Mastering Finance-Linked Swaps: A Definitive Guide to Principles, Practice & Precedents (Market Editions)

mastering finance-linked swaps

a definitive guide to principles, practice and precedents

a definitive guide to principles, practice and precedents

GARY WALKER Gary Walker worked in the London banking market for twelve years (including two as head of the loan and derivatives documentation team at Daiwa Europe Bank plc) before qualifying as a solicitor in the mid-1990s. After six years in the capital markets and derivatives practices of City firms Wilde Sapte and Clifford Chance, he moved to Birmingham in May 2000, joining Wragge & Co in September 2001. Gary is cited in The Legal 500 (1994) and in Chambers Guide to the Legal Profession (2001/2 and 2002/3), sits on various ISDA working groups and is an occasional contributor to the work of the Technical Committee of the UK Association of Corporate Treasurers. He is an active conference speaker and article writer and an expert on the law and documentation of OTC derivatives. At Wragge & Co, he is engaged in co-building the UK’s first dedicated, regional, end-user focussed capital markets and derivatives practice. Gary holds an MA (Cantab.) in Law and Economics, a Diploma (with dist.) in Legal Practice and a summa cum laude in Law Relating to Banking from the Chartered Institute of Bankers. He brings nearly two decades of industry, in-house legal and private practice experience to the subject matter of this book.

“I will be very glad to have Mastering Finance-linked Swaps at the ready on my shelf.” – Jeffrey Golden, Partner, Allen & Overy “The best treatment of the subject I have read. Walker’s judicious insights and fair minded but trenchant views make this an invigorating read. This is the ‘must have book’ on the subject and I hope will lead to a much needed reform of market practices.” – Paul Harding, Managing Director, Derivatives Documentation Ltd “Mastering Finance-linked Swaps is a refreshingly honest account of the current level of understanding of financial derivatives… It is both an educational tool and a professional source book. Gary Walker is to be congratulated – I wish I had written it!” – Margaret T. Garner, Special Legal Counsel “Gary Walker clearly sets out the background to derivatives, its strategy and application. Mastering Finance-linked Swaps should be required reading for those lawyers working in finance and especially those working in isolation in banks and similar institutions.” – Mia Franks, Solicitor, Group Treasury, Bradford & Bingley plc “Packed with practical insights, this is a timely, lively and provocative book.” – Jonathan Shann, Partner, Freshfields Bruckhaus Deringer “A concise and very clear guide to the area of finance law where debt and hedging meet, and a valuable reminder of how easily people forget that they meet at all. Practitioners on each side of the divide should learn a great deal from this book.” – Ian Annetts, Partner, Allen & Overy

mastering finance-linked swaps

mastering finance-linked swaps

"A thought-provoking book that has practical applications for all in project finance." – Paul Sullivan, Head of UK & European Project Finance, Royal Bank of Scotland "Mastering Finance-linked Swaps is the ideal read for any practitioner who aspires to work in house or in private practice in today's market for structured products. In one volume this book offers the reader primer, tutor, aide memoire dictionary and friend." – Claude Brown, Partner, Clifford Chance.

mastering finance-linked swaps a definitive guide to principles, practice and precedents GARY WALKER

Mastering Finance-linked Swaps is the first book to offer clear, detailed, practical guidance on the key commercial, operational, legal and documentation issues that can arise. It provides lenders, swap providers and borrowers with the confidence and technical ability to ask the right questions at the right time so as to ensure that, whatever the nature of the financing, the swap is correctly integrated into the structure.

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market editions

WALKER

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Mastering Finance-linked Swaps provides: • a unique perspective on the UK swap and loan markets • a critique of current practice in the UK finance-linked swap market • a comprehensive analysis of the key issues in the context of all major UK debt finance structures • numerous examples and practical solutions taken from real-life transactions • clear, diagrammatic illustrations throughout • a model of finance-linked swap documentation • essential checklists to help the reader • analysis of repackagings, securitizations and other specialized applications • guidance on project managing the finance-linked swap process

market editions

mastering finance-linked swaps a definitive guide to principles, practice and precedents Mastering Finance-linked Swaps plugs a gap in the literature in timely fashion – finance-linked swaps are hot and can only be expected to get hotter. This book builds a bridge for practitioners on the banking and finance side of the markets to cross over more comfortably to the sometimes intimidating world of derivatives and, in so doing, removes barriers to entry that may have kept many lawyers and consultants from giving the sophisticated derivatives advice that their clients deserve in this area. It is rare today that a project lender, property development financier, PFI banker, MBO debt provider or securitization investor does not insist on its borrower taking out some form of interest rate and/or cross-currency hedging. By and large, however, the implications of integrating a swap into a structured financing are little understood and often ignored. Mastering Finance-linked Swaps will be of invaluable use to: bankers • traders • documentation specialists • lawyers • accountants • corporate treasurers • corporate and property finance consultants • venture capitalists • PFI professionals • rating agency analysts • regulators

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In an increasingly competitive world, we believe it’s quality of thinking that will give you the edge – an idea that opens new doors, a technique that solves a problem, or an insight that simply makes sense of it all. The more you know, the smarter and faster you can go. That’s why we work with the best minds in business and finance to bring cutting-edge thinking and best learning practice to a global market. Under a range of leading imprints, including Financial Times Prentice Hall, we create world-class print publications and electronic products bringing our readers knowledge, skills and understanding which can be applied whether studying or at work. To find out more about our business publications, or tell us about the books you’d like to find, you can visit us at www.pearsoned.co.uk

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market editions

Mastering Finance-linked Swaps A definitive guide to principles, practice and precedents First Edition

Gary Walker

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PEARSON EDUCATION LIMITED Head Office: Edinburgh Gate Harlow CM20 2JE Tel: +44 (0)1279 623623 Fax: +44 (0)1279 431059 Website: www.pearsoned.co.uk First published in Great Britain in 2003 © Pearson Education Limited 2003 The right of Gary Walker to be identified as Author of this Work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. ISBN 0 273 66198 1 British Library Cataloguing in Publication Data A CIP catalogue record for this book can be obtained from the British Library. Library of Congress Cataloging in Publication Data Applied for. All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without either the prior written permission of the Publishers or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers. 10 9 8 7 6 5 4 3 2 1 Typeset by Mathematical Composition Setters Ltd, Salisbury, Wiltshire. Printed and bound in Great Britain by Bell & Bain Ltd, Glasgow The Publishers’ policy is to use paper manufactured from sustainable forests.

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Contents

About the author Disclaimer Acknowledgements Preface

ix x xi xiii

1 Introduction What is a finance-linked swap? Comparison with stand-alone derivatives Comparison with fixed rate loan arrangements Comparison with other finance-linked derivatives Size and shape of market Structural formats Current market practice

1 3 5 7 10 10 11 12

2 Swap and loan markets compared Similar but different? Economic differences Documentation differences Operational differences Legal differences Cultural and conceptual differences Does it matter?

15 17 17 20 22 24 25 26

3 Key commercial considerations Hedging strategy Economic symmetry Credit symmetry Prepayment Security and intercreditor issues Transferability

27 29 34 40 43 44 47

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4 Key documentation considerations Swap documentation Loan documentation Security documentation Intercreditor documentation Ancillary documentation

49 51 70 73 76 77

5 Key legal and regulatory considerations Overview Capacity and authority Suitability Reliance Reputation, regulatory and litigation risk Advisor liability

79 81 81 83 85 87 90

6 Market-specific considerations Common themes Project financings Property financings PFI financings MBO financings

93 95 96 100 110 116

7 Repackagings and securitizations Overview Purpose of swap Illustrative structures Rating agency approaches and criteria Significance for swap documentation Significance for swap providers

121 123 123 125 134 137 144

8 Specialized applications Swaps linked to debt capital market instruments Share scheme hedges Swaps with AAA-rated derivative product companies Accrual swaps Building society applications Private client applications

145 147 150 153 155 156 158

9 Project managing finance-linked swaps Who manages? Managing the borrower Managing the lender
syndicate Managing the swap provider

159 161 161 162 163

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Managing the rating agencies Operational issues and timing Cost Post-drawdown issues and restructuring the deal 10 Conclusions What constitutes best practice? Barriers Drivers A vision for the future Annexes Bibliography Index

164 164 166 166 167 169 169 172 173 175 219 221

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About the author

Gary Walker worked in the London banking market for 12 years (including two as head of the loan and derivatives documentation team at Daiwa Europe Bank plc) before qualifying as a solicitor in the mid 1990s. After six years in the capital markets and derivatives practices of City firms Wilde Sapte and Clifford Chance, he moved to Birmingham in May 2000, joining Wragge & Co in September 2001. Gary is cited in The Legal 500 (1994) and in Chambers Guide to the Legal Profession (2001
2 and 2002
3), sits on various ISDA working groups and is a regular contributor to the work of the Technical Committee of the UK Association of Corporate Treasurers. He is an active conference speaker and article writer and an expert on the law and documentation of OTC derivatives. At Wragge & Co, he is engaged in co-building the UK’s first dedicated, regional, end-user focused capital markets and derivatives practice. Gary holds an MA (Cantab.) in Law and Economics, a Diploma (with dist.) in Legal Practice and a summa cum laude in Law Relating to Banking from the Chartered Institute of Bankers. He brings nearly two decades of industry, in-house legal and private practice experience to the subject matter of this book.

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Disclaimer

This book is intended to provide an informational and illustrative overview of its subject matter. It is not intended to provide legal, tax or other advice in respect of any particular situation, contractual relationship or contemplated transaction. The laws and regulations applicable to structured loan transactions and over-the-counter derivatives are complex and subject to frequent change. Users of this book should consult their legal and other advisers as they deem appropriate in the preparation and negotiation of finance-linked swap and related documentation. The author regards the examples given in this book as illustrative only and neither he nor Wragge & Co assumes any responsibility for any use to which specimen documents or suggested provisions are put. The views expressed in this book are those of the author alone.

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Acknowledgements

Beginning with Wragge & Co, my thanks go to Tom Barr, Sharmil Rayarel, Elizabeth Scholes and Paula Warne for ad hoc research, to Tamsin Fernie for obtaining copyright consents, to Tom Price for ideas on Chapter 5, to Stephen Kenny and Stephen Sellers for insights into the PFI market, to Quentin Poole for giving me time off to write, to Jonathan Denton for proofing the entire manuscript and to Lynsey Telford for ploughing through countless retypes and d-t-p-ing the illustrations. Outside of Wragge & Co, my thanks go to my publishers and their review panel, to Mia Franks of Bradford & Bingley plc for objective and temperate criticism throughout, to Claude Brown of Clifford Chance for various pointers on Chapter 7, to Jonathan Shann of Freshfields Bruckhaus Deringer and Paul Harding of Derivatives Documentation Limited for encouraging the idea in the first place and to each of ISDA, the LMA, S&P, Moody’s and Fitch for allowing me to quote from them and their materials. Last, but not least, I am indebted to my wife, Katharine, for support and sandwiches beyond the call, to our two cats – Sophie and Cleo – for reminding me that, no matter what you type onto it, a piece of paper is just as much fun to play with and to international chess master Michael Basman, comedian Harry Hill, BMW motorcycle company and distillers of Islay single malt whiskies for giving me the inspiration that comes from daring to be different and succeeding in spite, perhaps because, of it. Regardless of the contributions that others have made to this book, any errors and omissions are mine and mine alone.

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Preface

This book has its origins in a series of workshops, entitled ‘Finance-linked Swaps’, that Jonathan Shann and I co-delivered in December 1998 to a group of acquisition, asset, debt, property and project finance lawyers drawn from the banking and finance practice of City firm Wilde Sapte. Jonathan and I have since moved on, as indeed has Wilde Sapte and the world as a whole. What has not changed is the general laxity towards finance-linked swaps – particularly at the smaller-ticket end of the market – that prompted the workshops in the first place. The purpose of this book is to reopen and advance the discussion. ‘Finance-linked swap’ is not a term of art. It was, so far as I can recall, coined by me and first used in the title to the workshops referred to above. I continue to use it as a convenient term of reference (and, of course, use it throughout this book) and have seen it used independently around the market. In any event, it serves its purpose. Elsewhere in this book, the expression ‘borrower’ almost always means an incorporated entity, ‘market’ means one or more of the wholesale financial markets, ‘FSA’ means the Financial Services Authority, ‘ISMA’ means the International Securities Market Association, ‘LMA’ means the Loan Market Association, ‘LIBM’ means the London inter-bank market, ‘LIBOR’ means the London interbank offered rate, ‘MLA’ means mandatory liquid assets, ‘SPV’ means a special purpose vehicle and ‘ISDA 1992 Master Agreement’ means the 1992 Master Agreement (Multicurrency-Cross Border) as published by the International Swaps and Derivatives Association, Inc. (‘ISDA’). This book comprises ten chapters and eight annexes. For some readers, particularly those unfamiliar with swap transactions or ISDA documentation, it may be as well to begin at the back with Annexes 1 and 2. For more seasoned professionals, the choice is theirs – many of the chapters can happily be read in isolation. The important point to note is that this book is written to appeal as much to those who already have an appreciation of the issues that arise in the context of finance-linked swaps as it is to those who are approaching the subject matter for the first time. It is also intended to be as relevant and helpful to professionals working on, say, mid-ticket loan transactions in the regions as to those plying their trade in, say, the London xiii

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capital markets. Although written primarily from an English law perspective, much of this book is of general application and should resonate with practitioners in other jurisdictions. Chapter 1 explains what a finance-linked swap is and looks at current practices in the finance-linked swap market. Chapter 2 continues the theme with a detailed look at the essential differences between the swap and the loan markets – differences that go a long way to explaining (but not necessarily excusing) some of the practices alluded to in Chapter 1. Chapters 3, 4 and 5 are, in many ways, the most important of this book. They outline, in turn, the key commercial, documentation and legal/regulatory considerations that affect nearly all finance-linked swap arrangements. Chapters 6, 7 and 8 are for the specialist. They apply the principles discussed in Chapters 3, 4 and 5 to a number of discrete markets and product types, from relatively straightforward and commonplace financings through to repackagings, securitizations and other exotic structures. Chapters 9 and 10 offer practical guidance to better management of the finance-linked swap process, some concluding thoughts and a vision for the future. The annexes are intended simply to supplement the chapters. Annex 1 provides a summary of the economic fundamentals and dynamics of interest rate swap transactions. Annex 2 offers an overview of the nature and architecture of ISDA documentation. Annex 3 sets out a number of documentation and deal-specific checklists and Annexes 4 to 7 contain examples of ‘model’ finance-linked swap documentation. Annex 8 is by way of epilogue and considers the impact of the new ISDA 2002 Master Agreement on the conclusions reached and recommendations made in this book. At various points, my treatment of the subject matter is deliberately simplistic or highly stylized. In other places, it is polemical. If either approach offends, I can only apologize. Mountains were never conquered by those who started at the summit or who lacked courage and, so far as financelinked swaps are concerned, there are as many still at base camp as there are others en route, but for whom the mist obscures the enormity of the journey ahead. I hope, whether you are a seasoned climber or just starting out, that you are able to work around the imperfections and navigate your way, successfully and enjoyably, through the pages that follow.

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1 Introduction

What is a finance-linked swap? Comparison with stand-alone derivatives Comparison with fixed rate loan arrangements Comparison with other finance-linked derivatives Size and shape of market Structural formats Current market practice

1

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1 · Introduction

WHAT IS A FINANCE-LINKED SWAP? At its simplest, a ‘finance-linked swap’ is a swap entered into by a borrower to hedge its interest rate and
or currency risk under a particular debt instrument. As a general rule, it does not matter what form the debt takes – most of the principles discussed in this book apply equally to bank loans, project bonds, debt capital market issues and so on. What characterizes financelinked swaps is their importance to the debt obligation to which they are linked. Let us assume that a borrower enters into a bilateral term loan facility agreement under which it raises sterling at a margin over LIBOR. Both the borrower and, as a consequence, the lending bank are exposed to future rises in interest rates, the occurrence of which may jeopardize the ability of the borrower to service or repay the loan and, in turn, may affect the creditworthiness or rating of the borrower, the viability of the project or other purpose for which the loan was advanced and the likelihood of the lending bank recovering interest and
or its principal. To mitigate these risks, the borrower enters into an interest rate swap under which it pays fixed and receives LIBOR, in each case calculated by reference to a principal amount corresponding to that of the loan. It pays the LIBOR flow that it receives under the swap to the lending bank in satisfaction of its interest payment obligations on the loan (the two, effectively, cancel out) and is left with a simple, fixed rate payment obligation to the swap provider (which is often the lending bank itself). The effect is two-fold: the borrower fixes its cost of borrowing and the lending bank finds itself party to a project or structure from which the interest rate risk has been removed. It goes without saying that the swap provider in this arrangement has, in agreeing to receive fixed and pay LIBOR, assumed the very same interest rate risk that the borrower wanted to lay off. Typically, the swap provider will counter-hedge that risk with a ‘back-to-back’ swap – a swap with a third party that mirrors the terms of the original swap between the swap provider and the borrower – or, more commonly, the risk will be managed on a ‘portfolio’ basis as described later in this chapter. Figures 1.1a and 1.1b provide a diagrammatic overview of the basic cash flows. For simplicity, these ignore credit
funding spreads and repayments of principal associated with the respective instruments. Where, additionally, the borrower is exposed to currency risk – where, for example, its funding is denominated in one currency and its revenues are received in another – it may be appropriate for it to swap out not only its interest rate risk but also its exposure to cross-currency fluctuations. Figure 1.2 provides a simplified illustration. 3

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Mastering Finance-linked Swaps Figure 1.1a

Finance-linked swap: lending bank and swap provider as same entity

LIBM

Principal

LIBOR Principal

LIBOR Market/ Portfolio Fixed

Lending bank & Swap provider

LIBOR LIBOR

Borrower

Fixed

Figure 1.1b

Finance-linked swap: lending bank and swap provider as different – perhaps related – entities

Principal

Principal Lending bank

LIBM LIBOR

LIBOR

100%?

