K
Derivatives
Andrew V. Petersen, Partner and
Duncan Batty, Assistant,
K&L Gates LLP
Contents
General Introduction
Introduction: what is the purpose of a derivative in a secured
lending context?
Types of derivative transactions which are relevant in a secured
lending context
Interest Rate Swaps and Currency Swaps
Other types of derivative transactions
Document Architecture: Master Agreement, Schedule,
Confirmations and Credit Support Annex
Some history
The documentation
Provisions of the Master Agreement and the Schedule
Recital, Heading and Date
Section 1: Interpretation
Section 2: Obligations
Section 3: Representations
Section 4: Agreements
Section 5: Events of Default and Termination Events
Section 6: Early Termination; Close-out Netting
Section 7: Transfer
Section 8: Contractual Currency
Section 9: Miscellaneous
Section 10: Offices and multibranch parties
Section 11: Expenses
Section 12: Notice
Section 13: Governing Law and Jurisdiction
Signature Block
Confirmations
Interest rate swap
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K1
Pro forma Confirmation (short form) in relation to an
interest rate swap to be entered into in connection with a
loan agreement
To be provided in Release 34
K2
Pro forma Schedule in relation to a Master
Agreement being entered into in connection with a
loan agreement
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Practical Lending. R.33: October 2008
General Introduction
What is the purpose of a derivative in a secured lending context?
At the broadest level, derivatives are products with a price and value
derived from an underlying asset or assets, a certain reference point
or event or an index (a ‘‘Reference Point’’) which is variable. They
may be used to give a party exposure to (or limit a party’s exposure
to) a Reference Point or Reference Points. Derivatives come in many
forms and may be tailor made to fit the needs of the parties that
enter into them. Users of derivatives either pass unwanted risk to a
willing counterparty which assumes that risk for a price, or take on
risk in exchange for a payment. A simple example is an option, a
basic derivative building block. In the case of a share option, one
party, the holder of the option, pays a premium to obtain the right to
purchase (or sell) an underlying asset—the shares. The other party,
the writer of the share option, receives the premium as payment for
granting the option and in return for that payment becomes obliged
to perform, i.e. to transfer the shares at a pre-determined price, upon
the exercise of the option. In this way, the option is used to manage
or take advantage of risk relating to the fluctuating value of the
shares.
This Chapter, in focusing on issues relevant to secured lending, is
concerned with derivatives entered into in respect of managing
interest rate risk via interest rate swaps. In secured lending transactions, these are the most widely traded over-the-counter (‘‘OTC’’)
derivatives by a decisive margin and indeed derivatives managing
interest rate risk have the largest volume of trades—over 60 per
cent—of the overall derivatives market. Of the $596,004bn in outstanding OTC derivatives at the end of 2007, the Bank of
International Settlements has estimated that $393,138bn involves
interest rates as their Reference Point contracts. Interest rate swaps
alone comprised $309,588bn.
Interest rate swaps are a response to the volatility of interest rates.
In a secured lending transaction, the base interest rate determines the
borrower’s interest payment obligations. There are many different
types of base interest rates (including base rates, prime rates, US federal rates, LIBOR, EURIBOR, etc.) on which the interest rate on a
loan may be based. The interest rate set by the lender directly correlates to the credit risk of the borrower—the higher the credit risk the
higher the interest rate to be paid by the borrower. Thus there is a
need for a derivative such as the interest rate swap that lowers finanPractical Lending. R.33: October 2008
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General Introduction
cing costs by providing the possibility for a lender to hedge cash flow
against interest rate volatility. However, it should be noted that
interest rate swaps are only a part of the spectrum of derivative
arrangements which have been developed. Derivatives may also be
based on other assets: a bond, a commodity, shares, currency or an
index such as a commercial property index.
Derivatives can be ‘‘stand alone’’, in which case they will not be
linked to another product or obligation. For example, a hedge fund
may believe that the value of UK office property will increase over
the next year. Instead of going out and physically purchasing office
buildings to benefit from any gain in value (incurring significant
transaction costs in the process and resulting in it holding a very illiquid asset), the hedge fund can enter into a derivative contract with a
trading counterparty (who thinks that the value of UK office property will remain constant or decrease) with a Reference Point of one
of the property indices which are published. Payments to the hedge
fund or the trading counterparty under the derivative contract will
depend on how the index varies. Here the hedge fund has gained
exposure to UK office property via the derivative contract without
having to actually purchase office buildings. In the secured lending
context, derivatives are generally not ‘‘stand alone’’ and instead are
linked to another product or obligation (i.e. a loan). Such derivatives
are usually designed to minimise the exposure of the borrower under
this underlying loan to variables which relate to the loan and over
which it has no control.
Types of derivative transactions which are relevant in a
secured lending context
Interest Rate Swaps and Currency Swaps
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At its simplest, an interest rate swap is a contract pursuant to which
the parties agree to make periodic payments to each other by applying alternative rates to a corresponding notional amount. In effect
two counterparties exchange fixed and floating rate cash flows with
each other. The most common type of interest rate swap is the socalled ‘‘vanilla’’ interest rate swap, namely the fixed/floating swap in
which the fixed-rate payer promises to make periodic payments based
on the application of a fixed rate to a notional amount to the floatingrate payer, who in turn agrees to make periodic payments based on
the application of a floating rate (such as three month LIBOR) to the
same notional amount to the fixed-rate payer. Payments are confined
to the periodic fixed and floating payments—there is no exchange of
the notional amount.
By way of example, in a secured lending transaction involving a
sterling loan advanced from a lender to a borrower at an interest rate
of LIBOR (or an alternative floating rate) plus a margin, both the
lender and the borrower are exposed to future rises (and falls) in the
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General Introduction
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underlying rate of LIBOR. Any increase to such underlying interest
rate would result in the borrower’s interest payment obligations
increasing and possibly the borrower being unable to meet or service
such enhanced interest obligations. In turn this could hinder the
lender in recovering its periodic interest payments and, potentially,
the principal amount of the loan. This is particularly relevant in a
real estate finance transaction context involving an SPV borrower.
On the basis of its due diligence, the lender is relying on the rental
income from the underlying property, as opposed to the trading performance of the borrower, to service the borrower’s interest obligations under the loan. If LIBOR were to increase it would be
unlikely that it would be matched by increases in rental income and
the borrower may struggle to meet its interest obligations without
there being any change to the status of the underlying properties.
This is not in the interests of either the borrower or the lender.
To mitigate this risk, the borrower may seek to limit its exposure to
LIBOR via an interest rate swap. The principal participants in an
interest rate swap are a dealer and an end-user, both referred to as
‘‘counterparties’’ in derivatives parlance. The end-user (the borrower
under the loan) and the dealer (a hedge counterparty, usually a bank
or financial institution and often a related arm of the entity which
provided the initial loan) can fix a rate of interest at the start of the
term of the loan. The borrower will pay amounts based on the application of this fixed rate to the set notional amount to the hedge counterparty throughout the term. In return the hedge counterparty will
pay amounts based on the application of LIBOR to the set notional
amount to the borrower throughout the term. The borrower will then
pay the LIBOR amounts received on the interest rate swap to the
lender to satisfy its interest obligations. The reference amount on
which the fixed and LIBOR payments are based will be a notional
amount corresponding to the principal amount of the loan or a proportion of the principal amount of the loan. The net effect is that the
borrower fixes its interest rate and cost of borrowing, giving it certainty over the interest which it will be obliged to fund during the
term of the loan. This form of interest rate swap is a fixed-for-floating interest rate swap. As such, the hedge counterparty takes the risk
of any rise or fall in the underlying interest rate and, accordingly, will
bear any loss should the underlying floating rate increase above the
fixed rate paid by the borrower and enjoy any gain should the underlying floating rate decrease below the fixed rate paid by the borrower.
Of course, the hedge counterparty may hedge its own exposure by
enticing into a back-to-back transaction. This will reduce any loss
(and also any gain) it may make.
There is also a benefit to the lender in that it can be confident that
the borrower will be able to meet its LIBOR obligations during the
term of the loan, the interest rate risk has been removed from the
loan structure. In the real estate finance context, the removal of this
variable places greater emphasis on the performance of the underPractical Lending. R.33: October 2008
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General Introduction
lying property, on which the lender has performed diligence and
should therefore be more comfortable being exposed to.
Given that lenders will often insist that the borrower’s floating rate
exposure under the loan be fully hedged, the question of why the
loan is not made at a fixed rate is often asked. A fixed rate loan is one
where the interest payable by the borrower remains constant during
the term of the loan with the effect that, to the borrower, the loan is
economically equivalent to a floating rate loan subject to a full fixedfor-floating interest rate swap. There are a variety of reasons for the
overwhelming number of loans being made at a floating rate. From
the lender’s perspective, lenders generally funds themselves at a floating rate and therefore prefer to lend at floating rates to avoid having
to manage any interest rate risk. It is also usually easier to syndicate
or securitise loans if they are at a floating rate. Additionally, if the
hedge counterparty is a part of the lender’s organisation, the swap
allows the lender to sell two products (i.e. the loan and the interest
rate swap) to the borrower. From a borrower point of view, some
borrowers prefer the transparency of the swap and the ability to independently (i) quantify the fixed and floating rates which are payable
and (ii) terminate the fixed and floating obligations. Some borrowers
also like the flexibility of hedging only a proportion of their exposure
to the floating rate, which will give some benefit from a drop in
underlying interest rates.
There are additional variables which a borrower may be exposed
to. For example, the borrower could be exposed to movements in
currency exchange rates. If a borrower obtains the bulk of its income
in US dollars but its obligations under a loan are denominated in
sterling, the borrower is exposed to the US dollar to sterling
exchange rate. Should the value of the US dollar fall, the borrower’s
ability to meet its sterling denominated obligations under the loan
could be prejudiced. The borrower can remove this risk by entering
into a currency swap with a hedge counterparty so the US dollar:
sterling exchange rate is fixed at the start of the term of the loan. The
borrower will pay US dollars to the hedge counterparty at this fixed
exchange rate throughout the term, and in return the hedge counterparty will pay US dollars to the borrower at the prevailing market
exchange rate throughout the term. Again the notional amount on
which the US dollar and sterling payments are based will be the principal amount of the loan. The currency swap therefore ensures that
movements in the underlying US dollar: sterling exchange rate will
not prejudice the borrower’s ability to comply with its obligations
under the loan. Alternatively, there may be a mismatch between the
rate at which the borrower obtains its income and the rate at which
its obligations on the loan are based. If, for example, a borrower who
is a financial institution obtains income from products based on
EURIBOR but interest on its loan is based on LIBOR, there is a
danger that the difference between LIBOR and EURIBOR could
prejudice the borrower’s ability to comply with its obligations under
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the loan. A derivative contract known as a basis rate swap could be
entered into to remove the risk of this mismatch.
