) cross default with agreements executed by Specified Entities (Section 5(a)(vi)), (iii) the bankruptcy of a Specified Entity (Section 5(a)(vii)) or (iv) the merger of a Specified Entity with another person resulting in diminution of the creditworthiness of the resulting entity (Section 5(b)(iv)). For the company, the scope of Specified Entity should be as narrow as possible, with “not applicable” being the preferable choice for the Schedule. On the other hand, the company would tend to prefer that the swap provider be subject to a definition of Specified Entity that covers those subsidiaries or affiliates that are the basis of the company’s credit analysis of the swap provider. After all, a hedging transaction is only as valuable as the credit of the swap provider. Frequently however, the definition of Specified Entity for many swap providers is “not applicable”, as the credit of the provider is the sole relevant transactional determinant.

    The definition of “Cross Default” is another key item of interest to the company. The Cross Default definition will tie the hedging transaction to a default under another specified agreement in excess of a negotiated threshold in Section 5(a)(vi) of the Master Agreement. The company should modify Section 5(a)(vi) to provide that

    “an Event of Default shall not be deemed to have occurred under either (1) or (2) above if: (aa) the event or condition referred to in (1) or the failure to pay referred to in (2) is caused by an error or omission of an administrative or operational nature; (bb) funds were available to such party, any Credit Support Provider of such party or any applicable Specified Entity of such party, as the case may be, to enable it to make the relevant payment when due; (cc) such relevant payment is made within three (3) Local Business Days; and (dd) the Specified Indebtedness has not been declared due and payable under the applicable agreement. In addition, the phrase “, or becoming capable at such time of being declared,” is hereby deleted from Section 5(a)(vi) of the Agreement.

    These changes have several desirable features. First, an administrative error may not give rise to a default if promptly cured prior to acceleration of any indebtedness under the applicable financing. Second, a default under the swap documents is tied to the acceleration, rather than the mere occurrence of a default, under a material indebtedness agreement. This is a higher threshold than mere “existence” cross default, and can be crucial where the company does not want to see its swap protection lost as a result of the occurrence of a protracted renegotiation of financial or other covenant problems that are otherwise subject to a negotiated solution. By excluding the phrase “, or becoming capable at such time of being declared,” from Section 5(a)(vi) of the Master Agreement, the company can, for example, resolve credit agreement defaults through negotiation without worrying about whether foreign exchange or interest rate swap protection may be lost, or escalated in price by an opportunistic swap provider, due to a default that the lender has no real interest in using to accelerate the underlying obligations.

    The “Threshold Amount” is a materiality threshold. The lower the Threshold Amount, the broader the scope of the Event of Default under the Master Agreement. If Specified Indebtedness is modified to include obligations other than those set forth in the Master Agreement and to address other types of indebtedness, this definition will become crucial to limiting the scope of events that would permit the swap provider to terminate on account of an event of default. Many companies try to set their Threshold Amount at the same US dollar equivalent as the cross default threshold in their principal bank credit facility. This negotiated term should be easy to justify, as it reflects a previously negotiated estimate of what the parties define as material. Efforts to set the Threshold Amount at an exceedingly low level should be resisted.The Threshold Amount also applies to the swap provider, and the company should attempt to set this amount at a level that reflects the size and strength of the swap provider. For the swap provider, this is sometimes set as a percentage of the net worth of the swap provider based on the swap provider’s published financial statements.

    Sometimes the parties provide for an “Additional Termination Event” that results if the swap provider is no longer a lender under the company’s revolving credit agreement. This should be resisted where possible.  If a hedge transaction is in the nature of an insurance policy against shifts in market rates, the company would not want its “insurance” to be subject to termination merely because the swap provider’s lending policies have changed and it sold its loans to another party.

    The swap provider, if not an entity formed under US law, should be asked to document the company’s claims for no withholding (for tax purposes) on payments to the swap provider. Because the company would typically be required to gross up payments for any tax derived withholding obligations, the company should require both tax documentation (on suitable IRS pre-printed forms where applicable) and representations and warranties that support the company’s position that no withholding is required on payments made by the company to the swap provider.

    Finally, the company, if publicly held, should be careful to provide that periodic disclosure obligations of the company to the swap provider will be either upon request or simply satisfied by timely filings publicly accessible on EDGAR.

    Other significant swap documentation issues will be addressed in subsequent installments of this practice tips series. 

    This edition of Fulbright's Corporate and Business Transactions Practice Series was prepared by partner Josh Agrons from Fulbright's Houston Corporate & Business Transactions Practice Group. If you would be interested in exploring this further, please contact Josh Agrons at [email protected] or 713 651 5529.