LIBOR

LIBOR Market/ Portfolio

Swap provider Fixed

Fixed

Figure 1.2

Borrower

Finance-linked cross-currency and interest rate swap £ Principal

£ Principal Lending bank

LIBM £ LIBOR

£ LIBOR

Borrower

100%? £ LIBOR

£ LIBOR Market/ Portfolio

£ Principal $ Principal $ Fixed

4

Swap provider

£ Principal $ Principal $ Fixed

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1 · Introduction

Each of the swaps in Figures 1.1a, 1.1b and 1.2 is ‘finance-linked’ because of the economic interdependence that exists between it and the loan. Another way of looking at this is to say that the swap exists only to hedge the loan (or that the loan is hedged only to the extent that the swap exists). This interdependence is complicated by the fact that loan and swap transactions – even finance-linked swap transactions – are, almost invariably, documented as independent financial contracts. To achieve economic interdependence, therefore, it is necessary that the two contracts at least know what the other is saying and, in most cases, that they are tailored so that each is, in fact, saying the same thing. Other interdependencies, or ‘symmetries’ as they are sometimes called, exist and need reflecting in the respective agreements. These symmetries are dealt with in greater detail in Chapter 3. Certain borrowers do not need to hedge at all. A borrower whose revenues are positively correlated to LIBOR may be able to borrow at LIBOR with little or no fear of interest rate rises. In such circumstances, the borrower is said to be ‘self-hedged’. Other borrowers may simply take a view and decide not to hedge even though there is an objective case for doing so. Where there is some flexibility built into the structure or some tolerance within the cash flows, a decision not to hedge may, especially in the short term, be entirely rational. Where these mitigants do not exist, however, a finance-linked swap will usually be the answer. Before proceeding, it is useful to distinguish finance-linked swaps from certain other instruments.

COMPARISON WITH STAND-ALONE DERIVATIVES A stand-alone derivative is one that is not linked specifically to another instrument – debt or otherwise. In the present context, stand-alone transactions can be categorized as either ‘portfolio’ or ‘pure’. ‘Portfolio’ transactions exist in both the borrower and the bank market. Many borrowers, particularly those whose funding comprises obligations of different types, structures, profiles and maturities, regularly hedge on a portfolio basis – that is to say, they enter into interest rate and currency hedges that provide broad and generic protection for their obligations, as opposed to hedges that are tailored explicitly to individual liabilities. Banks act in a similar manner, but on a much larger scale. In simple terms, they aggregate as many offsetting positions as they can and leave any fine-tuning to the margins. So if, for example, a bank’s swap division enters into £100 million notional of interest rate swaps as a fixed rate receiver
LIBOR payer and at the same time its (independently motivated) retail division sells to its high 5

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Mastering Finance-linked Swaps

net worth customers £100 million principal of fixed rate bonds (the proceeds of which are invested by the bank at LIBOR), then, assuming broadly similar fixed rates, payment dates and maturity profiles on the respective instruments, the bank’s ‘book’, on a portfolio approach, is balanced. Too much fixed income on the one hand or too few bonds on the other and it is not. So fine-tuning, often with another swap, is required. Figure 1.3 illustrates the general principles.

Figure 1.3

Bank with balanced book: all cash flows are matched Fixed LIBOR LIBOR LIBM

Bank

Swap market

Fine-tuning?

Principal Principal Fixed

Retail market

There is, by definition, no formal degree of interdependence between the hedge and the hedged position in portfolio transactions. As a result, the documentation for such transactions does not need to be tailored in the same way that it does for finance-linked swap arrangements. ‘Pure’ stand-alone derivatives are not hedges at all. They are synthetic investments (or divestments) characterized by a desire on the part of one (occasionally both) of the parties to take an unmatched position in a given underlying. If, for example, ABC Co enters into an equity swap as a notional investor (i.e. receiver of equity upside and synthetic dividends on share X), its interest does not extend beyond the terms of the derivative. If, however, ABC Co enters into an equity swap to hedge a share X-linked obligation that it has to a third party, its interest in the terms of the derivative extends to how the terms of that derivative interrelate with the terms of the third-party obligation. The second of the two swaps brings us back to the subject matter of this book. We return to the question of stand-alone vs. finance-linked transactions, in the specific contexts of housing associations and building societies, in Chapters 6 and 8. 6

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1 · Introduction

COMPARISON WITH FIXED RATE LOAN ARRANGEMENTS A fixed rate loan is one where the interest payable by the borrower remains at the same rate for the entirety of the loan. Structurally, it is a very simple arrangement, as Figure 1.4. illustrates. Fixed rate loan

Figure 1.4

Principal Lending bank

Borrower Fixed

In economic terms, a fixed rate loan is identical to the finance-linked swap arrangements considered earlier, as a comparison of Figure 1.4 with either of Figures 1.1a or 1.1b will quickly reveal. Indeed, fixed rate loans are often referred to as ‘derivative embedded’ insofar as they possess, implicitly, the characteristics of those arrangements (technically speaking, the difference between the two is that, as the forward curve moves, it is the swap, in a finance-linked structure, and the loan, in a fixed rate arrangement, that moves in or, as the case may be, out the money). Not surprisingly, then, a fixed rate lender will, in a manner reminiscent of a finance-linked swap provider, seek to manage its interest rate exposure, either by entering into a back-to-back swap with a third party – perhaps via its own swap desk – or by ‘portfolio managing’ the risk. Figure 1.5 provides an illustration. Fixed rate loan with counter-hedge

Figure 1.5

LIBM

Principal

LIBOR

LIBOR Market/ Portfolio

Principal Lending bank

Fixed

Borrower Fixed

A related concern of the fixed rate lender will be to ensure that, if it becomes necessary to terminate its counter-hedge – because the borrower fails to draw under the fixed rate loan facility, becomes insolvent or otherwise – it has a claim against the borrower for any costs and losses that it suffers as a result. Equally, a borrower should seek to recover any corresponding gains. 7

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What, then, are the differences between a fixed rate loan and a financelinked swap structure? An obvious starter is that the former can be documented under a single loan agreement whereas the latter requires the addition of a swap document. As for the respective loan agreements, one will contain fixed and the other (necessarily more detailed) floating interest rate provisions. The indemnity provisions within fixed rate loan agreements also require a little thought. They need to capture not only ‘conventional’ break funding costs that are common to all loan arrangements – for example, those that arise as a result of the borrower failing to draw a contractually agreed advance, prepaying an advance other than on a scheduled interest payment date, failing to meet its contractual payment obligations or otherwise being in default under the loan agreement – but also swap-related losses of the type considered in the previous paragraph. In finance-linked swap structures, on the other hand, a degree of bifurcation is possible (and necessary where the lending bank and swap provider are different entities), resulting, with correct drafting, in a loan agreement that concerns itself only with ‘conventional’ break funding costs and a swap agreement that concerns itself only with losses that are associated with a break of the swap. Several additional points are worth making in this context. Swap break indemnity provisions in fixed rate loan agreements sometimes seek to make the borrower liable for losses that result from a break following default by the swap counterparty – that is, the entity that provides the counter-hedge to the fixed rate lender. This seems unprincipled per se and is in any event at odds with practice in the finance-linked swap market, where it is rare that the borrower takes any responsibility for the performance of an entity that hedges the swap provider’s own obligations to the borrower. Moreover, where the lender hedges on a portfolio basis, it is difficult to see how it can have any claim at all for swap break costs. No swap exists that is specifically related to the loan, so nothing can be broken. Instead, the lender should content itself with the knowledge that, in a balanced and sizeable portfolio, every break loss will, in aggregate and over time, be matched by a comparable break gain. Occasionally, an enlightened fixed rate borrower will ask its lender how it intends to hedge and may decline to give a swap break costs indemnity if the answer is ‘on a portfolio basis’ – at the very least it should argue the point or insist that the indemnity is tied in to a ‘notional’ back-to-back swap, whose own parameters are agreed prior to drawdown and set out in the loan agreement. More often than not, however, it will simply give the indemnity. Where indemnities of this sort are legitimately required by the lending bank, they need careful and explicit drafting, as the well-known Scottish case The Governor and Company of the Royal Bank of Scotland v Dunedin Property Investment Co Ltd 14 March 1997 Unreported (held in favour of the bank, on the facts, at appeal) amply illustrates. In a perfect world, especially since the 8

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amount that a fixed rate lender will have to pay to – or may be entitled to recover from – its swap counterparty (if one exists) on a break is invariably prescribed by the related swap contract, the relevant indemnities would also accurately reflect that prescription, rather than employ, as they often do at present, a somewhat airy ‘all swap break costs, losses and expenses’ formula. The borrower, at least, would benefit from a greater degree of certainty, objectivity and transparency in relation to break costs if such a methodology were followed. From the lender’s perspective, any security that is taken from the borrower should be expressed to secure not only loan principal, interest and fees but also swap break costs picked up by the relevant indemnities. Similarly, any financial covenants imposed upon the borrower should, adopting a rational and even-handed approach, be dynamic enough to take account of not only potential swap break costs but also gains. In practice, both points are frequently overlooked. Failure to engineer the covenants is perhaps understandable, since it necessitates the incorporation of an ‘external swap valuation’ mechanism within the loan agreement. Failure to extend the reach of the security documents, however, is inexcusable. Having established that fixed rate loans are simpler to document than economically equivalent finance-linked structures – save, perhaps, in relation to their break provisions – the real question is why they are not more frequently employed. The reasons are multifarious and interrelated. Somewhat obviously perhaps, a bank typically funds itself at floating rates and so prefers to lend at floating rates. If it lends at fixed rates, it is the bank – as opposed to the borrower – that is faced with the problem of how to manage its interest rate risk. In addition, banks are much happier selling as opposed to buying derivatives. Bid
offer incentives aside, the sale of a derivative by one part of the bank to an entity that has just borrowed money from another part of the bank represents two pieces of business, not one. From an organizational perspective, certain banks may be poorly equipped to manage hybrid loan
derivative structures that sit uneasily between discrete and culturally divergent debt and derivative trading divisions. Finally, many borrowers prefer the flexibility of a derivative arrangement that is both transparent – the LIBOR and fixed rate components within finance-linked structures being individually quantifiable – and separable, and thus independently terminable, from the debt obligation to which it is linked. This is not to say that fixed rate loans do not exist. Most banks are happy to offer and structure commercial fixed rate loan packages – some on a highly commoditized basis – to
for borrowers that require them. Where, in particular, borrowers are constrained by regulatory and
or vires considerations from entering into ‘conventional’ derivatives, fixed rate loans play a part in enabling them to enter into loan arrangements into which the derivative is embedded. Housing associations – to which we return in Chapters 5 and 6 – are good examples of such borrowers. 9

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COMPARISON WITH OTHER FINANCE-LINKED DERIVATIVES Most of this book is concerned with the integration of interest rate swaps into day-to-day financing structures. This reflects the predominance of the interest rate swap as the hedging instrument of choice in relation to such arrangements. Nevertheless, other types of derivative can be employed to hedge debt and other financial obligations. In an interest rate context, option products such as caps, collars and floors are frequently encountered as an alternative to a swap. Outside of the interest rate management arena, currency, inflation, equity, credit and other derivatives are employed to hedge specific items on both sides of the balance sheet – assets as well as liabilities. The back-to-back swaps discussed earlier in this chapter may also be viewed as a form of ‘linked’ derivative. These other instruments feature in this book. Some of the more specialized ‘linked’ applications are afforded a chapter of their own. The principles, however, are fundamentally the same whatever the nature of the derivative.

SIZE AND SHAPE OF MARKET The size of the finance-linked swap market is difficult to gauge. No formal statistics exist but a reasonable approximation can be made through an interpolation of swap and loan market statistics. Taking the swap market as a starting point, the aggregate global outstanding notional amount of interest rate and currency derivatives as at December 2000 (the latest year for which comparable Bank of England figures are available) stood at just over $60 trillion (source: ISDA 2000 YearEnd Market Survey). Applying sensible conversion rates gives a rough estimate of the UK’s share of this figure as £10 trillion. Not all of these outstandings will have been finance-linked swaps – a significant number will have been back-to-back or portfolio transactions – but the figure at least sets an upper boundary. Bank loans to the UK corporate sector at the same time aggregated around £0.5 trillion (source: Bank of England 2000 Statistical Abstract, published in 2002). This statistic represents a not unreasonable lower boundary if, as seems likely, the total of unhedged or portfolio-hedged principal comprised within it was no less than the amount of contemporaneously outstanding, swap-hedged principal under UK debt capital market (including, for the argument, repackaging and securitization) transactions not included in the Bank of England corporate loan statistics. On this reckoning, as at December 2000, the outstanding notional amount of swap transactions explicitly linked to UK corporate loans and debt capital market issues lay somewhere between £0.5 trillion and £10 trillion. 10

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Determining the shape of the finance-linked swap market requires no such convolutions. Broadly, it can be divided into swaps that are linked to debt capital market transactions (including, as before, repackagings and securitizations) and swaps that are linked to bank loans. UK debt capital market transactions are invariably big-ticket, Londonoriginated, rated and documentation intense. UK loan transactions exist across a wider spectrum. The bigger deals (and almost all syndicated transactions) tend to be originated in London, may be rated and can rival the most esoteric capital market transactions for complexity. Mid- to smallticket London loan transactions are generally less structured, less documentation intense and invariably unrated. Loans originated in the regions tend to carry the smallest tickets but are often structurally just as complex. So far as the swaps themselves are concerned, it used to be the case that these were always originated in London, even in relation to loans that were originated in the regions. Recently, however, there has been a sea change, many of the banks that are physically present in the regions now running local desks with money-market, fx and interest rate derivative dealing capability. However, all documentation for finance-linked swaps, even those originated in the regions, continues to be produced centrally – more often than not in-house – from London. The relevance of these distinctions will become apparent shortly.

STRUCTURAL FORMATS UK debt capital market, repackaging and securitization transactions have, over recent years, become commoditized to such a degree that reasonably standardized documentation is the starting point for all but the most esoteric and innovative structures. Generally, the swap component of the transaction is documented on ISDA terms and the swap provider is a highly rated City institution, whose role may extend from that of simple swap counterparty to the relevant issuer to that of arranger for the transaction as a whole. It is probably also fair to say that, with the exception of pockets of issuer-side work, such transactions are, from a legal and documentation perspective, handled almost exclusively by large, London-based firms. Matters in the loan markets are not so easily categorized. Loan documentation, for example, adopts various formats. At the big-ticket end of the UK market, LMA primary loan market documentation is now prevalent and has, to a large extent, put an end to the ‘battle of the forms’ that tended to stymie negotiations in pre-LMA days. That battle continues, of course, where, for whatever reason, LMA documentation is not employed. At the mid- to small-ticket end of the market, banks and law firms, both in London 11

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and in the regions, invariably use proprietary forms as a starting point, falling back to LMA positions or deferring to locally agreed, market-specific protocols if negotiations reach an impasse. Needless to say, the existence of so many different formats is inefficient but may, even over the long term, be inevitable in a fragmented and diverse loan market. On the swap side, the identity of the swap provider may vary from transaction to transaction. In a syndicated loan transaction, the swap is often, but need not be, provided by one or more members of the syndicate. Where the loan is bilateral, the role will usually be fulfilled by the lender itself or by one of its affiliates. The precise relationship of the swap provider to the other parties to the transaction has important commercial and documentation implications that are considered in Chapters 3 and 4. Documentation for the swap – again, ISDA based – may also vary in format. More often than not, the starting point will be the swap provider’s house bilateral Schedule and a related Confirmation. Occasionally, the swap provider will send out a long-form Confirmation that attempts to circumvent the need for a Schedule. Whatever the format – each to be examined in detail in Chapter 4 – the level of focus on and ultimate accuracy of the swap documentation varies enormously. It is to current market practice in this area that we now turn.

CURRENT MARKET PRACTICE In most debt capital market, repackaging and securitization transactions, the swap is an important, if not key, component of the deal and generally requires a significant amount of rating agency-required and commercially driven engineering. The documentation, therefore, tends to be drafted by specialist derivatives lawyers, acting for the arranger, before being passed to the issuer’s and (to the extent not itself the arranger) swap provider’s own specialists for review. Appropriate lawyers are enlisted early on in the process, often at term sheet stage, and form part of a wider legal team that includes capital markets, tax and other relevant expertise and within which the degree of cross-specialization literacy is high. At a commercial level, the swap is keenly priced – often being put out to competitive tender – and is transacted contemporaneously with the rest of the deal. Practice is, as a general rule, very good. Practice around big-ticket, rated and
or syndicated loan transactions ought not to be far off that described in the previous paragraph. Matters are not made any easier, however, by the fact that LMA primary loan market documentation addresses none of the issues raised in this book. Moving down through the mid- to the small-ticket loan arena, practice begins to 12

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vary enormously. Often the borrower receives no proper legal or other advice in relation to the swap, the documentation for which is signed by the borrower – unreviewed by it or its lawyers – in whatever form the swap provider sends it. The end result, frequently, is a contract that may not represent best value or the optimal hedging strategy, does not accurately hedge the loan and is at odds, commercially, with the rest of the deal. There are numerous reasons for this unsatisfactory state of affairs. First, it is clear that the bigger the deal ticket, the greater the degree of professional responsibility, potential liability or risk to reputation that is attached to structuring or advising on a particular transaction; and the larger the fee purse out of which to meet the cost of employing a specialist derivatives lawyer. In complex transactions, in other words, it is often worth paying to get things right. The converse offers a superficially attractive argument – if it is a small-ticket deal, why worry too much about the risk and why enlist a specialist? After all, a reputable swap provider can be relied upon to put together a documentation pack that does the job. Or can it? Recently, a London swap trader expressed disbelief at a suggestion that his bank’s house Schedule was not appropriate for a hedge into a management buy-out vehicle being financed by his regionally based banking colleagues. When asked whether the buy-out bankers or their local lawyers had ever spoken to the swap documentation team in London – ever, let alone in relation to the deal in question – he started to see the point. Similarly, a financial engineer admitted that his bank’s P&L ‘would not’ (he was using the words liberally) stand the cost of undertaking the engineering that was necessary properly to customize his bank’s house Schedule to ensure that it worked for smallticket finance-linked swap structures. The issues were understood but neither he nor the bank wanted to do anything about them. His view was that if a borrower were to raise the issues, the bank would (and did, so long as the borrower’s lawyers – at the borrower’s cost – undertook the drafting) be accommodating. A second point, equally uncontroversial, is the continuing lack of understanding in many quarters of the market as to the fundamental nature of a swap. Annex 1 covers the ground in detail but the following provides a brief summary. Swaps and other derivative instruments can give rise to unpredictable, sometimes volatile, two-way credit exposures. They are, in many respects, identical to loans but with the added complications that the amount of credit exposure fluctuates from day to day and does so in such a way that it can turn today’s ‘lender’ into tomorrow’s ‘borrower’, and vice versa. Yet many bankers and debt finance lawyers treat the swap as something extraneous to the loan agreement – even to the deal as a whole – and so overlook simple commercial issues that they would seize upon immediately if the swap were labelled ‘care: two-way loan agreement’. Schuyler K. Henderson, a well-respected derivatives lawyer on the London circuit, hit 13

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the nail on the head some years ago in a far-sighted and thought-provoking article (Journal of International Business Law, 1997) that, building from observations on the ‘ubiquity of derivatives financing and the dominance of derivatives methodology’, concluded with the rhetorical question: ‘Is there a future for a financial lawyer who is not also a derivatives lawyer?’ A related and final point is the propensity for ISDA documentation to be viewed as a documentary panacea. Undoubtedly, the modularity that characterizes ISDA terms means that it can handle a huge diversity of derivative transactions, from the most simple to the most esoteric. However, the documentation is, like any other precedent, only a starting point – the more complex or structured the transaction, the more the documentation needs to be moulded to ensure that it fits the deal. A more recent article, this one by Martin Hughes (Journal of International Banking and Financial Law, 1999), summarized the problem eloquently. Hughes wrote: ‘One of the virtues of the ISDA approach is that it can handle very complex transactions. Thus, traders, lawyers and transaction management teams have become used to using a relatively complex set of contractual rules and provisions to handle both the simplest and the most complex transactions. This has unforeseen consequences. Simple transactions are documented in a complex fashion, which may be unnecessary but this is not a fundamental problem. Worryingly, however, very complex transactions are processed as if they were simple just because the complex documentation they require is structurally identical to that which is used for things that really are simple. As a result, complex transactions involving genuinely difficult documentation are handled inappropriately.’ Although Hughes was writing in the context of credit derivatives, the principle is universal. Some of the structures considered in this book are not simple and even those that are straightforward require elemental engineering if they are to hold water. The three points discussed above – misguided faith in the accuracy of the hedge provider’s documentation, a lack of understanding of the product and misplaced trust in the omnicompetence of ISDA precedents – play a significant role in perpetuating poor practice in the finance-linked swaps market. Other contributory factors exist, not least of which are the core differences between the swap and loan markets considered in the next chapter.

