Chatham Financial’s Matt Hoffman and Michael Ashby assert that end users should explore some of the smaller terms of ISDA agreements when negotiating these agreements. The authors explore three terms included in ISDA agreements worthy of review to help all parties reach fair agreements.
When negotiating ISDA agreements, corporations and their counsel often focus on certain specific legal terms commonly known to be problematic to end users. However, other terms — which banks often propose in the spirit of facilitating a swift and easy negotiation or credit and legal approval process — often are accepted at face value and without closer exploration. These terms usually seem harmless and actually may sound like a good idea; but often the opposite is true.
Right to Transfer Without Consent
Section 7 of the ISDA Master Agreement outlines the terms pursuant to which either party may transfer the ISDA or any rights and obligations thereunder. The default position under standard ISDA documentation is that either party may transfer its rights and obligations under the ISDA, subject to the prior written consent of the other party, except in specified circumstances related to either mergers and acquisitions, asset transfers, or amounts owed in connection with early terminations.
Banks commonly seek to change this transfer provision to specifically allow them the unilateral right to transfer their rights and obligations under the ISDA without consent. Some banks go further, proposing not only a unilateral right to transfer, but also that they can transfer their rights and obligations to any third party. When corporations push back, banks, as a compromise, will offer to require that their transferee be a bank affiliate that has the same credit rating as the bank at the time of transfer. While this may appear to be a fair compromise, there are several reasons that a corporation should have the right to choose the bank counterparty it faces, regardless of its credit rating and bank affiliation.
For one, evolving regulations, including the Foreign Account Tax Compliance Act (FATCA), the Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), and the European Market Infrastructure Regulation (EMIR), could result in problematic tax consequences and very different compliance requirements and expenses based upon the jurisdiction and business of the bank’s proposed counterparty. In addition, a potential Eurozone dissolution could result in complexities and difficulties in trades with European entities. None of these issues is addressed by the ratings or affiliations of the proposed counterparty. Further, these are some of the issues known today, but they were not even on the radar just a few years ago. It is impossible to predict what other issues could arise in the future and how a company could be impacted.
For these and other reasons, corporations should approach these provisions with caution. As a compromise, the corporation might propose that that such consent will not be unreasonably withheld or delayed. If a corporation has a good reason to object to facing a proposed bank counterparty, it should not be obligated to face that party.
Incorporation of Loan Covenants
In Part 5 of the ISDA Schedule, banks sometimes include a provision entitled “Incorporation of Loan Covenants” or “Incorporation by Reference of Terms of Credit Agreement”. In this provision, banks refer to certain affirmative and negative covenants (i.e., agreements to do or not do certain things) contained in the parties’ loans or credit agreements, and seek to incorporate these covenants in the ISDA. Banks typically justify the use of this provision by saying it will shorten the credit approval process by using the credit underwriting associated with the loan. Many companies think this is a good idea, reasoning that it is harmless to do so because they have already agreed to the terms of the credit agreement. But this is not always the case.
For one, these “incorporation of terms” provisions often “freeze” the covenants as of the date of the ISDA without taking into account any future amendment to the loan or credit agreement, unless the bank agrees to do so in writing. This can be problematic because Section 5(a)(ii) of the ISDA Master Agreement provides that it is an Event of Default to fail to comply with or perform any agreement or obligation under the ISDA. Reading these provisions together it is clear that if a company decides to amend its loan covenants, but the bank does not consent to “unfreezing” the covenants in the ISDA, then the company can find itself in default under the ISDA. Additionally it could be that the covenants of the ISDA and loan or credit agreement conflict with one another such that the company is in violation of one or the other.
This type of provision can also undermine other negotiated terms in an ISDA, such as cross-acceleration. Further, if the ISDA contains a Credit Support Annex (CSA), incorporation of loan covenants arguably constitutes excessive and unnecessary protection and security to the bank. Ultimately, incorporation of loan covenants is unnecessary because the breach of covenants in a loan or credit agreement that results in the acceleration of loan obligations is already captured by Cross Default (Section 5(a)(vi) of the ISDA Master) and often is covered by Credit Support Default (Section 5(a)(iii) of the ISDA Master) and/or Additional Termination Events (Part 1(h) of the ISDA Schedule). If the breach of a loan or credit agreement covenant would not give rise to a default under the loan or credit agreement, then it should not do so under the ISDA.
Most Favored Nation Clauses
When negotiating ISDAs with multiple banks simultaneously, it is common that one or two banks will not agree to certain terms to which all other banks agree. While these outlier banks may not be entirely comfortable agreeing to the term or terms in question, they want to maintain the relationship and have a chance to bid on the derivatives business. At this point, the outlier bank may suggest a “most favored nation” (MFN) clause, which often represents the bank’s last attempt at compromise before it decides whether to agree to the corporation’s terms or stand firm. A MFN clause generally states that the bank shall always be subject to the most beneficial terms given to other banks by its counterparty. For example, if the corporation ever agrees to give its bank counterparty cross-default instead of cross-acceleration, the requesting bank would also receive cross-default, even if this other agreement occurred sometime in an unrelated negotiation in the future.
MFN clauses can be very general or very specific and can appear in many places within an ISDA, which is why they can have different consequences. The problem is that the MFN looks at the offending term in a vacuum without considering the other terms and key points in an ISDA negotiation. Different counterparties have different issues that are important to them, and it is common that the sum of the terms in an ISDA will achieve the appropriate balance of protection for both sides.
The nuanced and sometimes complex aspects of ISDAs can have the unintended consequence of complicating the ability of a corporation to conduct business as usual. These are just a few of the ways companies can miss opportunities to protect themselves by not understanding the implications of seemingly harmless ISDA terms. Taking extra time and investing in additional knowledge when negotiating ISDAs will help in reaching fair agreements for both the bank and the corporation.
Capitalized terms used in this article refer to terms contained in ISDA Master Agreements and Schedules thereto, referred to simply and collectively as ISDAs.
