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Liquidity & The ISDA Master Agreement

Ensuring liquidity should be the primary goal in negotiating an ISDA Master Agreement (the "Agreement") for smaller, non-rated customers, such as a hedge fund or a middle-market corporation. Often highly leveraged and with little room for error, these customers should focus their efforts when negotiating the Agreement with a dealer on limiting the dealer's opportunity to terminate the Agreement. Unfortunately, however, customers (typically through expensive outside counsel), often instead use up valuable negotiating capital on esoteric legal issues that may only remotely affect a customer's situation.

A dealer typically wants the right to terminate the Agreement at the first sign of its customer's economic difficulties, such as a cross default or a decline in the customer's net worth. Because of the fluctuating nature of derivatives, a dealer wants to quickly terminate any growing exposure from outstanding transactions as its customer's credit deteriorates. Early termination of its Agreement with the dealer, however, may only further a customer's growing liquidity crisis.

Upon early termination, a customer that is out-of-the-money on its trades with the dealer may end up having to make large termination payments. Depending on its agreements with other dealers, an early termination could possibly give other dealers the right to terminate their agreements with the customer. Even if the customer is in the money, it may not be able to replace important terminated hedging transactions. Termination of the Agreement may be the beginning of the end for a customer in economic difficulty.

Cross Default

One of the most important signs of a customer's financial deterioration for a dealer is the occurrence of a cross default by the customer with one of its other creditors. Under the Agreement, a cross default takes place upon the occurrence or existence of an event of default with respect to "specified indebtedness". For the provision to apply, however, the parties must affirmatively elect for the cross default provision to apply to either or both parties.

The parties must also agree on the definition of specified indebtedness. Specified indebtedness is defined in the Agreement to be "any obligation (whether present or future, contingent or otherwise, as principal or surety or otherwise) in respect of borrowed money." Dealers often will want to expand the definition beyond the concept of "borrowed money" to include obligations under other types of financial transactions, such as forwards, repurchase agreements, securities lending agreements, or even exchange derivatives such as futures and options. Dealers may even try to define it to include any contractual obligations of the customer. The broader the definition of specified indebtedness, the more likely that a cross default will occur to the customer.

In addition, many of the new types of obligations added to the definition of specified indebtedness, such as repos, are prone to technical defaults. Although these technical defaults are generally cured or waived in the ordinary course of business, they could provide an aggressive dealer with an opportunity to terminate the Agreement upon their occurrence.

The parties must also agree on appropriate cross default thresholds. This is the amount that a default must exceed before it will constitute a cross default. Although the dealer will want a threshold of 2-3% of its equity for itself, it will insist on a more modest number for the customer ranging from $0-20 million. The smaller the threshold, the more likely that a cross default will occur to the customer.

In addition, as with all cross default provisions, the customer should be careful that the agreed upon threshold amount not be lower than its cross default threshold in its other finance agreements. For example, if the threshold were lower in the Agreement than the threshold under its loan agreement, a small payment default on specified indebtedness might trigger the cross default under the Agreement, which in turn might inadvertently trigger the cross default under its other finance agreements.

A customer should insist that a cross default only occur upon the "cross acceleration" of the other indebtedness, as opposed to merely the existence of a default. Under the standard cross default language in the Agreement, an event of default can occur upon a default under other indebtedness, irrespective of whether the other creditor accelerates the specified indebtedness. By requiring that the default result in an acceleration of the underlying indebtedness, a dealer would not be able to terminate the Agreement until the other creditor actually accelerated the specified indebtedness.

Dealers generally resist a cross acceleration requirement because it limits their ability to concurrently negotiate with its customer during any work-out discussions the customer might be having with another lender. For example, a creditor could persuade the customer to pledge additional collateral in exchange for not accelerating the indebtedness. If the dealer could not declare a cross default under the Agreement at that same time, it would not be able to negotiate the same terms with the customer as did the other customer's creditors.

Credit Event Upon Merger

A "credit event upon merger" is a termination event under the Agreement. It occurs if a party participates in a merger (or enters into a similar type of transaction) and the resulting entity is "materially weaker" after the event. The rationale for the provision is that a party may not have entered into the Agreement with the customer that is now materially weaker because of a merger. Like the cross default, the parties must elect for the credit event upon merger to apply.

Unfortunately, the term "materially weaker" is not defined in the Agreement. The dealer may attempt to define an objective test that would measure when the resulting entity becomes materially weaker. For example, the resulting entity would be considered materially weaker if its credit rating were materially affected or if it failed designated financial covenants.

The parties may also want to expand what is meant by a credit event upon merger. The dealer may suggest that recapitalizations through the issuance of new forms of stock or debt would constitute a credit event upon merger. A customer may want to resist such a definitional change because of the potential restrictions it could pose on its ability to change its capital structure. The occurrence of such a change in its capitalization, however, would still require the resulting entity to be materially weaker to constitute a termination event.

Additional Termination Events

A dealer may insist on adding "additional termination events." Additional termination events are generally treated under the Agreement similar to events of default. If an additional termination event has occurred with respect to a party, that party is referred to as the "affected party." Upon the occurrence of such an event, the dealer would have the right to terminate the Agreement at a time precisely when the customer most needs to maintain its liquidity.

The most common additional termination events negotiated are those that result from a change in the financial condition of the affected party. This could be triggered by a credit downgrading or by the failure to maintain a certain level of capital or net worth, or a failure to maintain certain financial ratios.

An additional termination event could also result from a problem unique to the counterparty such as the failure of an Affected Party to maintain a certain legal or regulatory status. Failure to notify the non-affected party of certain events or to deliver certain information could also be an additional termination event. Finally, if the affected party is dependant on the leadership or direction of certain individuals, the resignation or death of such individuals could also result in early termination.

Son of First Method

Designating "first method" as a method for determining damages upon the termination of the Agreement has become obsolete. The effect of first method was to deprive the defaulting party of any payments upon the termination of the Agreement in the event that the defaulting party was "in the money". Now, however, dealers are often insisting on the right to delay making payments to a customer upon an early termination of the Agreement until the dealer is completely satisfied that the defaulting party has no further payment obligations to it, something that could takes days or even weeks to resolve.

Delaying payments on an early termination date, however, can result in significant liquidity problems for a customer. Upon an early termination of the Agreement, if the customer is in the money, it is probable that a customer may be counting on the dealer's payment in order to meet any obligations it has on the early termination date to other parties. If such payments were withheld by the dealer, the customer would be unable to use such amounts to meet its obligations with other counterparties, perhaps triggering additional defaults under other agreements for the customer.

Limiting Cure Periods

The Agreement was drafted by ISDA with cure periods much more liberal than may be typically seen in other finance contracts due to what drafters viewed as the unique characteristics of the OTC derivatives market. Dealers, however, have begun to limit these cure periods. For example, instead of permitting a customer three business days to cure a payment default, the dealers are narrowing it to one. Similarly, dealers are requesting only a five-day cure period for breach of certain other provisions while the agreement normally provides for 30. Narrowing of such cure periods may not be in a customer's best interest. These more limited cure periods are probably not sufficiently long for a customer experiencing economic difficulties to resolve the underlying defaults.

Although there are numerous legal issues affecting the ISDA Master Agreement that are negotiated, the most probable issues that may affect a smaller customer deal with terminating the agreement upon the occurrence of some financial difficulty. Because of that, the customer should focus its efforts on limiting as much as possible these early termination opportunities.

This week's Learning Curve was written by Christian Johnson, associate professor at the Loyola Law Schoolin Chicago.

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