Do End-Users Benefit From Entering Into ISDA Master Agreements?

Without a crystal ball, and given the breadth of transactions that can be entered into between parties to an International Swaps and Derivatives Association Master Agreement, it is almost impossible to predict whether a particular provision will benefit one party or the other.

  • 11 Jul 2004
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Provisions That Can Benefit Either Party

Without a crystal ball, and given the breadth of transactions that can be entered into between parties to an International Swaps and Derivatives Association Master Agreement, it is almost impossible to predict whether a particular provision will benefit one party or the other. This is particularly true in the case of the tax provisions (see Section 1(d) of the ISDA Master Agreement and Part 2 of the Schedule), the Force Majeure Event/Illegality provisions (Section 5(b)(i) and (ii) of the 2002 form), and the Close-out Amount valuation method (defined in Section 14 of the 2002 form), as discussed below.

 

Tax Provisions

The ISDA Master Agreement contains a number of extremely important provisions regarding withholding taxes. In general terms, these provisions serve three functions: (1) they enable the parties to establish the necessary legal and factual basis for concluding whether the payments under the transaction are subject to any withholding tax; (2) if, contrary to the expectations of the parties, payments under the swap are held to be subject to withholding, they allocate the financial burden of the withholding tax to either the payor or payee of the payment; and (3) in certain circumstances, they allow the party that bears the financial burden of any such withholding tax to terminate the transaction. These provisions are important to U.S. end-user taxpayers, particularly when entering into derivatives transactions with non-U.S. counterparties or U.S. counterparties that are not corporations, because an unforeseen withholding obligation can have a serious impact on the economics of a transaction.

Though special rules for swaps that qualify as "notional principal contracts" exempt most swap payments from U.S. foreign withholding tax obligations, the exemption from "backup" withholding with respect to certain types of payments generally applies only if the non-U.S. counterparty represents in the transaction confirmation or a master agreement that it is a "foreign person" (unless, presumably, the payor knows or has reason to know that the representation is false).1 This tax representation and certain other tax-related representations generally are included in Part 2 of the Schedule to the ISDA Master Agreement. The form of Schedule also includes as an optional provision a representation to be made by the payee that the payments qualify under the relevant tax treaty between the countries in which the parties are located. If it turns out that the payee's representation is false, the withheld amount can be deducted from the payment otherwise due to the payee.

The parties also need to consider the possibility that a change in law can affect the tax status of their transactions. The ISDA Master Agreement benefits both parties because its tax provisions clearly allocate the financial burden of the withholding if a withholding tax is imposed, whether or not due to a change in law.

 

Force Majeure Event/Illegality Provisions

The new Force Majeure Event/Illegality provisions of the ISDA Master Agreement reflect the experiences of the entire derivatives industry following the September 11th terrorist attack, when payment and delivery systems were inoperative. The provisions entitle the parties to terminate "Affected Transactions" following a specified "Waiting Period" and defer the parties' obligations until such time as payment/delivery is practicable. Because it is impossible to predict what particular events could cause such disruption, the term "Force Majeure Event" is defined only with respect to its effect (i.e., an event that prevents a party from making or receiving a payment or delivery) and therefore has broad applicability.

 

Close-out Amount

During the Asian currency crisis of 1997 and the Russian financial crisis in 1998, the derivatives industry learned that the Market Quotation valuation method (preferred by most end-users, with most dealers preferring the more flexible "Loss" method) was not workable because the turbulence of markets made quotations unreasonable or illiquid markets rendered quotations unavailable. More recently, many end-users facing Enron as defaulting party have had their own difficulties with Market Quotation.

These lessons are reflected in the new termination payment valuation method (called "Close-out Amount") in the 2002 form of the ISDA Master Agreement. "Close-out Amount" was intended to be a compromise between the perceived objectivity of Market Quotation and the perceived subjectivity of Loss. While, in most cases, the non-defaulting party is not permitted to rely on internal data, the range of permissible third-party information has expanded beyond actual quotes for replacement trades to include a broad range of "relevant market data."

 

Benefits to the Defaulting Party--Two-way Termination Payments

It is well settled that a party that materially defaults on its contractual obligations without a prior default by another party to the contract will be entitled to damages only if, prior to its default, it conferred a tangible benefit on the non-defaulting party. Otherwise, a default by one party frees the non-defaulting party from its obligations under the contract and the defaulting party is not entitled to receive any compensation for loss of its bargain or other damages.2 If this rule were applied to derivatives transactions, a defaulting party would not receive the benefit of its bargain from any of its outstanding transactions with its counterparty, even if all of them were "in the money" at the time of the breach.3

Under the 1992 form of ISDA Master Agreement, counterparties can elect to have "two-way termination payments" govern their transactions following an event of default by choosing "Second Method" in the Schedule to the 1992 form. The 2002 form of ISDA Master Agreement eliminates this choice and provides instead that the Close-out Amount (or its absolute value) of all terminated transactions will be paid to whichever party is net "in the money." Thus, upon a default, if the non-defaulting party decides to terminate the outstanding trades, those trades will be valued at market prices, allowing the "in the money" counterparty to receive the benefit of its bargain, even if that party is the defaulting party.

 

Conclusion

In most circumstances it is to the advantage of most dealers and most end-users to enter into a master agreement governing all their transactions. The ISDA Master Agreement is usually the best choice, particularly in its 2002 form, because it is the product of broad-based market experience covering the entire history of the derivatives markets, for the most part represents standard market practice, and is the most widely-used multiple product master agreement form available today.

 

Micah Bloomfield
Sherri Venokur
This week's Learning Curve was written bySherri Venokur, special counsel,Micah Bloomfield,Mark Speiser, partners, andEleanor Cotter, associate, atStroock & Stroock & Lavanin New York

 

 

Eleanor Cotter
Mark Speiser


  • 11 Jul 2004

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1 Citi 241,652.19 924 8.19%
2 JPMorgan 223,721.63 996 7.58%
3 Bank of America Merrill Lynch 216,064.78 722 7.32%
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5 Goldman Sachs 158,954.58 518 5.39%

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1 JPMorgan 32,522.19 61 6.56%
2 BNP Paribas 32,284.10 130 6.51%
3 UniCredit 26,992.47 123 5.44%
4 SG Corporate & Investment Banking 26,569.73 97 5.36%
5 Credit Agricole CIB 23,807.36 111 4.80%

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Rank Lead Manager Amount $m No of issues Share %
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1 Goldman Sachs 10,167.68 46 8.81%
2 JPMorgan 9,894.90 42 8.58%
3 Citi 8,202.25 45 7.11%
4 UBS 6,098.17 23 5.29%
5 Credit Suisse 5,236.02 28 4.54%