th
28 Annual Ernest E. Smith Oil, Gas & Mineral Law Institute
How To Use The ISDA Master Agreement
March 22, 2002 Westin Oaks Hotel Houston
Paul E. Vrana Craig R. Enochs Fundi A. Mwamba
Jackson Walker L.L.P. 1100 Louisiana Street, Suite 4200 Houston, Texas 77002 713-752-4200
Sponsored by The University Of Texas School Of Law
TABLE OF CONTENTS
I. II. III. III. IV. V. VI. VII. VIII. IX. X.
INTRODU INTRODUCTIO CTION...... N............ ........... ........... ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............1 ......1 DERIVA DERIVATIVE TIVES S ............ ................. ........... ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ......... ...1 1 A BR BRIEF IEF OVERVI OVERVIEW EW OF THE ISDA ISDA ............ .................. ............ ........... ........... ............ ............ ............ ............ ............ ........... ..........3 .....3 DEVELO DEVELOPMEN PMENT T OF ISDA ISDA ............ .................. ............ ............ ............ ............ ............ ............ ............ ........... ........... ............ ............ ............ ........ .. 5 NEED FOR FOR THE MASTER MASTER AGREEM AGREEMENT ENT IN TODAY’ TODAY’S S OTC OTC MARKE MARKETS TS ........... ................6 .....6 MASTER MASTER AGREEM AGREEMENT ENT AND AND RELA RELATED TED DOCUME DOCUMENTS NTS ARCHI ARCHITECT TECTURE URE ............7 ............7 SUMMARY SUMMARY OF WHAT CONTRACT CONTRACT DOES............................................................... 12 ELECTIONS ELECTIONS UNDER UNDER AGREEMENT.......................................................................... AGREEMENT.......................................................................... 15 PRACTIC PRACTICAL AL CONSIDE CONSIDERA RATION TIONS S ............ .................. ............ ........... ........... ............ ............ ............ ........... ........... ............ ............ ........ .. 17 CONCLU CONCLUSIO SION N ............ .................. ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ............ ........ 18
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I.
INTRODUCTION
As energy energy transa transacti ctions ons have have become become more sophis sophistic ticated ated,, over-th over-the-c e-coun ounter ter (“OTC (“OTC”) ”) derivatives have emerged as valuable tools to limit the risk and optimize the value of these transac transacti tions. ons. Despit Despitee a comm common percep perception tion of deriva derivativ tives es as a new and untested untested financi financial al product, product, anecdotes anecdotes of derivatives derivatives transactions transactions date back to ancient ancient Greece, Greece, where Aristotle Aristotle wrote about a philosopher named Thales using derivatives to corner the olive press market and reap a large financial windfall. 1 The advantage parties to OTC derivative derivative transactions transactions today enjoy o ver Thales is their ability to use the International Swaps and Derivatives Association, Inc. (“ISDA”) 2 Master Agreement (“Master Agreement”) to identify, monitor and manage the risks associated with OTC derivative transactions. This article (i) provides a basic background on derivatives; (ii) provides an overview of the Master Agreement; (iii) recounts a brief history of the ISDA and Master Agreement; (iv) explains the advantages gained by using the Master Agreement and the ISDA Credit Support Annex to the Master Agreement (“Annex”) for OTC derivative transactions; (v) describes the contrac contractt archi architectu tecture re of the Master Master Agreem Agreement; ent; and and (vi) (vi) addres addresses ses practi practical cal consider considerati ations ons associated with successfully negotiating a Master Agreement. II.
DERI ERIVATIV TIVES
Despite the ancient roots of derivatives, what constitutes a derivative is still unclear to most most people today. Derivatives Derivatives are financial instrumen instruments ts that derive derive their value from u nderlying nderlying 3 product but do not invlolve the purchase, sale or exchange of that product. Risk factors may include: (i) the price of a bond, commodity, currency, or share; (ii) a yield or rate of interest; (iii) an index of prices or yields; (iv) weather data such as inches of rainfall or heating-degree-days; or (v) insurance data such as claims paid for a natural disaster. 4 Participants in the energy industry can use derivatives to address a wide range of their financial and risk management needs. needs. For example, example, a natural gas gas producer may wish to reduce downward downward price risk by locking in a minimum price price he will receive receive for his natural gas. gas. One way to accomplish accomplish this goal is by the purchase of a financial put option, giving the producer the right to be paid if the price of natural gas falls falls below the put o ption ption strike price. price. The cost of the derivative derivative would depend in part upon the difference between the minimum price sought and the price for natural gas at the time the derivative was purchased. Derivatives differ from standard commodity transactions in that they usually settle on a financial financial rather than physical physical basis. basis. Although Although derivatives derivatives reference reference commodity commodity quantities quantities in valuing the derivatives, derivatives are usually settled by the payment by one party to the other and not by the physi p hysical cal delivery of the underlying underlying commodity. commodity. In the example of the natural natural gas producer in the previous paragraph, the financial put option would not give him the right to sell natural gas to his counterparty, but rather would entitle him to be paid by the counterparty the amount amount by which the put option strike strike price exceeds the market price price of natural gas. gas. Therefore, Therefore, while the producer still must sell and deliver the physical natural gas to purchasers at a market price, he will also receive from the seller of the put option payment in the amount by which the market price for natural gas at the time the natural gas is sold is less than the put option strike price.
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Rather Rather than being being traded traded on an exchange exchange,, OTC derivati derivatives ves are privatel privately y negoti negotiated ated transac transacti tions ons between between parties. parties. Eligibi Eligibili lity ty to parti particip cipate ate in an OTC derivativ derivativee transac transacti tion on is 5 governed by the Commodity Exchange Act and is generally restricted to a class of persons and entities with sufficiently sizable assets and/or presumed sophistication to understand and manage the risks associated with derivatives. 6 Many types of derivatives exist, and while it is beyond the scope of this paper to discuss the vast array of derivatives in detail, a brief discussion of the two most common energy-related derivatives follows: 1.
Options
Options contracts give the option holder the right, but not the obligation, to exercise the contract contract at a predetermi predetermined ned price during during a specific specific period of o f time.7 Options may be the option to sell, called a “put option,” or the option to buy, called a “call option.” 8 Options can be used for hedging hedging as well as for speculative speculative purposes. The producer discusse discussed d earlier who purchased the put option to create a minimum price for the natural gas he sold was using the option as a hedge, reducing his risk to market declines in natural gas, while an investor purchasing a call option in the hopes the natural gas market market will rise is using using his option to specula speculate te on o n the market. Options Options can be sold through organized exchanges, or they can be negotiated and sold on the OTC market. American-style options may be exercised at any time before the option expires, while European options options may only be exercised exercised on the date they expire.9 The The issu issuer er of the the option option makes makes money by chargi charging ng the the purc purcha hase serr a fee fee (usua (usuall lly y a percentage of the face value of the underlying asset) to secure the option. If prices remain stable, opti option on writer writerss make make only only the origi original nal fee fee they they colle collecte cted, d, known known as the the “prem “premiu ium, m,”” on the the transaction. If prices are volatile, however, option writers may suffer losses far greater than the value value of the premium received. received. For example, example, assume assume that an option writer writer sells sells a financiallyfinanciallysettled call option to a counterparty giving the counterparty the right to payment if natural gas prices prices exceed a specified specified strike strike price. Once the option writer writer has collected the premium, premium, it will not be entitle entitled d to any furthe furtherr payments payments under under the transacti transaction. on. Howeve However, r, the option option writer’ writer’ss liabil liability ity is virtual virtually ly unlimi unlimited ted as its its obligati obligations ons under under the transa transacti ction on are determi determined ned by the difference between the strike price and the current market price of natural gas at the time the transaction is settled. 2.
Swaps
Swaps Swaps are are priva privatel tely y negoti negotiate ated d OTC OTC deri deriva vativ tives es that that are are not trad traded ed on organ organiized zed exchanges. exchanges. In a swap transaction, transaction, two parties parties agree to exchange a series of payments based based on 10 different instruments. Upon settl settlemen ement, t, the paymen paymentt obligati obligations ons are netted netted,, and and the party party owing owing the net net amount amount pays the other. Swaps Swaps are general generally ly used for hedging hedging to alter alter a party’ party’ss exposu exposure re to marke markett volati volatili lity. ty. An example example of a swap swap would involv involvee Party Party A, the holder holder of a fixed-price natural gas position, entering into a swap with Party B, the holder of an index-price natural gas position. position. Party A, seeking seeking to participate participate in the natural natural gas market market price volatili volatility, ty, would agree to pay Party B the fixed price of natural gas and in exchange would be paid a market-sensitive index price by Party B, who would enter into the transaction with the goal of reducing reducing its risk exposure exposure to price volatility. volatility. If the index price price rises above the fixed price, Party
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B will be obligated obligated to pay Party A the difference difference between the the two prices. On the other hand, hand, if the index price falls below the fixed price, Party A would be obligated to pay Party B the difference between the two prices. III. III.
A BR BRIE IEF F OVERV OVERVIEW IEW OF THE THE ISDA ISDA The Master Agreement has the following characteristics: 1.