One final aspect of derivatives contracts is worth mentioning at this
point. As the derivative contract is based on an underlying variable,
the value of the derivative contract fluctuates according to the movement of this underlying variable. This means that in a full fixed-forfloating interest rate swap the hedge counterparty assumes the same
interest rate risk that the borrower wanted to eliminate. In the context of an interest rate swap, when setting the fixed rate the borrower
will pay to the hedge counterparty, the hedge counterparty will generally extrapolate how it thinks the relevant underlying floating rate
(say LIBOR) will move during the term of the loan and calculate
what it believes the average daily rate of LIBOR to be during the
term (the hedge counterparty will refer to various sources when making this determination). This average daily rate will be set as the fixed
rate which the borrower pays to the hedge counterparty. On day one,
the value of the interest rate swap contract to borrower and hedge
counterparty is zero—the fixed payments the borrower will pay and
the floating payments the hedge counterparty will pay will be equal.
However, this will not be the case if LIBOR does not move in line
with the hedge counterparty’s extrapolation and will mean either: (i)
the floating payments received by the borrower will be less than the
fixed payments paid to the hedge counterparty; or (ii) the floating
payments received by the borrower will be greater than the fixed payments paid to the hedge counterparty. In situation (i), the borrower
is said to be ‘‘out of the money’’; in situation (ii), the borrower is said
to be ‘‘in the money’’. Movement in the underlying rate can mean
that the borrower or the hedge counterparty may be ‘‘in the money’’
at different times during the term of a hedging transaction. To eliminate these differences the hedge counterparty will often counterhedge the risk of movements with a ‘‘back-to-back’’ swap —an
interest rate swap with a third party swap provider which will mirror
the terms of the underlying interest rate swap between the hedge
counterparty and the borrower.
Other types of derivative transactions
There are other types of derivatives transactions which may be relevant in the secured lending context but which are not seen quite so
regularly as interest rate swaps and currency swaps. A brief description of these types of derivatives is set out below:
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(a) Interest rate cap or ceiling—this sets a maximum rate
of interest which the end user will be obliged to pay. The
buyer of the cap (usually the end user) will pay the prevailing floating rate of interest up to the set maximum rate;
the seller (usually the dealer) will compensate the buyer if
the floating rate exceeds the cap. The end user will usually
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General Introduction
be obliged to pay a premium for the cap which will depend
on the level of the cap.
(b) Interest rate floor—a floor sets a minimum interest rate
to protect the buyer of the floor (usually the dealer) from
losses resulting from a decrease in the prevailing floating
rate. The seller of the floor (usually the end user) compensates the buyer if the prevailing interest rate drops below
the floor. Again the buyer of the floor will usually have to
pay a premium to the seller.
(c) Interest rate collar—this is a combination of an interest
rate cap and an interest rate floor. The end user purchases
an interest rate cap from the dealer but, at the same time,
sells the dealer an interest rate floor.This protects the end
user by capping its exposure to a rising interest rate but
sacrifices the profitability of the transaction if the interest
rate drops. The interest rate floor aspect of the collar will
often reduce the premium payable by the end user.
The principles outlined above would apply equally to caps, floors and
collars which use currency exchange rates as the Reference Point
rather than interest rates.
Document Architecture: Master Agreement,
Confirmations and Credit Support Annex
Schedule,
Some history
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In the early years of derivatives prior to 1985, dealers of derivatives
each used their own wording for trade documentation and legal
counsel for each side expended an enormous amount of time reviewing documentation. The lack of standardisation in derivative documentation resulted in unnecessarily delayed processing (or, in some
cases, non-processing) or injurious delays to the parties. The lack of
standardised derivatives documentation limited the growth of derivative products and impaired secondary markets in swaps and other
complex instruments of finance. Over time, dealers used other dealers’ forms, but standardisation eluded market participants prior to
the mid- to late-1980s. Derivatives gradually turned from novel
finance transactions to widely-used transactions accompanying complicated deals. The need for standardisation of terms and documentation among dealers to reduce costs and facilitate liquidity finally
materialised. Most importantly, speed in execution of trades was
recognised, which led to the formation of an important dealers
association, the International Swaps and Derivatives Association, Inc.
(ISDA) chartered in 1985. ISDA has, since its inception, represented
market participants in the derivatives industry.
June 1985 further witnessed ISDA promulgating its Code of
Standard Wording, Assumptions and Provisions for Swaps, which
focused on cash flows and payments upon termination, which most
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swap dealers in the US rapidly approved. This was followed in
August 1985 when the British Bankers’ Association (BBA) introduced the British Bankers’ Association of Interest Rate Swaps
(BBAIRS) guidelines, which were primarily used for swaps between
banks. In 1986, ISDA revised and expanded its code and in doing so
facilitated the development of the ISDA Master Agreement.
Subsequently, in 1987, 1992 and again in 2002, ISDA refined its
Master Agreement and released standard definitions and forms of
confirmations to document individual derivatives transactions. Early
forms of the Master Agreement mimic, in many ways, the ISDA and
BBA codes. The 1990s witnessed the emergence of credit derivatives
and over the last few years property derivatives have also come of
age. Today, ISDA represents over eight hundred member institutions, businesses and governmental entities that hail from sixty
countries on six continents and the Master Agreement remains the
overarching legal document evidencing the vast majority of rights and
obligations of the two sides to a derivatives trade.
The documentation
There are four ‘‘levels’’ to the ISDA documentation architecture. At
the top of the documentation hierarchy is the Master Agreement, a
document with a form that never changes; its dispute resolution and
other broad terms apply to every trade unless varied by the parties.
The idea behind this document is to settle the ‘‘boilerplate’’ terms.
The Schedule to the Master Agreement and the Credit Support
Annex are used to vary the terms of the Master Agreement in several
important respects. Finally, the economic of each trade and other
details are evidenced by Confirmations, which document the terms
of the individual transactions which operate under the umbrella of
the Master Agreement (as modified by the Schedule and the Credit
Support Annex). These will each be dealt with in turn.
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(a) Master Agreement—the first level, or the foundation, is
the Master Agreement that envelops all derivatives transactions between the counterparties at any time during the
term of the Master Agreement (the Master Agreement terminates by mutual agreement or pursuant to the termination mechanics described in greater detail in the
agreement itself). This is standard prescribed form document devised by ISDA so that its terms do not have to be
varied from transaction to transaction—it is a major faux
pas to try to amend the Master Agreement other than via
the Schedule or a Confirmation (see below). The Master
Agreement applies to the vast array of derivatives transactions which may be entered into by the counterparties,
from interest rate swaps to foreign exchange trades to various combinations of products. Most of the terms (e.g. certain Events of Default) are mutually applicable to the two
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counterparties. Some of the key features of this agreement
include: covenants to furnish information; standard representations that are typically included in other real estate
finance documentation; Events of Default (including the
failure to pay or deliver upon settlement of a trade; breach
of the agreement unless remedied within thirty days, failure to provide or maintain required amounts of collateral,
a breach of representations, and other defaults under the
Master Agreement, including the insolvency of either
party); and provisions setting forth the consequences of
termination. These will be dealt with below.
Whilst the Master Agreement is not amended and provides a world-wide standard, the parties have a choice of
three versions of the Master Agreement to use, either: (i)
1992 Master Agreement (Local Currency—Single
Jurisdiction);
(ii)
1992
Master
Agreement
(Multicurrency—Cross Border) or (iii) 2002 Master
Agreement (offered as a Multicurrency—Cross Border
form only). As can be seen, in 1992 there were the two
forms: multicurrency cross-border and single currency
local. However as a result of the single currency local form
rarely being used it was dropped in favour of the multicurrency—cross border form launched in 2002. For a variety of reasons (for example familiarity and replication of
previous agreed forms based on the 1992 Master
Agreement) use of the 2002 Master Agreement is not as
widespread, although its popularity is increasing, the 1992
Master Agreement (Multicurrency—Cross Border) still
appears to be the most popular globally accepted form.
Under a Master Agreement the dealer (usually a bank or
financial institution) is usually designated as Party A and
the end-user (the borrower in a secured lending context)
will be designated as Party B.
(b) Schedule—the Schedule, in customising the Master
Agreement to fit the needs of the particular parties, is
where amendments to the Master Agreement are documented and where certain optional or boilerplate provisions of the Master Agreement are activated or deactivated, modified and/or supplemented. The Schedule
typically includes customised termination provisions
referred to as Additional Termination Events, or ATEs
(for example, if the credit ratings of the dealer providing
the derivative fall below a certain level, or the assets under
management of an end-user fall below a certain level, the
end-user or the dealer respectively may terminate the
Master Agreement), as well as credit-related terms and a
wide array of covenants and representations that add to,
limit, or reduce the covenants and representations within
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the Master Agreement. A discussion of the key provisions
of the Schedule (and how they relate to the Master
Agreement) is set out below. The Schedule forms part of
the Master Agreement to create a single document. The
Schedule and the Master Agreement are designed to provide an umbrella of terms and conditions which govern
multiple derivatives transactions entered into between the
parties thereto which reference such Schedule and Master
Agreement and address the unique risks associated with
the two parties, their roles in executing derivatives trades
and the products traded by the parties. Each individual
derivative transaction is termed a ‘‘Transaction’’, and the
economic terms which are specific to that transaction are
documented in a Confirmation. In a derivative which is
related to a secured lending transaction, there will generally only be a small number of Transactions entered into
under the umbrella created by the Master Agreement and
the Schedule (such as an interest rate swap and/or cap
and/or a currency swap). By contrast, a large number of
Transactions may be entered into under the umbrella of a
Master Agreement and Schedule involving a hedge fund
and its trading counterparty.