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Similar but different? Economic differences Documentation differences Operational differences Legal differences Cultural and conceptual differences Does it matter?

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SIMILAR BUT DIFFERENT? The modern over-the-counter (OTC) derivatives market is just over 20 years old. This period has seen phenomenal growth – from the seminal US$290 million World Bank : IBM cross-currency swap of August 1981 to aggregate global interest rate and fx derivative notionals as at 30 June 2002 of US$82.7 trillion (source: ISDA 2002 Mid-Year Market Survey). Extrapolate for the intervening period, add in equity, commodity, credit, inflation, weather and other product types and it is not difficult to imagine that figure standing, today, well in excess of $100 trillion. Such growth is possible in a short time frame only if there is a catalyst to ignite it, an infrastructure to support it and sufficient innovation to fuel it. The catalyst for the OTC derivatives market was the ‘parallel’ or ‘back-toback’ loan market that developed in the 1970s to provide non-residents wishing to raise sterling with a means of circumventing UK exchange controls. The technique involved two parties, one resident and the other nonresident, making cross-currency loans to each other in equivalent amounts and for the same term. When UK exchange controls were abolished in 1979, such loans continued to be used as a cost-effective means of hedging longterm currency exposures. From there it was but a small step to extend the concept, via parallel loans denominated in the same currency, to ‘notional’ loans involving no exchange of principal at all, i.e. interest rate swaps. The infrastructure that supported this development was the banking market out of whose parallel loan activities the OTC derivatives market grew. These two factors – catalyst and infrastructure – explain many of the similarities between the swap and loan markets today. The third factor – innovation – explains many of the differences. A fast-growing, dynamic market encourages innovative practices. Innovation is no respecter of convention: it forces change and things get done differently. This chapter is concerned with the similarities and the differences as well as, more generally, with the way that innovation in the swap markets is changing – or at least having an influence on – the way that the loan markets operate. These considerations together are key to an understanding of the issues that arise in the context of finance-linked swaps.

ECONOMIC DIFFERENCES The similarities between a swap and a loan are obvious. Credit instruments give rise to credit exposure, the existence of credit exposure focuses the attention of the creditor on the debtor’s credit quality, concerns as to credit 17

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quality motivate due diligence, the requirement for enforceable documentation and the employment of risk reduction and mitigation techniques. In these respects, swaps and loans are identical. One of the key dissimilarities is less obvious, certainly to those approaching derivatives for the first time. Under an interest rate swap, there is no exchange of principal. The exposure that does arise is, instead, a function of the relationship between expected interest rates on the date the swap is entered into (as it is these that determine the fixed rate on that date) and changes in expected interest rates between that date and maturity. Such changes cause the swap, over its life, to move in and out the money by frequent and unpredictable (but objectively measurable) amounts. We say that the party that is in the money from time to time is holding a contingent asset – an ‘asset’ because the in-the-money amount represents quantifiable credit exposure on the other party (akin to a loan in the relevant amount to that party) that is ‘contingent’ because it is payable only on a termination of the swap ahead of its scheduled maturity date. Conversely, we say that the party that is out the money from time to time is holding a contingent liability. The key point to note in the context of this book is that, under an interest rate swap, it is not just the swap-providing bank that may have credit exposure on its swap-buying customer – it is equally possible, indeed likely, that the swapbuying customer will from time to time have credit exposure on its swapproviding bank. On the other hand, except in times of extreme volatility, the amount of exposure under a swap is likely to be a low, single-figure percentage of the applicable notional amount. In the context of finance-linked swap arrangements, therefore, there will be a lot less exposure under the swap relative to the amount of principal at stake under the loan to which it relates. Nevertheless, such exposure is a risk that is to be mitigated wherever possible. Contrast the foregoing with the position of a lending bank and its borrower under a loan agreement. As well as being one-way in nature and the result of an initial payment of cash from the lender to the borrower, the credit exposure that arises is, ignoring amortization, reasonably static – being equal to outstanding principal plus accrued interest and fees. It used to be the case that matters stopped there. Periodically, perhaps annually, the loan would be reviewed by the bank, an assessment made of the borrower’s creditworthiness and, if not strictly in default but nevertheless credit-impaired in some way, provision would be made in the bank’s books to cover any anticipated loss. The modern approach – driven by advances in probability-based and correlation-sensitive loan valuation models, themselves supplemented by the availability in the secondary debt and credit derivative markets of real-time loan values and prices – is different. The value of a loan is driven by what the model and the market say it is, not simply by what a bank’s credit department subjectively believes it to be. For the purposes of this book, however, the simplifying assumption is made 18

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that a bank’s exposure under a loan is what it would be on a conventional basis. It is worth pausing for a minute to illustrate some of these differences tangentially. In the English law case Peregrine Fixed Income Ltd v Robinson Department Store Public Co Ltd (Commercial Court 18 May 2000) the issue that came before the Court was the quantification of exposure under a transaction pursuant to which one party had agreed to pay to the other a number of annual instalments that, in aggregate, exceeded a single payment made by the latter to the former at inception. On any reckoning, this was a loan transaction (albeit that the Court preferred not to view it that way, a point we shall return to) that was, unusually, described as a ‘swap’ and documented under an ISDA 1992 Master Agreement. Circumstances dictated that, under the agreement, it fell to the ‘borrower’ – itself heavily creditimpaired at the time – to determine the amount it owed to the ‘lender’ in respect of the transaction by seeking quotations from various dealers in the swap market. The selected dealers took one look at the poor credit standing of the borrower and, calculating what they would be prepared to pay to the lender to take over its rights against the borrower, returned a figure far below that which the borrower actually owed. Needless to say, the lender argued that this led to a commercially unreasonable result and the Court, in the end and for a variety of reasons, agreed. The lender was entitled to pursue the borrower for the full amount owed to it. The case is important for a variety of reasons, but it also demonstrates the difference in approach that occasionally exists between the swap and the loan markets. Had, for example, the Court asked a banker to tell it how much was outstanding under the transaction, there is little doubt that he or she would have aggregated the remaining instalments, added in any unpaid interest and arrears of principal and discounted, to present value, the total to arrive at a number – the same number that the Court had to strain to reach wearing its ‘swap market’ hat. The swap dealers, on the other hand, took a ‘derivative’ approach. The question that they answered was the amount of dividend that a creditor of the borrower could reasonably expect to recover on a loan of the relevant size, taking into account all the circumstances including the borrower’s impaired credit standing; whereas the question that the borrower actually required to be answered was the size of the loan by reference to which that dividend was to be calculated. The economic differences highlighted above – real vs. notional principal and one-way static vs. two-way dynamic exposures – have implications for swap documentation generally that we shall come on to below. They also have implications for many other documents within typical finance-linked swap structures (not least the loan agreement), implications that will be considered in detail in Chapter 4. Other economic differences between swaps and loans – for example, their pricing and their regulatory capital 19

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treatment – are dealt with in passing in Annex 1 but are otherwise outside the scope of this book.

DOCUMENTATION DIFFERENCES There are three principal categories of difference between loan and swap documentation: ■ ■ ■

differences of substance; differences of form; differences in scope.

Differences of substance Swaps, as we have seen, give rise to bilateral and fluctuating credit exposures whereas loan exposures are unilateral and static. Loan agreements, therefore, tend to be relatively simple, needing only to recite the obligations of the borrower and the rights of the lender against the borrower in default of those obligations. They also tend, for obvious reasons, to be skewed heavily in favour of the lender. Swap agreements, on the other hand, need to contemplate the possibility that either party may be the ‘borrower’ or ‘lender’ from time to time (so the rights and obligations of the parties need to operate bilaterally), need also to reflect differences in creditworthiness between the parties (so the termination provisions need to be capable of being skewed accordingly) and need to include a mechanism enabling exposure(s) under the agreement to be valued, crystallized and, wherever possible, net-settled on an early termination. These are some of the more important differences of substance. Others exist, particularly at the micro-level, and will be considered in detail in Chapters 3 and 4. Undeniably, swap agreements are, in substance at least, much more complicated than loan agreements.

Differences of form At a macro-level, and as noted in Chapter 1, the launch in 1999 (and revision in 2001) of LMA primary loan market documentation brought a degree of standardization to UK loan agreements that, up until then, had not existed. One of the many motivations behind the LMA’s initiative was a desire to achieve economies of cost and time in the documentation process. It is a little ironic, therefore, that as the LMA documents are aimed at bigticket (including syndicated) transactions, they are rarely utilized for the mid- to small-ticket deals that would most benefit from these economies. It is a further irony that, in considering how to achieve its aim, the LMA 20

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rejected ISDA’s modular approach to documentation on the grounds that it – the LMA – wanted to produce a precedent that looked as much as possible like existing loan formats. While undoubtedly the LMA achieved the latter aim, it did so at the cost of the effective disenfranchisement of significant sectors of the market – sectors in which most borrowers are not (or not yet perhaps, as there are signs that attitudes may be changing) willing to entertain a 100-page document in the context of a small-ticket, bilateral, vanilla term loan. It is worth remembering, in this context, that ISDA’s modular approach has been willingly and successfully adopted to record the vast majority of OTC derivative transactions that are outstanding globally today, regardless of ticket size, counterparty type or location, underlying, deal type, structure or complexity. At the same time, as we have seen, ISDA documentation is inherently more complicated. If an inherently more complicated document can be successfully deployed, globally, for derivative transactions having, as their underlying, variables as diverse as interest rates, equities, commodities, loans, weather, freight and inflation, it is a wonder that a document that is simpler in substance – and intended only for use in the context of straightforward loan instruments – cannot be modularized for the benefit of UK loan market participants. Perhaps, in this regard, ISDA documentation is the victim of its own success. In other words, it is so much more flexible, malleable, universal and easy to work with than current loan documentation that it is perceived, particularly by the loan markets, as being simple. That perception, as Martin Hughes reminded us in Chapter 1, could not be further from the truth. As a general rule, ISDA documentation needs care and attention – more so than a loan agreement, in fact. And in the context of finance-linked swap arrangements, the current practice of overengineering the loan agreement while neglecting the swap documentation is, even allowing for the relatively small amount of credit exposure that arises under the latter, difficult if not impossible to justify. At a micro-level, the terms of the vast majority of loans are set out within a single document. ISDA documentation, on the other hand, adopts a multi-form ‘Master plus Schedule plus Confirmation(s) plus Definitions’ approach that is described in detail in Annex 2. Over and above this, there are significant differences in the terminology employed by the two types of documentation. To give just a few examples, ‘break costs’, ‘arrears’ and ‘security’ are, to lenders, what ‘close-out amounts’, ‘unpaid amounts’ and ‘credit support’, respectively, are to swap providers. These differences merely accentuate the other divides that exist between the markets. As to why they exist, the explanation is in part historical, in part cultural, in part a consequence of the way that derivatives are traded and in part a consequence of the diversity of OTC derivative instruments that the documentation is required to cover. 21

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Differences in scope It is precisely the scope and reach of ISDA documentation – which brings with it a need on the part of the derivatives lawyer to understand not only derivatives per se but also a huge range of underlying markets – that makes derivatives so interesting. Supplement the diversity of the product range with a myriad of attendant legal issues – issues that seldom arise in the context of loan instruments – and one is confronted by an immensely complex practice area, the nature of which belies the fact that many debt finance lawyers remain reluctant to grasp the nettle when it comes to finance-linked swaps. For present purposes, the reader need note only that ISDA documentation is sufficiently flexible to handle a huge range of transactions (not just derivatives – consider the Peregrine case referred to above, which concerned a loan documented under ISDA terms!), whereas loan documentation has, essentially, only single-product capability. Let us now consider some important operational differences between swap and loan instruments.

OPERATIONAL DIFFERENCES The operational aspects of loan transactions are reasonably straightforward. Once the loan document is agreed – and that will typically be a matter between the bank’s structuring, arranging and marketing departments, the borrower and their respective lawyers – all that is required on the part of the borrower is to serve a drawdown notice on the lender, for the rate applicable to the drawing to be set and notified to the borrower and for the relevant funds to be paid as the borrower directs. That process is repeated on each occasion that the borrower either rolls over an existing advance or draws a fresh advance. The significant point to note is that the legal and contractual aspects of the arrangement are often completed long before the borrower draws down any part of the loan – and so the responsibilities of the lending bank’s loan administration function are confined to processing drawdown requests, to rate fixing and notification, to payment and redemption administration and to related duties. In relation to swap transactions, by contrast, the ongoing processes are similar but there are important differences at the front end of the transaction. In the inter-bank interest rate swap market, for example, usual practice is for the headline terms of the swap – key dates and conventions, the notional amount, the fixed rate and any spread – to be agreed between dealers over the telephone (at which point, in most jurisdictions at least, a binding oral contract comes into being), each dealer thereafter generating a deal ticket that is passed through to their respective back-offices for booking, payment processing and Confirmation-generation purposes. Back office will 22

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check to see whether an ISDA 1992 Master Agreement (or equivalent) is in place and, if none exists, will send details of the trade and the new counterparty through to the bank’s swap documentation department with a request that it makes contact with the counterparty to begin negotiations. Either way, back office will then prepare a form of Confirmation (or, increasingly in the case of vanilla, commoditized transactions, a Confirmation will be generated – and exchanged – electronically) to be sent to the counterparty for checking and signature. The point, then, is that back-office personnel are themselves heavily involved in the documentation process, since it is they who are charged with the additional task of producing a document – the Confirmation – that forms a key part of the contractual relationship between the parties. Inevitably, Confirmations will occasionally be dispatched containing inaccuracies that may or may not be remedied before the document is signed. Does this matter? Of course it does – but perhaps it is not so serious. After all, the transaction itself is not complicated and the parties will, in the event of a dispute, be able to call upon the original deal tickets, tape recordings of the dealers’ conversations and the dealers themselves, and will also have a mutual interest in being seen in the market to be willing to correct, promptly and in a commercial manner, documentation that is manifestly inaccurate. What is significant is that errors occur. That is why, outside of the vanilla swap arena, specialist front-office derivatives lawyers work closely alongside traders, back office and legal departments alike to ensure that the more complex trades are documented correctly. Returning to the finance-linked arena, Confirmation generation for swaps linked to big-ticket loan transactions tends, for the reasons just given, to be the province of specialist lawyers acting for the bank and the borrower; and the only detail that will be missing from the Confirmation prior to its signature will be the fixed rate itself. Typically, a dealer from the swap-providing bank will offer a rate to the borrower – usually by telephone into the room at which the wider loan transaction is being completed – which, if accepted, will be inserted by manuscript into the Confirmation, whereupon that document, an ISDA 1992 Master Agreement and its related Schedule will be signed by the respective parties. In relation to swaps linked to mid- to small-ticket loan transactions, by comparison, a hotchpotch of practice exists. As noted in Chapter 1, there is a reluctance on the part of the borrower to employ a specialist derivatives lawyer and an equal reluctance on the part of the debt finance lawyers looking after the loan aspects of the transaction to concern themselves with the swap documents. As a result, the borrower tends to receive the swap documentation directly from the swap provider, often in two parts (a Schedule from the swap provider’s documentation team and, separately, a Confirmation from its back office), invariably without an explanation of what each does and 23

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almost always long after the related loan transaction has been completed. As an aside, the latter tendency is almost certainly at odds with the FSA’s recent (July 2002) Consultation Paper 141, which, updating Section 8.1 of the Conduct of Business Handbook, requires Confirmations to be dispatched ‘as soon as practicable in accordance with good market practice’. More generally, neither the Schedule nor the Confirmation will reflect the loan transaction but, instead, will be accompanied by a letter from the swap provider asking the borrower to sign and return the ‘enclosed market standard documents’ (or similar). Occasionally, there will be a recommendation to the borrower to seek legal advice in relation to the documents – advice that the borrower will, for several reasons, generally not heed. First, it will be so relieved to see the back of the negotiations leading up to completion of the loan transaction that it will not want to reopen them with respect to the swap. Second, its bankers will encourage it to sign with the minimum of fuss, partly out of a genuine (but mistaken) belief that the documents are indeed standard and partly because they too will have moved on to the next deal. Third, if it does consult its lawyers – and the relevant firm does not have the expertise to be able to advise – the lawyers concerned are much more likely to acquiesce in the standard form argument than admit that they cannot advise (and risk losing the borrower’s business). Finally, even if it does consult a specialist, it will be put off both by the fee quote for the review and by the bad news that the review will not only entail making significant amendments to the swap documentation but will also necessitate amendments to the loan and other documentation that the borrower thought it had successfully completed some months previously. Needless to say, these impulses are accentuated the smaller the deal-ticket; the more fragmented the transaction (as where the swap is sold regionally but documented in London, the loan provider and swap provider are different entities, the respective loan and swap teams do not communicate, etc.), the lesser the degree of expertise within the borrower’s legal team and the greater the length of time between the date of completion and the date of receipt of the documents. The last of these factors is further accentuated if the obligation to hedge is a condition subsequent – as opposed to precedent – to the making of the loan.