The The Mas Master ter Agre Agreem emen entt is desi design gned ed to to gove govern rn OTC finan financi cial al trans transac acti tions ons.. The The Master Master Agreement Agreement does not contain provisions provisions relating relating to the physical delivery delivery of o f any energy commodity commodity or the t he purchase purchase or sale sale of exchange-traded exchange-traded securities. securities. Any sale for exchange-traded securities should be made using a registered broker, and any transaction transaction for the t he purchase purchase and sale of physi p hysical cal comm co mmodities odities should be made pursuant to an agreement with provisions relating to issues such as title transfer, transportati transportation, on, metering metering and delivery points. The Master Agreement Agreement should only be used to document transactions that are settled on a financial basis.
2.
Two versi versions ons of the Master Master Agreem Agreement ent may be used. used. The Master Master Agreem Agreement ent has two two vers versiions, ons, the the Loca Locall Cu Curr rren ency cy-S -Siingle ngle Juri Jurisd sdiiction ction versi ersion on and and the the Multic Multicurr urrency ency-Cr -Cross oss Border Border versi version. on. The existenc existencee of two versi versions ons permit permit parti parties es to elect elect a versi version on that that may be used used intern internati ational onally ly and with with multipl multiplee curr curren enci cies es or a form that that omi omits any term terms, such such as mul multi-j ti-juri urisdi sdicti ction onal al tax provisions provisions,, not applicable applicable to transactions transactions in a single single jurisdic jurisdiction. tion. Participants Participants in ener energy gy-r -rel elat ated ed OTC OTC deri deriv vati ative tran transsacti action onss most ost comm ommonl only use use the the Multicurrency-Cross Border version.
3.
The Master Master Agreem Agreement ent contain containss an optional optional Credi Creditt Suppor Supportt Annex Annex.. The Annex Annex is optional but is widely used in most Master Agreements for energy-related OTC derivative derivative transactions transactions.. The Annex contains contains extensive provisions provisions concerning the posting and return of collateral, the types of collateral that may be used, and the treatment of collateral by the secured party.
4.
The The Mast Master er Agr Agree eem ment ent has has exte extens nsiive sup suppo port rtiing docu docum menta entati tion on.. ISDA ISDA has has produ produce ced d a wide wide array array of supp supporti orting ng mater materia ials ls for the the Mast Master er Agre Agreem emen ent, t, incl includi uding ng defin definiitions tions and and user’ user’ss guide guides. s. This This docum documen entat tatiion is desig designe ned d to preven preventt dispute disputess and to facili acilitate the consis consistent tent use and interp interpreta retati tion on of the Master Master Agreemen Agreement. t. These These materi materials als are produced produced by ISDA and are regularly regularly updated to reflect the most recent regulatory or market changes.
5.
The Master Master Agreem Agreement ent is designed designed to contr control ol multipl multiplee transa transacti ctions ons.. The Master Master Agreement Agreement sets forth all of the general terms and c onditions onditions necessary necessary to properly properly allocate the risks of the transactions between the parties but does not contain any com commerci ercial al term termss spec specif ifiic to a par particu ticullar tra transacti saction on.. Once Once the the Mast Master er Agreem Agreement ent is execute executed, d, the parti parties es can enter enter into into nume numerous rous transacti transactions ons by agreeing to the material commercial terms over the telephone as evidenced by a written confirmation without any need to revisit the underlying terms contained in the Master Agreement.
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6.
The The Mast Master er Agr Agreem eemen entt is is the the basi basiss for for oth other er energy energy-r -rel elate ated d cont contra ract cts. s. Many Many of the standard form agreements now in use in the energy industry can trace many of their provisions and their treatment of certain issues to the Master Agreement. Terms originally developed for the Master Agreement are commonly found in other contracts unrelated to OTC derivatives, such as the GISB Base Contract for Short-Term Sale and Purchase of natural Gas and the EEI Master Power Purchase & Sale Agreement.
7.
The Master Master Agreem Agreement ent is widely widely used used by by a vari variety ety of counterp counterparti arties. es. Althoug Although h it is ofte often n view viewed ed as a tool tool for banks anks and and finan nancial cial compa compani nies es,, the the Mas Master ter Agreement Agreement is widely used by a wide variety variety of counterparti counterparties. es. Producers, Producers, energy traders, and large end users all utilize the Master Agreement and OTC derivatives to reduce reduce their their energy energy commodi commodity ty risk, risk, while while inves investors tors inclu includin ding g banks banks and insur insurance ance compani companies es may use the Master Master Agreem Agreement ent to reduce reduce risks risks in their their portf portfol oliios or to spec specul ulate ate on movem ovemen ents ts in the ener energy gy marke markets. ts. The The Maste Masterr Agreement is in no way limited in its use or restricted to a small population of users.
8.
The The Mas Master ter Agreem greemen entt provi provide dess signi signifi fican cantt cred crediit prote protecti ction on to to its its use users rs.. The Master Agreement provides several mechanisms to help reduce parties’ credit risk to each each oth other incl ncludi uding: ng: (i) (i) the the righ rightt to term termin inat atee and and liqui quidate date all all of the the transactions under the agreement when a default occurs; (ii) the right to set-off obligations owing between the parties; (iii) the right to withhold payment after the occurrence of an event of default; (iv) the right to demand collateral from the counterparty under certain conditions; and (v) the ability to monitor and adjust the exchange of collateral as frequently and as specifically as the parties desire.
9.
The The Mas Master ter Agre Agreem emen entt redu reduce cess lega legall ris risk. k. The The Maste Masterr Agr Agreem eemen entt signi signifi fican cantly tly diminishes three legal risks parties assume when they enter into OTC derivative transacti transactions. ons. First, First, it improves improves the enforceabili enforceability ty of oral transactions transactions so parties can enter into transactions by phone rather than waiting to exchange executed written written confirmations confirmations.. Second, it contains contains numerous represen representations tations to ensure that that both both parti parties es abide abide by all regul regulato atory ry requi requirem remen ents ts relate related d to the the OTC derivati derivative ve transac transaction tionss and that that neither neither party party will will violate violate feder federal al law law or incur incur unan unanti tici cipa pate ted d tax tax obl obligati gation onss by virt virtue ue of ente enteri ring ng into nto OTC deri deriv vativ ative transactions with the other party. party. Third, the Master Agreement’s credit provisions redu reduce ce the the risk risk resu resullting ting from from an OTC OTC deri deriva vativ tivee count counter erpa part rty’ y’ss enter enterin ing g bankruptcy and the expense and effort a party must expend to work through any such proceeding.
10. 10.
The The Master Master Agr Agreem eemen entt reduc reduces es cont contra ract ct risk risk.. The The Master Master Agr Agreem eemen entt reduce reducess contract risk by reducing variance of the contract terms across a party’s contracts with with all counterpar counterparti ties es and between between counterpar counterpartie tiess and affili affiliates ates.. The Master Agreement Agreement achieves achieves this both by its own standardized standardized terms and a party’s use of of a consisten consistentt Schedule and Annex for all of its Master Agreements. Agreements. The burden of tracking the contractual terms of thousands of transactions is eased considerably
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by the the abili ability ty to ensu ensure re consi consist sten entt term terms are are used used in all of a party party’s ’s Master Master Agreements.
IV. IV.
11.
The Master Master Agre Agreemen ementt reduce reducess the the parti parties’ es’ liqu liquidi idity ty risk. risk. Liqui Liquidi dity ty risk risk is is the the risk that a party may not be able to enter into or terminate a needed transaction. By having a Master Agreement and the early termination and liquidation and setoff rights it contains, contains, parties parties significantly significantly reduce their liquidity liquidity risk. The Master Agreement also increases the number of transactions parties can enter into due to their ability to net credit exposure, thereby increasing the liquidity of the OTC derivative market as a whole.
12.
The Master Master Agre Agreem ement ent facil faciliitates the docume documenta ntati tion on proces process. s. By standa standardi rdizin zing g the terms of OTC derivative transactions, the Master Agreement enables parties to engage in more transactions while requiring less time and expense to put the transacti transactions ons in place. place. This increase increase in efficiency efficiency moves moves parties’ resources resources away from adminis administrati trative ve functi functions ons to be deploye deployed d in other other areas areas that may lead lead to increased revenues.