(c) Credit Support Annex (‘‘CSA’’)—like the Schedule
and each Confirmation, the CSA supplements the Master
Agreement and Schedule and is a document produced by
ISDA that is designed to be customised by counterparties
to accommodate the parties’ respective credit risks. The
CSA states the parties’ duties to provide or lodge collateral
(via an outright transfer of title in the case of an English
law CSA and via the grant of a security interest in a New
York law CSA) to the other party to support the payment
obligations of the parties under the various Transactions
entered into under the umbrella of the Master Agreement
and Schedule. It further specifies provisions relating to the
return of such collateral, the type of collateral that may be
lodged and amount of credit given for each type of collateral and includes other rights, remedies and covenants
with respect to the collateral as well as its custody. In a
standard derivative transaction, the CSA provides that as
one party moves ‘‘out of the money’’ on a Transaction it is
obliged to provide collateral to the other to support its
potential payment obligations were that Transaction to be
terminated. If that party were to move further ‘‘out of the
money’’ on that Transaction, additional collateral is
obliged to be provided; if that party were to move ‘‘in the
money’’ or less ‘‘out of the money’’ there is a mechanism
for all, or a proportion of, the collateral provided to be
released. In a secured lending context, the CSA is often
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redundant as the hedge counterparty will either be the
lender itself or will be included as a finance party or a
secured party under the underlying loan documents, and
thereby have an interest in the security package granted by
the borrower under these underlying loan documents. In
other words, obligations owing to the hedge counterparty
will be secured and the back up provided by the CSA is
not necessary. For this reason, the provisions and mechanics of the CSA will not be examined here.
(d) Confirmations and Definitions—as mentioned above,
whilst the Schedule and Master Agreement provide a
framework for multiple derivatives transactions between
the parties thereto, the terms of a specific derivative transaction (a ‘‘Transaction’’) will be set out in a Confirmation.
The Confirmation records the details of the Transaction
identifying, amongst other items, the derivative product,
the term of the Transaction and, importantly, the cash
flows and termination payments for the Transaction as
well as the ISDA definitions that apply to that
Transaction. In addition, the Confirmation may also
include individual modifications to the Master Agreement
not specified in the Schedule which are to apply for that
Transaction only.
ISDA has published a variety of pro forma (or short form)
Confirmations specific to particular derivatives transactions which reference and incorporate standard ISDA
definitions that are integrated by cross-reference into the
Confirmation evidencing the Transaction. ISDA has published the 1991 ISDA Definitions and its successor the
2000 ISDA Definitions (and related Annex) containing
standard definitions for a variety of Transactions which
involve fixed and floating rate swaps and currency swaps.
There are other definitions for more complex derivatives,
but in the case of interest rate swaps and currency swaps,
the parties should consider using the form of confirmation
which incorporates the 2000 ISDA Definitions. Further,
as the definitions are periodically updated, the parties
should always check to ensure they are using the current
definitions. Other short form confirmations should be
used for other derivatives transactions (such as credit derivatives or equity derivatives). A pro forma short form
Confirmation in respect of an interest rate swap entered
into in relation to a loan agreement is set out below.
The alternative approach is to use a long-form confirmation which is often intended to circumvent the need for
a Schedule and Master Agreement, being essentially a
shortened and combined version of those two documents
that incorporates the key credit, early termination and
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other terms of the Master Agreement, Schedule and CSA.
Long-form Confirmations are not as popular as shortform and will not be examined in great detail in this
Chapter.
It is important to remember that the Schedule and each
Confirmation evidencing a Transaction form part of the relevant
Master Agreement and are expressed to form a single agreement
between the parties; each Confirmation does not represent a separate
agreement between the parties. This ‘‘single agreement’’ concept is
important to the operation of the close-out netting provisions of the
Master Agreement. In practice, in a secured lending interest rate
swap, this will not be problematic as there is typically only a small
number of Transactions entered into under the umbrella of the
Master Agreement (for example a fixed-for-floating interest rate swap
and (perhaps) an interest rate cap). However, where there are multiple Transactions which are the subject of the Master Agreement,
the close-out netting provisions are of more importance. In such a
situation, on the insolvency of a party and the termination of all
Transactions, it will be necessary to distil amounts owing from one
party to the other and vice versa to a single net amount. If the
Confirmation is in respect of a Transaction which is linked to an
underlying obligation (such as a loan from lender to borrower), it is
vital that the economic terms set out in the Confirmation match
those of the underlying obligation.
Finally, before turning to the actual terms of the ISDA documentation it is worth mentioning that ISDA also produces useful User
Guides alongside various manuals on the detail of the ISDA documentation and useful commentary on navigating and negotiating
such documentation and these are always useful starting points for
parties getting to grips with interest rate swaps and other derivatives.
Provisions of the Master Agreement and the Schedule
This section involves a discussion of certain key provisions of the
Master Agreement and terms which often feature in the Schedule in
the order set out in the actual ISDA Master Agreement. Some of the
terms of the Master Agreement will be familiar to those that have
knowledge of term loan agreements in that it contains some of the
boilerplate provisions, representations and covenants and events of
default often seen in loan agreements. However, a crucial difference
is that the Master Agreement contains the concept of reciprocity,
with clauses applying to both parties. Where relevant, differences
between the 1992 Master Agreement (Multicurrency—Cross Border)
and the 2002 Master Agreement are highlighted.
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Recital, Heading and Date
The names and identities of the parties to the Master Agreement and
Schedule should be specified in the recital and headings of the
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Master Agreement and the Schedule. Importantly, the identity of the
parties will often affect the availability of set-off and netting and thus
where parties are not ‘‘ordinary’’ companies or corporations, for
example pension trusts, partnerships or charities (amongst others),
care should be taken to identify exactly who the parties to the trade
are. Further, the date from which the agreement has effect should
also be specified on the first page of the Master Agreement and
Schedule (achieved by dating the Master Agreement and Schedule
‘‘as of [date]’’, allowing the parties to stipulate that the terms of the
Master Agreement and Schedule apply to Transactions already existing at the time the Master Agreement is signed. This is relevant as
Transactions are often entered into (and Confirmations in respect of
such Transactions signed) before a Master Agreement and Schedule
are finalised.
Section 1: Interpretation
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Section 1(a) provides that in the event of any conflict, the provisions
of a Confirmation prevail over the Schedule and in turn the provisions of the Schedule prevail over the Master Agreement. Section
1(c) confirms that the Master Agreement (including the Schedule)
and all Confirmations form a single agreement between the parties
thereto. As mentioned above, this ensures that individual
Confirmations do not constitute separate and distinct agreements
between the parties which is helpful to the effectiveness of the closeout netting provisions and also attempts to prevent an administrator
appointed in respect of a party cherry-picking profitable Transactions
and disclaiming un-profitable Transactions.
Section 2: Obligations
K–010
K/14
Section 2(a) confirms that each confirmation sets out the specific
terms of each Transaction and when and how payments in respect of
such Transaction will be paid. Payments are required to be made ‘‘in
freely transferable funds (not subject to any exchange controls) and
in a manner customary for payments in the required currency’’; if
delivery is required then the delivery is to be made on the due date
‘‘in the manner customary for the relevant obligation’’ (s.2(a)(ii)).
Section 2(a)(iii) makes it clear that payment and delivery obligations
are subject to no Event of Default or Potential Event of Default (see
below) having occurred and which is continuing and that no Early
Termination Date has occurred or been effectively elected or designated. Note, that whilst the continuation of an Event of Default or
Potential Event of Default allows parties to withhold delivery or payment, the simple occurrence of a Termination Event is not sufficient
to allow parties to withhold or suspend delivery or payment. The
Termination Event must have led to the declaration or election of an
Early Termination Date before delivery or payment can be withheld.
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Section 2(b) provides that either party can change its account for
payment or delivery by five Business Days notice to the other.
Section 2(c) contains the netting arrangements and provides that
payments due on the same date and in the same currency in respect
of the same Transaction will be netted. The 1992 Master Agreement
allowed the parties to broaden this by specifying in Pt 4(i) of the
Schedule that a single amount would be determined for all amounts
payable on the same date in the same currency, regardless of whether
the amounts were payable in respect of the same Transaction. The
parties can also specify a start date for such payment netting. The
netting provisions only apply to payments due on the same date and
is different from the concept of close-out netting discussed above that
applies regardless of the dates on which payment is due in respect of
a range of contracts. In the 2002 Master Agreement this concept has
been given the name ‘‘Multiple Transaction Payment Netting’’ and,
if elected, will only apply if Transactions are between the same offices
of the parties. As discussed above, where there are a series of
Transactions between the parties, on an insolvency of one party the
other party should be able to terminate all Transactions, calculate the
amounts owing by that party to the other on all Transactions and
vice versa, and net these amounts to produce a single amount payable by one party to the other. As such, the netting provisions are
important so as to reduce risk in the insolvency of one party. Netting
all payments due on the same date in the same currency under all
Transactions to produce a single payment obligation avoids the situation where X becomes insolvent and Transactions 1, 2, 3, 4 and 5
are terminated, Y is out of the money on Transactions 1, 2 and 3 and
obliged to pay to X the amount it is out of the money, Y is in the
money on Transactions 4 and 5 and has to claim in the insolvency
proceedings of X for the amount it is in the money and is unlikely to
obtain the full return of such amount, thereby suffering a ‘‘double’’
loss. A simple example is if, on a given day, Y owes X £100 and, in
return, X owes Y £150, only £50 is payable by X to Y on such date
thereby eliminating the risk that Y pays X £100 and loses £150
because X becomes insolvent before paying Y. This is known as the
‘‘Herstatt risk’’ named after the famous incident on June 26, 1974, in
which the German Herstatt bank was closed due to insolvency during German banking hours, but before the start of US banking hours.
As a result, the bank failed to make payment on the US dollar legs of
foreign exchange transactions even where it had already received the
deutschmark payments on such transactions. The netting provisions
avoid this double loss and the ‘‘Herstatt risk’’ as the payment obligations under Transactions 1, 2, 3, 4 and 5 are netted and replaced
by a single amount, which Y either pays to X or claims for in the
insolvency proceedings of X. These provisions were tested in
September 2008 with the failure of Lehman Brothers, a prevalent
hedge counterparty in the United States and Europe, resulting in trillions of sterling, euro and US dollar contracts being cancelled or set
Practical Lending. R.33: October 2008
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K–010—K–012
General Introduction
off. It is a testament to the robustness of the ISDA architecture that
at the time of writing these contracts had held their ground in the
market place and parties were achieving settlement, although disputes in these matters cannot be ruled out.