LEGAL DIFFERENCES A good summary of the principal legal considerations affecting OTC derivative transactions can be found in Chapter 4 of Paul C. Harding’s book Mastering the ISDA Master Agreement, to which the reader is referred. Perhaps to Paul’s list might be added a word or two about the enforceability 24

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of oral contracts and the admissibility in evidence of taped conversations but, whatever the content of the list, it is fair to say that few of the considerations are relevant to the transacting of loan business. Loans are uncomplicated instruments that have been in existence for centuries. As a product they are well understood, the legal environment is settled and the insolvency analysis, in particular, is made easier by the fact that only one of the parties is a creditor under the arrangement. Contrast the foregoing with the transacting of swap business. The swap market is, relatively speaking, immature and swaps are fundamentally different from loan instruments in certain key respects – consider again the mutuality and volatility of credit exposures that arise under the former and the importance, as a result, that is placed by a solvent party on being able to net positive and negative exposures on the insolvency of its counterparty. As a result of these differences, swaps cause trouble from time to time, not least to the Courts. One need only look back to the judgments of the House of Lords in the leading case of Hazell v Hammersmith and Fulham LBC [1992] AC 1 (also considered in Paul’s book) to see the difficulty that the Court had in conceptualizing early finance-linked swap arrangements as anything but speculation. More recently, the Peregrine case provides an example of a Court straining to arrive at a result that, it is suggested, would have been reached much more quickly had the parties simply disregarded the form of the transaction and acknowledged that it was, in substance, not a swap at all but in fact a loan. At the cutting edge of the OTC derivatives market, and more recently still, questions such as the legal nature – derivative contract or insurance policy – of financial guarantees, weather risk management contracts and so on continue to vex. Fortunately, finance-linked swaps are relatively undemanding from a legal perspective. That said, the two legal issues that tend to crop up again and again are capacity – for certain types of borrower – and reliance
suitability. We deal with both issues in later chapters.

CULTURAL AND CONCEPTUAL DIFFERENCES Related to some of the economic differences alluded to earlier in this chapter are certain cultural and conceptual differences that characterize the two markets. At a macro-level, for example, the real-time mind-set of the swap markets – pursuant to which credit exposures under derivatives are marked to market daily (and sometimes even intra-day) – is having a profound influence on the way that loan providers (and their regulators) view and, more significantly, measure exposures under loan instruments. That process may, in the long run, alter the way that finance-linked swap arrangements 25

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are regulated, i.e. not as discrete, albeit interrelated, loan and swap contracts but as synthetic, derivative-embedded instruments. In turn, that process will be all to the good if it leads to a greater appreciation of, and willingness to tackle, the issues that are raised in this book. At a conceptual level, certain other mind-sets are worth referring to. When negotiating a cross default provision, for example, a banker will be thinking in terms of a default or acceleration above a certain threshold. A swap provider, by contrast, will be thinking about early termination above a specified marked-to-market exposure. In terms of set-off, a banker will be looking to quantify its exposure and then set it off against, for example, a deposit of the relevant borrower. A swap provider will be looking to quantify individual swap exposures, to net positives against negatives and only then to set off any residual exposure. These and similar mind-set differences often cloud the debate in the context of finance-linked swap arrangements.

DOES IT MATTER? The differences discussed in this chapter lead, in practice, to all manner of problems, ranging from inaccurate documentation, cash flow asymmetries and over-sensitive credit provisioning to legally or conceptually flawed arrangements. In truth, however, the differences unhelpfully mask what are, in fact, overwhelming similarities, not only between swap and loan instruments but also between the respective markets in which they are structured and sold. These similarities mean that the problems that do arise ought to be easily surmountable. In Chapter 3, we begin to bridge the divide with a detailed look at the key commercial considerations that need to be borne in mind when seeking to integrate a swap into a loan structure.

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Hedging strategy Economic symmetry Credit symmetry Prepayment Security and intercreditor issues Transferability

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HEDGING STRATEGY The hedging strategy that best suits the requirements of a given borrower in relation to a given financing will be determined by a number of factors. These include the size and duration of the loan, the likelihood of the borrower prepaying the loan ahead of maturity, the degree of tolerance of its expected cash flows (and related debt covenants) to rises in interest rates, the extent to which it is prepared to give up the benefit of falls in interest rates and the shape of the forward curve. Lender and shareholder
investor sensitivities will also be influential, as will the existence or otherwise of any natural hedge. Whatever the precise strategy – and it is impossible to generalize – the question will ultimately boil down to whether to use a swap, an option or some combination of the two. Once that has been decided – and often the borrower will employ specialist consultants to advise it in relation to strategy – it will then be necessary to address questions of timing, pricing and implementation.

Swaps A swap, assuming it is priced at the money, has the obvious attraction that it carries no upfront cost to either of the parties. Superficially less attractive – to the borrower in particular – is the opportunity cost that the borrower suffers if floating rates sit for longer than expected below the fixed rate that it has locked in through the swap or if it is out the money when the swap, for whatever reason, is or needs to be terminated ahead of its scheduled maturity date. These are superficial disincentives, only, because the opportunity cost is simply the price that the borrower pays for interest rate certainty and the early termination cost is simply the net present value of its remaining payment obligations under the swap. Borrowers sometimes lose sight of the latter fact and are tempted, in circumstances where they would like to bring about a termination of the swap but are put off by the cost, to ‘hang on’ to see whether the cost will come down over time. This is wishful thinking, of course, since the cost may actually go up (and up and up). Assuming, therefore, that its cash flow will bear it and
or that an early termination is, objectively and economically, the right (or, as we shall see for certain types of entity, the only) thing for it to bring about – as where, in a finance-linked context, the related loan is repaid early and there is no other liability in the borrower’s balance sheet to which the swap can be ‘allocated’ – a super-rational borrower will simply swallow hard and pay. The alternative is for it to take the pain at the front end through an option or swaption product. 29

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Options The most common type of interest rate option in a finance-linked context is a ‘cap’. For an upfront premium, a purchaser of a cap limits its exposure to interest rate rises above an agreed ‘strike’ rate – receiving one or more compensating payments from the cap provider – and enjoys the additional benefit that comes from floating rates sitting below the strike from time to time (since it pays less interest on the related loan). There are, additionally, no break costs to worry about – by contrast, the borrower may, on an early termination of the cap, be entitled to receive a rebate of the premium and
or a mark-to-market payment from the cap provider. Certainly, a well-advised borrower will enquire at the outset as to whether and on what terms the cap provider is prepared to return to the borrower any ‘value’ in the cap on an early termination. Figure 3.1 provides a simplified illustration of the cash flows within a finance-linked cap. As with the finance-linked swap arrangements considered in Chapter 1, the cap provider will usually, but need not, be the loan-providing bank. Finance-linked cap (where strike # x%)

Figure 3.1

Principal Lending bank & cap provider

LIBOR Premium

Borrower

Payment (of LIBOR ⫺ x) if LIBOR ⬎ x%

The disadvantage of a cap is that it can be prohibitively expensive for the borrower. There are, however, two principal ways in which it can defray the cost. The first is for it to buy an out-the-money cap, i.e. one in respect of which the strike is significantly above prevailing fixed rates. The more out the money the cap, the lower the premium but the greater the amount of floating rate risk to the borrower (since it receives nothing from the cap provider unless and until floating rates rise above the strike). The second is for it concurrently to sell, to the cap provider, a ‘floor’, i.e. a contract pursuant to which the borrower is obliged to make one or more payments to the cap provider equal to the amount by which an agreed (lower) strike exceeds floating rates from time to time. In return for it giving up some of the benefit of lower interest rates in this way, the borrower receives a premium. Not uncommonly, the respective strikes of the cap and floor (together known as a ‘collar’) are positioned so that the premia exactly offset, giving the borrower costless protection. Figures 3.2a and b provide simplified diagrammatic and graphic illustrations of the cash flows under a costless finance-linked collar. 30

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Diagrammatic illustration of costless finance-linked collar (where y ` x)

Figure 3.2a

Principal Lending bank & collar provider

LIBOR Payment (of y ⫺ LIBOR) if LIBOR ⬍ y%

Borrower

Payment (of LIBOR ⫺ x) if LIBOR ⬎ x%

Graphic illustration of costless finance-linked collar

Figure 3.2b

etc. i%

Collar provider pays borrower

x No payment under collar y Borrower pays collar provider

Inception

Maturity

t

Swaptions It is possible for a swap and an option to be combined in an effort to give the borrower the best of all worlds. One alternative is for the borrower to enter into a conventional swap but to grant the swap provider an option either to extend the term of the swap (for a pre-agreed further period) at maturity or to cancel it – usually at zero cost to either party – on one or more specified dates ahead of maturity. Such structures preserve the costless features of a swap, reduce the borrower’s effective funding rate (since the granting of the option carries with it a premium) and may, in certain circumstances, avoid early termination costs. They are viable, however, only if consistent with the borrower’s overall hedging strategy. 31

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Conventional swaptions may additionally be used to give the borrower flexibility in relation to the timing of drawdowns and repayments. Hybrid variants also exist, e.g. ‘trigger’ swaps that knock the borrower into a preagreed fixed rate (and pay the borrower LIBOR) only when a strike ceiling rate is breached, thereby eliminating some of the initial carry-cost associated with vanilla swaps in an upward-sloping forward curve environment. In general, however, swaptions appear much less often than discrete swap and option structures.

Timing As noted in Chapter 2, best practice in relation to finance-linked swap arrangements dictates that the swap is put in place at the point of drawdown of the related loan. This has the obvious advantage of certainty – the borrower locks in a fixed rate at the outset – and also encourages the parties at least to consider the swap documentation in the context and as an integral part of a related loan agreement. Theoretical-to-real risks for all parties in relation to ‘point-of-drawdown’ swaps are that the borrower commits to the swap but the loan remains undrawn (either on account of the lender’s failure to fund or the borrower’s inability to satisfy the lender’s conditions precedent to drawing); or that the borrower draws the loan but the swap is ineffective on account of the borrower’s inability to meet relevant conditions precedent imposed by the swap provider. To the extent that these issues are more real than theoretical, they can be addressed by appropriate undertakings and indemnities between the parties. Occasionally, for example, the borrower will obtain the agreement of the swap provider to an immediate break of the swap (i.e. if, for whatever reason, the loan is not drawn) in return for an indemnity from the borrower to the swap provider relating to the latter’s costs in breaking any back-to-back arrangement. Often, however, particularly at the smaller-ticket end of the loan markets, the swap is expressed to be a condition subsequent to the drawing of the loan. Typically, this takes the form of an undertaking on the part of the borrower, to be fulfilled within x months of drawdown, to enter into an interest rate swap (or similar) that hedges all or a specified minimum percentage of the loan, for all or a specified minimum percentage of its term, at an effective rate to the borrower of not more than y%. The only advantage to this approach is that it removes some of the theoretical risks alluded to in the context of ‘point-of-drawdown’ swaps. Otherwise it has little to commend it, since it not only exposes the borrower to upward shifts in the forward curve between the point of drawdown and the point at which it enters into the hedge but also means that little or no thought is given to engineering the loan and other documents to accommodate the swap documentation that will, eventually, have to be put in place. As observed in Chapter 2, the swap 32

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and loan documents in such circumstances remain at worst unengineered, while at best the accommodation has to be effected by way of a post-drawdown side letter to the loan agreement that necessarily requires the management time, consent and signature of the lending bank and the borrower. In a benign interest rate environment, i.e. where the forward curve is inverted, flat or gently upward sloping, interest rate risk may be something that both lender and borrower are happy to live with. Indeed, in such an environment, it is not unusual to see the borrower’s obligation to hedge made subject to a ‘trigger’, i.e. to become effective only if swap rates breach a pre-agreed ceiling rate. Needless to say, forward conditionality of this sort relegates any consideration of the interrelationship between the loan and swap documentation to the bottom of the pile, but a well-advised borrower will nevertheless seek a commitment from its lending bank to ‘revisit’ the loan agreement, in good faith, if and when the obligation to hedge is triggered. In relation to the trigger itself, some thought is required. An obligation to hedge ‘if fixed rates exceed x%’ is of no advantage if there occurs a one-off ‘spike’ in interest rates that is not repeated for the rest of the term of the loan. Better, therefore, is to couch the obligation in terms of fixed rates exceeding x% on, say, three consecutive month ends.

Pricing To the extent that it is within its control – as where, for example, the borrower is borrowing from a syndicate of banks, some or all of whom are willing to quote for the swap business – the borrower should encourage a competitive process whereby interested banks tender on a pre-agreed basis and the borrower transacts only with the successful bank(s). An alternative is for one or more banks in the syndicate to act as a ‘front’ for the borrower, each fronting bank itself seeking quotes in the swap market and backing out the cheapest of those obtained to the borrower. In either case, the borrower may look to its hedging strategy advisors both to assist with the tender process and, more specifically, to validate the prices at which the banks tender.

Implementation Often, the borrower’s hedging strategy will be embodied in a strategy document, itself accompanied by a more formal term sheet setting out the general terms of the swap or other instrument purchased by the borrower. An example of such a term sheet is given in Annex 4. While strategy documents and term sheets are of invaluable assistance to the specialists charged with putting the relevant swap documentation in place, they can only go so far. The rest of this chapter is concerned with the detailed commercial points that follow from a determination by the borrower of its hedging strategy. 33

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ECONOMIC SYMMETRY Whatever the exact nature of the hedge, the borrower, its lender and the swap provider (if a third party) ought all to have a vested interest in ensuring that the economic terms of the swap (or option) mirror those of the loan contract to which it relates – the borrower and the lender because inconsistency between any of the key economic variables can lead to significant adverse cash flows, and the swap provider because, once the inconsistency has caused an initial payment problem for the borrower, it will come under pressure from both the borrower and the lender to make relevant amendments to the swap documentation so that the error does not recur. Better, therefore, to get it right in the first place. There may also, from the borrower’s perspective, be an accounting imperative. Under new International Accounting Standard 39, a borrower wishing to ‘hedge account’ a finance-linked swap (i.e. wishing to achieve accounting neutrality as between the LIBOR payable on the loan and the LIBOR receivable under the swap) must satisfy an ‘effectiveness’ test. Narrowly interpreted, the test requires there to be broad economic symmetry (which the Standard defines as at or close to 100% at inception and within 80
–
125% otherwise) between the swap and the loan – so a hedge for 70% of the loan principal, for example, would, presumably, not be ‘effective’. Broadly interpreted, the test requires the underlying documentation to hold water not merely from an economic perspective but also from the perspectives of structural integrity and legal enforceability. Doubtless practice will evolve over time, but certainly the requirement for effectiveness is to be welcomed if it helps shape the way that finance-linked swap documentation is perceived and negotiated in the future. Before looking at each of the key economic variables within financelinked swap arrangements, it is worth reminding ourselves of the constituent elements of loan interest and swap payments and where these fit within the respective contractual frameworks.

Loan interest The quantum of simple interest payable on an interest payment date under a typical loan is calculated according to the following formula: i
t = p × r% ×
n
y where: i
t # the amount of interest payable on a given interest payment date t; p # the amount of loan principal outstanding for the relevant interest period; 34

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r # the relevant per annum rate (inclusive of margin and MLA costs) for the relevant interest period; n # the number of days in the relevant interest period; and y # the number of days in a year for interest calculation purposes. Each of the constituents in the above formula – and the formula itself – will appear in, or at least be discernible from, the terms of the loan agreement and relevant communications between the lender and the borrower relating to drawdown, rollover and rate-fixing. In particular, the loan agreement will stipulate a business day convention (setting out what is to happen if t falls on a day that is not a business day and defining what ‘business day’ means), will contain rate source and rate setting conventions (specifying the primary means of ascertaining r, one or more disruption fallbacks should r be unascertainable and the procedure for resetting r at the beginning of each interest period) and will stipulate both what n is (or how it is to be determined) for each interest period and a number for y (which may or may not include an adjustment for leap years).