DEVE DEVELO LOPM PMEN ENT T OF ISDA ISDA
The need for a standard swap agreement arose prior to the deregulation of the United States energy markets.11 Individual interest rate and currency swap dealers developed different contracts with different terms and conditions. 12 Negotiating these contracts often consumed a great deal of time and money. The result was the formation of the International Swap Dealers Association in 1984.13 ISDA ISDA is a trade trade associ associati ation on compose composed d of dealers dealers and marke markett parti particip cipants ants engaged engaged in transac transacti tions ons in the OTC derivati derivative ve marke markets. ts. ISDA ISDA was created created to encour encourage age the prudent prudent and efficient development of the OTC derivative markets by: (i) promoting practices conducive to the efficient conduct of the business; (ii) promoting the development of sound risk management practi practices; ces; (iii) (iii) fostering ostering high high standa standards rds of commerci commercial al conduc conduct; t; (iv) (iv) advancin advancing g intern internati ational onal publ public ic under understa stand ndin ing g of the the busi busines ness; s; (v) (v) educa educati ting ng memb member erss and and other otherss on legi legisl slati ative ve,, regulatory, legal, accounting, tax, operational, technological and other issues affecting them; and (vi) creating a forum for the analysis and discussion of and representing the common interest of its member memberss on these these issues issues and devel developmen opments. ts.14 In addition addition,, ISDA produces produces standar standard d form documentation for privately negotiated derivative contracts with terms specifically tailored to the specific needs of the parties. The result has been the development of the Master Agreement and the Annex. ISDA initially consisted of 11 members whose goal was to develop standard definitions for terms terms typicall typically y found found in swap swap agreem agreements ents..15 The The Swaps Swaps Code, Code, intr introdu oduce ced d in 1985 1985 and and updated updated in 1986, 1986, consis consisted ted of standar standard d defini definition tions, s, repres representa entati tions ons and warran warranties ties,, events events of 16 default, and remedies. In 1987, ISDA produced three documents: (i) a standard form master agreement for U.S. dollar interest-rate swaps; (ii) a standard form master agreement for multi-currency interest-rate
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and currency swaps (collectively known as the “1987 ISDA Master Agreement”); and (iii) the interest rate and currency definitions.17 The 1990s result resulted ed in major major document document product production ion by ISDA, ISDA, incl includi uding ng (i) (i) a revised revised version of the Swaps Code, known as the 1991 ISDA Definitions, drafted and replaced later by the 2000 ISDA Definitions; (ii) a revision to the 1987 Master Agreement resulting in the 1992 Master Master Agreem Agreement; ent; (iii) (iii) the User’ User’ss Guide Guide to the 1992 1992 Master Master Agreem Agreement, ent, draft drafted ed in 1993, 1993, expl explai aini ning ng in detai detaill each each secti section on of the 1992 1992 Mast Master er Agreem Agreemen ent; t; (iv) (iv) the the Comm Commoditi odities es Derivatives Definitions, drafted in 1993 and supplemented in 2000; and (v) the Annex, providing for collateral documentation, finalized in 1994, followed by its User’s Guide in 1995. 18 Member Membershi ship p in ISDA compri comprises ses approxi approxima mately tely 555 member ember organiz organizati ations ons from from 41 differ different ent countri countries es,, 210 of which which are Prima Primary ry Members Members (dealer (dealer firms firms)) consisti consisting ng of banks, banks, secu securi riti ties es compan companie iess and and larg largee corpor corporat atiions. ons. Ther Theree are are 182 182 Assoc Associiate Membe Members rs (serv (servic icee providers) consisting of professional firms and corporations, and Subscribers such as end-users make up the remaining 163 members.19 To promote the OTC derivatives industry, ISDA holds international conferences, providing the most recent information and training in such areas as documentation, collateral and risk management.20 In addition, ISDA regularly appears before legislative and regulatory bodies to advocate issues on behalf of its members. 21 V.
NEED FOR THE MASTER AGREEMENT IN TODAY’S OTC MARKETS
As energy markets began to deregulate and a market for energy-based derivatives began to emerg emerge, e, large large energy energy trading trading and marke marketin ting g firms firms began began using using the Master Master Agreem Agreement ent to document derivative transactions. The Master Master Agreem Agreement ent documents documents the overall overall terms o f the relati relationsh onship ip between between the parties, parties, providing providing for payment provisi provisions, ons, representati representations ons and warranties warranties,, and provisions provisions for early termination termination,, while while the Annex governs the pledging and management of collateral collateral to secure secure a party’s payment obligations. The Master Master Agreem Agreement ent is consid considere ered d a “mast “master” er” contrac contractt becau because se of its function unction in allowing the parties to transact multiple transactions in the future using the terms in the same master master contract. contract. The Master Master Agreem Agreement ent is quite quite lengthy engthy,, and the negoti negotiati ation on process process can be burdensome, but once a Master Agreement is signed, the documentation of future transactions between parties parties is reduced reduced to a brief confirmation confirmation of the material material terms of the transaction. transaction. The confirmation automatically becomes part of and is governed by the general terms established in the Master Agreement. Agreement. Parties Parties may exchange exchange numerous numerous confirmations confirmations over time, resulting resulting in dozens or hundreds hundreds of transaction transactionss between between them. Without Without a master master contract, the parties parties would be required to enter into numerous voluminous contracts and exchange hundreds of payments. The Master Master Agreem Agreement ent can reduce reduce transac transaction tion costs, costs, howeve however, r, by reduci reducing ng the contract contractual ual requirements for each transaction to a single-page confirmation and by permitting the netting of payme payment ntss betwe between en the the parti parties es,, resul resultin ting g in one payme payment nt bein being g made made.. Usag Usagee of the the Master Master Agreement increases the efficiency of OTC transactions and thereby increases the profitability of the transaction for both sides. sides. The Master Agreement Agreement also aids in reducing disputes disputes by providing exten extensi sive ve resour resource cess defin definin ing g its term terms and and explai explaini ning ng the the inten intentt of the the contra contract ct,, ther thereby eby preventing disputes from beginning as well as providing a neutral resource to interpret standard
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contractual contractual terms. terms. Finally, Finally, the Master Agreement Agreement greatly aids in r isk and credit management management for the parties. parties. As a result of all of these these advantages, advantages, most energy marketing marketing and trading companies companies require that all OTC derivative transactions be conducted using a Master Agreement. VI.
MASTER AGREEMENT AND RELATED DOCUMENTS ARCHITECTURE A.
Master ter Agree greem ment ent
The Master Agreement is structured to provide the framework around which the rest of the ISDA documentation documentation is built. The preprinted preprinted Master Agreement Agreement is never altered except to insert the names of the parties, but is customized through use of the Schedule to the Master Agreement Agreement (“Schedule”), (“Schedule”), a document document containing containing elections, elections, additions additions and amendments amendments to the Master Master Agreem Agreement. ent. While While compreh comprehensi ensive ve guides guides exist exist for detai detaile led d discuss discussiion of the Master 22 Agreement and Annex, this paper is intended to describe some of the issues with which every user of the Master Agreement should be familiar. There There are two versi versions ons of the Master Master Agreem Agreement, ent, the local versi version on for transa transacti ctions ons between parties located in the same jurisdiction who are transacting in only one currency, and the multicurrency version for use when parties are located in different jurisdictions transacting in different different currencies. currencies. Despite Despite this distinction, distinction, the multicurrency multicurrency version version is often used even when transactions are in the same jurisdiction and payment will be in the same currency in order to incl includ udee the the more compre comprehe hens nsiv ivee provi provisi sions ons contai containe ned d in the the mul multicur ticurre renc ncy y versi version. on. The The provisions included in the multicurrency version but not in the local currency version concern issues such as taxes, currency of payment, the use of multiple offices to enter into transactions, and the designation of an agent for service of process. As previously discussed, 23 the Master Agreement does not contain any terms specific to a transaction, such as price, quantity or the identity of the buyer and seller, but rather leaves the negoti negotiati ation on and documentati documentation on of those those terms terms to a separa separatel tely y execute executed d confi confirmation rmation.. The confirmati confirmation on establishes establishes the parameters parameters of performance performance.. However, However, these obligations obligations are limited limited by the condition that a party is not obligated to make any payment or deliver or return any collateral if an Event of Default has occurred or is occurring or an Early Termination Date has occurred.24 This illustrates one advantage of the Master Agreement, namely that its drafters consi conside dere red d many many undes undesiirable rable scena scenari rios os that that coul could d occur occur,, such such as an oblig obligati ation on to pay pay a counterparty who is in default, and drafted the provisions of the Master Agreement to prevent these undesirable scenarios from arising. The Master Master Agreem Agreement ent is designed designed so that that counte counterpa rparti rties es may engage in an infini infinite te number number of transactions transactions in any month without requiring requiring the negotiation negotiation of anything anything other ot her than the materi material al terms o f perform performance ance of each indivi individual dual transacti transaction. on. While While this saves saves a tremend tremendous ous amount amount of backoff backoffice ice and legal legal time, time, this this still still burden burdenss the risk risk managem management ent and accounti accounting ng departments with the responsibility and inherent risk of tracking and settling all the various transacti transactions. ons. To address this this concern, the Master Agreement Agreement permits permits the netting netting of payments due under the same transaction so that only a single amount is exchanged between the parties, rather than numerous numerous payments payments involving involving the same transaction. transaction. This increases increases the efficiency efficiency of o f the accounting process by reducing the number of individual payments that must be made and tracked and saves saves the parties expenses expenses incurred in every payment such as wire transfer transfer fees. fees. To