Section 2(d) deals with withholding and other taxes with the effect
that, if the payer has to deduct tax from a payment to the payee, then
it must gross that payment up to ensure the payee receives the full
amount of the payment notwithstanding the tax deduction—a familiar concept from typical term loan agreements. As a result each
party may make elective tax representations (discussed below)
regarding tax deductions. Detailed discussion on this subject is
beyond the scope of this section as the negotiations thereof depend
on the individual parties tax status and position.
Section 3: Representations
K–011
Representations are divided into two categories: general representations and tax representations. The general representations are set out
in s.3 of the 1992 Master Agreement and the 2002 Master
Agreement, are relatively ‘‘standard’’ and will be familiar to those
with knowledge of loan agreements (for example absence of litigation, non-conflict with laws, corporate status and capacity, no
material litigation, no events (or potential events) of default and so
on) and, unless modified by the Schedule, are given by both parties
to the agreement. Whilst these representations are standard, parties
should ensure that these representations are reviewed before entering
into any Master Agreement. It is worth noting that these general
representations are evergreen and are deemed to be repeated by each
party on each date the parties enter into a Transaction; thus the parties must monitor these representations to ensure continued compliance whilst the agreement is in place. According to s.5(a)(iv)
(discussed below), an Event of Default occurs if a representation
(other than a tax representation) is materially untrue.
Additional representations may be inserted into Pt 5 of the
Schedule. The scope of additional representations will be dictated by
the matters on which the relevant parties require comfort. For
example, if one party is a fund, then the other party may require
representations as to the assets under management of the fund. The
scope of such additional representations is always a matter of negotiation for the parties. Typical additional representations are that
neither party has relied on the other for investment advice in respect
of entering into a Transaction and that it is capable of assessing the
merits and risks of entering into a Transaction. Examples of these are
set out in the pro forma Schedule below.
Section 4: Agreements
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K/16
Whilst this s.4 is termed ‘‘Agreements’’, essentially this section
imposes covenants on the parties to the Master Agreement. As
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General Introduction
K–012—K–013
stated, such covenants are not dissimilar to those contained in term
loan agreements albeit much less elaborate. Section 4(a) constitutes
the parties’ obligation to provide certain information to the other at
certain points. The parties must specify in the Schedule (usually in
Pt 3) or a Confirmation any forms or documents which are to be
provided and when. It is common for delivery of authorising corporate resolutions, constitutional documents and legal opinions to be
required. Credit support documents such as security agreements,
guarantees and letters of credit will also be included in the deliverables list if relevant (and these should also be specified as ‘‘Credit
Support Documents’’, see para.K–013 below). Section 4(a)(iii) also
requires the parties to deliver certain documents to the other to
ensure that the other party can make payments under the Master
Agreement (or Credit Support Document) without any deduction or
withholding on account of any tax. This obligation has effect without
the parties having to specify the documents to be delivered in the
Schedule or Confirmation.
In addition to deliverables, s.4 imposes obligations on the parties
to the Master Agreement to maintain all necessary corporate authorisations to enable it to continue to be party to the Master Agreement
and to comply with all relevant laws which, if breached, would materially prejudice that party’s ability to perform its obligations under
the Master Agreement or any Credit Support Document. Finally,
s.4(d) and (e) impose certain undertakings regarding the payment of
tax. Again, whilst these covenants are fairly standard, the parties
should ensure that they can comply with these covenants before
entering into any Master Agreement.
Section 5: Events of Default and Termination Events
The first point to note about Events of Default and Termination
Events (as described at paras (a) and (b) below respectively) is that,
as discussed above, they apply to both parties to the Master
Agreement (i.e. they are reciprocal). However, some of these events
may be triggered by an event involving a third party. The Events of
Default in s.5(a)(v), (vi) and (vii) and the Termination Event in
s.5(b)(v) (in the 2002 Master Agreement, s.5(b)(iv) in the 1992
Master Agreement) apply to any Specified Entity, hence Pt 1(a) of
the Schedule gives the parties the option to specify any entities to be
included within the meaning of the term Specified Entity for each
such Event of Default and Termination Event. Furthermore, certain
Events of Default and Termination Events apply to Credit Support
Providers, and the meaning of Credit Support Document specified in
Pt 4(f) of the Schedule is also relevant for certain Events of Default
and Termination Events. The party whose action or inaction triggers
the Event of Default is termed the Defaulting Party and the other
party the Non-Defaulting Party; the party or parties who are affected
by a Termination Event (including an Additional Termination Event)
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General Introduction
are termed the Affected Parties and any party not affected by a
Termination Event is termed a Non-Affected Party. Generally, upon
the occurrence of an Event of Default or Termination Event the
Non-Defaulting Party or the Non-Affected Party (as appropriate)
may terminate. The Events of Default are those that one would normally expect to see in a term loan agreement, such as non-payment,
material misrepresentation, defaults and insolvency.
(a) Events of Default—these will be considered in turn:
(i)
Section 5(a)(i) applies to the failure of a party to
make any payment or delivery when due. In the
2002 Master Agreement a grace period of one
Local Business Day after notice of the failure to pay
has been given—a notice must be given to protect
against mistakes—and one Local Delivery Day after
notice of the failure to deliver has been given is permitted. This is a reduction from the three Local
Business Day grace period for failure to pay and
failure to deliver in the 1992 Master Agreement.
(ii)
Section 5(a)(ii)(1) applies to any failure to comply
with any agreement or obligation under the Master
Agreement after the expiry of a 30 day grace period
after notice of the failure to comply has been given
except for repudiations. Section 5(a)(ii)(2) is a new
clause added to the 2002 Master Agreement and
adds an Event of Default if any party repudiates or
challenges the validity of the 2002 Master
Agreement (including the Schedule), any
Confirmation or any Transaction evidenced by a
Confirmation. This means that a party may have a
right of early termination before a party has physically failed to perform, if that party has clearly indicated an intention not to perform its obligations.
This is broader than the corresponding provision of
the 1992 Master Agreement which gave a right to
terminate Transactions in the event of a repudiation of a Specified Transaction or a Credit Support
Document only.
(iii)
Section 5(a)(iii) includes comparable provisions to
s.5(a)(ii) in relation to a Credit Support Document
provided by or in respect of a party and specified as
such in the Schedule. An Event of Default under
this section occurs if: (A) a party or a Credit
Support Provider breaches a Credit Support
Document and such breach is not cured within any
applicable grace period; (B) the Credit Support
Document or security interest granted therein
expires or fails before all obligations under related
Transactions are satisfied (note that the ‘‘security
K/18
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General Introduction
(iv)
(v)
K–013
interest’’ aspect of this Section was new to the 2002
Master Agreement); or (C) a party or a Credit
Support Provider repudiates a Credit Support
Document.
Section 5(a)(iv) provides that an Event of Default
is triggered if representations (other than payer and
payee tax representations) set out in a Master
Agreement or Credit Support Document are
breached by either a party or a Credit Support
Provider.
Section 5(a)(v) is a type of cross-default provision
and applies to certain breaches of any ‘‘Specified
Transaction’’ by a party, any Credit Support
Provider and any Specified Entity of a party.
‘‘Specified Transaction’’ is defined very broadly
and covers a wide range of finance-type transactions between one party (or any Credit Support
Provider or any Specified Entity of it) and the other
party (or any Credit Support Provider or any
Specified Entity of it), for example swaps, options,
caps and floors plus any transaction which is ‘‘similar’’ to any such transaction. The 2002 Master
Agreement expands the definition substantially
from that used in the 1992 Master Agreement.
Whilst on the face of it this seems like a broad
Event of Default, it should be remembered that this
provision does not apply to any transactions
between a party (or any Credit Support Provider or
any Specified Entity of it) and any third party or to
any Transactions under the Master Agreement
between the parties.
Three scenarios trigger an Event of Default under
s.5(a)(v) of the 1992 Master Agreement: (A) a
default which results in the liquidation, acceleration
or early termination of that Transaction; (B) a
default in making any payment or delivery due on
the final payment date or any early termination
date of any Specified Transaction after giving effect
to any applicable grace period. Note that in relation
to (B), as set out above, the 2002 Master
Agreement reduces the grace period which is
deemed to feature in the documentation constituting the Specified Transaction from three Local
Business Days to one Local Business Day. The
2002 Master Agreement also seperates failure to
pay from failure to deliver, with a failure to deliver
having to result in the acceleration or early termination of all (not some) transactions under the docu-
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General Introduction
(vi)
K/20
mentation constituting the Special Transaction
before an Event of Default due to a failure to deliver is triggered; and (C) a repudiation of a
Specified Transaction in whole or in part.
In addition to the amendment mentioned in the
paragraph above, the 2002 Master Agreement
expands these scenarios by adding reference to
credit support arrangements relating to a Specified
Transaction. Therefore, under the 2002 Master
Agreement such an Event of Default is not restricted to a default under a Specified Transaction—it
also includes a default under a credit support
arrangement entered into in respect of a Specified
Transaction.
The application of such an Event of Default can be
broadened or narrowed by amending what is
included within the definition of ‘‘Specified
Transaction’’ and the entities included within the
definition of ‘‘Specified Entity’’ and ‘‘Credit
Support Provider’’.
Section 5(a)(vi) will only apply to a party (and any
Specified Entity and Credit Support Provider of it)
if it is specified as applying in Pt 1(c) of the
Schedule. This cross-default provision is triggered
by the occurrence of the following under any
agreement relating to any obligation in respect of
borrowed
money
(defined
as
‘‘Specified
Indebtedness’’): (A) a default or similar event
under such agreement which has resulted in the
Specified Indebtedness becoming, or becoming
capable of being declared, due and payable; or (B)
a default in making any payment on its due date
under such agreement after giving effect to any
applicable grace period.
If this section is specified as applying it should also
include a ‘‘Threshold Amount’’, and the Event of
Default will only be triggered if the default results
in the Threshold Amount being exceeded. In the
1992 Master Agreement, point (A) and point (B)
were viewed as separate when it came to determining whether the Threshold Amount had been
exceeded. The 2002 Master Agreement modifies
this and the two limbs are aggregated—the parties
can add the defaults under (A) and (B) to determine whether the Threshold Amount has been
reached.
