ISDA master agreement negotiations are often never-ending, expensive and tedious. Negotiations can take months as parties battle over legal, business and credit terms. Although much has been done to standardize the documentation process, there are still numerous issues that parties must negotiate prior to executing the ISDA master agreement. In addition, parties often insist on making additional amendments to the ISDA master agreement that they believe are necessary to minimize legal and credit risks.
Although negotiations can still deadlock over important terms, much can still be done to speed up negotiations. In particular, there are seven deadly sins that can slow the process. Avoiding many of these pitfalls can result in faster and more efficient negotiations.
Abdicating Negotiations To The Lawyers
Traders and credit officers do themselves a great disservice by abdicating negotiations to their lawyers. Under great time pressures, traders and credit officers prefer to leave ISDA negotiations to others. Unfortunately, the traders and credit officers often incorrectly assume their lawyers understand what is important to them.
Because lawyers are primarily trained to deal with legal issues, these can take an inflated importance in comparison with other equally important business considerations. Troubled by a particular legal uncertainty, a lawyer may focus on resolving this issue at the expense of other issues.
A trader or credit officer alert to this possibility will monitor the negotiations, watching for issues that he considers unimportant but that may be sidetracking negotiations.
Traders also assume that the lawyer can extract important credit and business concessions from the other side. Unfortunately, these types of issues are usually best resolved between the business and credit people. The lawyer is often ineffectual because of his need to secure the credit and business officers' approval prior to agreeing to a non-standard business or credit term. The lawyer often has difficulty in knowing how to weigh the importance of one business issue against another.
Traders and credit officers can also resolve sticky and time consuming business and credit issues by negotiating these with their counterparts prior to the beginning of the ISDA negotiation. For example, resolving in advance key business issues such as the cross-default threshold or whether a credit event upon a merger will apply.
Trading Before The ISDA Negotiation
Is Completed
Most firms require that the parties enter into an ISDA master agreement as a matter of credit policy prior to trading. This is because the ISDA master agreement governs all of the contractual terms other than the terms of the trade itself. Specifically, the ISDA master agreement governs what happens when a party defaults, when netting and set off are permitted, and the governing law and other legal boilerplate issues.
This policy, however, is almost uniformly ignored at some point by even the most conservative dealer. In order to lock in particularly favorable economic terms, the parties will often trade before the ISDA master agreement is negotiated. Parties, however, should be aware that their respective negotiating positions are stronger if they refuse to trade prior to agreeing upon the critical business and legal issues in the ISDA master agreement. After the trade, a party will have little leverage to resolve the remaining difficult issues in an ISDA master agreement.
Insisting on executing the master agreement prior to trading can be a tremendous motivator. Although negotiations can take months, ISDA negotiations can be agreed upon in 24 hours given sufficient incentive.
Negotiating Before A Trade Is Pending
Parties may attempt to negotiate an ISDA master agreement prior to even considering a particular trade. Parties often mistakenly believe that initiating the negotiation before a trade has been developed will save time and ensure that the ISDA master agreement is in place prior to trading. Although the parties have more time to negotiate the ISDA master agreement, the advantage is illusory. If no trade is in the process of negotiation, the parties will be reluctant to compromise over important issues.
Requesting Non-Market Amendments
Nothing drags an ISDA negotiation out longer than requesting changes that do no reflect market standards. Unfortunately, each dealer has developed its own standard form of the Schedule and Credit Support Annex to the ISDA master agreement, typically full of special credit, business and legal provisions that the dealer believes are important. Opposing parties, however, are typically resistant to such changes for several reasons.
First, many parties are reluctant to stray too far from market practice. They are concerned first that non-market changes may introduce legal uncertainty into the agreement if these provisions are not generally accepted in the industry. Second, many of these non-market changes may require operational changes for a counterparty. For example, a party may want to shorten the time that a party may take to deliver or return collateral. Unfortunately, the counterparty's internal operations may not permit these new time periods.
A party should also be careful if it is using outside counsel. Outside counsel often bring their own non-market amendments and provisions to the negotiation. Many outside lawyers believe that adding such provisions and changes in a negotiation is how they bring value to the engagement. The client should carefully monitor their outside counsel's requested changes to the ISDA master agreement in order to avoid delays in negotiations over these peculiar provisions. The client should also provide their outside counsel with the party's negotiating positions and explain what is important and not important to them.
Failure To Get Document Deliveries
As part of the negotiation of the ISDA master agreement, parties agree to make document deliveries to each other. These can include such items as incumbency certificates, annual statements, tax forms, or legal opinions. Although the majority of these deliveries are required to be made upon execution of the ISDA master agreement, these deliveries are often put off until execution copies of the ISDA master agreement have been exchanged.
Obtaining these documents after execution, however, can be difficult. After signing the agreement, a busy laywer will often move on to the next negotiation without following up on the deliveries. The only leverage a party will have against their counterparty will be to give notice and threaten to terminate the agreement. However, it would be an intrepid party who actually terminated an ISDA master agreement based on a failure to deliver documents.
But these undelivered documents are important to a party. First, a party's internal auditors may find them out of compliance with their own credit policies if the file is not complete and could result in trading being suspended. Second, documents such as secretary's certificates and opinions provide legal certainty for a party when entering into trades with new counterparties. Third, many provisions such as the tax provisions only provide legal protections if particular deliveries are made.
Lean And Mean Staffing
Over-the-counter derivative dealers typically operate with a lean OTC documentation staff. The staff count is kept low both for budget purposes and because of the difficulty in hiring experienced lawyers or documentation specialists. Failure to be adequately staffed, however, can result in additional negotiation delays.
Faced with time pressures and competing projects, lawyers or documentation specialists may not focus on the most important ISDA negotiations. Instead they may respond to aggressive traders' or credit officers' demands that they work on their agreements first, as opposed to negotiations that may be necessary to begin profitable trading with a new counterparty. Supervisors need to monitor the priorities of their documentation specialists or lawyers in order to insure that the most important work is done first.
Maintaining a small staff of lawyers and documentation specialists may also be counterproductive for several reasons. First, one reason for high turnover for documentation specialists and lawyers among dealers may be caused by burnout. Staff, especially in New York, may attempt to escape a never ending work load by moving to a different firm.
Second, maintaining a small staff may be penny wise but pound foolish. Failure to put into place ISDA master agreements with new counterparties because of a staffing shortage may result in missed trading opportunities.
Prisoner To One's Own Policies
In an effort to standardize documentation among its various counterparties, a party will often develop policies and positions. Strict and unbending adherence to these positions, however, may slow down negotiations and can result in bad decisions. A party may also inadvertently make unwise concessions and decisions in its efforts to follow a particular policy.
For example, a party may require that it have the ability to post certain types of collateral or insist upon certain threshold amounts for pledging purposes. It may be unwise to push for such provisions, however, depending upon the type of trading activity that is anticipated to be done. Often times, a trader may know in advance that the type of trades that they are doing will only require that the other party perform. In such a situation, the types of eligible collateral may be irrelevant if the party never has to post collateral.
Conclusion
Because of continuing legal uncertainty and credit risk in the OTC market, ISDA master agreements will probably always prove difficult to negotiate. Avoiding unnecessary delays in completing these agreements, however, will pay dividends. By negotiating ISDA master agreements more quickly, this will potentially open up the possibility for even more profitable trading to be done between the parties.
This week's Learning Curve was written by Christian Johnson, associate professor of law at Loyola University Chicago School of Law. Please contact Johnson at cjohns6@wpoiit.luc.edu