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furthe furtherr facil faciliitate settli settling ng transacti transactions ons and reduce reduce costs, costs, most counte counterpa rparti rties es agree agree to net net all all amounts due on a single day regardless of whether amounts are due under a single or multiple transacti transactions. ons. It is important to note that this netting netting righ r ightt is different different from the legal right of set25 off discussed later. Netting Netting is an accounting accounting convenience utilized utilized on an ongoing basis basis between parties while set-off is used as a final settlement of accounts that extinguishes the mutual debts owed between the the parties in exchange exchange for a new, net amount amount due. The parties are incentivi incentivized zed to pay in a timely timely manner by the imposition imposition of interest interest on any amounts paid paid after the due date. Due to the limited limited t ypes of entities that may participate participate in OTC derivative derivative transactions, transactions, it is important for the parties to verify that each has the proper authorizations to participate in the transacti transactions. ons. The ISDA contains a series of representati representations ons that address address the internal and external authorization authorizationss a party must have to partici participate pate in OTC derivative derivative transactions transactions.. These include but are not limited to representations that: (i) a party is duly organized and in good standing; (ii) it has the power to enter into the agreement; (iii) the entering into of a Master Agreement would not violate any law, provision of its organizational documents or any court order or judgment; (iv) no events of default, potential events of default or termination events have occurred or are continuing or would occur upon the execution of a Master Agreement; (v) no lawsuit has been filed filed against against the party party that that coul could affect affect the validi validity, ty, legali egality or enforce enforceabi abili lity ty of the Master Master Agreement; (vi) and all information provided to the other party in connection with the Master Agreement Agreement will be accurate. It is common for parties to supplement supplement these representation representationss with additional additional representations representations in the Schedule, Schedule, often addressing addressing in greater detail t he eligibility eligibility of the parties to engage in OTC derivative transactions and the arms-length relationship of the parties in any any OTC OTC deri deriva vativ tivee trans transac acti tion on.. In recog recogni niti tion on that that circ circum umsta stanc nces es may may chan change ge after after the the execution execution of the Master Agreement, Agreement, the Master Agreement Agreement requires requires that these representations representations be made at the time the Master Agreement is executed and are deemed repeated at the time any transaction is entered into. The netting and set-off rights parties are given in the Master Agreement cause parties to calculate their financial exposure under OTC transactions on a net basis, i.e., a party calculates the difference between what it owes a counterparty under a Master Agreement and what the counterp counterpart arty y owes it under under the same same agreem agreement. ent. These These calcul calculati ations ons are made made on a markmark-totomarke markett basi basiss to reflec reflectt the current current market arket posi position of each transa transacti ction. on. In support support of these these prac practi tices ces,, the the Uni United States States Bank Bankru ruptc ptcy y Code Code exem exempts pts parti partici cipan pants ts in OTC OTC deri derivat vativ ivee transactions from the automatic stay provisions of the Bankruptcy Code and permits them to setoff obligations owed between the creditor and the bankrupt party even during the pendency of a bankru bankruptcy ptcy stay order. order.26 While While this this provi provides a credi creditor tor some some relief relief from from a counterp counterpar arty’ ty’ss bankruptcy by permitting the set-off of obligations due and owing, it does not provide relief from the exposure exposure to future positions positions that that have not yet become become due and a nd owing. In recognition recognition of this problem, the Master Agreement contains provisions permitting a creditor party to terminate and liqui liquidate date transac transaction tionss upon a counterp counterpar arty ty’s ’s bankru bankruptcy ptcy or other other defaul defaultt under under the Master Master Agreement. The Master Agreement provides the parties two means by which the Master Agreement and all transactions transactions thereunder thereunder may be terminated upon the occurrence occurrence of specified specified events. The first is the occurrence of an Event of Default, which permits a party to terminate the Master Agreement Agreement and liquidate liquidate all transactions transactions if the other party is affected affected by an Event of Default. Default. In contrast, Termination Events may affect both parties, are usually the result of the actions of 8
third-parties, and may provide the affected party a grace period to cure the Termination Event before the other party may terminate and liquidate the Master Agreement. 27 Some examples of Events of Default include: (i) a party’s failure to make payment or deliver collateral after receiving notice of such failure; (ii) a failure of or default under credit support support provided to the other party; (iii) (iii) any misrepres misrepresentati entation; on; (iv) a default under a financial financial obligation obligation to a third third party; and (v) bankruptcy bankruptcy.. Terminati Termination on Events include: include: (i) a change in a law making performance under the Master Agreement illegal; (ii) a merger that impairs the credit of the resulting entity; (iii) a merger that causes a party to pay increased taxes; or (iv) a change in tax laws aws or proce procedu dure ress that that incr increa ease sess a party party’s ’s taxes taxes.. The The part partiies may provi provide de for elect elect Additional Events of Default or Additional Termination Events in the Schedule. The party responsible responsible for or to whom an Event of Default Default applies applies is called the Defaulting Defaulting Party and the other party is called called the Non-defaulting Non-defaulting Party. If an Event of Default Default occurs o ccurs and is continuing, the Non-defaulting Party may, at its option, declare an Early Termination Date. When a Term When Termin inati ation on Even Eventt occur occurs, s, the the part party y affe affecte cted d by the the Termi Termina nati tion on Even Eventt is design designated ated the Affe Affected cted Party. Party. If a Termin Terminati ation on Event Event affects affects both parties, parties, both parties parties are designated designated Affected Affected Parties. Parties. An Affected Affected Party is obligated obligated to promptly promptly notify the other party in detail of the occurrence of the Termination Event when it discovers that the Termination Event has occurred. occurred. Certain Certain Termination Termination Events require the parties to negotiate negotiate to permit permit the Affected Party Party to trans transffer its oblig obligati ation onss to a diff differ eren entt offi office ce or affil affilia iate te if doing doing so will will cure cure the the 28 Termination Event. Other Termination Events that affect both parties require the parties to employ reasonable efforts to attempt to negotiate to cure the Termination Event. 29 If an Event of Default or Termination Event is cured prior to a party’s delivery of notice of an Early Termination Date to the other party, the right to declare an Early Termination Date is extinguish extinguished. ed. If the Event of Default or Termination Termination Event is not cured, an Early Termination Termination Date may be declared. declared. Once notice of an Early Termination Termination Date is given, the early termination termination process is allowed to run its course even if the Event of Default or Termination Event ceases to exist exist before the Early Terminati Termination on Date. Further, Further, once notice of the Early Termination Termination Date has been been given, given, no further urther paymen payments ts or deliv deliveri eries es of collateral collateral related related to the transacti transactions ons to be terminated on the Early Termination Date are required even though the Master Agreement is not terminated until the Early Termination Date. Upon the occurrence of the Early Termination Date, all transactions under a particular Master Master Agreem Agreement, ent, as well as the Master Master Agreem Agreement ent itself, tself, are termin terminated ated and and liqui liquidated dated at marke markett values values as of the Early Termin Terminati ation on Date into into a Settl Settlemen ementt Amount. Amount. Two importa important nt elections shape the liquidated value of the transactions. The first election is which of two methods to use in calculating the Settlement Amount. The First Method permits payment of a Settlement Amount only to the Non-defaulting or Nonaffe affecte cted d Party Party;; if the the Non-d Non-def efaul aultin ting g Party Party or Non-af Non-afffected ected Part Party y woul would other otherwi wise se owe a settlement amount to the Defaulting Party or Affected Party, any such amount is deemed to be zero. The premise premise behind this method is that that a party who defaults under the contract contract should should not receiv receivee a benefi benefitt in the form of a Settlem Settlement ent Amount Amount as a resul resultt of the default. default. The Second Second Method permits either party to receive a Settlement Amount, pursuant to the rationale that a
9