Swap payments The formula for the calculation of payments under an interest rate swap is identical to that for loan interest payments save only in respect of the terminology employed and the fact that, under a typical swap, there will be two amounts, one fixed and one floating, to be calculated on any given payment date. So the formula looks like this: p
t = na × r% × dcf where: p
t # the fixed
floating amount payable on a given fixed rate payer
floating rate payer payment date t; na # the notional amount for the relevant calculation period; r # the relevant fixed
per annum rate (!
0 spread) for the relevant calculation period; and dcf # the applicable ‘day count fraction’ (conceptually identical to the ‘n
y’ constituent of the loan interest formula given earlier). Despite the economic similarity between the two formulae, none of the constituents of the swap payments formula – nor the formula itself – appears in the ISDA 1992 Master Agreement. Instead, the constituents are divided between the Confirmation and the relevant ISDA Definitions that are incorporated by reference into the Confirmation. The Confirmation itself specifies the relevant payment dates (t, t
1, t
2 etc.) and ascribes a business day convention to these; sets out the notional amount, the fixed rate and the 35

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relevant floating rate source; and specifies a day count fraction with respect to both fixed rate and floating rate payer payment obligations. But for the formula itself and for precisely what is meant by, say, a given business day convention, a given rate source, a given day count fraction, etc., it is necessary not only to turn to the relevant Definitions but also to scroll down a menu of alternatives until one comes to the one that is employed in the Confirmation. To give some context here, the reader might like to reflect on the fact that the 2000 ISDA Definitions – themselves, it is to be remembered, supplemented by an Annex – contain three different business day conventions, six different meanings for £ LIBOR and six different day count fractions. The point to the foregoing is not to teach the reader trivial financial mathematics. It is to illustrate that, in order to achieve economic symmetry between a loan instrument and a swap that is intended to hedge it, each and every one of the constituents within the respective formulae needs to correspond, from a definitional and contractual perspective, to its counterpart in the other. With so many variables to choose from within the relevant ISDA Definitions and with such a diversity of loan agreement precedents, this is not always as simple an exercise as it first seems. In the context of endemic malpractice in the finance-linked swap market, where debt finance lawyers rarely look at swap documentation and swap documentation personnel rarely look at loan agreements, it is impossible. Matters are made worse because many in the market are unattuned to the requirement for economic symmetry. A recent example, raised with a lending banker, highlighted the fact that the business day convention in his loan agreement was different to that set out in the draft Confirmation prepared by his swap documentation colleagues, raising a potential risk for the client of having to pay interest on the loan ahead of receipt of the corresponding floating rate payment under the swap. His initial response – ‘my people wouldn’t put a convention in that wasn’t market’ – gave way to common sense and symmetry was achieved in the end. A separate incident arose lately in the context of a bank seeking to lend to a client at base rate but to sell it a LIBOR-denominated hedge. Most recently, completion of a project financing was unnecessarily delayed well into the night when it was discovered that the modelling for the borrowing SPV’s effective rate (i.e. the sum of the fixed rate under the swap and the margin and MLA costs under the loan – the two LIBOR flows cancelling out) had not factored in the MLA costs component. Eventually it was concluded that there was enough ‘fat’ in the deal to enable the parties to sign – but surely that conclusion ought to have been a term sheet, not pre-completion, consideration? At the other end of the spectrum, even those who are versed in the nuances cannot afford to take matters for granted. By way of one of several possible illustrations, consider the rate source provisions within LMA 36

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primary market documents. These specify that £ LIBOR will be the British Bankers’ Association (BBA) Interest Settlement Rate and the related LMA User’s Guide suggests Telerate Page 3750 as one appropriate screen page. Both the 1991 and 2000 ISDA Definitions include ‘GBP-LIBOR-BBA’ as a menu rate source option and the relevant definition within each provides that £ LIBOR will be the rate that appears on Telerate page 3750 as of 11 a.m. on the morning of the relevant reset date. One could be forgiven, therefore, for imagining that, by electing ‘GBP-LIBOR-BBA’ in the Confirmation of a swap that was intended to hedge an LMA-documented, Telerate-referenced loan, one had at least achieved rate source symmetry. Right? Wrong! If the screen rate is unavailable, the LMA’s ‘BBA
Telerate’ defaults to three reference banks, averages and rounds up to four decimal places, whereas ISDA’s ‘BBA
Telerate’ defaults to four reference banks, averages and does not round. In addition, successor screen pages are dealt with differently and, under LMA documents, parties may elect a time other than 11 a.m. as the relevant fixing time. Anyone tempted to dismiss these ‘basis risks’ (as they are known) on the grounds that market disruption in the LIBM is an unlikely occurrence faces the uphill task of explaining why the fallbacks and elections are required in the first place. The incontrovertible fact is that basis risk exists, has the potential to cost the borrower dearly in certain circumstances and needs addressing through an appropriate amendment to one or other of the loan agreement and swap documentation. We return to the detail of economic symmetry in Chapter 4 when we look at the drafting points that arise in the context of finance-linked swap Confirmations. In the meantime, we finish with a number of further observations relating to some of the key variables considered above.

Loan principal
notional amount It is axiomatic that the notional amount of the swap should correspond to or at least move in tandem with the principal amount of the loan. As simple a concept as that appears, there are some difficult issues to consider. It is essential, for example, that the accretion
amortization profile of the swap notional (which is usually fixed at the outset) and the drawdown
repayment profile of the loan principal should mirror each other – otherwise the borrower will be under- or over-hedged for at least some and perhaps all of the life of the loan. Where the borrower’s desire (or obligation) is to hedge only a specified percentage of the loan, as is often the case in practice, the same principle holds true, but rateably. In respect of loan arrangements that involve some degree of flexibility or uncertainty around drawdown and repayment, the only sensible way for a borrower to maintain synchronicity (unless it is prepared to pay any break costs that arise each time the notional is reset) is for it to enter 37

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into, at the outset, one or more swaptions that enable it to lock in, today, a future fixed rate or, as the case may be, to come out of an existing fixed rate, in the future, at zero cost. As well as being non-trivial from a documentation perspective, particularly in a finance-linked context, such arrangements have cost implications for the borrower, either in terms of an upfront premium or, in the case of zero-cost exit swaptions, an (upward) adjustment to the ongoing fixed rate. In the context of revolving facilities, particularly where the borrower’s funding requirements are so unpredictable as to make it impossible for it accurately to position its swaption requirements, perhaps all that it can realistically do is enter into a generic hedge at the outset for an (expected) average amount and life of debt funding.

Key dates Clearly it is not just the respective interest
swap payment dates that need to be synchronized. If economic symmetry is to be achieved, the drawdown date, final repayment date and interest fixing dates under the loan need also to correspond with, respectively, the effective date, termination date and reset dates under the swap. As described earlier, each of these dates will appear in or be determinable from the loan agreement or, as the case may be, the Confirmation (the latter as supplemented by the relevant ISDA Definitions). The reader will, as before, note the different terminology that is employed, as between loan and swap instruments, to describe identical economic concepts.

Rate
rate source There are two additional points to consider in the context of achieving rate
rate source symmetry. The first is a general one and relates to so-called ‘stub’ periods. Stub periods occur most frequently at the front end of loan transactions and are a consequence of the fact that borrowers and banks prefer interest payments to be made at month end and
or on customary quarter or half-year dates. Often, the first drawing under a loan will be on a day other than one of these preferred dates, with the result that the first interest period will be shorter (hence the term ‘stub’) than those that follow. The rate for that first period will, therefore, usually be calculated by linear interpolation, i.e. by plotting a straight line between rates for ‘conventional’ periods either side of that first period and inferring the stub rate from the plotted line. Stub periods may also arise at the back end of loan transactions – where, for example, a borrower knows in advance that it is going to repay a loan on a specific date and contractually agrees to repay on that date, but the date itself is not a conventional interest payment date. 38

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In many cases, stub rates at the front end of loan transactions are simply offered to the borrower on a take-it-or-leave-it basis, although a sophisticated borrower will often ask to see the bank’s methodology in arriving at the rate and may even, depending on circumstances, insist that the rate be calculated by non-linear (i.e. weighted) interpolation. In respect of the back end of the transaction, the loan agreement needs to set out clearly the methodology to be employed for setting the rate in relation to the final stub period. Stub periods arise in exactly the same way, and for exactly the same reasons, in relation to payments under swap transactions. In the context of finance-linked swaps, therefore, the borrower will want to ensure that any front-end stub rate (and the methodology to be employed to calculate any back-end stub rate) is identical for the swap and the loan. Interestingly, both the 1991 and 2000 ISDA Definitions contain standard language to bring about linear interpolation whereas LMA primary loan market documentation is silent on the issue. The second point is one of co-ordination and communication. To take an example, one role of the facility agent in a syndicated loan transaction is to handle the rate-fixing process. It will do this by obtaining the relevant screen rate and notifying it to each of the syndicate banks and the borrower, accompanied by appropriate settlement instructions. If, as is likely, one of the syndicate banks is the swap provider and if, as is hoped, the relevant documentation has been tailored to ensure that the applicable rate source and fixing dates are identical as between the loan and the swap, the agent might usefully, as part of the process, notify the borrower and the swap provider of the relevant swap rate and of the corresponding settlement instructions in relation to payments to be made under the swap. In practice, this does not often happen and, instead, the swap provider sends out its own, separate notification and settlement instructions to the borrower. As well as being inefficient, the procedure is prone to operational error, inviting at best confusion and at worst borrower over-payment and a need for a corresponding correction. The problem becomes more acute in the context of fallback rates. For even if the swap and loan agreements do provide identical market disruption fallbacks (i.e. if, to take our earlier BBA
Telerate example, both contracts are expressed to fall back to the same number of reference banks and to employ identical fallback methodology), basis risk still exists to the extent that the reference banks selected by, respectively, the lender
facility agent under the loan and the calculation agent under the swap are different – and so provide different rates – or are the same but provide different rates to reflect differences in the standing of the entity that is seeking them. These difficulties would disappear if all parties agreed that one or other of the lender
facility agent and the calculation agent should seek
notify the relevant rate and that the rate so sought
notified should be the rate applicable to payments under both the loan and the swap. The minimal changes that would be necessary 39

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to the underlying documentation to make this happen would, it is suggested, be a small price to pay in return.

Settlement Related to some of the issues just discussed is the question of settlement. In the context of a simple bilateral loan – particularly where the swap provider is itself the lending bank or is an affiliate of the lending bank – the optimal arrangement for the borrower would be to make one payment only (i.e. the fixed rate under the swap plus the margin and any MLAs on the loan) and for the two LIBOR-related flows simply to be net-settled pursuant to standard settlement instructions incorporated into the loan and swap documents. Again, this rarely happens. Admittedly, the swap itself is often net-settled, reducing the number of payments to be made between the parties from three to two, but the point is that a single payment ought, with a little thought and some minor amendments to the relevant documentation, to be achievable, with attendant administrative, cost and settlement risk-reduction benefits for all concerned. In the context of structured or syndicated transactions, particularly those involving collection and payment accounts, these same settlement issues necessarily demand, and as a consequence tend to receive, this level of engineering. In a cross-border context, where international time zones may make a net settlement in the normal sense impossible to achieve, it will be preferable to incorporate escrow provisions that minimize daylight risk between the parties.

CREDIT SYMMETRY Once ‘economic’ basis risk has been dealt with, the parties will want to turn their attention to minimizing ‘credit’ basis risk. The latter arises because loan agreements – themselves a disparate class of instruments on account of the multitude of precedents in existence – contain credit provisions (e.g. representations, covenants and events of default) that are detailed, heavily negotiated and often highly ‘personal’ to the borrower and the relevant financing. Swaps, by contrast, are almost always documented using a single precedent – the ubiquitous ISDA 1992 Master Agreement – the credit provisions of which are, as a matter of general practice, much less heavily negotiated. Sum these differences, throw in some of the other factors considered in Chapter 2 and it is absolutely certain that, even as between a single bank
swap provider and its borrowing
swap-buying customer, a 40

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comparison of the credit provisions within the respective loan and swap agreements will reveal markedly different credit sensitivities and tolerances. Where the two agreements are not specifically related, i.e. outside of the finance-linked swap arena, this outcome may offend the purist but will not unduly concern the bank (provided that it has adequate, zero-threshold cross default rights across the two agreements) or the borrower (provided that it understands that the bank is likely, in a crunch, to look to the most sensitive of any discrepant credit provisions). In the context of typical finance-linked swap arrangements, however, credit asymmetry of this nature raises serious issues for all parties. The swap provider, for example, will be concerned to ensure that it is not in a weaker position (in terms of credit provisioning under the swap agreement) than the bank lender(s) under the loan agreement. The borrower and the bank lender(s), on the other hand, will not want the swap provider to call a default under the swap agreement in circumstances that do not constitute a default under the loan agreement – from the borrower’s perspective in particular if, as is most likely to be the case, a default under the swap agreement gives rise to a cross default under the loan agreement. From an intercreditor perspective, and in the context of a syndicated loan, questions will arise as to whether the swap provider should or should not be bound by majority lender decisions under the loan agreement and whether and to what extent its contingent exposure under the swap should give it syndicate voting rights of its own. In this regard, the swap provider will, in practice, need some unilateral termination rights (e.g. for non-payment in respect of the swap) but may, in other cases (e.g. cross default, breach of key documents, etc.), agree to its own disenfranchisement or to be bound by majority lender decisions under the loan agreement. For their part, lenders will often seek step-in
cure rights on a borrower non-payment under the swap, enabling them to stay the swap provider’s termination right that would otherwise arise following such non-payment. There are several possible ways of dealing with the concerns that arise from asymmetry of credit provisioning and the related intercreditor issues. The crudest and most inefficient approach (and not recommended – it is mentioned only because it is so prevalent in practice) is to do nothing. Next best is to incorporate an ‘inconsistency override’ provision somewhere in the loan agreement to the effect that, in the event of an inconsistency between the credit terms of the loan agreement and the credit terms of the swap agreement, the credit terms of the loan agreement will prevail. This method has the attraction of being simple, but it may not cover all the bases (it begs, for example, the question as to whether an omission is an inconsistency); leaves the borrower exposed to the extent that the override provision is unenforceable (e.g. for contractual uncertainty); is, in relation to structured transactions, at odds with the level of engineering to which the rest of 41

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the deal is generally subjected; and, finally, will not work where the lender and the swap provider are different entities but the latter is not made party to the loan agreement and is otherwise unwilling to agree to be bound by the provision. Better, therefore (albeit somewhat lengthy as a process), is to disapply – with respect to the borrower – the ‘standard’ credit events within the swap agreement and replace them, verbatim, with the credit events from the loan agreement. Best and most efficient, however, is to disapply most of the credit events within the swap agreement – leaving the swap provider with unilateral termination rights for borrower non-payment
nonperformance under the swap – and to supplement that with a cross acceleration provision that gives the swap provider a further termination right to the extent that the lender (or majority lenders, as the case may be) accelerate(s) the loan. A provision that obliges the lender(s) to copy the swap provider into any notice of acceleration is a useful and obvious adjunct to the foregoing. Where, as may occasionally be desired, the maturity of the swap is to extend beyond the term of the loan (a so-called ‘sunset’ swap), it is necessary to build in, at the outset, provisions that ‘switch back on’ the disapplied events of default once the loan has been repaid. Applying similar logic, the swap provider, lender and borrower ought also to ensure that there are no material asymmetries between the representations, covenants and non-credit-related termination events contained in the swap and loan agreements, making such amendments as are necessary to harmonize tolerances, grace periods and carve-outs and to preserve general intercreditor equilibrium between the two. In addition, the parties will need to pay particular attention to the various borrower covenants within the loan agreement to ensure that they are not inconsistent with the swap arrangements. Widely drafted negative covenants – for example, those restricting disposals, off-balance sheet financing arrangements and the creation of security interests – may need amending so that the entering into of the swap and the making of payments and
or the creation of netting and set-off rights in connection therewith do not put the borrower in technical breach of the loan agreement. Careful consideration will also need to be given to any financial covenants within the loan agreement, since net payables
receivables under the swap are material to interest cover covenants and the periodic marking-to-market of the swap is relevant to covenants relating to borrower indebtedness levels. Related to the foregoing is the (often tenuous) presupposition that the borrower is able, accurately, to measure the mark-to-market for the purposes of certifying ongoing compliance with the relevant covenant(s). As a matter of general practice, it is rare that ‘credit engineering’ of the sort outlined above is undertaken other than at the very sophisticated end of the market. 42

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PREPAYMENT As noted earlier in this chapter, the loan principal and swap notional in a finance-linked swap arrangement ought to move in synch. It follows that, if the loan is voluntarily prepaid (we will come on to mandatory prepayments shortly) otherwise than in accordance with its scheduled maturity
amortization profile, the borrower must be able to bring about a rateable early termination of the swap. There will, therefore, need to be express provisions to that effect in the swap agreement, accompanied by a contractual mechanism to bring about relevant adjustments to the ongoing swap notional and a settlement of the mark-to-market. Acting super-rationally (assuming it has the choice, that is – certain types of borrowers may have no alternative but to terminate), the borrower will, on a loan prepayment, exercise its swap termination right. As we have observed, however, borrowers are inclined to act less than dispassionately when a termination carries with it a break cost. In practice, therefore, a prudent lender
swap provider will want to negotiate its own right to break the swap, rateably, on a prepayment (thereby effectively forcing the borrower’s hand) or, where the lender and swap provider are separate entities, the lender will want to extract from the borrower, through the loan agreement, an undertaking to effect the relevant early termination. An alternative method of dealing with the issue of prepayment is to build into the swap documents, at the outset, provisions that bring about an automatic and pro tanto write-down of the swap (as well as, of course, a crystallization and payment of the mark-to-market) on a prepayment of the loan. The latter approach sacrifices flexibility for certainty. Of course, a swap agreement may need to be terminated otherwise than as a consequence of a simple, voluntary prepayment of the loan by the borrower. In a finance-linked context, an acceleration of the borrower’s obligations under the loan agreement – whether by reason of a borrower event of default or a mandatory prepayment event – will, with correct structuring and drafting, give the swap provider an early termination right. This right will sit over and above its ‘retained’ rights to terminate for borrower nonpayment
non-performance under the swap agreement (discussed above in relation to credit symmetry) and any rights under that agreement to terminate for non-credit-related events such as tax events and illegality. Where the swap agreement makes provision for an affected party to transfer its rights and obligations to another office or to an affiliate – in either case with a view to circumventing the tax event or illegality so that the swap remains in place – it is sensible, from a lender
syndicate perspective, to build into the documentation a veto that enables the lender
syndicate, acting reasonably, to object to the transfer on credit, policy or other commercial grounds. On the other side of the coin, it is conceivable that the swap provider will itself 43

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become insolvent or will otherwise default on its obligations under the swap agreement, whereupon it will be the borrower wanting to bring about an early termination. Since it is impossible to predict when an early termination might occur, which of the parties will bring it about and which of the parties will be in and which out the money at the relevant time, all eventualities, not least the respective security positions of the parties, need to be catered for at the outset. It is to the question of security for close-out amounts that we now turn.

SECURITY AND INTERCREDITOR ISSUES Unless the swap is exactly at the money when it is terminated (a rare occurrence) one of the borrower and the swap provider will owe the other a closeout amount on early termination. Key concerns of each of the parties in this regard are as follows.

Swap provider The swap provider will, to the extent that it is not already so by virtue of being a
the lending bank, expect to be a pari passu beneficiary under the security package given by the borrower to the lending bank(s). In the context of a syndicated loan, the security arrangements will almost inevitably have to be structured through a trust or similar vehicle but, in a single bank
affiliated swap provider scenario, other ‘routes’ into the security package are possible. Figure 3.3 provides an example of such a structure that is employed by at least one City lending institution.