Again the scope of this potentially very broad provision can be varied via the Schedule. First, the size
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General Introduction
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of the Threshold Amount will have a major impact
on the scope of this Event of Default: the higher
the Threshold Amount the narrower the application. When setting a Threshold Amount the parties should ensure that the stated amount includes
the equivalent amount in any other currency. To
avoid any doubt, if a party wants this Event of
Default to apply irrespective of the amount
involved it should make it clear that the Threshold
Amount with respect to a party is zero. Secondly,
this Event of Default can be transformed from a
‘‘cross-default’’ provision to a ‘‘cross-acceleration’’
provision by deleting ‘‘or becoming capable at such
time of being declared’’ from (A). Parties may also
wish to include a grace period before its failure to
pay triggers an Event of Default which should mirror any payment grace periods contained in the
underlying loan documents. This is important
where the hedging relates to a loan agreement to
avoid a ‘‘false’’ Event of Default under the hedging
documents. If no grace period is incorporated into
the hedging documents (or this does not match the
grace period in the loan documents) there could be
an Event of Default under the hedging documents
but not under the loan documents. However, the
cross-default provisions of the loan documents will
almost certainly mean the Event of Default under
the hedging documents triggers an event of default
under the underlying loan documents, with the
result that there will be an event of default under
the underlying loan documents where there would
otherwise not be. Finally, the scope of the definitions of ‘‘Specified Entity’’ and ‘‘Specified
Indebtedness’’ can be amended to restrict or
broaden the application of this Event of Default,
for example by expanding to include derivative
transactions with third parties, or narrowing to
exclude trade borrowings incurred in the ordinary
course of a party’s business.
(vii)
Section 5(a)(vii) is triggered if a party (or any
Credit Support Provider or any Specified Entity of
it) is subject to any bankruptcy or insolvency proceedings (or any analogous proceedings in any relevant jurisdiction). Whereas the 1992 Master
Agreement allowed a 30 day grace period before an
Event of Default was triggered, the 2002 Master
Agreement differentiates between proceedings
brought by the principal regulator or other primary
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K–014
K/22
General Introduction
insolvency official of a party (or any Credit Support
Provider or any Specified Entity of it) and proceedings brought by a third party. Proceedings brought
by the latter are subject to a 15 day grace period;
proceedings brought by the former immediately
trigger an Event of Default. Reducing the grace
period from 30 days to 15 days can be seen as a
compromise between needing to protect the party
which is subject to the proceedings (for example if
these are brought frivolously or vexatiously) and
the other party needing to act quickly.
Whilst the Master Agreement is drafted to catch
proceedings in jurisdictions other than England
and the United States with an analogous effect, if
parties know that a specific jurisdiction will be
involved (e.g. due to the place of incorporation of a
Specified Entity or Credit Support Provider) they
may wish to specifically refer to insolvency proceedings peculiar to such jurisdiction.
(viii) Section 5(a)(viii) applies to the situation where a
party (or its Credit Support Provider but not a
Specified Entity of it) merges with, or transfers the
majority of its assets to, another entity and such
party either (A) fails to assume the obligations of
that party under a Master Agreement or the obligations of a party or a Credit Support Provider
under a Credit Support Document; or (B) the benefits of a Credit Support Document cease to be
available after the completion of the relevant
Transaction.
(b) Termination Events—these will be considered in turn:
(i)
Under s.5(b)(i) a Termination Event is triggered if,
following the entry into a Transaction by the parties and other than due to action taken by a party
or its Credit Support Provider or failure by that
party to comply with its obligations to maintain
authorisations under s.4(b) (see above)) it becomes
unlawful: (A) for the office through which that
party makes or receives payments or deliveries
regarding such Transaction to make or receive the
necessary payments or deliveries or to comply with
any of the material provisions of the Master
Agreement with respect to such Transaction; or (B)
for a party or its Credit Support Provider to perform or comply with its obligations under any
Credit Support Document.
In the 1992 Master Agreement there is an obligation on the party affected by the events above
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(the ‘‘Affected Party’’) to use reasonable efforts to
transfer any Transaction affected by such events to
another party in order to avoid this Termination
Event. This obligation is not repeated in the 2002
Master Agreement.
(ii)
Section 5(b)(ii) of the 2002 Master Agreement
inserts a new Termination Event for force majeure,
which covers certain events which would not be
included within the Termination Event for illegality
at s.5(b)(i). This Termination Event is triggered if,
due to a force majeure reason or an act of state
which occurs after a Transaction is entered into:
(A) if becomes unlawful for the office through
which that party makes or receives payments or
deliveries regarding such Transaction to make or
receive the necessary payments or deliveries or to
comply with any of the material provisions of the
Master Agreement with respect to such
Transaction or it becomes impossible or impractical for such office to perform or comply; or (B) a
party or its Credit Support Provider is unable to
perform or comply with its obligations under a
Credit Support Document relating to that
Transaction or it becomes impossible or impractical for such party or Credit Support Provider to so
perform or comply.
It is important to note that, for such event or act of
state to constitute force majeure and trigger this
Termination Event, the relevant event or act of
state must be beyond the control of the office, party
or Credit Support Provider and the relevant office,
party or Credit Support Provider must have been
unable to overcome the relevant problem after
using all reasonable efforts to do so.
In addition to the conditions mentioned in (i) and
(ii) above, the illegality or force majeure
Termination Events will only be triggered after giving effect to any provisions set out in a
Confirmation or elsewhere in the Master
Agreement.
Both the illegality and force majeure Termination
Events are anticipatory—they are triggered if it
would be unlawful to (for example) make a payment on a certain day if, hypothetically, the payment was required to be made on that day even if,
in fact, no such payment is actually required on
that day.
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General Introduction
(iii)
(iv)
(v)
K/24
Following the occurrence of an illegality event or a
force majeure event a ‘‘waiting period’’ of three
Local Business Days for illegality or eight Local
Business Days for force majeure applies from the
date that the relevant event occurs during which
performance is suspended. Payments and deliveries
under any Transaction affected by an illegality or
force majeure event are delayed until the first Local
Business Day (or Local Delivery Day) following the
expiry of the relevant waiting period or the date
that the illegality or force majeure event ceases to
exist if earlier.
Section 5(b)(iii) and (iv) of the 2002 Master
Agreement (s.5(b)(ii) and (iii) of the 1992 Master
Agreement) are Termination Events relating to certain taxation matters. Section 5(b)(iii) of the 2002
Master Agreement (s.5(b)(ii) in the 1992 Master
Agreement) is referred to as a ‘‘Tax Event’’ and is
triggered if, due to a change in tax laws or the
action of any tax authority, a party is either obliged
to gross-up any payments to the other or make a
deduction in respect of tax from any payment
received by it. Section 5(b)(iv) of the 2002 Master
Agreement (s.5(b)(iii) in the 1992 Master
Agreement) is referred to as a ‘‘Tax Event Upon
Merger’’ and is triggered if, due to the merger or
transfer of one party with or to another, a party is
either obliged to gross-up any payments to the
other or make a deduction in respect of tax from
any payment received by it.
Section 5(b)(v) of the 2002 Master Agreement
(s.5(b)(iv) of the 1992 Master Agreement) applies
if so specified in the Pt 1(d) of the Schedule and
has the effect that a Termination Event is triggered
if (essentially) there is a change of ownership or a
merger of one party (or a Credit Support Provider
or Specified Entity of it) and the creditworthiness
of the resulting entity is ‘‘materially weaker’’ than
that of such party, Credit Support Provider or
Specified Entity. The parties may seek to clarify the
meaning of ‘‘materially weaker’’ in the Schedule by
reference to rating downgrades of the resulting
entity itself or its debt.
Section 5(b)(vi) of the 2002 Master Agreement
(s.5(b)(v) of the 1992 Master Agreement) allows the
parties to specify Additional Termination Events in
Pt 1(g) of the Schedule and the Affected Party in
respect of such Additional Termination Events.
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Unless specified in the Schedule, there is a presumption that Additional Termination Events will apply
to all Transactions and that the Non-Affected Party
will have the right to terminate. Examples of
Additional Termination Events are set out in Pt 1(g)
of the example Schedule below. In the context of
hedging arrangements which relate to loan agreements, a broad range of Additional Termination
Events can be seen as not especially necessary: the
hedge counterparty is protected by the events of
default in the loan agreement which will apply to the
hedging documents by virtue of their classification
as a ‘‘Finance Document’’ in the underlying loan
agreement and the cross default provisions of the
Master Agreement. In addition, the hedge counterparty would usually be included as a ‘‘Finance
Party’’ or ‘‘Secured Party’’ in the underlying loan
documents and have an interest in the security package in respect of the loan so that it has security for
payments owing to it. This is especially so given that
the hedge counterparty is often part of the lender’s
organisation. In other derivative arrangements (for
example those entered into to provide trading
arrangements for hedge funds), the hedge counterparty does not have these protections and Additional
Termination Events are ‘‘more’’ necessary.
In a secured lending context, borrowers should ensure that they
review the proposed Events of Default and Termination Events to
ensure that these do not detract from the position they have negotiated in the underlying loan or finance documents. If these do not
dovetail and the hedging documents are broader than the events of
default contained in the loan documents, there is a risk to the borrower that an Event of Default is triggered under the Master
Agreement which, of itself, would not constitute an event of default
under the loan documents. However, the Event of Default under the
Master Agreement will trigger the cross-default provisions of the loan
documents and create an event of default under the loan documents
which would otherwise not have occurred.
Section 6: Early Termination; Close-out Netting
(a) Procedure for termination
The procedure for termination following the occurrence of
an Event of Default or a Termination Event is set out in
Section 6 of the Master Agreement.
Once an Event of Default has occurred and is continuing,
the Non-Defaulting Party may specify an Early
Termination Date for all Transactions then in place. In the
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K–015
General Introduction
event that the parties specify that Automatic Early
Termination under s.6(a) applies in Pt 1(e) of the
Schedule, the occurrence of certain of the insolvency
events set out in s.5(a)(vii) (see above) will result in all
(note not some) outstanding Transactions being terminated automatically, no notice is required.