Defaulting Party should be entitled to the benefit of its contractual bargain so long as the Nondefaulting Party is kept whole. The second election the parties make related to the Settlement Amount is whether to use the the Mark Market et Quota Quotati tions ons or Loss Loss meth method od to valu valuee the the liqui liquida dated ted trans transac acti tion ons. s. The Marke Markett Quotation Quotationss method method uses the valuations valuations of the liquidated liquidated transactions transactions from various participants participants in the relevant relevant OTC derivati derivative ve marke markett to calcul calculate ate the Settlemen Settlementt Amount. Amount. The Loss valuati valuation on method method measures easures the Non-def Non-defaul aulting ting/Non /Non-af -affec fected ted Party’ Party’ss economi economicc loss due to the early termination, including the cost to unwind any related hedges. Rega Regardl rdless ess of the the meth method od chose chosen, n, any amoun amounts ts payabl payablee with with respe respect ct to the the early early termination and liquidation of transactions are subject to any set-off provisions agreed to by the parties. parties. These These set-off provisions provisions vary in their scope,30 but they permit the Non-defaulting party to elect whether to employ set-off and at a minimum allow the Non-defaulting Party to set-off any Settlement Settlement Amount Amount it would owe to the Defaulting Defaulting Party against any amounts the Defaulting Defaulting Party Party owes to the Non-def Non-defaul aultin ting g Party Party under under the the Master Master Agreement. Agreement. This This set-of set-offf right right is valuable valuable for several reasons: (1) it extinguish extinguishes es the underlying underlying debts and gains and replaces them with a single net amount, greatly aiding in the management of the aggregated amount between the parties and reducing the Non-defaulting Party’s risk exposure;31 and (2) if the Defaulting Party is embroiled embroiled in bankruptcy bankruptcy proceedings, proceedings, it reduces the amount and number number of o f claims in the bankruptcy proceeding and can increase the Non-defaulting Party’s cash liquidity related to those claims. The Master Agreement restricts assignment rights to ensure the parties can control the identi identity ty of their respectiv respectivee counterp counterpar arty. ty. The assignm assignment ent claus clausee in the Master Master Agreem Agreement ent prohibits transfers without consent unless: (i) the transfer is made in conjunction with a merger, consolidation consolidation,, or other business business event where where all a ll or substanti substantially ally all of the t he assets of the transferor have been transferred to the other entity; or (ii) the transfer is an assignment of amounts owed by the other party pursuant to an Early Termination. The Master Agreement Agreement contains a set of boilerpl boilerplate ate miscellan miscellaneous eous provisions provisions intended intended to address issues in advance to prevent the issues from being the subject of a dispute between the parties parties at a later date. These These provisions provisions include an entirety clause, clause,32 a modification restriction,33 a statement that all remedies are cumulative,34 a counterparts provision,35 a waiver restriction,36 and a headings limitation.37 Shoul Should d a party party incu incurr any costs costs or expe expens nses es in enforci enforcing ng its right rightss unde underr the the Mast Master er Agreement against the other party, Section 11 provides for the recovery of those costs from the other other party party.. While While some states, states, such such as Texas, Texas, may offer offer simil similar ar rights rights,,38 this this provisi provision on is particularly useful in both providing a broader right to recovery than most states offer and in eliminating any need to research the treatment of this issue by the particular jurisdiction whose law is chosen to govern the Master Agreement. Whilee the Whil the parti parties es are are free free to elec electt the the law of any any juri jurisd sdic icti tion on to gove govern rn the the Maste Masterr Agree greem ment, ent, the the most ost com commonly only chos chosen en juri urisdicti sdiction on by ener energy gy trad tradiing and and marke arketi ting ng counterparti counterparties es is New York. New York has a long long history history of addressing addressing complex business business issues in its statu statutes tes and and for tackl tacklin ing g compl complex ex busi busines nesss issu issues es in the the finan financi cial al and and comm commoditi odities es
10
industri industries. es. The foundation foundation for this is the New York General Obligations Obligations Statute Statute39 whereby any person person may file file suit suit in a New York State State court court against against a forei foreign gn corpora corporati tion on or other other nonnonresident resident if: (1) the suit arises arises out of an agreement specifying specifying the use of New York law (and, if the obligation is equal to or greater than $250,000, no relationship to the State of New York need be shown shown for the the elect electiion of New York York law law to be enf enforceab orceable le); ); and and (2) (2) the the suit suit concer concerns ns a 40 transac transacti tion on with with an aggrega aggregated ted value value of at least east $250,000 $250,000.. Parti Parties also also usuall usually y consent consent to jurisdiction and venue in New York City, because New York City courts have a reputation for proficiency in complex business litigation, fairness to all parties regardless of their jurisdiction of origin origin,, inclu includin ding g foreign oreign parti parties, es, and a desire desire to welcom welcomee cases cases invol involvin ving g partici participan pants ts from from jurisdicti jurisdictions ons outside outside of New York. The Master Master Agreemen Agreementt also requires requires that that the parties parties waive waive all immunities they may have to being sued or the exercise of any remedy against the party with immunity.41 The The Mast Master er Agre Agreem emen entt concl conclude udess with with a defini definiti tions ons secti section. on. Parti Parties es to the the Mast Master er Agreement should be aware that not all definitions are included in Section 14 of the Master Agreement but may be included in the text of the Master Agreement, the Annex, a Schedule, a Paragraph 13, or the separately published Commodity Definitions.42 It is also noteworthy that term terms may may have have defin defined ed meani meaning ngss even even thoug though h they they are are not not capi capital taliz ized ed in the the text text of the the agreement. B.
Annex
The Annex is not required by the terms of the Master Agreement, but almost all parties using using the Master Master Agreemen Agreementt also also requi require re the use of the Annex. Annex. The insisten insistence ce on using using the Annex stems from the fact that the Annex contains the vast majority majority of the credit terms related to a Master Agreement. The Annex’s mechanism for the requirement to deliver or return collateral is based on whether a party’s exposure to the other party exceeds its credit threshold. 43 If it exceeds the thre thresh shol old, d, it must ust deliv deliver er coll collateral ateral to the the other other part party y, and and if its expos exposur uree is less less than than the thresh threshold old,, then any collater collateral al it has has previou previously sly posted posted must be returne returned d to it. Neither Neither party is obligated to deliver or return collateral unless the amount to be transferred exceeds a minimum transf transfer er amount, and any amount to be transfe transferred rred is rounded rounded to an agreed agreed amount. amount. If cash is posted as collateral, the Annex provides for the payment of interest on that cash amount each month by the secured party. The parties may elect conditions restricting a party’s right to hold collateral, 44 and if a party fails to meet these requirements, it may still request collateral from the other party but any such collater collateral al must be held held by a custodi custodian an that meets meets certain certain requirem requirements ents.. If a party party is not affe affecte cted d by an ongoin ongoing g Event Event of Defaul Defaultt or Termi Terminati nation on Event Event,, then then it may may freely reely use, use, commingle or otherwise dispose of collateral as it sees fit, provided that it must exercise the same same standar standard d of care as it would would exerci exercise se toward its own property property.. This provisi provision on permit permitss a great deal of flexibility in a party’s use of another party’s collateral, even permitting a secured party to rehypothecate the other party’s collateral for the secured party’s benefit, and thereby greatly greatly improves the liquidity liquidity of collateral posted posted under the Annex. Annex. However, However, thi t hiss flexibility flexibility also causes the inherent danger that a counterparty might utilize collateral given to it and not be
11
able to return the collateral collateral when required required under the Annex. This This danger often causes parties parties to a Master Agreement to strike this provision . The The Anne Annex x contai contains ns certa certain in repre represe sent ntati ation onss relate related d to the the colla collater teral al,, incl includi uding ng representations that a party has the power to grant a security interest in collateral transferred, it has the right to transfer collateral, the transfer of collateral will create a valid and perfected security interest for the benefit of the party receiving the collateral, and performance under the Annex Annex will will not create create any security security intere interest st in the collater collateral al other other than than any securi security ty intere interest st created by the Annex. The Annex concludes with a set of definitions, but as previously noted, 45 this is by no means a comprehensive list. C.
Schedul Schedulee to the Master Master Agreem Agreement ent and and Paragra Paragraph ph 13 to the Annex Annex
In addition addition to the Master Agreemen Agreementt and Annex, Annex, parti parties es are required required to negoti negotiate ate a Schedule to the Master Agreement (“Schedule”) and a Paragraph 13 to the Annex (“Paragraph 13”). The Schedule and Paragraph 13 are used to make all amendments to and customizations of the Master Agreement Agreement and Annex, includin including g the elections of the various various options presented to the parties in the Master Agreement and Annex and the addition of provisions not contained in the Master Master Agreement. Agreement. The Schedule Schedule and Paragra Paragraph ph 13 contras contrastt with with the Master Master Agreem Agreement ent and Annex in that while the Master Agreement and Annex are always the same, it is rare for the forms forms of Schedule Schedule and Paragrap Paragraph h 13 of any two parties parties to be exactly exactly alike. alike. The Schedul Schedulee and Paragraph 13 are always separately executed from and in addition to the Master Agreement and Annex. VII. VII.
SUMMA SUMMARY RY OF THE OPER OPERATI ATION ON OF OF THE THE MASTER MASTER AGREEM AGREEMENT ENT
The The Master Master Agre Agreem emen entt addre address sses es five five prima primary ry issu issues es inher inheren entt to OTC OTC deri deriva vativ tivee transactions. A.