Figure 3.3

‘Indirect’ security structure: single bank lender and affiliated swap provider (i) Counter-indemnity (ii) Security (for loan and for counter-indemnity) Lending bank Guarantee (of borrower’s obligations under swap)

100%

Swap provider

44

Guarantee (of swap provider’s obligations under swap)

Borrower

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Under the above structure, the lending bank guarantees the borrower’s obligations to the swap provider under the swap and the borrower, in turn, counter-indemnifies the lending bank for claims made by the swap provider under the guarantee. In return for the counter-indemnity, the borrower receives a guarantee from the lending bank for the obligations of its swapproviding subsidiary. It is the counter-indemnity that effectively gives the swap provider a ‘route’ into the security package provided by the borrower to the lending bank. What is intended to happen, on a borrower default under the swap, is that the swap provider claims upon the borrower and, failing payment, claims under the guarantee. The lending bank pays out under the guarantee and then looks to the borrower under the counterindemnity (and, through that, to the underlying security). The arrangement seems paradoxical but is in fact perfectly logical, the only real risks to the swap provider being unenforceability of the guarantee or a failure by the parent bank to meet its obligations under it. The latter risk may in any event be mitigated if the swap provider is able to enforce the underlying security under the common law doctrine of marshalling. The foregoing presupposes that it is the swap provider that is in the money on a close-out. Where the swap provider is out the money, it will ordinarily want a contractual right to set off any close-out amount payable by it to the borrower (under the swap agreement) against any amount owing by the borrower to it under any other agreements between it and the borrower – and it will therefore need to ensure that there is an appropriate setoff clause within the swap agreement and that the same does not conflict with the terms of any negative pledge or similar provision within the related loan agreement. As we are about to see, however, swap provider set-off rights of this nature may be inconsistent with lending bank concerns, particularly in a syndicated loan context where the swap provider is one of the lenders.

Lending bank(s) Where the borrower is out the money on an early termination of the swap, the lending banks face a potential dilution of their security (to the extent that it has to be shared with the swap provider) and a general swelling of the creditor pool, but otherwise have no real issues to consider. Where the borrower is in the money, however, numerous questions arise. The first is whether the amount payable to the borrower should form part of the security for amounts due by the borrower under the related loan agreement. Assuming the answer to be yes, the nature of the borrower’s rights over which the security is to be given needs to be carefully defined (not least to address the priority of any netting and
or set-off rights of the swap provider) and both the swap and the loan agreement need expressly to contemplate and permit the creation of the relevant security interest. Where the 45

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swap provider does have a right of set-off under the swap agreement and is also a member of the syndicate, the lending banks may wish to ‘insulate’ the right so that any close-out amount due by the swap provider to the borrower in respect of the swap is applied first against the borrower’s obligations to the swap provider under the loan agreement. In practice, even if not explicitly insulated, any set-off effected by the swap provider will probably be caught by standard ‘sharing’ provisions within the loan agreement, i.e. the benefit of the set-off will have to be shared across the syndicate in any event. Needless to say, questions of swap provider set-off, security and ranking become more complicated if there is more than one hedging bank in the syndicate.

Borrower The borrower has two key concerns in relation to the security package that it gives to the swap provider and
or the lending bank(s) for amounts payable by it under the loan and
or in respect of the swap. First, as noted above, it will want to ensure that any security rights that it creates over amounts due to it by the swap provider are adequately defined (so, for example, it will want to charge only net – as opposed to gross – receivables under the swap agreement) and are permitted by both the loan and swap agreements – otherwise, it risks being in breach of one or both from the outset. Second, it will want, wherever possible, to negotiate specific amendments to the definition of ‘secured liabilities’ (or similar) within the relevant security documents, so as to ensure that any security granted by it (or by a third party) is expressed to secure only what it owes net of anything that is owed to it by the swap provider. In the context of the arrangements described in Figure 3.3, for example, the borrower will want to ensure that the granting of the counter-indemnity is permitted under the terms of the loan agreement, that any assignment in favour of the lending bank of the borrower’s rights against the swap provider is permitted under the terms of the swap agreement and, finally, that both documents are expressed to secure the borrower’s liabilities to the lending bank net of any obligations of (i) the swap provider to the borrower under the swap agreement and (ii) the lending bank under the guarantee that the borrower receives in respect of those obligations. Similarly, the borrower will want an express right of set-off against the lending bank in respect of the latter’s obligations under the guarantee. On an analogous note, the borrower will also want a carve-out from the ‘failure to pay interest’ event of default within the loan agreement, preventing the lender from calling a default (or at the very least suspending the right) to the extent attributable to a failure of the swap provider to meet its 46

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payment obligations under the swap. In a project or SPV financing – where the borrower may be entirely reliant on swap provider performance if it is to meet its interest payment obligations under the related loan agreement – such a carve-out is often critical. In practice, however, it is rare that security arrangements for financelinked swap structures are subject to the level of scrutiny and engineering that the above analysis would seem to suggest is necessary.

TRANSFERABILITY In the context of a finance-linked swap arrangement under which the swap provider is both a
the lender and has a right of transfer
assignment under the loan agreement, the borrower (and, where relevant, the rest of the syndicate) will want to know what is intended to happen to the swap on a transfer
assignment of the swap provider’s loan commitment to another lender. While on the face of it the neatest solution is for the swap to follow the loan, that may expose the borrower to a break cost. A similar problem may arise if the borrower has a right to novate the loan (for example, to a designated affiliate) and the swap agreement contemplates a parallel novation mechanism. If these issues cannot be resolved at the time the loan and swap agreements are negotiated, the two documents should at the very least contain a commitment on the part of all relevant parties to revisit the question, in good faith and in a commercially reasonable manner, at the time of the relevant transfer
assignment
novation. More generally, the rights and
or obligations of the parties to the swap agreement to effect a transfer for the purposes of avoiding certain termination events will need examination and may need to be restricted accordingly. Finally, the borrower will almost certainly want to see a provision enabling it to transfer, by way of security, its rights under the swap agreement. We return to the question of transfer
novation of finance-linked swaps, in the specific context of property finance transactions, in Chapter 6. In this chapter we have simply emptied out the pieces of the jigsaw onto the table. In Chapter 4, we begin to assemble the puzzle through appropriate documentation.

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Swap documentation Loan documentation Security documentation Intercreditor documentation Ancillary documentation

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SWAP DOCUMENTATION As a general rule in the context of finance-linked swap transactions, the loan documentation will take the lead and the swap documentation will follow. In principle, this seems correct. As observed in previous chapters, not only is the amount of credit exposure under the loan component of the financing likely always to be far in excess of that arising under the corresponding swap component, but also, more philosophically, the swap exists only to hedge the loan. In practice, this order of events makes the job of negotiating the swap documentation much easier than it would be in a stand-alone context since, by the time that the swap is required to be put in place (all the more so if the obligation to hedge is a condition subsequent to the making of the loan), all the key commercial issues – or at least all those relating to the loan – ought to have been resolved. This does not mean that the task of documenting the swap is reduced to the trivial or that there is no case for a separate term sheet relating to the swap. On the contrary, what the exercise loses in terms of its requirement for commercial input it gains in its technical intricacy. It is here that the dualdisciplined debt finance and derivatives lawyer referred to in Chapter 1 comes into his or her own, for such a lawyer is able not only accurately to cross-weave the swap into the other transaction documents but can also add value and integrity to the deal by ensuring that those other documents have at least one eye on the swap. Before examining the intricacies, however, it is worthwhile spending some time thinking about the path and format that the swap documentation may take. The path that the swap documentation takes depends, as we observed in Chapters 1 and 2, on a number of factors, ranging from ticket size and deal complexity to investor and
or rating agency diktats. In essence, however, the question comes down to whether to document today or tomorrow. Best practice in this regard is for the swap documentation to be put in place in its entirety (i.e. ISDA Master ! Schedule ! Confirmation) at or prior to one of two critical dates – the drawdown date if the swap is a condition precedent to the making of the loan, and the expiry date of the applicable ‘window’ period if it is a condition subsequent. The alternative is for a pre-Master Confirmation (incorporating standard ISDA interregnum language, about which more below) to be exchanged, at or prior to one of the two critical dates as before, that locks in the key economic terms of the swap but leaves negotiation of the Schedule, and signature of its overlying ISDA Master, to a later – albeit usually unspecified – date. A gloss on the foregoing is the practice of one or two City swap providers to issue ‘long-form’ Confirmations – again at or prior to the applicable 51

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critical date – that seek, in the (supposed) interests of time, cost and borrower-friendliness, to obviate the need for a Schedule and Master by importing, into the Confirmation, the key credit, early termination and other variables that would ordinarily be documented under the more formal architecture constituted by those two documents. A word of clarification is in order here. The term ‘long-form Confirmation’ is commonly used in the market to describe Confirmations in respect of which no ISDA Definitions booklet exists (e.g. inflation derivatives) or in respect of which the transaction is so inherently complicated that it demands a supplemental-to-Definitions solution (e.g. credit default swaps used in the context of synthetic securitization structures). Such documents are still ‘Confirmations’ in the conventional sense (and so require and are expressed to supplement an overlying Master and Schedule) – they are just much longer and more explicit than the more typical ‘short-form Confirmations’, templates for which can be found in relevant ISDA Definitions booklets. The term ‘long-form Confirmation’, when used in a finance-linked context, means something altogether different. Here, the aim is to compress the traditional Master ! Schedule ! Confirmation package into a single document that looks like a Confirmation but in fact includes a lot more – most of the Master if it is doing its job properly. Thus, the term ‘long-form Confirmation’ in a finance-linked context bears a special meaning. We assess the merits of long-form Confirmations – in the unified
compressed sense – shortly. Where the obligation to hedge is a condition subsequent, the borrower is, as we observed in Chapter 3, commercially exposed to increases in the fixed rate and there is a temptation for the parties to take their collective ‘eye’ off the swap documentation ‘ball’. An interesting question is whether any additional risks arise where interim and
or compromise documentation solutions – such as pre-Master and long-form Confirmations – are employed. The answer is almost certainly yes and, since the risks are common to condition precedent and condition subsequent environments, the solutions ought to attract scrutiny by lenders, swap providers and borrowers alike. We look at both in some detail.

Pre-Master Confirmations Pre-Master Confirmations are prevalent in the world of derivatives. The ISDA 1992 Master Agreement expressly contemplates them and most ISDA Definitions booklets include interregnum provisions for insertion into preMaster documentation. Such Confirmations exist in recognition of the fact that movements in forward curves, particularly in volatile markets, can cause significant differences in fixed rates, option premia and so on. 52

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Consequently, it may be essential for parties to trade ahead of formal and complete documentation. A pre-Master Confirmation serves a dual purpose in this context. First, it does what most Confirmations do, which is to say it ‘confirms’ a pre-existing oral contract. Second – and where it differs from its post-Master cousins – it commits the parties to negotiate, in good faith, with a view to putting in place promptly an overarching ISDA Master and Schedule; and subjects the parties, in the interregnum, to the provisions of an ‘unadulterated’ Master (i.e. one to which no Schedule is appended). In a stand-alone context, pre-Master Confirmations may just about be excusable on grounds of commercial imperative, but they do expose the parties to a greater or lesser degree of commercial and documentation risk – a fact that is overlooked in many quarters of the market. These risks are an unavoidable consequence of the fact that it is the Schedule that brings certain provisions of the ISDA Master to life. To take a simple example, Part 1(c) of the Schedule to the ISDA 1992 Master Agreement requires the parties to make an election as to whether the cross default provisions of the Master will or will not apply. Absent an election, it is impossible to determine whether, on the occurrence of a cross default with respect to either of them, the other has a termination right – unless, perhaps, the parties are able to point to an overwhelming convention in the market and
or to a course of dealings between them that might resolve the issue one way or the other. Moreover, rigorous application of the English law contra proferentem rule – under which ambiguous or uncertain contractual provisions are interpreted in favour of the party against whom it is sought to enforce them – is likely to lead to the conclusion that, where an elective exists but no election has been made, the provision is either ineffective in toto or effective but inapplicable. Either way, in our example, no termination right will exist. Readers familiar with ISDA documentation, and the Schedule in particular, will no doubt be able to conjure up other ‘indeterminates’ that arise in a pre-Master Confirmation context. For those less familiar with the documentation, many examples exist. Indeed, such is their number that it is possible to argue that the standard ISDA interregnum provision – which deals with only two ‘indeterminates’: choice of law and termination currency – is, as a matter of English contract law, void for uncertainty. This is a disturbing thought, given the extent to which pre-Master Confirmations abound in the market place. There are ways around the pre-Master conundrum. First, avoid Confirmations in a pre-Master context except where absolutely necessary. Second, if they cannot be avoided, make every effort to keep the ‘documentation gap’ – i.e. the gap between the date the pre-Master Confirmation is issued and the date that the Master and Schedule are put in place – to an absolute minimum. This may, of course, require more resource. Third, compromise. Identify those variables within the Schedule that are critical 53

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and those that are not – and address those that are within the pre-Master Confirmation (so elect for cross default, for example, if you have concerns that your counterparty may cross default during the ‘documentation gap’). Beware, however – if all or most of the variables are on your critical list, you may just as well negotiate a Schedule and be done with it. Finally, if you do trade on a pre-Master basis and do make specific, Schedule-type elections in the relevant Confirmation, do ensure that, if any of those elections is reversed, amended or qualified at the point at which the Master and Schedule are put in place, an appropriate change is made to the ‘polarity’ of Section 1(b) (Inconsistency) of the Master. Section 1(b) provides, among other things, that in the event of a conflict between the provisions of the Master (including its Schedule) and the provisions of a Confirmation, the provisions of the Confirmation will prevail. This is eminently sensible in the context of Confirmations that are put in place on a post-Master basis, since it enables the parties to reverse, amend or qualify (with respect to individual transactions only – more general ‘surgery’ will require a formal amendment agreement) entrenched provisions in the Master by making a simple, contrary stipulation in a Confirmation. But it achieves completely the wrong result in the context of pre-Master transactions, the provisions of which are, by definition, non-entrenched. Without labouring this last point, let us reconsider our cross default example. Assume that A and B transact on a pre-Master basis and elect, in their pre-Master Confirmation, that cross default will apply to A (but not to B). It is the only deal they do. A’s documentation team eventually gets around to negotiating a Schedule with B and at that point A insists on a mutual application of the cross default provisions. B agrees and both sign (B, happily, because it ‘knows’ about Section 1(b); A, happily, because it does not). Two days later, B defaults on a loan from a third party and A tries to terminate. B, rightly, points out that A cannot do that, on account of Section 1(b). Reread Section 1(b) if you do not believe this sorry tale. And before the lawyers among you plead ‘intention’, do remember that B will agree that its intention was that cross default should apply – but only to transactions going forward, not to the transaction represented by the pre-Master Confirmation. Otherwise A would have insisted upon (and B may or may not have agreed to) an appropriate amendment to Section 1(b) or to the terms of the original Confirmation. The reader might, as an aside, wonder why ISDA’s Documentation Committee passed up a suggestion to reverse the polarity of Section 1(b), in respect of pre-Master Confirmations, as part of its recent (begun 1999; completed 2003) exercise to rewrite the 1992 Master Agreement. Its explanation was that it did not want to be seen to encourage the use of pre-Master Confirmations. As laudable a motive as that is in itself, it is hardly in keeping with market practice and is not internally consistent. Consider not only the opening words of the ISDA Master 54

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(‘ ... have entered and
or anticipate entering into one or more transactions ...’) but also the standard interregnum provisions discussed above. What are these doing if not encouraging – or at the very least facilitating – pre-Master transactions? Is there any argument for pre-Master Confirmations in a finance-linked swap context? Not really. First, they are avoidable because of the lead-time that exists between a borrower deciding to borrow and the bank making the loan (or, as the case may be, between the bank making the loan and expiry of the condition subsequent ‘window’) – time enough, with the will of the parties, to put the full suite of swap documentation in place. Second, and related to the first point, the degree of tailoring implicitly required in the context of finance-linked swap documentation means that none of the parties will want, if acting rationally and prudently, to run ‘documentation gap’ risk. One need only think back to the credit symmetry, security and intercreditor concerns highlighted in Chapter 3 to see that compromise in the ‘documentation gap’ is not a plausible alternative and that the bland choice is ‘run’ or ‘don’t run’ the risk. With time in abundance, that decision ought to be easy.

Long-form Confirmations Long-form Confirmations present analogous difficulties. Such documents, being Confirmations, Masters and Schedules wrapped into one, necessarily have to cover all, or at least most of, the bases. At one level, a long-form Confirmation that does cover all the bases – i.e. replicates all the provisions of the Master and makes all relevant elections – is, in substance, no different to a Master ! Schedule ! Confirmation. So why bother with it? The two justifications most commonly given are, first, that a single, long-form Confirmation is, optically, more attractive to a borrower (particularly, so the argument goes, an unsophisticated borrower) than the typical triumvirate of Master ! Schedule ! (short-form) Confirmation; and second, that there are certain provisions within the usual Master ! Schedule combination that are redundant
uncritical
overly verbose in the context of a finance-linked swap and can therefore be dispensed with. Let us suppose that there is a justifiable level of ‘redundancy’. The fallacy that brings down the whole house of cards is the presupposition that an unsophisticated borrower is going to appreciate (in both senses of the word) the differences. In order to advise on a long-form Confirmation, for example, it is first necessary to understand what has been left out, second to understand why it has been left out and third to analyze whether or not the omission exposes the borrower to risk. Invariably, it is necessary to negotiate so-called ‘redundant’ provisions back in. If this represents the best that swap providers can offer, in terms of user-friendliness, then negotiating a Schedule may be the better alternative. 55

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In addition, long-form Confirmations almost certainly fall outside the terms of reference of ISDA-commissioned generic netting opinions, which means that swap providers may not, without an express regulatory derogation, be able to net, for capital adequacy purposes, exposures arising under them. In the context of the majority of long-form Confirmations, this may not be an issue since they are likely, by their nature, to relate to a single swap or a single option. But where, as is conceivable, they relate to more than one instrument, a regulatory capital inefficiency may arise for the swap provider. If that inefficiency is passed on to the borrower in terms of the cost of the hedge, a real issue then also arises for the borrower. While pre-Master or long-form Confirmations may not be ideal solutions in a finance-linked context, the latter may have a limited role to play in the context of small-ticket, option-based hedging instruments, where only one party (the hedge provider) has ongoing payment obligations and the borrower – provided it receives a minimum level of comfort through the longform Confirmation – can take a commercial view. A model long-form Confirmation for a finance-linked cap is, accordingly, included at Annex 7. The model, which is based on a recently concluded transaction between a

Figure 4.1

Alternative paths and formats in the finance-linked swap documentation process

“Full ISDA” approach (swap ⫽ condition precedent)

agree fixed rate here

agree fixed rate here

“Full ISDA” approach (swap ⫽ condition subsequent) Pre-Master Confirmation (swap ⫽ condition precedent)

agree fixed rate here agree C here

• ‘gap’ risk • Section 1(b) risk

agree M&S here

agree fixed rate here agree C here

agree M&S here

agree fixed rate here

Completion

• rate risk • ‘gap’ risk • Section 1(b) risk • documentation risk • netting-compliant?

agree LFC here

Long-form Confirmation (swap ⫽ condition subsequent)