In the event that a Termination Event (other than force
majeure) occurs, an Affected Party is obliged to notify the
Non-Affected Party of such Termination Event. If a
Termination Event due to force majeure occurs, each
party must use reasonable efforts to notify the other party
of the event (an absolute obligation to notify would be
inappropriate here as the force majeure event may render
one party physically unable to notify the other). The party
permitted to designate an Early Termination Date is set
out in s.6(b)(iv) and varies according to the Termination
Event which has occurred: the basic position in the case of
an illegality or force majeure is that both parties have the
right to designate an Early Termination Date in respect of
all Affected Transactions once the applicable waiting
period has expired; in the event of a Tax Event Upon
Merger the Burdened Party (i.e. the party who is obliged
to pay the additional tax following the merger or transfer
of a party) has the right to designate an Early Termination
Date in respect of all Affected Transactions; in the event of
an Additional Termination Event where there are two
Affected Parties, either Affected Party has the right to designate an Early Termination Date in respect of all Affected
Transactions; and in the event of a Credit Event Upon
Merger or an Additional Termination Event and there is
only one Affected Party, the party which is not the
Affected Party may designate an Early Termination Date
in respect of all Affected Transactions. In terms of termination rights, provided the Termination Event is continuing, the general rule is that any or all Transactions affected
by the Termination Event, such Transactions being
Affected Transactions, (or all Transactions in the event
that the Credit Event Upon Merger or any Additional
Termination Events are triggered) may be terminated by
the designation of an Early Termination Date by not more
that 20 days’ notice to the other party. In the event of an
illegality or force majeure which is outstanding following
the expiry of any relevant waiting period, all or any
Affected Transactions may be terminated.
Once designated, the Early Termination Date will occur
on the date specified regardless of whether the
Termination Event or Event of Default is continuing. If
the Early Termination Date has been designated following
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K–015
a Credit Event Upon Merger, Additional Termination
Event (presumably, see above) or an Event of Default, all
Transactions will be terminated. If the Early Termination
Date has been designated following an illegality, force
majeure, Tax Event or Tax Event Upon Merger, only
Transactions affected by such event will be terminated.
Transactions which are terminated in this way are termed
‘‘Terminated Transactions’’. Section 6(c)(ii) provides that
neither party is obliged to make payments or deliveries in
respect of payments or deliveries which are scheduled to
be made after the Early Termination Date. Instead, payment and delivery obligations are replaced by the amount
calculated as being payable pursuant to s.6(e) (termed the
Early Termination Amount in the 2002 Master
Agreement). See para.K–016 below for a discussion of the
calculation of the Early Termination Amount.
Each party is to make the calculations required of it pursuant to s.6(e) on or as soon as reasonably practicable
after the occurrence of an Early Termination Date. Each
party must give the other a reasonably detailed statement
of its calculations in determining the Early Termination
Amount and the account to which the Early Termination
Amount should be paid. If the Early Termination Amount
is payable following an Event of Default, it is payable on
the day that notice of the amount payable is effective pursuant to s.6(d)(ii)(1); if the Early Termination Amount is
payable following a Termination Event, it is payable two
Local Business Days after the date that notice of the
amount payable is effective.
The method of calculating payments owed followed an
Early Termination Date is significantly different in the
2002 Master Agreement compared to the 1992 Master
Agreement. The 1992 Master Agreement provided two
methods of measuring payment: Market Quotation—
based on an assessment of value in the open market; and
Loss—the reasonable belief of the amount payable by the
party making the assessment and used when Market
Quotation could not be determined or would not produce
a commercially reasonable result. ‘‘Market Quotation’’ was
the default position and was the most popular method
chosen by market participants. The 2002 Master
Agreement replaces this with a single calculation termed
the ‘‘Close-out Amount’’, and this involves two limbs. The
first paragraph of this calculation provides that the party
making the calculation must determine the losses or costs
incurred, or gains received, in replacing the economic
equivalent of the material terms of the Terminated
Transaction(s) (the ‘‘economic equivalent’’ wording is
Practical Lending. R.33: October 2008
K/27
K–015—K–016
K–016
K/28
General Introduction
similar to the Market Quotation method of the 1992
Master Agreement). The second paragraph requires the
party making the determination to use commercially
reasonable procedures and to act in good faith when determining the Close-out Amount and that a Close-out
Amount will be determined for an individual Terminated
Transaction or a group of Terminated Transactions, thus
enabling the party making the determination to base their
calculation on particular aspects of a Transaction or
Transactions. Finally, the second paragraph states that the
determination of the Close-out Amount will be made as of
the Early Termination Date unless such a determination
would be commercially unreasonable, in which case the
determination will be made as of such date following the
Early Termination Date which would be commercially
reasonable. There are various types of information which
the party making the determination may consider (for
example quotes from third parties and market data), and
these are listed in the third to fifth paragraphs of the
‘‘Close-out Amount’’ definition.
The 1992 Master Agreement set out two payment
methods: the First Method whereby if a single net amount
was owing to the Defaulting Party by the Non-Defaulting
Party, the Non-Defaulting Party would not be obliged to
pay such amount; and the Second Method which provided
for two-way payments (the Non-Defaulting Party would
be obliged to pay any net amount owing to the Defaulting
Party). The Second Method was overwhelmingly more
popular and this is the sole payment method included in
the 2002 Master Agreement.
(b) Calculation of payments on early termination—
Under the 2002 Master Agreement, the Early Termination
Amount includes: (A) payments in respect of obligations
which were payable or deliverable prior to the Early
Termination Date but which were not satisfied prior to the
Early Termination Date; (B) payments in respect of obligations which would have been payable or deliverable if all
conditions precedent to payment or delivery had been satisfied or if the Early Termination Date had not been designated; and (C) payments for the future value of the
Terminated Transactions. (A) and (B) are calculated
under the ‘‘Unpaid Amount’’ definition; (C) is calculated
under the ‘‘Close-out Amount’’ definition.
Following an Event of Default, the Early Termination
Amount is calculated as follows: the Close-out Amount for
each Terminated Transaction (or group of Terminated
Transactions) is calculated by the Non-Defaulting Party
and the aggregate calculated (these may be positive or
Practical Lending. R.33: October 2008
General Introduction
K–016
negative numbers). The aggregate of the Close-out
Amounts is then added to the Unpaid Amounts owed to
the Non-Defaulting Party. The Unpaid Amounts owed to
the Defaulting Party are then subtracted from this number. If a positive number results, this is paid by the
Defaulting Party to the Non-Defaulting Party; if a negative
number results, this is paid by the Non-Defaulting Party
to the Defaulting Party.
Following a Termination Event where there is a single
Affected Party, the Early Termination Amount is determined as if an Event of Default had occurred, save that
the Non-Affected Party makes the determination rather
than the Non-Defaulting Party.
Following a Termination Event where there are two
Affected Parties, each party makes its determination of the
Close-out Amount for each Terminated Transaction (or
group of Terminated Transactions), and an amount equal
to 50 per cent of the difference between the higher and
lower figures established. This amount is added to the
Unpaid Amounts of the party which calculated the higher
net amount and Unpaid Amounts owing to the other party
subtracted from this total. If a positive number results, the
party with the higher net amount pays that amount to the
other party; if a negative number results, the party with
the higher net amount pays that amount to the other
party.
(c) Currency of Termination Payments
Payments on early termination are made in the
Termination Currency specified in Pt 1(f) of the Schedule.
The fallback Termination Currency under the 2002
Master Agreement is Euros for an English law governed
Master Agreement and US Dollars for a New York law
governed Master Agreement. The fallback under the 1992
Master Agreement was US Dollars only.
(d) Set-off
Section 6(f) of the 2002 Master Agreement is a set-off
provision which was not included in the 1992 Master
Agreement. This set-off provision is of crucial importance
in an insolvency context following termination—in the
absence of such a provision the Non-Defaulting Party
could be obliged to make payment to the insolvent
Defaulting Party but have a very low chance of obtaining
payment of amounts owed to it by the Defaulting Party.
The new s.6(f) ensures that, following an Event of
Default, a Credit Event Upon Merger or other
Termination Event where all Transactions are Affected
Transactions and there is a sole Affected Party, any Early
Termination Amount payable by one party will be set off
Practical Lending. R.33: October 2008
K/29
K–016—K–019
General Introduction
against any other amount payable to that party, whether
such other amounts arose under a Master Agreement or
otherwise. This set-off takes place at the option of the
Non-Defaulting Party or the Non-Affected Party.
Whilst such a set-off provision is not included within the
1992 Master Agreement, it would be standard for the parties to incorporate such a provision in the Schedule thereto
and an example provision is included in the pro forma
Schedule set out below.
Section 7: Transfer
K–017
Section 7, in attempting to protect the netting provisions, discussed
above, following an assignment of rights contains a general prohibition by either party on the transfer of its rights and obligations under
a Master Agreement without the written consent of the other. There
are two exceptions to this where: (A) the transfer results from a
merger of one party with another entity; or (B) the transfer is by a
Non-Defaulting Party of its interest in any Early Termination
Amount payable to it. It should be noted that transfer includes the
granting of a security interest by a party over its interest in a Master
Agreement, so parties should ensure that necessary consents are
obtained before any such security interest is granted.
Section 8: Contractual Currency
K–018
All payments under a Master Agreement are to be made in the currency specified as the contractual currency by the parties.
Section 9: Miscellaneous
K–019
K/30
Section 9 contains various miscellaneous provisions, the most
important of which are discussed below.
Section 9(b) provides that amendments, modifications and waivers
must be in writing and signed by both parties to be effective. The
2002 Master Agreement inserted a definition of ‘‘electronic messages’’ to make it clear that email correspondence is not sufficient to
comply with the requirements of this section.
Section 9(c) makes it clear that the parties’ obligations under the
Master Agreement do not terminate simply on the termination of a
Transaction, although clearly if a Transaction is terminated the parties’ obligations under that Transaction cease.
Section 9(e)(i) provides that the parties may execute and deliver a
Master Agreement and any amendments thereto in counterparts,
including by fax and electronic messaging system (which, as above,
does not include email). Section 9(e)(ii) states that a Confirmation in
respect of a Transaction will be entered into as soon as practicable
after the parties agree on the terms of such Transaction. This recognises that parties will often agree a Transaction via telephone and
Practical Lending. R.33: October 2008
General Introduction
K–019—K–020
makes it clear that the parties are bound from the moment that this
agreement is reached, even if it has not been formally documented at
that time.