Reduce Reducess Credi Creditt Risk Risk Associ Associated ated with with Finan Financial cial Transa Transacti ctions ons
OTC transacti transactions ons by their nature nature do not not raise raise many of the concerns concerns associ associated ated with physical physical transactions transactions in the same commodities commodities.. For example, example, issues issues involving gas transportati transportation on or the failure failure of power power generati generation on are irrelevan irrelevantt to an OTC transac transaction tion.. However However,, while while risk reduction is always beneficial, the elimination of some risks amplifies the importance of the remaining risks. Chief among among these risks is the credit risk risk of counterparties. At their core, transactions under a Master Agreement are nothing more than a transfer of paymen payments ts from one party to the other. other. These These are usually usually made made on a net net basis basis,, with with each party owing owing money oney to the the other other unde underr vari various ous mul multiple tiple trans transac acti tions ons,, and and the the amoun amounts ts owed owed are are typically quite large, with energy trading and marketing companies often exchanging tens or hund hundre reds ds of mill milliions of doll dollars ars each each month onth unde underr Mas Master ter Agree greeme ment ntss with with vari arious count counter erpa part rtiies. es. If this mutual mutual cash cash flow flow is disrup disrupted ted by the failure ailure of one party to pay its obligations, the effect can be damaging, as a net obligation or receivable an entity anticipated being due in a month will suddenly turn into a larger exposure upon the other party’s failure to pay. pay. For example example,, assum assumee that Party Party A owes Party Party B $25 million million in a month month under a Master 12
Agreement, Agreement, and Party B owes Party A $50 $50 million million in the same month. month. Party A would would normally expect expect a net net receiv receivabl ablee of $25 milli million on from from Party B for this this month. month. If the parties parties do not net obligations and Party A makes its payment to Party B not knowing Party B will not make its corresponding payment, Party A will lose $50 million as a result of paying $25 million to Party B and never never receiving the $50 million million from Party B. The Master Master Agreem Agreement ent addres addresses ses this this issue issue by creati creating ng a sophis sophistica ticated ted colla collateral teral and security system that functions to protect the parties while creating as flexible a mechanism for doing doing so as the parties parties desire. The Master Master Agreement Agreement permits permits the parties to select any kind of colla collateral teral they desire, desire, althoug although h typicall typically y cash, cash, thirdthird-par party ty guaranti guaranties es and letter letterss of credi creditt are used. used. The parties parties set individ individual ual threshol thresholds ds for each other other beyond beyond which which collater collateral al must be provided to reflect the individual evaluation each party may have of the creditworthiness of another.46 The parties also elect how frequently the credit exposure each party has to the other must be monitored and how frequently and in which amounts collateral must be delivered and returned. returned. The existence of these variables variables results results in Master Master Agreements Agreements resembling resembling snowflakes, snowflakes, where where they are all identifi identifiable able as Master Agreements Agreements but no two are exactly exactly alike. However, However, in doing so the Master Agreement provides the parties powerful and individualized tools to manage their their credit exposure according according to their their own individual individual credit credit poli po licies cies and risk tolerances. tolerances. No oth other stan tandard dardiized zed ener energy gy trad tradiing and and marke arketi tin ng con contrac tractt addr addres essses thi this issue ssue as comprehensively as does the Master Agreement, and in so doing the Master Agreement, when managed in a diligent manner, is usually considered to provide parties the lowest credit risk of any standardized agreement. B.
Provi Provides a Ri Right to Termin Terminate ate Upon the Occurr Occurren ence ce of Certai Certain n Events Events
OTC derivatives carry a substantial risk of forward exposure, i.e., the risk that their value will change change drastically drastically as the market moves up or down over time. This risk risk is minimized minimized by the performance obligations of the other party, in particular by the payment of amounts owed and the posting posting of additional collateral collateral when necessary. necessary. However, However, when a party cannot cannot rely on the t he other party’s performance, the market risk dramatically increases, and most parties will prefer to exit their their marke markett position positionss rather rather than accept accept this risk. Most contrac contracts ts do not permit permit a party party to terminate its obligations subsequent to an adverse occurrence with sufficient ease to allow a party party to quickl quickly y addres addresss its incre increased ased market market risk. risk. In response response to this, this, the Master Master Agreement Agreement provi provide dess for two diff differ eren entt means eans by which which the the Mast Master er Agre Agreem emen entt and and the the Trans Transacti actions ons thereunder may quickly be terminated and the OTC positions unwound. As previously previously discussed, discussed,47 parti parties es may be able able to termi terminat natee and and liqui liquidat datee a Mast Master er Agreement and/or some or all of the Transactions upon the occurrence of an Event of Default or Termination Termination Event. This right right provides provides parties the advantage of the certainty that they can exit Transactions with minimal market risk if certain events occur, and the likelihood and extent of any legal challenge to such action is reduced by the express inclusion of such right in the Master Agre Agreem emen ent. t. The The rece recent nt event eventss surr surroun oundi ding ng Enron Enron eviden evidenced ced the the trem tremendou endouss impac impactt the the flexi flexibil biliity of the Master Master Agreem Agreement ent has on the overall overall efficiency efficiency of the OTC marke markets. ts. Enron Enron 48 was the large largest st trader trader in natural natural gas and power power deriva derivativ tives es prior prior to its bankrup bankruptcy tcy filing filing.. Contrar Contrary y to the predi predicti ctions ons of many many market market observ observers ers and and despi despite te this this signifi significan cantt market market position, Enron’s default under its OTC derivative transactions caused at most a minor ripple in the the marke arketpl tplac ace, e, with with littl littlee mater materiial impa impact ct on eith either er short short-t -ter erm m or longong-ter term m prici pricing ng.. 13
Counterparties were able to invoke the early termination provisions of the Master Agreement to quickly segregate the Enron obligations, isolate them from the remainder of their trading book, quantify quantify and affix their value and continue continue in business. business. If parties had been required required to negotiate negotiate release from their contracts with Enron or terminated the contracts with the risk that Enron might file suit for such action, the marketplace could very well have ground to a halt upon the demise of such a major major marke markett parti particip cipant. ant. Instead Instead,, the market market contin continued ued functioni functioning ng without without any discernible impairment. C.
Provi Provides des Meth Method od for Liqui Liquida dati tion on
The other facet of the early termination provisions that give them so much power is the means by which parties are able to swiftly and objectively calculate the value of the terminated transactions, thus permitting them to exit their positions without concern that the method by which which their damages damages were measured measured might might be challenge challenged d by a legal legal proceedi proceeding. ng. The costs incurred incurred by the terminating terminating party are addressed as well, well, leaving leaving few issues for dispute other than the proper market market numbers numbers to use to value value the terminated transacti transactions. ons. As shown by the Enron bankru bankruptcy ptcy,, compani companies es were were rewarde rewarded d in the market marketpl place ace when they were were able able to quickly quickly quantify quantify their exposure exposure to Enron with certainty certainty.. This certainty certainty could be seriously misplaced misplaced if not for the valuation provisions of the early termination provisions. D.
Provide Providess Right Right to Requi Require re Margin Margin in Certai Certain n Circum Circumsta stance ncess
The right to demand and the obligation to deliver collateral are often hotly contested in contracts. contracts. Many contracts contracts do not specificall specifically y discuss collateral collateral,, and a nd many rely upon t he UCC49 fall fallba back ck provi provisi sions ons to enf enforce orce thei their colla collater teral al right rights. s. The The UCC UCC is inap inappli plicab cable le to many 50 contracts, however, and even when it does apply its rights to demand collateral are couched in vague, ambiguous terms that lend themselves to challenge by the party from which collateral is demanded.51 Once collateral is transferred under the UCC, it is up to the parties to determine how the collateral is valued, how frequently it is valued, what the secured party may do with the collateral collateral and what rights the party providi providing ng collateral has to the return of the collateral collateral.. The Master Master Agreement Agreement resolves all of these issues in advance by specifically specifically addressing addressing the rights of the parties to collateral and requiring the parties to detail what collateral policies will apply and how they will be applied. By resolving resolving these issues in advance, parties parties are provided better credit credit certai certainty nty,, reduce reduced d credi creditt risk, risk, a reduce reduced d likel likeliho ihood od for disputes disputes concer concerni ning ng the posti posting ng and treatment of collateral and lower transaction costs. E.
Righ Rights ts to Set-of t-off f
As discussed previously, a party’s exposure to a counterparty can depend greatly on whether the obligations between the parties can be set-off against each other. 52 Although some set-off rights exist in the United States Bankruptcy Code53 and at common law54, these rights typically typically do not provide provide the extent of set-off OTC derivative derivative counterparties counterparties require. require. The Master Agreement fills this gap by reserving all set-off rights the parties may otherwise have 55 and by adding express set-off rights for the Non-defaulting Party upon the termination and liquidation of the Master Master Agreement. Agreement.56 These set-off rights provide the parties to a transaction assurance that any any expos exposur uree they they might might suffe sufferr due due to the the earl early y termi termina nati tion on and liqui liquida dati tion on of the the Maste Masterr Agreement will be netted against obligations they owe to the other party and any collateral held
14
by the parties. With With these assurances in hand, the parties parties are able to offer greater credit credit leverage leverage than they otherwise would. VIII.
ELECTIONS ELECTIONS UNDER AGREEMENT AGREEMENT
Every Master Agreement Agreement presents presents the parties parties with w ith certain standard standard elections. elections. While While this paper is not intended to comprehensively address every contractual option available under the Master Agreement, this section highlights and summarizes the most common elections. A.
Autom Automati aticc Early Early Termi Termina nati tion on
Thi This opti option perm permiits the the part partiies to elec electt to hav have the the Mast Master er Agree greeme ment nt and and all all Transactions automatically terminate upon the occurrence of certain bankruptcy or insolvency events.57 This is desirable in the event the parties have no other means to avoid the automatic stay provisions of the United States Bankruptcy Code and would thereby be prevented from enforcing enforcing the early termination termination and liquidati liquidation on scheme detail d etailed ed in Sections 5 and 6 of the Master Agreement. Agreement. This election election is typically typically not made, however, however, due to its overlap overlap with provisions provisions of o f the United United States States Bankru Bankruptcy ptcy Code that that excl exclude OTC derivati derivatives ves from the automa automatic tic stay 58 provisions. Further, it is presently unclear whether this provision is enforceable in the United States States or Canada Canada.. This provis provisiion is most useful useful when when the choice choice o f law is a juris jurisdic diction tion other other than the United States or when there is an issue issue of whether the transactions transactions entered into under the Master Agreement will be excluded from the automatic stay provisions of the United States Bankruptcy Code. B.
