Magazine article The RMA Journal

The ISDA Agreement: Key Document Considerations in Today's Market: In Today's Volatile Market, the Importance of Properly Documenting and Negotiating ISDA Agreements Takes on a New Level of Significance. Each Institution's Risks and Exposures Will Present New Challenges in Negotiating Agreement Terms

Magazine article The RMA Journal

The ISDA Agreement: Key Document Considerations in Today's Market: In Today's Volatile Market, the Importance of Properly Documenting and Negotiating ISDA Agreements Takes on a New Level of Significance. Each Institution's Risks and Exposures Will Present New Challenges in Negotiating Agreement Terms

Article excerpt

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In today's market, an increasing number of commercial banks and other institutional investors are parties to privately negotiated and monitored derivatives contracts, typically known as "over the counter" derivatives. With no formal clearinghouse to serve as an intermediary, the International Swaps and Derivatives Association (ISDA) has promulgated a set of standard documents intended to address several key risk-allocation and risk-shifting provisions. These standardized documents traditionally consist of a master agreement, a supporting schedule, individual transaction confirmations, and one or more additional documents that may include a guaranty or a credit support annex.

The ISDA Master Agreement

The master agreement is the principal document in an ISDA transaction, setting forth the standard terms and conditions applicable to all individual transactions agreed to between the counterparties. (1) Standard in the master agreement are provisions governing conditions precedent, netting, withholding tax, events of default, termination events, and governing law, among other areas. (2) The master agreement is traditionally based on a standard form issued by the ISDA--either its 1992 form or its 2002 form. While reflective of the "standard" terms and conditions, these master agreement forms are intended to be negotiated and customized to individual transactions, although frequently they are not heavily negotiated.

The ISDA Schedule

The schedule to the master agreement amends and supplements that agreement by customizing some standard terms and conditions. The schedule also is based on a standard ISDA form, but is far more likely to be subject to negotiations and modifications between the counterparties to account for deal-specific provisions.

When drafting the ISDA schedule, commercial banks should be aware of several common issues:

* Joint and several liability between parent-subsidiary groups. Frequently, especially when the bank's customer is a multinational corporation, the master agreement will apply not only to the parent corporation but also to various domestic and foreign subsidiaries that may enter into transactions under the same master agreement. From a commercial bank's perspective, it would be preferable if the parent corporation and its various subsidiaries were jointly and severally liable for the others' obligations under the master agreement. This joint and several liability offers the bank the ability to pursue any and all members of the corporate group in the event that any member breaches the master agreement or is in default of any payment. Customers frequently resist this approach, however, so it is essential that the bank obtain, at a minimum, a satisfactory guaranty from the parent corporation covering the risks and liabilities of the individual subsidiaries.

* Cross-default provisions. The cross-default provisions, which typically are incorporated into ISDA schedules, vary from deal to deal. For a commercial bank, an ideal cross-default provision would state that any default by the customer 1) in the payment of any other debt obligation (regardless of whether such obligation is owed to the bank) or 2) under any covenant of the customer's lending arrangements (regardless of whether such arrangement is with the bank) constitutes a default under the ISDA master agreement. Such a provision is likely to meet with strong resistance from the customer, particularly if the bank is not a lender to the customer or has only a foreign exchange or other similar swap or derivative relationship with the customer. While a number of compromises are possible, commercial banks need to be careful in considering how cross-default provisions are drafted to ensure that the terms of the ISDA schedule correspond with the bank's comfort level for credit risk with respect to the customer.

* Nature and extent of set-off rights. …

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