56

• rate risk

agree M&S&C here

Pre-Master Confirmation (swap ⫽ condition subsequent) Long-form Confirmation (swap ⫽ condition precedent)

• no risk

agree M&S&C here

agree fixed rate here agree LFC here

Completion ⫹ 3/6 months

Completion ⫹ n months/years

• rate risk • documentation risk • netting-compliant? t

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City cap seller and a regional buy-out vehicle, includes hedge provider payer tax representations and document delivery obligations, a limitation on borrower default, various early termination electives and one or two other essentials – none of which appeared in the original ‘long-form’ provided to the management team by the hedge provider. That was a fair amount on path and format. Figure 4.1 provides the reader with a digestible, diagrammatic overview. We now turn our attention to the detailed drafting points affecting the Schedule and the Confirmation – and thereafter the loan and related documentation. We assume, as our base case, that the borrower (‘Party B’) is taking a simple swap for the entire principal amount of the loan; that the lending bank and the swap provider are one and the same (‘Party A’); that all swap documentation is to be executed concurrently with the related loan agreement; and that the loan itself, for £100 million, is to be drawn in full on execution, attracts quarterly LIBOR and amortizes by £10 million on each anniversary of drawdown. We also assume that the borrower’s obligations under the swap and the loan are to be guaranteed by the borrower’s parent (‘Parent’) and that Parent, the borrower and the lending bank are all UK incorporated limited liability companies. Figure 4.2 provides a diagrammatic illustration of the base case. Base case loan and swap

Figure 4.2

Parent

Guarantee £100m (amortizing) 10-year loan Lending bank & swap provider ‘Party A’

Quarterly LIBOR Quarterly LIBOR Fixed

Borrower

‘Party B’

We deviate from the base case where that is helpful to the wider discussion. To the extent that the reader is unfamiliar with the detail of ISDA and
or loan documentation, the bibliography at the end of this book is a helpful starting place. For those wishing to study the base case in context, the analysis that follows corresponds to the term sheet set out in Annex 4 and serves as a commentary to the model Schedule and Confirmation set out in Annexes 5 and 6. 57

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The Schedule The central idea that pervades negotiation of a finance-linked swap Schedule is very simple. Wherever a provision or an elective of the Schedule relates to the swap provider, it is treated in exactly the same way as it would be treated in the context of a stand-alone negotiation with that provider. So, you reach for Gooch & Klein, Harding, ISDA’s own User’s Guide and
or the swap provider’s house policy on such matters and off you go. But where a provision or an elective relates to the borrower, you reach for the loan agreement. And where a provision or an elective relates to the borrower and concerns credit sensitivity, you simply disapply it. We refer to this principle throughout the base case study as the ‘General Rule’. The lender’s position (qua swap provider) will be tidied up and protected, in due course, through cross acceleration provisions into the loan agreement. Note, however, that the General Rule is inapplicable where the swap provider is unrelated to the lender or where the wider transaction is rated. We consider the former issue under ‘Intercreditor Documentation’ later in this chapter and the latter issue in Chapters 6 and 7. Part 1 Termination Provisions

(a) Specified Entity. By application of the General Rule, there are unlikely to be any Specified Entities for either party. From the borrower’s perspective, it is contracting with a swap provider whose credit standing is assumed to be good (or good enough). It might be different if the lending bank and the swap provider were separate entities, since the borrower might want to designate the bank (if related to the swap provider and if not itself a designated credit support provider) and
or certain other affiliates of the swap provider as a Specified Entity for one or more of the four stated Section 5 purposes. From the swap provider’s perspective, it is concerned only with the terms of the loan agreement, which may or may not contain its own (or analogous) ‘Specified Entity’ default provisions. This brings us back to the General Rule. If the loan agreement does contain such provisions, these will be picked up through the cross acceleration mechanics to be built into the Schedule; if it does not, such provisions should not be in the swap agreement either. In short, all that is required is an across-the-board ‘not applicable’. (b) Specified Transaction. Unless the swap provider is intending to transact exotic derivatives with the borrower or Parent, there is nothing to be gained by amending the definition of ‘Specified Transaction’ and so it is usually left as it stands. Note, in any event, that any amendment will be for the exclusive benefit of the borrower, since, by application of the General Rule, Section 5(a)(v) (Default under Specified Transaction) will be disapplied with respect to both it and Parent. 58

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So that there is no confusion here, it is worth reiterating that the terms ‘Specified Transaction’ and ‘Transaction’ are mutually exclusive – a ‘Transaction’ being a transaction entered into under the Master and a ‘Specified Transaction’ being a transaction (of the type listed in the Section 14 definition) entered into between any combination of the two parties to the Master, their respective Specified Entities and their respective Credit Support Providers, in each case under any agreement other than the Master. A disapplication of Section 5(a)(v) with respect to the borrower and Parent does not, therefore, prejudice the swap provider in any way. If the borrower defaults in respect of a Transaction (i.e. in our example, the base case swap), the swap provider has a termination right by virtue of Section 5(a)(i) (Failure to Pay or Deliver). It also has an indirect termination right if and to the extent that the Section 5(a)(i) default constitutes an event of default under the loan that feeds back into the swap agreement (but which would you exercise?). If the borrower (or Parent) defaults under a Transaction in the nature of a Specified Transaction, the question of whether the swap provider has a termination right will depend, first, on whether an event of default arises under the loan agreement (which is a question for the swap provider – qua lender – to think about when negotiating the loan agreement) and, second, on whether that occurrence triggers (as it should) a termination right under the swap agreement. As always, we come back to the General Rule. (c) Cross Default. The pattern dictated by the General Rule should by now be starting to emerge. The borrower will want the provisions of Section 5(a)(vi) (Cross Default) to be disapplied with respect to it (and, by way of compensation, a specific cross acceleration provision into the loan agreement will be reintroduced for the benefit of the swap provider in Part 5 of the Schedule) and to be applied with respect to the swap provider. Concerns of the borrower in the latter regard will be the usual ones – Threshold Amount (with a zero tolerance in respect of borrower deposits), expansion for third-party derivatives and so on. (d) Credit Event Upon Merger. This is no different, in principle, to Cross Default – so disapply with respect to the borrower; apply with respect to the swap provider. (e) Automatic Early Termination. As a consequential matter, the Automatic Early Termination elective can generally be disapplied with respect to the borrower since, by operation of the General Rule, there will be no Section 5(a)(vii) (Bankruptcy) on which to ‘hang’ it. From a negotiating perspective, the swap provider will expect even-handed treatment and so, absent a compelling legal reason for application with 59

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respect to it (or, indeed, the borrower), a mutual disapplication is the suggested (and, in practice, likely) outcome. (f) Payments on Early Termination. Market Quotation and Second Method are common electives in the context of a vanilla finance-linked swap arrangement. The latter is an incontestable choice. As for the former, a much more intelligent election – especially where the swap provider intends to hedge its exposure under the swap on a back-to-back basis – is Loss, since this explicitly embraces back-to-back termination costs. In spite of this, what tends to happen in practice is that Market Quotation is elected in the Schedule (more often than not a knee-jerk reaction by the swap provider to its house policy in relation to standalone transactions) and the lender takes, additionally, a Loss-type swapbreak indemnity from the borrower in the loan agreement. Something similar happens in ‘indirect security’ structures of the type considered in Chapter 3 (albeit, of course, that swap-break indemnities in those structures are expressed to be given to the lender for the benefit of its swapproviding affiliate). On any analysis, this represents a duplicative and unnecessary approach to swap-break indemnities, since such provisions clearly belong (and are already provided for – the point) in the swap documentation. Anyone doubting this need simply ask themselves whether they would expect to see break indemnities relating to the loan replicated in the swap agreement. The answer, of course, is no. So Loss may be a more appropriate election than Market Quotation, depending on whether and how the swap provider is hedging its own swap risk, and any swap-break indemnities in the loan agreement are otiose and can simply be deleted. (g) Termination Currency. To facilitate post-termination set-off, it makes sense for this to be GBP, i.e. the same currency as the base case loan. (h) Additional Termination Event. For reasons outlined in Chapter 3, the parties will want to include here termination provisions that give one or both of them the right to terminate the swap (rateably) on the occasion of a voluntary or mandatory prepayment of the loan by the borrower. A well-advised borrower will insist on the provisions being couched as Additional Termination Events (rather than additional Events of Default) for several reasons: first, to reflect the ‘innocent’ nature of typical prepayment events under loan agreements; second, related to the first point, to accomplish (through designation of both parties as ‘Affected Parties’) a termination of the swap at mid-market as opposed to bid; and third, to minimize the risk of the early termination giving rise to a cross default under any other financing agreement to which the borrower is party. 60

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Part 2 Tax Representations

Common practice, in the context of vanilla finance-linked swap arrangements, is for both parties to make the standard Payer Representations and for the standard Payee Representations to be disapplied. There is, however, no substitute for putting the representations under the microscope on a deal-by-deal basis, especially so in a cross-border context. Part 3 Agreement to Deliver Documents

By application of the General Rule, the document delivery obligations imposed upon the borrower with respect to the swap should be no more onerous than those imposed upon the borrower with respect to the loan. Where the lender and swap provider are one and the same (as in the base case) or are closely affiliated, most if not all of the obligations can simply be picked up through the condition precedent
subsequent provisions within the loan agreement. There will always be swap-specific document delivery obligations, of course, such as borrower signing authorities, tax forms and
or legal opinions, and it is often right that these should be included as Part 3 Schedule items, but financial, security and constitutional documents, for example, need not – to the extent already required to be delivered by the borrower pursuant to the loan agreement – be replicated in this Part of the Schedule. From the borrower’s perspective, its document delivery requirements of the swap provider will generally be no different to those that would have existed in a stand-alone context. Part 4 Miscellaneous

(a) Addresses for Notices. On the face of it, the notice provisions in the swap documentation and those in the loan agreement ought to be identical. While that is true, it is worth bearing in mind that the departments of the lender (qua lender) and the lender (qua swap provider) are likely to be operationally and organizationally discrete, with the result that each will want to receive copies of all notices sent to
by the borrower (whether itself qua borrower or qua swap counterparty) by
to the other of them. Accordingly, the loan and swap documentation will need to contain fuller-than-normal provisions that oblige the borrower to cross-copy notices served under the swap documentation to the lender (and notices served under the loan agreement to the swap provider) and that further oblige the lender (qua lender) and the lender (qua swap provider) to cross-copy to each other all notices served on the borrower (whether qua borrower or qua swap counterparty). Parent might reasonably require all notices to be cross-copied to it too. Where the lender and the swap provider are discrete entities, the foregoing mechanics are probably a necessity. 61

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(b) Process Agent. If a Process Agent is stipulated with respect to the borrower in the loan agreement (unlikely, given the facts of the base case), a mirror stipulation should be made in the Schedule. The borrower (qua swap counterparty) will itself need to consider whether it requires a Process Agent to be stipulated with respect to the swap provider. (c) & (d) Offices
Multibranch Party. Given the nature of a finance-linked swap arrangement and the fact that the scope of the documentation is commonly restricted to the finance-linked swap(s) in question (see below), it is rare for the swap provider to contract other than through its head office or to require Multibranch flexibility. Where, however, the swap provider is incorporated overseas and provides the swap through a local office, the borrower should seek from the swap provider (at a head office level) the usual Section 10(a) representation and should insist on the relevant office being designated as such under the Multibranch provisions of the Master. Tax, notice, Process Agent, governing law and jurisdiction provisions should all be revisited accordingly. (e) Calculation Agent. In a finance-linked swap arrangement, the swap provider will almost always undertake the role of Calculation Agent. This seems right in principle and is probably advisable in syndicated and
or highly structured arrangements, where the Calculation Agent is (or at least ought to be) required to take its lead from the facility, bond or other agent for the structure. (f) & (g) Credit Support Document
Provider. In the context of the base case, Parent’s guarantee and Parent will need to be designated, respectively, as a Credit Support Document and a Credit Support Provider with respect to the borrower. In the wider context – where, for example, the lender and swap provider are different entities and
or where the swap provider’s entitlement to security is subject to a formal intercreditor arrangement – best practice is to detail all relevant security in the Schedule but to make it clear that it is subject to third-party rights. Occasionally, as where the intercreditor agreement itself contains indemnities in favour of the swap provider, it may be appropriate to designate it as a Credit Support Document in its own right. (h) Governing Law. Clearly, this ought to mirror the governing law of the loan agreement. (i) Netting of Payments. For reasons outlined in Chapter 3, best would be for the settlement netting provisions of the Master to be replaced in their entirety with provisions (mirrored in the loan agreement) obliging the borrower to make a single quarterly payment to the lender, being the fixed rate under the swap plus any margin and other costs on the loan – 62

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everything else being net-settled. In practice, it is payments under the swap that tend to be net-settled, leaving the borrower having to pay LIBOR ! margin ! MLAs on the loan and to pay
receive net under the swap. The Schedule in Annex 5 adopts the latter approach, notwithstanding its inherent inefficiency. Note that to achieve single Transaction net settlement under the ISDA 1992 Master Agreement, it is necessary to employ a confusing double negative, i.e. to disapply the (standard form) paragraph in the Schedule that itself disapplies single Transaction net settlement. Note also that net settlement (other than through an escrow arrangement) may not be achievable at all in a crossborder context. (j) Affiliate. As tempting as it is to leave the definition untouched, it is a convenient reminder of the representation that each party is required to make – at Section 3(c) of the ISDA 1992 Master Agreement – concerning the absence of material litigation with respect to it or any of its Affiliates. To the extent that the lender (qua lender) does not benefit from such a representation in the loan agreement, the General Rule tells us that the lender (qua swap provider) should be similarly deprived in the swap documentation. Part 5 Other Provisions

Part 5 of the Schedule is the vehicle through which the bulk of amendments are made to the Master to reflect the requirements of the parties – a lawyer’s paradise, some might argue. Certain provisions – such as contractual set-off rights, consent to recording, disapplication of the Contracts (Rights of Third Parties) Act 1999, EMU conversion (on a UK accession), escrow provisions, etc. – are as worthy of consideration for inclusion in a finance-linked swap context as they are in a stand-alone environment. There are, however, a number of key areas where a pure stand-alone approach will not work. These areas, in no particular order, are as follows. (i)

Scope. Given the interdependence between a finance-linked swap and its related loan instrument, particularly in relation to early termination, it is common to include a provision that expressly restricts the scope of the swap documentation to the transaction(s) that hedge(s) the loan. In one sense, therefore, ‘mastering’ finance-linked swaps involves doing precisely the opposite! Where it is envisaged that the borrower and the swap provider will undertake additional derivatives business that is not specifically related to the loan (or where that is not envisaged but circumstances change to make it the case), both will want to consider whether it is appropriate to transact that business under the ‘scope-restricted’ documentation – and if so, whether and what amendments will need to be made to it so as to accommodate the 63

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additional transaction(s) – or whether, as is sometimes the case, discrete documentation (linked by appropriate cross default or cross acceleration provisions) is the preferred solution. (ii) Non-reliance. Most swap providers are as assiduous in including non-reliance representations in their house Schedules as they are in refusing to qualify those representations even if the circumstances of their relationship with a given counterparty demand it. Two points are worth making in this regard. First, at the small-ticket end of the finance-linked swap market, borrowers are, generally speaking, heavily reliant on the advice, expertise and structuring recommendations of the swap provider. Second, a swap provider cannot – by pointing to contractual representations alone – escape liability for misadvising a borrower if the facts are that (i) the borrower was relying on the swap provider (and the swap provider knew or ought to have known that that was the case); (ii) the swap provider misadvised it; and (iii) the borrower suffered loss as a result. In short, where there is a degree of reliance, the representations need to be tailored and there is no point in the swap provider trying to pretend that that tailoring will prejudice it – in fact, the swap provider will probably be in a much better position through having sought to agree with the borrower the exact scope and extent of its advisory responsibilities. We pick up these themes in greater detail in Chapter 5, but the sooner that swap providers get used to the fact that non-reliance representations are neither inviolate nor a panacea, the better for all it is suggested. (iii) Confirmations. In a finance-linked swap context, there is no need to specify that one or other of the parties will deliver – and that the other will sign and return – Confirmations by a certain time, in a certain format and in accordance with a specified procedure. In practice there will only ever be one Confirmation (paper as opposed to electronic) and this is best signed, together with the overlying Master and Schedule, at the completion meeting relating to the wider deal. (iv) Limitation on Default. Established practice in relation to financelinked swap arrangements is to disapply, with respect to the borrower (qua swap counterparty), most of the events of default within the Master and to insert, in their stead, a general event of default, being the acceleration by the lender of the borrower’s obligations under the loan agreement. The justification for this practice is that the swap provider needs to be able to terminate only for certain key events arising with respect to the borrower (again, qua swap counterparty) but otherwise must play second fiddle to the lender in terms of deciding whether and when to accelerate the loan (and, thereby, the swap). 64

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As to what those key events are, there is no settled practice but, as a general rule, the swap provider invariably ‘retains’ Section 5(a)(i) (Failure to Pay or Deliver) and one or both of Section 5(a)(ii) (Breach of Agreement) and Section 5(a)(iv) (Misrepresentation) and ‘gives up’ the rest. Having said that, even these three events can be disapplied if the loan agreement includes ‘failure to pay under
material breach of
misrepresentation under key documents’ as an event of default and if the swap documentation is expressed to be one of those key documents. What the swap provider needs to bear in mind in this context is that the more events of default it gives up, the less control it has over when and in what circumstances it may terminate the swap; conversely, the more it retains, the less control the lender has over the continuity of the swap arrangements. The swap provider should also note that it cannot act in relation to ‘non-retained’ events of default unless and until the lender accelerates the loan – the mere occurrence of a default under the loan agreement will not be enough. Where the lender and the swap provider are one and the same or are closely affiliated, these considerations are perhaps academic, but where the swap provider has little or no voting power (as in, say, a syndicated loan arrangement), the issue is a critical one for both it and the syndicate members. To the extent that the swap provider retains termination rights with respect to certain events of default, it makes sense to conform these to their counterparts in the loan agreement. So if, for example, the borrower enjoys a five-business-day grace period for ‘failure to pay’ under the loan agreement, Section 5(a)(i) of the Master should also be pushed out to five business days. An additional check to ensure conformity of the definition of ‘business day’ does not go amiss in this regard. Moreover, to the extent that the swap provider customarily insists on amendments, for its own benefit, to the events of default applicable to it within the Master (remember that, by application of the General Rule, most if not all will continue to operate for the borrower’s benefit), such amendments should be inserted into Part 5 of the Schedule in the normal way. Examples, familiar in a stand-alone context, are cross default vs. cross acceleration, cross default carve-out for administrative
operational errors, exclusion of general (i.e. non-borrower) deposits from Specified Indebtedness and so on. Finally, in this regard, it is not uncommon for the swap provider to agree further to limit the extent of the events of default and termination events that are applicable to the borrower (qua swap counterparty) if the hedge is a simple option product in respect of which the borrower has fully performed by paying the applicable premium. A 65

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standardized provision that achieves this end can be found on page 6 of ISDA’s User’s Guide to the 1992 ISDA Master Agreements. (v)

Notification of Default. Any provisions requiring the borrower (qua swap counterparty) to notify the swap provider of the occurrence, with respect to it, of an event of default or potential event of default under the swap agreement ought, by application of the General Rule, to be conformed to the corresponding provisions (if any) in the loan agreement.