Section 9(h) of the 2002 Master Agreement is a new section which
updates the provisions regarding interest and compensation set out in
ss.2(e) and 6(d)(ii) of the 1992 Master Agreement. Section
9(h)(i)(1) of the 2002 Master Agreement replaces s.2(e) of the 1992
Master Agreement, and provides that in the event that a party
breaches a payment obligation, it is obliged to pay interest on the
overdue amount at the default rate on demand for the period from
the due date of the payment to the date of the actual payment. The
default rate is specified in s.14 of the Master Agreement as the cost
of funds of the party entitled to the payment plus 1 per cent. Section
9(h)(i)(2) provides that a party which breaches a delivery obligation,
will on demand: (A) compensate the other party as set out in the relevant Confirmation or elsewhere in the Master Agreement; and (B)
pay interest on the fair market value of the of the property due to be
delivered. As per payment obligations, interest is to be paid for the
period from the prescribed date for delivery to the date of actual
delivery at the default rate.
Section 9(h)(i)(3) of the 2002 Master Agreement deals with payments which have been deferred. Any deferring party must pay
interest on payments which have been deferred because a condition
precedent has not been met from the date the payment should have
been made to the date of actual payment at the rate calculated under
para.(a) of the Applicable Default Rate definition, being a rate equal
to that offered to the payer by a bank in the interbank lending markets in the relevant currency. Any payments deferred during a waiting
period following an illegality or force majeure event incur interest
from the date the payment should have been made but for the deferral pursuant to s.5(d) (see above) until the date the illegality or force
majeure event ceases to exist or the date an Event of Default or
Potential Event of Default occurs with respect to that party at the
rate calculated under para.(c) of the Applicable Default Rate definition, being a rate equal to the mean average of the rate equal to
that offered to the payer by a bank in the interbank lending markets
in the relevant currency and the rate at which the payee would be
charged were it to have to fund the relevant payment.
Interest on Unpaid Amounts and Early Termination Amounts is
dealt with in s.9(h)(ii). Interest accrues on the amount of a payment
obligation from the date that the payment was required to be made
to the Early Termination Date at the Applicable Close-out Rate. The
Applicable Close-out Rate varies according to the classification of the
party who has not made the required payment—amounts payable by
a Defaulting Party accrue interest at the Default Rate (see above);
obligations payable by a Non-Defaulting Party are deliverable at the
Non-default Rate or the rate available to such Non-Defaulting Party
in the interbank market for deposits in the relevant currency.
Practical Lending. R.33: October 2008
K–020
K/31
K–020—K–021
General Introduction
Obligations deferred due to a force majeure or illegality incur interest
at a rate offered by prime banks to other prime banks in the interbank market for the currency in question. All other cases after a
Termination Event, the rate of interest is a rate equal to the mean
average of the rate equal to that offered to the payer by a bank in the
interbank lending markets in the relevant currency and the rate at
which the payee would be charged were it to have to fund the relevant payment.
Section 9(h)(ii)(2) of the 2002 Master Agreement provides that
interest is to be paid on the relevant Early Termination Amount for
the period from the Early Termination Date to the date of actual payment at either: (A) if the Non-Defaulting Party owes the Early
Termination Amount, the Non-default Rate; or (B) if the Defaulting
Party owes the Early Termination Amount, the Default Rate. If an
Affected Party or a Non-Affected Party owes the Early Termination
Amount, the interest rate is a rate equal to the mean average of the
rate equal to that offered to the payer by a bank in the interbank
lending markets in the relevant currency and the rate at which the
payee would be charged were it to have to fund the relevant payment.
Section 10: Offices and multibranch parties
K–021
K/32
Section 10 allows the parties to elect recourse to a head office notwithstanding that the transaction may have been entered into
through a branch and not the head office. It is not common, given
the link between the lender and the hedge counterparty in many
interest rate swaps, for the hedge counterparty to contract other than
through its head office or to request the option of multibranch. In
practice a head office is normally responsible for its branch, but there
are instances where a head office can be relieved of responsibility and
thus parties can by election, specify branches through which transactions may be entered into. If this is done, according to s.10(b)
transactions may not be carried out through any other branches.
Where a hedge counterparty is incorporated overseas and provides
the interest rate swap through its branch office the standard s.10(a)
representation should be requested and the branch office should be
designated as such under the multibranch provisions. These provisions become important when considering the availability of netting
and were closely scrutinised during the September 2008 US bankruptcy and UK administration of various Lehman Brothers entities.
A branch may be subject to insolvency or bankruptcy proceedings
governed by local law which may include contradictory rights of setoff, local collateral rights rules and stays on contract cancellations or
terminations. These provisions may further have tax implications on
the parties and thus each party should be aware of the location of the
other parties such that a situation does not arise where local branch
assets are only available to local creditors and not foreign creditors,
Practical Lending. R.33: October 2008
General Introduction
K–021—K–026
for example as there is in the US state of New York where local
branch assets are ring-fenced for the benefit of local branch creditors.
Section 11: Expenses
Section 11 requires a Defaulting Party to compensate the reasonable
out-of-pocket expenses of a Non-Defaulting Party when enforcing
and/or protecting its rights under a Master Agreement or any Credit
Support Document.
K–022
Section 12: Notice
Section 12(a) sets out the methods of notice permitted under a
Master Agreement. The 2002 Master Agreement permits e-mail
delivery, although it should be remembered that ss.5 and 6 notices
may not be given by email.
K–023
Section 13: Governing Law and Jurisdiction
Section 13 details the governing law and jurisdiction provisions. The
governing law for the Master Agreement must be specified in Pt 4(h)
of the Schedule, and the parties have the choice of English law or
New York. Although it would be usual for the governing law of the
interest rate swap to mirror the governing law of the underlying debt
instrument, it is beyond the scope of this Chapter to consider the
relative merits of English law or New York law, and parties should
seek specialist advice before making such determination.
K–024
Signature Block
The name and title of signatories should be inserted in the signature
block, together with the date of signing by each party. Parties should
make it clear that if the parties intend the Master Agreement to be
effective from a particular date that this is clearly specified, as this
may not be the same as the date that the Master Agreement is signed.
K–025
Confirmations
As discussed above, Confirmations detail the commercial and economic terms in relation to a particular Transaction and form part of
the Master Agreement. Confirmations can be either short-form
(based on the pro-formas produced by ISDA) and need to be read in
conjunction with a Master Agreement and Schedule or long-form
(which incorporate a Master Agreement and Schedule).
A Confirmation will generally be prepared by the hedge counterparty and then sent to the borrower for their approval and agreement, which the borrower provides by signing and returning the
Confirmation. The introductory paragraph to the Confirmation
should confirm any ISDA definitions which are being incorporated
into the Confirmation (in the case of interest rate swaps the 2000
Practical Lending. R.33: October 2008
K–026
K/33
K–026—K–027
General Introduction
ISDA Definitions should be incorporated) and that the Confirmation
relates to and that it is governed by the Master Agreement between
the hedge counterparty and the borrower. In the event that a Master
Agreement has not been entered into when the Confirmation is
signed, the parties can confirm in this introductory paragraph that
they intend to enter into a Master Agreement in relation to the subject Confirmation and that, when finalised, this Master Agreement
will govern the terms of the Confirmation at hand. However, useful
discussion can be had by being more specific, so the provisions of a
short form Confirmation in relation to an interest rate swap and an
interest rate cap are mentioned below. A pro forma Confirmation in
relation to an interest rate swap is also set out below.
Other than this, there is limited scope for a discussion of the provisions of Confirmations in a general sense as Confirmations are, of
course, Transaction specific. There should be economic symmetry
between the Confirmation and the underlying debt instrument to
which the interest rate swap relates. Clearly the form of Confirmation
will vary according to the Transaction which is being entered into (a
Confirmation in relation to an interest rate swap will differ from a
Confirmation in relation to a currency swap), although useful discussion can be had by looking at specific types of Transactions.
Interest rate swap
K–027
K/34
(a) General terms
(i)
Notional Amount: the floating rate and fixed rate
payments are calculated by applying the respective
rates to the Notional Amount. If the underlying
loan is to be subject to a full interest rate swap then
the Notional Amount should be an amount equivalent to the full principal amount of the loan which
is outstanding from time to time. In the event that
the loan features scheduled amortisation payments,
the Notional Amount should reduce in line with
these amortisation payments. This is usually
achieved by setting out a table detailing how the
Notional Amount is to decrease as amortisation
payments are made such that the time and amount
of each pay-down directly results in a write-down of
the swap notional.
(ii)
Trade Date and Effective Date: the Effective Date
is the date on which the interest rate swap takes
effect and this should match the date of drawdown
of the loan. The Trade Date should match the
Effective Date.
(iii)
Termination Date: this is the date that the interest
swap arrangements cease to have effect and should
correspond to the final repayment date of the loan.
Practical Lending. R.33: October 2008
General Introduction
K–027
(b) Floating Amounts—this section sets out the provisions
relating to the payment of the floating rate, for example
the floating rate payer. It is worthwhile looking at some
aspects of this section in detail:
(i)
Floating Rate Payer Payment Dates: these should
match the interest payment dates on the underlying
loan. The borrower needs to receive payments of
the floating rate on each interest payment date to
ensure that it can pass these on to the lender and
comply with its interest payment obligations under
the loan.
(ii)
Floating Rate for Initial Calculation Period: this is
relevant where the period between the Effective
Date and the first Floating Rate Payer Payment
Date, or the period between the Termination Date
and the immediately preceding Floating Rate Payer
Payment Date, is less than the Designated Maturity
(see below) and stipulates a rate or a method to calculate a rate for such period. If no such periods
exist then this is irrelevant.
(iii)
Floating Rate Option: this determines the floating
rate which is payable by the Floating Rate Payer.
Reference needs to be made not only to the relevant floating rate (e.g. LIBOR), but also the provisions of the loan agreement which detail how
LIBOR is to be determined if, say, the usual source
of LIBOR is not available. Note also that the
interest swap is (usually) designed to provide a
matching floating rate flow and thus will be in
respect of the borrower’s floating rate exposure
only—it will not apply to the margin or any mandatory costs which the borrower is obliged to pay on
top of this.
(iv)
Designated Maturity: this is the period over which
floating rate payments are assessed, and should correspond to the interest periods under the loan.
(v)
Spread: usually no spread (or margin) will be payable in an interest rate swap as the hedge counterparty will incorporate its credit and funding costs
into the fixed rate which it offers the borrower.
