When a hedge fund decides to enter into derivatives, the first hurdle is a large stack of documents that must be signed with each trading counterparty. This stack will usually include an ISDA Master Agreement published by the International Swaps and Derivatives Association. The ISDA Master Agreement establishes the primary credit and legal terms between the parties. Although the ISDA Master Agreement is signed by the parties without any changes, it is a highly negotiated document that revolves around a 10- to 20-page “Schedule” to the ISDA Master Agreement that sets out all of the modifications, elections and other negotiated provisions. Most of the hedge fund’s negotiations with its counterparty (which typically is a derivatives dealer) will center on the instances in which the counterparty can terminate all of the open transactions in place between the parties and when the counterparty can liquidate all of the hedge fund’s collateral held under the ISDA Master Agreement.
The Credit Support Annex is another agreement that is usually part of the stack of documents provided with the ISDA Master Agreement. The CSA is a form document published by ISDA and is accepted by the parties in the form it is printed. Elections and modifications to the CSA are set out in a document attached to the CSA that is referred to as the Paragraph 13. Modifications to the CSA are made in a document referred to as the Paragraph 13 because the printed CSA form consists of 12 paragraphs. The CSA and Paragraph 13 set out the collateral terms for derivative transactions under the ISDA Master Agreement, including one-way or two-way collateral agreements.
In this article, I will highlight the structure of the ISDA Master Agreement and cover some of the primary credit and collateral terms that face hedge funds when entering into this necessary agreement.
ISDA Master Agreement
Since 1987, several forms of ISDA Master Agreements have been published. When discussing the ISDA Master Agreement in this article I refer to the version of the agreement most commonly used: the 1992 (Multicurrency–Cross Border) form of the ISDA Master Agreement as published by ISDA. Although a newer version of the ISDA Master Agreement was released in 2002, the 1992 form that I discuss in this article remains the form more commonly negotiated in the market today and preferred by end users such as hedge funds. To better address the concerns and issues faced by most hedge funds, I address key issues as they arise under the 1992 form of the Master Agreement. Even though some issues are specific to the 1992 form of the Master Agreement, many of the issues apply equally to both versions.
The ISDA Master Agreement and the Schedule that is made a part of the ISDA Master Agreement establish the legal and credit relationship between the parties. A number of situations under the Master Agreement can give a party the right to terminate the transactions that are subject to the Master Agreement. The Schedule allows the parties to designate the termination events known as additional termination events. Typical additional termination events faced by a hedge fund are declines in net asset value and changes in the investment manager. In this article I address the consequences of three categories of default and termination events under the Master Agreement: default under specified transaction, cross default and additional termination events.
Default under Specified Transaction
A critical default provision is the default under specified transaction, which is Section 5(a)(v) of the Master Agreement. The concept underlying this provision is that if a party fails to perform under any derivative transaction (whether or not that derivative is subject to the Master Agreement), the other party will have a right to terminate all transactions under the Master Agreement. Failure to perform under a derivative transaction is a significant credit event, signaling the credit deterioration of the defaulting party. Under this provision the non-defaulting party has the right to choose whether to continue the trading relationship under the Master Agreement. This is obviously an important right.
As specified in the Master Agreement, this provision only is triggered when there are defaults under other derivative transactions similar to those typically be entered into under an ISDA Master Agreement. Some counterparties seek to expand this default provision to include all transactions of any kind between the parties. This is done by expanding the definition of “specified transaction” beyond derivatives to include prime brokerage agreements, repurchase transactions, securities lending transactions, lending agreements, credit agreements and other agreements between the parties. If this expansion is agreed to by the parties, it means that any default by the hedge fund under any of these other agreements with the counterparty can result in an early termination of all transactions subject to the Master Agreement.
Expansion of this default under specified transaction provision poses a number of problems for hedge funds. For example, many prime brokerage agreements are signed by hedge funds without negotiation. Because some hedge funds view their prime brokerage relationships as demand facilities, they do not allocate much of their resources to the review and negotiation of prime brokerage agreements. One problem with accepting a standard from prime brokerage agreement without negotiation is that the agreement typically provides that it is an event of default if the prime broker has grounds for insecurity with respect to the hedge fund’s ability to perform. This is only one of a number of default provisions crafted to allow a prime broker to terminate this agreement. By accepting such a prime brokerage form containing provisions such as the grounds for insecurity provision, the prime brokerage agreement can have a ripple effect and also cause the termination of the Master Agreement, which typically contains longer-term transactions that can be very difficult, if not impossible, to replace. If the definition of specified transaction is expanded, the termination of the prime brokerage agreement by reason of default would provide a dealer with the right to terminate the Master Agreement.