Valuati Valuation on Method Methodss - Market Market Quota Quotati tion on Versus Versus Loss
As previ previously discuss discussed, ed,59 the the parti parties es to a Mast Master er Agree greem ment ent may elec electt to value alue termi termina nated ted trans transac acti tion onss using using eithe eitherr the the Mark Market et Quota Quotati tion on or Loss Loss meth methods ods.. The The Marke Markett Quotation method essentially averages the valuations given to the terminated transactions by various various neutral market market participants. participants. This method method is generally generally seen as the more objective method with the lower risk of gaming by the Non-defaulting Party in order to increase the payments owed to it for t he terminated terminated transaction transactions. s. The disadvantages disadvantages of this method method are that it assumes assumes the Non-defaul Non-defaulting ting Party was able able to obtain obtain the market market price quoted by the neutral neutral market market participants when various factors, including the timing of the liquidation, may have prevented the Non-defaulting Party from obtaining this price, and it does not specifically provide for the recovery of any costs relating relating to the unwinding unwinding of hedges hedges of the terminated terminated transactions. transactions. This can lead to the Non-defaulting Party either being undercompensated by the damages or a dispute between between the partie partiess as to wheth whether er the Non-defaul Non-defaultin ting g Party Party is entitle entitled d to recove recoverr its hedge hedge unwinding costs. The Loss method is an indemnity provision based on the economic loss realized by the Non-def Non-defaul aultin ting g Party Party as a result result of the terminati termination on of the Transacti Transactions. ons. This This method method is very subjective as it relies on the self-reporting of the Non-defaulting Party, permits the recovery of such amorphous damages as loss of bargain, and permits the Non-defaulting Party to estimate the value of its losses. 60 Further, the recovery of the cost of unwinding any hedge related to the termin terminated ated transac transaction tionss is specifi specificall cally y provide provided d for when when using using the Loss Loss method. ethod. Master Master
15
Agre Agreem emen ents ts betwe between en energy energy tradi trading ng and and marke marketi ting ng compan companie iess tend tend to util utiliz izee the the Marke Markett Quotation method in order to inject as much objectivity as possible into the liquidation process. C.
Firs Firstt Meth Method od Vers Versus us Secon Second d Meth Method od
The other variable in valuing liquidated transactions is the use of First Method versus Second Method. Method. First First Method permits only the Non-defaulti Non-defaulting ng Party to receive receive payment for the terminated terminated transaction transactionss while the Second Method allows either either party to receive payment. payment. The argument for using the First Method is that a defaulting party should not be rewarded for its default. default. The counter-argum counter-argument ent for the Second Method is that contract contract law envisions envisions both parties parties receiving the benefit of the contractual bargain, and so long as the Non-defaulting Party is made whole, whole, it is unjust to bestow bestow a win w indfall dfall on that party as well. well. The First Method Method also could wreak havoc on the defaulting party’s risk profile when it anticipates a gain from various transactions that that is wiped wiped out due to the use of the First First Method Method.. Parti Parties es will occasionall occasionally y alter the early terminati termination on provisions provisions to permit permit the Non-defaulting Non-defaulting Party to pick and choose which transactions transactions it wishes to terminate. terminate. When coupled coupled with the First First Method, this creates a tremendous tremendous incentive incentive for a party party to identif dentify y the trans transac acti tion onss unfav unfavora orabl blee to it, identi dentify fy a Event Event of Defaul Defaultt or Termination Event as soon as possible, and terminate only the transactions unfavorable to it so that it owes the counterparty counterparty nothing under those transacti transactions. ons. Energy trading trading and marketing companies tend to elect the Second Method. D.
Set-off
The Master Agreement permits the parties to enforce any set-off rights they may have when the payment amount after early terminati termination on is calculated. calculated. In general, general, parties may set-off the the oblig obligati ations ons owed owed to one one anoth another er under under a contra contract ct with without out any any expr expres esss right right to do so. so.61 However, However, this is typi t ypically cally insuffici insufficient ent for parties parties to a Master Agreement. Agreement. Parties Parties often elect in the Schedule to add a set-off provision permitting the set-off of all amounts owed between the parties parties to a Master Agreement Agreement under all contracts between them. them. This is particularly particularly desirable desirable for energy trading and marketing companies who will typically trade in both the physical and finan financial cial sides of one or more more comm commodities odities and theref therefore ore have have multipl multiplee contrac contracts ts betwee between n counterparties in order to avoid a circumstance where the Non-defaulting or Non-affected Party was required to pay the other party under one agreement with no reasonable expectation of payment by the other party under another agreement. Some parties add a provision permitting the set-off of obligations owed between affiliates of the parti parties. es. This This can be useful when sister sister companies companies of the partie partiess to a Master Master Agreement Agreement also enter into transactions and the Non-defaulting or Non-affected Party wishes to avoid making payment from one affiliate while the other affiliate fails to receive payment from the other party or its affiliate. affiliate. An example example of this is Party A and Party B entering entering into a Master Agreem Agreement ent to facil faciliitate tate OTC deri deriva vati tive ve trans transac acti tions ons while while each each has has an affi affili liate ate that that has has enter entered ed into into an agreement with the other party’s affiliate for entering into physical natural gas transactions. Despite the potential advantages this type of provision can provide, many companies are not permi permitted tted to entangl entanglee their their obligati obligations ons with the obligati obligations ons of affili affiliates ates.. This This issue issue is particularly acute as deregulation of the energy industry progresses in the United States and more compani companies es are divided divided into into regul regulated ated and and unregul unregulated ated subsi subsidia diarie riess that that are prohib prohibiited from from
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entering entering into transactions transactions involving involving each other. Companies Companies are also more reluctant reluctant to agree to cross-affiliate netting provisions as the companies grow in size and complexity and the issue of tracking tracking obligations obligations across all affiliates affiliates becomes becomes more and more cumbersome. cumbersome. It is not unusual unusual for an energy marketing and trading company to have more than 150 affiliates, each with their own credit and risk managers. managers. Parent companies companies of these affiliates affiliates are o ften unwilling unwilling to permit a single affiliate to enter into an agreement that would affect other affiliates, possibly without the knowledge of the other affiliates. On the other hand, as the Enron bankruptcy showed, it is not uncommon for the affiliates of two companies to have numerous contracts and transactions with each other, and it makes more sense to net these obligations obligations on an organizational organizational level than to have some affiliates affiliates pay the bankrupt bankrupt party and have other affiliates affiliates file as unsecured creditors creditors of the bankrupt party. party. Using cross-a cross-aff ffili iliate ate nettin netting, g, the credi creditor tor party party will will likely likely realize realize more more money in set-of set-offf value value for amounts amounts owed to it by the debtor party than it would receive receive as an unsecur unsecured ed creditor. creditor. Cross Cross-affiliate netting has the advantage of reducing the amount of time it takes to resolve claims with a bankrupt party, the expense of addressing these claims and the organizational energy and attenti attention on that that must must be devoted to these these claims claims.. Utili Utilizin zing g cross-a cross-affi ffili liate ate netti netting ng can lead lead to a much more efficient marketplace and lower transaction costs for the market participants. IX. IX.
PRACTI PRACTICA CAL L CONS CONSID IDER ERAT ATIO IONS NS
A party considering the use of the Master Agreement should take the following steps to implement the use of the Master Agreement for its transactions. 1.
Purch Purchas asee the the mater materiials. als. The Mas Master ter Agre Agreem emen ent, t, def defin iniitions tions,, user user’s ’s guides guides and and 62 other other materials aterials are all available available for sale sale from from ISDA. ISDA. These These materi materials als are essen essenti tial al to devel developi oping ng polic policie iess and and docum document entat atiion relate related d to the the Master Master Agreement.
2.
Devel evelop op the the form orms. Bef Before ore a par party ente enters rs into into a Maste asterr Agree greem ment, it is import important ant that the party party firs firstt devel develop op its its own set of forms forms and policie policiess which which reflect reflect its credit, credit, risk and trading strategies strategies and policies. policies. In addition to generating generating a document that can be forwarded for others’ consideration, the creation of forms will will als also crea create te a blue bluepr priint of poli policies cies for a part party y to foll ollow duri during ng ISDA ISDA negotiations negotiations ensuring ensuring the consistent consistent treatment treatment of o f issues across agreements. agreements. The process of creating form documents will also aid a party in identifying issues that may arise during negotiations so that these issues may be considered and solutions generated prior to the negotiation process with a counterparty.
3.
Prep Prepar aree the the suppo upporrtin ting docu docum ments ents.. Purs Pursua uan nt to Sect Sectiion 4 of the the Mas Master ter Agreem Agreement, ent, parti parties es typicall typically y requir requiree each other other to provi provide de the other other vari various ous documents relating to the corporate authority of each party to enter into OTC derivative transactions under the Master Agreement and the creditworthiness of each party party and its guarantor, guarantor, if any. any. These These documents documents often take take the form of certificates of authority and annual reports and at times may require an opinion of couns counsel el.. This This can take time time,, parti particul cularl arly y for a party party that has has not prev previiously ously
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entered into OTC derivative transactions and therefore has not required that such authorizations and documentation be put in place.
X.
4.