(vi)
Floating Rate Day Count Fraction: essentially this
is the number of days in a given interest period
divided by a year of duration x days (usually 365
days for interest rate swaps linked to LIBOR, 360
days for interest swaps linked to EURIBOR). The
methodology used in the loan agreement should be
inserted here.
Practical Lending. R.33: October 2008
K/35
K–027
General Introduction
(vii)
Reset Dates: these are the dates when the calculation of the floating rate payable under the swap is
reset and need to be aligned to the rate fixing dates
under the loan (usually the last day of the current
interest period or the first day of the subsequent
interest period under the loan).
(viii) Compounding: this is only relevant where the
underlying loan compounds interest, and the
arrangements should match those in the underlying
loan. It is relatively rare that this will be the case, so
in general this section can be disapplied.
(c) Fixed Amounts—this section sets out the provisions
relating to the payment of the fixed rate portion of the
interest rate swap. The amount of the fixed rate, the payer
of the fixed rate and the dates on which the fixed rate is to
be paid will be set out here. Note that the dates for payment of the fixed rate and the day count fraction in
relation to the fixed rate aspect of the swap should match
those relating to the floating rate portion of the swap.
(d) Account Details—each party should specify the account
into which payments under the swap should be made.
(e) Business Day/Business Day Convention—the business
day convention set out in the swap needs to match that in
the underlying loan documentation.
[K–038 follows]
K/36
Practical Lending. R.33: October 2008
Precedent K1 Pro forma Confirmation (short form) in relation
to an interest rate swap to be entered into in
connection with a loan agreement1
K–038
[Letterhead of Party A]
[Date]
[Name and address of Party B]
Dear .,
Re: Interest Rate Swap Transaction
Our ref: .
The purpose of this letter (this ‘‘Confirmation’’) is to confirm
the terms and conditions of the Transaction entered into between us
on the Trade Date defined below (the ‘‘Transaction’’). This
Confirmation supersedes any previous Confirmation or other written
communication with respect to the Transaction described below and
evidences a complete binding agreement between you and us as to
the terms of the Transaction described below. This Confirmation
constitutes a ‘‘Confirmation’’ as referred to in the ISDA Master
Agreement specified below.
The definitions and provisions contained in the 2000 ISDA
Definitions as published by the International Swaps and Derivatives
Association, Inc. (the ‘‘Definitions’’), are incorporated into this
Confirmation2. In the event of any inconsistency between the
Definitions and the provisions of this Confirmation, this
Confirmation will govern. [In addition, capitalised terms used in this
Confirmation and not defined in this Confirmation or the
Definitions shall have the respective meanings assigned to them in
the loan agreement dated . between, inter alios, Party B and ..]3
This Confirmation supplements, forms part of and is subject to the
ISDA Master Agreement dated as of ., as amended and supplemented from time to time (the ‘‘Agreement’’), between . (‘‘Party
A’’) and . (‘‘Party B’’). All provisions contained in the Agreement
govern this Confirmation except as expressly modified below.
1
2
3
Note that, as discussed at para.K–026, Confirmations detail the commercial and economic terms of
a specific Transaction and therefore vary from Transaction to Transaction. This is a pro forma is in
respect of an interest rate swap which has been entered into in connection with a loan agreement.
Substantial changes to the format and content of the Confirmation would be required were the
Transaction a different type of derivative.
The ISDA 2000 Definitions are relevant in relation to interest rate swaps. Again, if the
Confirmation is in respect of a different type of derivative, reference to alternative definitions produced by ISDA may be relevant.
This provision should be inserted if the parties intend to incorporate definitions used in the underlying loan agreement into the Confirmation (for example Interest Period, Interest Payment Date) to
guard against any potential mismatches between the terms used in the Confirmation and the terms
of the underlying loan agreement. A more detailed discussion of this is set out at para.K–026 and
K–027 above.
Practical Lending. R.33: October 2008
K/37
K–038—K–041
Pro forma Confirmation etc
The terms of the particular
Confirmation relates are as follows:
K–039
K–040
K–041
Transaction
to
which
this
General Terms:4
Notional Amount:
.5
Trade Date:
.6
Effective Date:
.6
Termination Date:
. [adjusted in accordance with the
Modified Following Business Day
Convention]7
Fixed Amounts:
Fixed Rate Payer:
[Party B]8
Fixed Rate Payer
Payment Dates:
.9
Fixed Rate:
.10
Fixed Rate Day
Count Fraction:
.11
Floating Amounts:
Floating Rate Payer:
[Party A]12
4
These are the terms which apply to both the fixed and floating aspects of the Transaction.
Applying the fixed and floating rates to the Notional Amount produces the question of payments
which each party is obliged to make. For an interest rate swap, the Notional Amount should be set
as the principal amount of the loan which is to be subject to the swap (this may be some or all of the
principal amount of the loan). The Notional Amount should reduce in line with scheduled amortisation payments to avoid over-hedging, and this is usually achieved by setting out a table detailing
how the Notional Amount us to decrease as the loan amortises. An example of such a table is set
out in the Appendix to this pro forma.
6
The Effective Date is the date on which the Transaction is to take effect (i.e. the date on which the
interest rate swap is to come into effect). This will usually be the date of drawdown of the loan. The
Trade Date should match the Effective Date. If the swap is a condition precedent to the loan then
the drawdown date would be the Effective Date. If the swap is a condition subsequent (post drawdown) then the Effective Date is the date on which the swap is intended to become effective.
7
The Termination Date is the date on which the Transaction ceases to have effect. This will usually
correspond to the final repayment date of the loan. For any shorter hedging period the applicable
date may be inserted. The business day convention should be cross checked to that in the underlying loan to ensure consistency.
8
In a standard interest rate swap relating to a loan agreement, Party B (or the Borrower) will usually
pay the fixed rate to Party A.
9
Fixed rate payments (and floating rate payments, see below) should match the interest payment
dates on the underlying loan. In other words, Party B should make its fixed payments and receive its
floating payments on each interest payment date to ensure that it can meet the interest payment
obligations under the loan on those days. If these payment dates under the swap and the interest
payment dates do not match then there is a danger that the floating amount received by Party B will
not be equal to the floating amount payable by it under the loan which could result in a shortfall.
10
This is the fixed rate which will be applied to the Notional Amount. This fixed rate will be agreed
between Party A and Party B before the Transaction is entered into.
11
In essence this is the number of days in a given interest period divided by a year with a duration of
a set number of days. Again the day count methodology used in the loan agreement should be replicated here to ensure that there is no mismatch.
12
In a standard interest rate swap relating to a loan agreement, Party A (or the hedge counterparty)
will usually pay the fixed rate to Party B. The hedge counterparty may well be a part of the organisation of the lender.
5
K/38
Practical Lending. R.33: October 2008
Precedents
K–041—K–042
Floating Rate Payer
Payment Dates:
.13
[Floating Rate for initial
Calculation Period:]
[.]14
Floating Rate Option:
.15
Designated Maturity:
[Three months]16
Spread:
[None]17
Floating Rate Day
Count Fraction:
.18
Reset Dates:
Compounding:
[The first day of each Calculation
Period]19
[Inapplicable]20
Account Details:
K–042
Accounts for payments to
Party A:
[Sort Code . with . Bank in favour of
Party A . account number .]21
Account for payments to
Party B:
[Sort Code . with . Bank in favour of
Party B account number .]9
Business Days:
[London]22
Please confirm that the foregoing correctly sets forth all the terms
and conditions of our agreement with respect to the Transaction by
responding within two (2) Business Days by promptly signing in the
13
14
15
16
17
18
19
20
21
22
The dates that the floating payments are made should correspond to the interest payment dates on
the underlying loan. See fn.9 above.
This is only relevant where the period between the Effective Date and the first Floating Rate Payer
Payment Date or the period between the Termination Date and the immediately preceding
Floating Rate Payer Payment Date is less than the Designated Maturity (see fn.16 below). The
applicable floating rate (or the method to calculate such floating rate) for this period should be stipulated.
This sets out the floating rate which is payable by the Floating Rate Payer and should include reference not only to the relevant floating rate (e.g. LIBOR) but also the provisions of the underlying
loan agreement which set out how LIBOR is to be determined if the usual source is not available.
This sets out the period over which the floating rate payments are assessed and should match the
length of the interest periods in the underlying loan agreement. If interest on the underlying loan is
paid quarterly, the Designated Maturity should be three months.
If the Floating Rate Payer is charging a Spread or margin (usually composed of its credit and funding costs) this should be specified here. Usually no Spread will be payable on an interest rate swap
as credit and funding costs will be incorporated into the fixed rate offered by the Floating Rate
Payer.
This should match the Fixed Rate Day Count Fraction. See fn.11 above.
The Reset Dates are the dates when the calculation of the floating rate is reset and should match
the rate fixing dates set out in the underlying loan agreement. For example, if the loan agreement
fixes the rate for an interest period on the first date of that interest period, the Reset Dates should
be the first day of each Calculation Period.
Compounding is only relevant if interest compounds under the underlying loan, which is relatively
rare. If interest does compound under the underlying loan, the compounding provisions should
match those of the underlying loan.
Each party should specify the accounts into which fixed/floating payments due to it should be
made. Note that if Party B is a borrower under an underlying loan agreement, the loan agreement
may stipulate the account into which floating payments are to be paid.
The Business Days and the Business Day Convention set out in the underlying loan agreement
should be mirrored here to ensure that there are no mismatches.
Practical Lending. R.33: October 2008
K/39
K–042—K–043
Pro forma Confirmation etc
space provided below and faxing the signed copy to ., facsimile number ., telephone .. Your failure to respond within such period shall
not affect the validity or enforceability of the Transaction as against
you. [This facsimile shall be the only Confirmation documentation in
respect of this Transaction and accordingly no hard copy versions of
this Confirmation for this Transaction shall be provided unless you
request.]23
Yours sincerely,
................................
For and on behalf of
[Party A]
Name:
Title:
Date:
Confirmed as of the date first above written:
................................
For and on behalf of
[Party B]
Name:
Title:
Date:
[Appendix]24
K–043
Relevant Dates
Notional Amount (£)
[K–044 follows]
23
24
K/40
This should only be inserted if the parties do not intend to provide hard copy originals of the
Confirmation.
This Appendix is only relevant if the Notional Amount of the Transaction is to decrease during the
term of the Transaction, for example due to scheduled amortisation payments on the underlying
loan. See fn.5 above.
Practical Lending. R.33: October 2008