Another concern for hedge funds is raised with stock lending and repurchase agreements. Failures to deliver securities are considered defaults under stock lending and repurchase agreements. Although failures to deliver are common occurrences under stock lending and repurchase agreements, they are still technically considered defaults without regard to whether the failing party pays the “buy in” amount resulting from the delivery failure. Whenever a hedge fund fails to deliver securities under a stock lending or repurchase agreement, the other party may have the right to terminate the Master Agreement.
Expanding the definition of specified transaction allows the contract with the easiest default provision to become the lowest common denominator for a hedge fund. Any default under any of the agreements between the hedge fund and its dealer may now give the dealer the right to terminate all of the transactions under the Master Agreement. If a hedge fund agrees to expand this default provision to include its other agreements, it should at a minimum, consider carving out technical defaults under those other agreements. In addition, a hedge fund should evaluate each of its agreements with its Master Agreement counterparty and determine if there are any default provisions under those agreements that are arbitrary or technical. Further, a hedge fund should also consider limiting this default provision to only payment defaults rather than all of the defaults (technical or otherwise) under any of its other agreements.
The 2002 Master contains an expanded default under specified transaction provision that includes a broad range of transactions and trading relationships between the parties. This expanded language, if the parties want to include it, must be added to the 1992 Master Agreement in the schedule that is made a part of the Master Agreement. Although the 2002 Master provides that the agreement governing any defaulted transaction (and all transactions governing such transaction) must be terminated before the default can be used as a reason to terminate the ISDA Master Agreement, this modification does not address the concern of many hedge funds that a counterparty concerned with the hedge fund’s creditworthiness or desiring to end the relationship for another reason could use a technical default under another agreement as a way to terminate both that agreement and the 2002 Master.
Another default provision under the Master Agreement is the cross default provision set out in Section 5(a)(vi). Cross default specifies that if a party to a Master Agreement defaults in any borrowed money obligations to anyone in excess of an agreed dollar amount, the other party to the Master Agreement can terminate all transactions under the Master Agreement. This cross default provision is broader than the default under specified transaction provision because it looks to the defaults by a party under its other third party agreements as a way to terminate the transactions under the Master Agreement. Under the standard form of the Master Agreement, the cross default provision is limited to borrowed money obligations, such as letters of credit and other lending agreements. If this cross default provision is left as it is defined in the Master Agreement, without modification, most hedge funds are not troubled by this provision because hedge funds do not typically issue debt or borrow money through typical lending arrangements and letters of credits. If this cross default provision were expanded to include all third-party relationships of a hedge fund, a default by the hedge fund under any third-party prime brokerage agreement (including a technical default where the agreement is not terminated) can result in the counterparty’s right to terminate the Master Agreement. As a result, if a default occurs under any of a hedge fund’s prime brokerage agreements, all of the hedge fund’s ISDA Master Agreements containing this expanded cross default provision can also be terminated. For a hedge fund, an expanded cross default provision also results in taking defaults down to the lowest common denominator among default provisions in all of its other agreements with its counterparties. The most loosely crafted default provision under any of its agreements with third parties could trigger a default under a Master Agreement including such an expanded cross default provision.
Typically, hedge funds resist this expansion to include all third-party agreements. If a hedge fund finds that it must agree to the expansion of this cross default provision, it typically carves out technical defaults under its other agreements. A hedge fund may also want to consider limiting any cross default to include only payment defaults instead of all defaults (technical or otherwise) under any of the other agreements. If an expanded cross default provision is proposed, a hedge fund should carefully review its other agreements to evaluate the defaults under these agreements that can trigger a termination under the Master Agreement.
Additional Termination Events
Additional termination events are often proposed in ISDA negotiations and are additional triggers that can provide a party with a right to terminate the transactions under the Master Agreement. Additional termination events that are frequently proposed for hedge funds will include reductions in net asset values, key man clauses, changes in investment manager and changes in the hedge fund’s trading strategy. Occasionally, changes in the amount of the assets under management by the hedge fund manager are proposed as an additional termination event. Each hedge fund must consider the possible significance of agreeing to any of these additional termination events. In considering net asset value declines proposed by a counterparty, hedge funds typically consider whether to accept NAV declines that are inclusive of or exclusive of redemptions. Hedge funds also consider whether the amounts proposed by the counterparty are appropriate to trigger a termination of the Master Agreement.