Mastering The ISDA Master

Daniel Cunningham, a partner at Cravath, Swaine & Moore, explains the best ways to use the ISDA Master Agreement

An article in the November 1995 issue of Derivatives Strategy listed 10 ways to improve on the ISDA Master Agreement. The 10 suggestions contain a number of points that are either already covered by the User's Guide to the 1992 ISDA Master Agreements or inaccurately describe the provisions of the 1992 ISDA master agreements. It is important to clarify these points to avoid misunderstandings and unnecessary changes to master agreements.

1. Use the right master agreement

Derivatives Strategy suggested that because most users choose to use the multicurrency master agreement, end-users often receive inappropriate documentation, causing delays as lawyers try to understand the document.

ISDA agrees that it is important to select the appropriate master agreement for the anticipated transactions at hand. That is why two agreements were developed, one for multicurrency transactions and one for local currency transactions. On page 1 of the User's Guide, we lay out the differences between the master agreements.

The multicurrency version of the ISDA master is more complicated but it is more versatile. One reason why many parties select it, even when entering into relatively straightforward transactions, is to cater to the development of their relationship over time. It is clearly preferable, in terms of both efficiency and the legal advantages of the single-agreement approach, to establish a comprehensive agreement rather than to use separately negotiated stand-alone agreements on each occasion that a new type of transaction is proposed.

2. Shrink collateral verbiage

ISDA offers a menu of four forms for collateral arrangements-one governed by New York law, two governed by English law, and one governed by Japanese law-from which a selection can be made based on where the parties are and where the collateral is located. Derivatives Strategy said that "the lawyerly urge to cover all possible cross-border contingencies has resulted in a standard collateral agreement of gargantuan proportions." This statement is incorrect in that each ISDA collateral agreement covers a number of variations for collateral arrangements, but none of them deals with cross-border contingencies.

3. Eliminate unnecessary protections

The November 1995 article suggested that in the case of "one-way business," where an end-user purchases an interest rate cap from a dealer, the liability is also one-way, but "the master agreement spells out default provisions for both parties." The parties may wish to make adjustments in these cases. ISDA's suggested language for doing so was laid out in 1989 when it published standard documentation for interest rate caps, collars and floors. In that documentation ISDA suggested a provision to deal with relationships where one party had satisfied all its payment obligations. In a commentary also published in 1989, ISDA explained the provisions further. These documents are available from the ISDA offices.

4. Specify interest on overdues

The November 1995 article says that the ISDA master agreement "does not address the issue of what the interest rates will be on overdue payments during the grace period."

Section 2(e) of the 1992 ISDA master agreements contains the following provision: "...Prior to the occurrence or effective designation of an Early Termination Date in respect of the relevant Transaction, a party that defaults in the performance of any payment obligation will, to the extent permitted by law and subject to Section 6(c), be required to pay interest (before as well as after judgment) on the overdue amount to the other party on demand in the same currency as such overdue amount, for the period from (and including) the original due date for payment to (but excluding) the date of actual payment, at the Default Rate."

ISDA believes that this provision clearly requires the payment of interest at the default rate during a grace period. The default rate is defined as the recipient's cost of funds plus 1 percent.

5. Set appropriate bankruptcy provisions

The November 1995 article stated that the master assumes that counterparties will be subject to the U.S. bankruptcy code. This is not true. The User's Guide explains the bankruptcy default provision as follows:

"...Accordingly, the Bankruptcy Event of Default has been drafted with the intention that it be broad enough to be triggered by analogous proceedings or events under any bankruptcy or insolvency laws pertaining to a particular party. However, the User's Guide also suggests that when a party to the transaction is organized in a jurisdiction outside the U.S. or England, the bankruptcy the event of default may need to be modified to refer to "specific insolvency concepts relevant in other jurisdictions."

6. Simplify tax withholding

The November 1995 article suggested that given the complications involved in withholding tax issues, "one remedy [would be to] have all parties simply state that they are not liable for withholding tax."

Withholding tax provisions, when they are necessary, are necessarily complex. It is not sufficient to have all parties simply state that they are not liable for withholding tax because under many tax systems a party cannot make this statement without receiving information about the tax status of its counterparty. This information is received through tax representations and tax forms. The suggested remedy does not work.

7. Get protection from merger situations

The November 1995 article noted that the ISDA master agreements allow "counterparties to terminate an agreement if one of them merges in such a way as to cause negative tax repercussions." It suggested that this termination event should not be used because "by leaving a time window between a merger announcement and a derivative deal's termination, a counterparty might be able to find a replacement swap and preserve the integrity of its hedging strategies." However, these suggested provisions are already reflected in ISDA's tax event upon merger (Section 6 (b) (ii) of the 1992 ISDA master agreement).

8. Disallow nit-pick defaults

The November 1995 article states, "The master creates an automatic default situation, triggered upon failure to pay any borrowings-even a few dollars-that result from a clerical error. Recommendation: set a reasonable threshold amount and technical default due to the failure to pay minor bills."

The master simply does not create the automatic default situation described upon failure to pay any borrowings. First, the cross-default event of default is optional. Second, a threshold amount concept is built into the cross-default provision in the ISDA master agreements. With the appropriate elections, in a schedule to an ISDA master agreement, it is a simple matter to have the cross-default apply and to set an appropriate threshold amount. The User's Guide contains a clear and detailed explanation of this provision.

9. Collateralize after downgrades

While it is true that amendments to create protection in the event of a counterparty's credit downgrade have been popular lately, we would like to point out the risks involved. Such provisions can have the effect of creating liquidity problems for a party after a downgrade, which may be a particularly bad time to face demands for substantial amounts of collateral. Recommendation 7 in the Group of 30 Study entitled "Derivatives: Practices and Principles" states that investing and funding forecasts "should examine the potential impact of contractual unwind provisions or other credit provisions that produce cash or collateral receipts or payments."

Dan Cunningham has represented ISDA on its documentation projects since 1984.