Coord oordiinate ate the the eff efforts orts of pers person onne nell. The The Mas Master ter Agree greem ment ent requ requiires res the the contri contribu buti tions ons of legal legal,, tradin trading, g, credi credit, t, risk risk managem management, ent, accoun accountin ting g and tax personnel to generate an entity’s customized Master Agreement and to address the issues issues that arise during the negotiation negotiation of a Master Agreement. Agreement. This will require require the integration of disparate groups and interests, and this integration takes time and and careful careful discussi discussion on to determ determin inee what what polici policies es will will best best repres represen entt a party party’s ’s 63 interests.
5.
Start Start earl early y. All All of thes thesee steps steps requi require re an exten extende ded d time time fram framee for for compl completi etion. on. Ample time must be allotted to lay the groundwork prior to entering into Master Agreements or a party risks creating uncertain or inconsistent policies which can increase the risk and workload after transactions commence.
CONCLUSION
OTC derivatives are extremely valuable tools to more precisely manage risk, increase the efficiency efficiency of the marketplace marketplace and increase increase the profits of the parties parties using them. However, However, OTC derivatives derivatives carry great risks risks if improperly improperly used, thus creating creating issues issues that could could cause the expense and risk of OTC derivatives derivatives to outweigh their utility. utility. By using the Master Master Agreement properly, properly, parties can reduce this risk and expense to a customized and comfortable level that allows for very efficient transactions.
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ENDNOTES
1
10 Myths About Financial Derivatives, Thomas F. Siems, Cato Policy Analysis No. 283, September 11, 1997
(citing Artistotle, Politics, trans. Benjamin Jowett, vol. 2, The Great Books of the Western World, ed. Robert Maynard Hutchins (Chicago: (Chicago: University of Chicago Press, 1952), book 1, chap. 11, p. 453). 2 The name was changed to International Swaps and Derivatives Derivatives Association in 1993. The association had previously previously been known known as the International International Swap Dealers Association. 3 Alternately, “[d]erivatives are financial instruments that derive their used to hedge risk and speculate on market movements, the value of which depends, at least in part, upon the value and risk factor of a related asset or liability.” Applied Derivatives, Glossary, February 2002, found at http://www.appliederivatives.com/glossary/index ; and The Derivatives ‘Zine, Derivatives Dictionary, November 2001, found at http://www.margrabe.com/Dictionary. 4 The Derivatives ‘Zine, supra note 3. 5 7 U.S.C. § 1, et seq., as amended (West 1999). 6 participant”). See 7 U.S.C.A. § 1a(12) (West Supp. 2001) (definition of “eligible contract participant”). 7 The Derivatives ‘Zine, supra note 3. 8 Id . 9 Applied Derivative , supra note 3. 10 The Derivatives ‘Zine, supra note 3. 11 Sean M. Flanagan, Student Note, The Rise of a Trade Association: Group Interactions Within the International Swaps and Derivatives Derivatives Association, 6 Harv. Negotiation Negotiation L. Rev. 211, 235-236 235-236 (2001). 12
Id. Id. 14 See International Swaps and Derivatives Association, Inc., Who we are - Mission, at 13
http://www.isda.org/wwa/index.html (last visited January 26, 2002). 235-236. Flanagan, supra at 235-236 16 Id. at 234. 17 243-245. Id. at 243-245. 18 243-245. Id. at 243-245. 19 International Swaps and Derivatives Derivatives Association, Inc., All About About Membership, Membership, at See International http://www.isda.org/membership/index.html (last visited January 26, 2002). 2002). 20 International Swaps and Derivatives Association, Inc., Conferences, at http://www.isda.org/conf/index.html See International (last visited January January 26, 2002). 2002). 21 E.g., http://www.isda.org/speeches/pdf/FeinsteinLetter.pdf . 22 See ISDA, User’s Guide to the 1992 ISDA Master Agreements (1993) (hereinafter ISDA User Guide); 1991 ISDA Definitions; 1994 ISDA Equity Definitions; ISDA Commodity Definitions. 23 See supra Section V. 24 International International Swap Dealers Association, Inc., Master Agreement Agreement §§ 5-6, at 5 (1992) (hereinafter (hereinafter ISDA Master Master Agreement). 25 See Section VII(E), i nfra. 26 11 U.S.C.A. § 362 (West Supp. 2001). 27 See infra Section VII. 28 See ISDA Master Agreement, supra note 6. 15
29 30
Id. E.g., many Master Agreements permit the set-off of amounts owed between the affiliates of the parties to the
Master Agreement and/or amounts owed under physical physical commodity agreements between the parties to the Master Master Agreement and/or their affiliates. affiliates. 31 E.g., If Party A declares an Event of Default due to Party B’s default, and Party A owes Party B $30 million under the Master Agreement while Party B owes Party A $50 million under the Master Agreement, Party A risks having to pay Party B while not getting paid in return, an $80 million exposure. exposure. However, However, if set-off is employed, employed, Party B would owe Party A $20 million, resulting in a $20 million exposure for Party A.
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32
This provision establishes that no agreements or indications of the intent of the parties exist regarding the subject of the Master Agreement other than those contained in the Master Agreement. 33 For any modification of the master Agreement to be effective, both parties must sign the written document detailing the modification. modification. 34 Contracts that contain contain liquidated damages typically typically limit recovery to those liquidated damages. However, However, the Master Agreement in this provision permits the parties to any other remedy available to it, such as injunctive relief or specific performance, and permits the parties to seek such remedies without necessarily terminating the Master Agreement or any Transaction. 35 As is typical in energy trading trading and marketing contracts, the Master Agreement permits the parties to exchange duplicate originals of the Agreement and/or signatures via fax with all such duplicates or facsimile copies constituting constituting an original document for purposes purposes of evidencing the contractual agreement agreement of the parties. Further, Further, the Master Agreement establishes that Transactions are binding as soon as they are agreed upon rather than at the time Confirmations are jointly executed, thus permitting a party to rely on an oral agreement and immediately establish other positions positions based on that oral agreement rather than requiring requiring for the complete execution of the confirmation. confirmation. It is not uncommon for days or weeks to elapse before a confirmation is fully executed, and without this provision parties would incur significant market risk in that the market could move substantially while the parties were awaiting the execution of confirmations. confirmations. This provision provision greatly improves the efficiency of OTC derivative derivative transactions, lowers transaction costs and decreases the likelihood that a counterparty will back out of a transaction on the basis that the transaction was not binding until a Confirmation was fully executed. 36 In some cases a party’s failure to take an action or waiver of a right can be construed by a court as a waiver of all similar rights. This provision provision rejects this approach in favor of permitting the parties to decline to exercise a r ight at any time without without prejudicing prejudicing any future r ights. 37 Headings and titles can sometimes be used to interpret the meaning of contractual provisions, but this section of the Master Agreement prevents headings from being used in such manner. 38 See TEXAS CIV. PRAC. & REM CODE, § 38.001 (V ERNON 1997). 39 N.Y. Gen. Oblig. Oblig. § 5-1401 (McKinney 1989). 40 N.Y. Jud. L. 27(b) (McKinney 1989). 41 This is occasionally a sticking point for quasi-governmental entities, but this issue can usually be separately negotiated in a mutually satisfactory manner and this provision serves the valuable role of identifying this issue for negotiation even if a party refuses to agree to its terms. 42 1991 ISDA Definitions; Definitions; 1994 ISDA Equity Definitions; ISDA Commodity Definitions. 43 The threshold is calculated using a threshold established by the parties and adding to it any collateral previously posted. 44 This usually prohibits a party from holding collateral if it is affected by an ongoing Event of Default or Termination Termination Event or fails to meet certain creditworthiness creditworthiness requirements. 45 See supra Section VI(A). 46 Parties frequently tie these thresholds to a matrix so the thresholds adjust themselves automatically in relation to changes in a party’s credit ratings. 47 See supra Section VI. 48 See The Power Marketing Association Online, at http://www.pmaconference.com/topmarketers 49 See Tex. Bus. Com. Code Ann. § 2.609 (Vernon 1994) (Right to Adequate Assurance of Performance) (The Uniform Commercial Code as set forth in the provisions of the Texas Business and Commerce Code will be hereinafter cited as the “U.C.C.”). 50 U.C.C. § 2-201 (Vernon (Vernon 1994). 1994). The UCC Article 2 only applies to transactions between merchants for for the sale of goods. 51 U.C.C. § 9 et. Seq. (Vernon 1994). 52 See supra Section VI. 53 11 U.S.C.A. § 553 (West Supp. 2001). 54 See Studley v. Boylston National Bank, 229 U.S. 523, 528 (1913). 55 See ISDA Master Agreement . 56 See ISDA User’s Guide, at 54. 57 often also elect to cause automatic termination termination to occur if a party’s party’s See ISDA Master Agreement, at 8. Parties often credit rating drops below investment investment grade. 58 11 U.S.C.A. § 362(b) (West Supp. 2001). 59 See infra Section V.
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60 61 62
See ISDA Master Agreemen, at 15. See supra Section VII(E).
ISDA offers all of its materials for sale at its website, www.isdsa.org www.isdsa.org.. An example of this is the tension between the trader desiring to enter into OTC derivative transactions, who is incentivized to assume risk to maximize return, and legal counsel, who is incentivized to minimize the risk in the Master Agreement. Agreement. 63
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