This article discusses end user concerns regarding the use of the ISDA Master Agreement and looks at some of the benefits. The second part, to be published next week, will focus on specific provisions, such as the tax implications.
The International Swaps and Derivatives Association Master Agreement1 is widely accepted as a comprehensive and legally enforceable master agreement, reflecting the collective experience of the derivatives industry. Its provisions address a range of legal issues relevant to derivatives, including bankruptcy laws, tax laws and judicial decisions, and it has become an industry standard.
Nonetheless, the question remains: Does the ISDA Master Agreement benefit end-users in derivatives transactions with dealer counterparties? Some end-users view the ISDA Master Agreement as a dealer-oriented document and prefer negotiating a non-standard master agreement or relying on individual trade confirmations. Others are wary of the ISDA Master Agreement because they believe its default provisions are more useful to non-defaulting parties, discount the possibility that their dealer counterparties will default despite dramatic evidence to the contrary in recent years, and consequently believe the default provisions are more likely to hurt them than to benefit them. Finally, end-users that are unfamiliar with the ISDA Master Agreement form may believe that they will incur unnecessary expense with the negotiation.
The Benefits Of An ISDA Master Agreement
Although the ISDA Master Agreement may not be appropriate for all end-users in all circumstances, it is usually the best choice for an end-user market participant. This article highlights some of the ways in which an ISDA Master Agreement benefits both parties and some of its specific advantages for end-users.
Certainty & Consistency
Because an ISDA Master Agreement governs the overall relationship between the parties, it provides two important benefits to both dealer counterparties and end-users: certainty and consistency. Without a master agreement, the rights and obligations of the parties in the event of a dispute would be governed by a combination of statute, common law and market practice. These could vary from transaction to transaction, depending on the determination in each instance of the appropriate venue and the applicable law. With an ISDA Master Agreement, the parties can select, in advance, the venue and the law for adjudicating all disputes under the agreement, eliminating at least one element of uncertainty in the dispute resolution process.
An ISDA Master Agreement also provides the parties with consistency: uniform termination triggers, grace periods, and remedies that apply to all transactions governed by the agreement. End-users avoid the cost of monitoring disparate rules for a myriad of transactions, savings that will help defray, if not exceed, the cost of negotiating the master agreement.
Because the ISDA Master Agreement represents accepted market practice, there is widespread familiarity with its terminology and provisions among market participants in every major financial market. Furthermore, ISDA has procured legal opinions from law firms in 39 countries regarding the enforceability of the Master Agreement's boilerplate provisions. The familiarity of market participants with the ISDA Master Agreement, buttressed by these legal opinions, can simplify the negotiation process and provide significant cost savings to both dealer counterparties and end-users.
The ISDA Schedule: A Roadmap For Negotiations
The standard schedule to the ISDA Master Agreement, which permits the parties to make various elections and otherwise customize the Agreement, addresses the major issues, such as the identification of Specified Entities (Part 1(a)), the determination of the Threshold Amount (Part 1(c)), the definition of Specified Indebtedness (Part 1(c)) and the applicability of certain Events of Default (e.g., Part 1(c) or (d)) that are likely to arise in the course of a derivatives transaction. Consequently, it provides a useful checklist for less-experienced end-users and an efficient mechanism for getting these issues on the table in the course of the negotiation, giving the end-user a more complete picture of the risks entailed in the covered transactions. Once the end-user becomes familiar with the Schedule and the manner in which it addresses the issues, future negotiations should proceed more smoothly.
Termination & Netting Rights--Avoiding Cherry Picking
The automatic stay provisions of Section 362(a) of the U.S. Bankruptcy Code generally prevent post-petition termination of a pre-petition executory contract by the non-debtor party. Under Section 6 of the ISDA Master Agreement, in the event of a default under any derivatives transaction governed by the Agreement, the non-defaulting party has the contractual right to terminate all transactions under the Agreement. All the amounts owed in connection with those transactions are then netted to yield one net amount payable by one party to the other.
Were it not for the safe harbor provisions of Sections 556 and 560 of the Code, Section 6 of the ISDA Master Agreement would conflict with the automatic stay provisions of Section 362(a) of the Code. Sections 556 and 560 of the Code preserve for a non-debtor swap participant its contractual termination and netting rights under a swap agreement. An ISDA Master Agreement falls within the definition of a swap agreement for purposes of Sections 556 and 560. Under Section 362(b) of the Code, the non-debtor counterparty to a forward contract or swap agreement can terminate existing derivatives transactions and exercise set-off rights with respect to such transactions without first having to obtain permission of the court. Issues that exist with respect to cross-product netting are not discussed in this article.
Therefore, non-defaulting ISDA Master Agreement end-users retain their rights under Section 6 of the ISDA Master Agreement with respect to all transactions other than spot trades, notwithstanding the automatic stay provisions of Section 362(a). Without the Section 6 termination rights, the debtor counterparty could attempt to cherry pick the transactions it wished to preserve and reject the rest. Because Section 6 prevents such cherry picking, a swap participant generally can assess its counterparty risk on an overall relationship basis. Though the safe harbor provisions obviously benefit the non-debtor, non-defaulting party, Enron and other recent corporate scandals should serve as an object lesson to end-users who discount the possibility that their counterparty might default.