(vi) Conformity of Termination Events. Strictly speaking, the termination events within Section 5(b) of the Master ought also to be conformed to their prepayment counterparts within the loan agreement. In practice, however, this tends not to happen and, with the exception of Section 5(b)(iv) (Credit Event Upon Merger) – which is usually treated as a non-retained event of default – the provisions are left unamended. Non-conformity of this nature may not be serious (a) given the nature of termination
prepayment events generally and (b) provided that the lender, the swap provider and the borrower each have at least the right, under the respective documents to which they are party, to call for repayment of the loan or, as the case may be, to close out the swap on the occurrence of, respectively, a termination event under the swap or a prepayment event under the loan that, in either case, results in a close-out of the swap or, as the case may be, a prepayment of the loan. (vii) Conformity of Other Substantive Provisions. Outside of the arena of events of default and termination events, there are several other areas of substance within the Master that, adopting a ‘counsel of perfection’ approach, ought to be conformed to the corresponding provisions of the loan agreement. Of these, perhaps the most important are Section 3 (Representations), Section 4 (Agreements) and Section 7 (Transfer). In practice, Sections 3 and 4 are often left as they are, the most common justification being that the very nature of the matters covered by those Sections reduces any ‘documentary basis risk’ to a minimum. Having said that, some swap providers adopt completely the opposite approach and replicate, in the Schedule, all the representations, agreements and covenants that are given by the borrower in the loan agreement. Without corresponding amendments to Sections 3 and 4, however, such an approach can lead to duplication and ambiguity. It is, in any event, arguably a waste of time. A breach by the borrower of any of the relevant representations, agreements and covenants will, adopting a subservient approach to borrower (qua swap counterparty) default of the sort outlined earlier in this chapter, be helpful to the swap provider only if the lender accelerates the loan. If the lender 66

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chooses not to accelerate, the swap provider is powerless to act, whatever the additional provisions say. Section 7, on the other hand, is often usefully amended (a) to prescribe what is to happen to the swap on a transfer by the lender of its commitment under the loan agreement and (b) to give express consent to the borrower (qua swap counterparty) enabling it to transfer to the lender, by way of security, its rights against the swap provider (to the extent not itself the lender). Where the borrower is an SPV and transfers, by way of security, all of its assets to a security trustee (including, as before, its rights against the swap provider), not only does Section 7 require amendment but Section 5(a)(viii) (Merger Without Assumption) also benefits from a saving provision that makes clear that the security transfer is not a ‘transfer’ for the purposes of that Section. (viii) Change of Account. The ability of the parties to change their account for receiving payments pursuant to Section 2(b) of the Master needs to be reviewed in the light of the account and settlement mechanics that are to apply to the finance-linked swap arrangements. (ix) Rating Agency Requirements. While not relevant to the base case, many of the issues discussed above are often resolved by prescription – in other words, they are settled by reference to applicable rating agency guidelines and criteria. We explore these aspects in Chapter 7 in the context of repackagings and securitizations, but it is always worth bearing in mind that rating agency criteria exist and can serve as a useful point of reference, even if not directly relevant to the transaction at hand. The reader will appreciate that the above list is not and cannot hope to be exhaustive, but it does at least bring out some of the issues that are likely to influence the drafting of the Schedule in a finance-linked swap context. The key point for the reader to take away is that a stand-alone approach to Schedule negotiation is simply not appropriate.

The Confirmation The central idea that pervades negotiation of a finance-linked swap (or option) Confirmation is as simple as that with which we started in relation to the Schedule. The intention is that it should give the borrower a LIBOR flow that is, in terms of amount and timing of payment, identical (or at the very least referable) to the LIBOR component of its interest payment obligations under the loan agreement. It is no accident, therefore, that all of the variables that we are about to consider relate directly to the quantum of the fixed and, in particular, floating rate leg of the base case swap. There are two ways to approach the task of achieving economic symmetry. The approach in relation to simple finance-linked swap arrangements (and 67

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adopted below in relation to the base case) is to replicate key dates and conventions within the Confirmation. So if, for example, the final repayment date of the related loan is 31 December 2005, that date is inserted into the Confirmation as the Termination Date. The alternative approach (adopted in relation to structured finance-linked swap transactions) is to cross-refer to defined terms used in the other finance documents. So, to continue with the current example, the Termination Date under the swap would simply be defined as ‘The Final Repayment Date (as defined in the Loan Agreement)’. Not only does the latter approach benefit from simplicity and accuracy, it also obviates the need to think too hard about conforming applicable business day conventions (since, again to take our example, any movement in the Final Repayment Date will necessarily result in a parallel movement of the Termination Date). The only reason the latter approach is not used at the vanilla end of the finance-linked swap spectrum is for reasons already identified, namely the lack of communication between loan and swap documentation professionals in relation to finance-linked swap arrangements. With these principles and the base case firmly in mind, the following considerations are relevant. (i)

Notional Amount. This will need to start at £100 million and to amortize in line with the repayment profile of the base case loan. Mechanically, amortization is usually achieved by attaching to the Confirmation a schedule that, taking its lead from the amortization profile within the loan agreement, specifies the time and quantum of each write-down of the swap notional. (ii) Effective Date. This will need to correspond to the drawdown date of the base case loan. The model Confirmation set out in Annex 6 reflects a drawdown date of 2 January 2003. (iii) Termination Date. This will need to correspond to the final repayment date (usually as specified in the loan agreement) of the base case loan. The model Confirmation set out in Annex 6 reflects a final repayment date of 31 December 2012. (iv) Fixed Rate Payer Payment Dates. Usually, these will simply mirror the Floating Rate Payer Payment Dates applicable to the swap. (v)

Fixed Rate. This will inevitably be the last variable to be inserted into the Confirmation. As noted in Annex 1, the quantum of the fixed rate is a function of the time at which the borrower enters into the swap with the swap provider. The model Confirmation set out in Annex 6 assumes a ten-year fixed rate of 5.125%. (vi) Fixed Rate Day Count Fraction. Usually, again, this will simply mirror the Floating Rate Day Count Fraction applicable to the swap. 68

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(vii) Floating Rate Payer Payment Dates. Each of these will need to correspond to its counterpart interest payment date in (or discernible from) the loan agreement. Given an assumed drawdown date of 2 January 2003, the interest payment dates under the loan will be 31 March, 30 June, 30 September and 31 December in each year. These are therefore reflected in the model Confirmation set out in Annex 6. (viii) Floating Rate for initial Calculation Period. The existence of first and final interest periods of a full three months means that there are no stub periods to worry about in relation to the base case. If any such period did exist, it would be necessary to stipulate a rate and
or a means of calculating a rate for that period. As observed in Chapter 3, ‘linear interpolation’ exists as an ISDA term of art to assist in this context. (ix) Floating Rate Option. Best practice here is to cross-refer to, or replicate in full, the rate source and fallback
alternative interest methodologies contained within the loan agreement. As observed in Chapter 3, the superficial similarity between certain ISDA rate source definitions and their loan market counterparts often belies subtle differences that can lead to unnecessary and unwanted interest basis risk for both parties. The model Confirmation set out in Annex 6 includes a replicating provision taken from a recent property finance-linked swap transaction. Note, as a general rule, that all that the swap is intended to provide is a matching LIBOR flow. It is not intended to pay the borrower’s margin or MLA costs under the loan, both of which components – when added to the fixed rate under the swap – increase the borrower’s effective rate and must, therefore, be included in any relevant cash flow models. (x) Designated Maturity. This will need to reflect the duration of interest periods under the loan, i.e. three months in the base case. (xi) Spread. Usually there is none in a finance-linked swap context, the swap provider taking out any credit and funding costs through the fixed rate that it quotes to the borrower. (xii) Floating Rate Day Count Fraction. Loan agreements do not generally make reference to a specific Floating Rate Day Count Fraction (this being, in essence, the number of days in a given interest period divided by a year of duration x days) but the actual fraction can usually be discerned from the loan agreement terms. Once discerned, all that the draftsperson needs to do is select, from the applicable definitions booklet, a matching ISDA Day Count Fraction (if one exists) and insert that into the Confirmation. If no matching ISDA Day Count Fraction exists, the draftsperson must simply replicate the loan methodology in the Confirmation. The model Confirmation set out in Annex 6 assumes a loan year of 365 days, unadjusted for leap years. 69

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(xiii) Reset Dates. These will need to correspond to rate fixing dates in the loan agreement. Ordinarily, rate fixing dates for the ensuing loan interest period are expressed to occur on the last day of the then current loan interest period or on the first day of that ensuing loan interest period. (xiv) Compounding. This can be disapplied. Relatively few commercial loans compound interest (interest on the base case loan, for example, being calculated and paid on a quarterly basis) but, where compounding is relevant, the compounding methodology needs simply to be conformed as between swap and loan. (xv) Business Day
Business Day Convention. The key to achieving symmetry between the variables considered above and their loan agreement counterparts is to ensure that the overlying business day convention is identical as between the swap and the loan. The model Confirmation set out in Annex 6 assumes that the base case loan is subject to a modified following business day convention, with London as the business day centre. Having considered in some detail the drafting of a typical finance-linked swap Schedule and Confirmation, we now turn matters on their head and examine how the swap impacts the drafting of the loan agreement and its related transaction documentation. It is a vindication of some of the observations made in earlier chapters of this book that the analysis that follows is rarely reflected in practice.

LOAN DOCUMENTATION The base case considers only one loan agreement, but it is always possible that other credit agreements will need to be taken into account. In project, leveraged or structured finance transactions, for example, there may exist, over and above the principal loan agreement, layers of mezzanine finance, deferred vendor consideration, intra-group funding and so on. To the extent that this is so, the points considered below are likely to be equally applicable. Note that, as with the base case Schedule and Confirmation, what follows is only an indication of the relevant issues. There is no satisfactory substitute for examination of the loan and any other credit agreement(s), preferably by a debt-literate derivatives lawyer (or a derivatives-literate debt lawyer), on a transaction-by-transaction basis.

Definitions There are three issues that crop up regularly in the context of the Definitions section of the loan agreement. The first is the definition of ‘swap agreement’. Many loan agreements 70

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define this amorphously as ‘an(y) interest rate protection agreement dated x between parties y and z’ or similar. The only reason for this approach is ignorance of the composition of typical finance-linked swap documentation. From a contractual integrity and certainty perspective, the definition demands something along the lines of ‘an ISDA 1992 Master Agreement (Multicurrency-Cross Border), a Schedule thereto (comprising such elections, variables and other provisions as the parties, acting in good faith and in a commercially reasonable manner, shall agree) and an interest rate Confirmation, each dated as of x and each entered into between parties y and z’. Second are the various ‘permitteds’ – permitted indebtedness, permitted security interest and permitted disposal – that occupy the front end of many loan agreements and that go to the negative covenants that the borrower is asked to give for the benefit of the lender. In order to ensure that the borrower is not in technical breach of any of these covenants, each of the definitions of ‘permitted indebtedness’, ‘permitted security interest’ and ‘permitted disposal’ needs to be expanded to include, respectively, the borrower’s contingent liability from time to time under the swap, the set-off and netting provisions contained within the Master
Schedule and the payments to be made by the borrower (qua swap counterparty) to the swap provider from time to time. Third is the tendency – where the lender and the swap provider are one and the same entity or are closely related – for the swap agreement (however defined) to be classified as a ‘finance document’ (or similar) for the purposes of the loan agreement. Several consequences flow from such a classification, some not so serious and others that should not be tolerated. The ‘not so serious’ consequences arise because many of the loan agreement provisions that bite on ‘finance documents’ are themselves dealt with in the swap documentation. Consider those relating to gross-up, default interest, borrower representations and agreements, break cost and currency indemnities, waiver, enforcement costs, stamp taxes, etc. Each of these provisions has its parallel in the ISDA 1992 Master Agreement and there is no good reason for duplicating any of them in the loan agreement. At the very least, the borrower is exposed to the risk of double-counting. More seriously, such duplication can lead to unintended economic consequences. For example, it is customary in the swap markets (and the ISDA 1992 Master Agreement reflects this custom) first, for each party to bear any increased costs suffered by it with respect to the swap and, second, for both parties to have limited swap transfer rights to avoid what otherwise would be an early termination of the swap. Classifying the swap agreement as a ‘finance document’, within a loan agreement that requires the borrower to indemnify the lender (or its affiliated swap provider) for increased costs under ‘finance documents’ or that imposes a blanket prohibition on the transfer or assignment of ‘finance documents’, is clearly, therefore, unhelpful. 71

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Application
source of funds In the context of a cross-currency hedge, the ‘application of funds’ provision ought, technically, to be amended to reflect the fact that it is not the loan monies themselves that will be applied for e.g. general corporate purposes, but instead the cross-currency receivable under the swap. A glance back to Figure 1.2 will better illustrate the point. More generally, any provisions in the loan agreement that prescribe how and in what order borrower receivables are to be applied and
or from where and in what order borrower payables are to be sourced – or, as in project and analogous financings, that provide for the capitalization of interest during the construction phase – should be cognisant of receivables and payables under the swap. In this vein, a recent, nine-figure property finance transaction was, incredibly, ‘put to bed’ with a loan agreement that included a property disposal provision that contemplated the payment of everything but close-out amounts due under the swap and a rent account mechanic that enabled the borrower to meet all of its expenses save for its periodic net swap payment obligations!

Loan payments In relation to interest payable under the loan, there is no point in the lender extending to the borrower the customary ‘one, three or six’ month interest period flexibility, since the borrower will – taking our base case as an example – only want to set interest periods that correspond to the Designated Maturity specified in the Confirmation. To do otherwise defeats the desired goal of economic symmetry. In relation to payments generally under the loan – whether of interest or principal – the borrower will want the usual ‘all payments to be made without set-off or counterclaim’ provision to be qualified to enable it to set off
counterclaim against the swap provider (where itself the lender or an affiliate of the lender) if and to the extent that the swap provider fails to meet its payment obligations to the borrower under the swap. The contractual set-off provisions within the loan agreement will require a corresponding amendment.

Covenants In addition to the covenants already discussed, any covenants that restrict off-balance sheet financings will need amending in contemplation of the swap. The financial covenants will also require thought. Any that relate to interest cover, borrowing and asset levels and
or gearing may need adjusting to take account not only of periodic (net) borrower receivables
payables under the swap but also of the quantum of the contingent (net) asset or, as 72

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the case may be, contingent (net) liability represented by the swap in the borrower’s hands from time to time.

Events of default Most obviously, the lender will usually want a right to demand repayment of the loan if the swap is terminated (i.e. in those rare circumstances where the event that gives rise to the termination does not itself constitute an event of default or mandatory prepayment event under the loan agreement). Much less obviously, the borrower will want a carve-out from the ‘failure to pay’ event of default where the relevant failure is (a) a failure to pay interest on the loan that is (b) directly attributable to a failure by the swap provider (where itself the lender or an affiliate of the lender) to meet its payment obligations under the swap.

Sharing Where the swap provider is a member of a loan syndicate, all parties will want to consider whether and to what extent the swap provider is entitled to retain amounts received from the borrower (qua swap counterparty) under the swap. Clearly, the swap provider must be able to retain ongoing swap payments, but the real issue centres on close-out amounts (where due to the swap provider, that is). To the extent that these are secured on the borrower’s assets, retention favours the swap provider but dilutes the security of the other syndicate members. To the extent that the swap provider is obliged to share, the converse is true. Where the swap provider is unsecured, it seems only right – adopting a risk-reward argument – that it should be entitled to retain whatever portion of the close-out amount it manages to recover. There is, however, no established practice in this area.

Euro conversion provisions For very obvious reasons, the treatment of the loan and the swap on an accession by the UK to EMU should be identical.

SECURITY DOCUMENTATION There are three key issues in the context of security documentation for finance-linked swap arrangements. One is a question of designation and the other two relate to scope and reach. 73

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Designation We suggested, in the context of the Schedule, that Parent’s guarantee ought to be formally designated as a Credit Support Document. There is an argument that it does not actually need to be – after all, it is almost certain to have been drafted as an ‘all monies’ guarantee and so, on the face of it, will extend to the borrower’s liabilities under the loan, the swap and any other debt obligation of the borrower to the lender. The reason for designating it in the Schedule is not, as the reader might imagine, to give the lender (qua swap provider) the benefit of Section 5(a)(iii) (Credit Support Default) – by application of the General Rule, Section 5(a)(iii) will be off limits to the lender – but to prevent Parent or the borrower (or any liquidator or receiver of either) from raising the (probably unmeritorious) argument that the failure to tick the ‘is there security?’ box in the Schedule means that the ‘all monies’ provision does not get a chance to bite on borrower amounts owing under the swap. ‘Better safe than sorry’ is the motto here.

Scope – what obligations are secured by the security? Staying with Parent’s guarantee for a while longer, the question that arises is the meaning of ‘all monies’ when used in the context of swap arrangements. Since the ISDA 1992 Master Agreement contains provisions that, in this and in many other developed jurisdictions, are sufficiently robust to achieve a net settlement on close-out, even in an insolvency, any guarantee for obligations arising under that agreement should itself be expressed to extend to net amounts only. While possibly an academic point in the context of finance-linked swap transactions (where there may be only one swap and therefore nothing to net on a close-out), there is no harm in making the amendment. A second issue, again pertinent to the guarantee and analogous to one of the borrower concerns highlighted above with respect to the loan agreement, is that Parent will want the usual ‘all guarantor payments to be made without set-off or counterclaim’ provision to be qualified to enable it to set off
counterclaim against the swap provider (where itself the lender or an affiliate of the lender) if and to the extent of any failure by the swap provider to meet its payment obligations to the borrower under the swap. An alternative is for the scope of the guarantee to be limited so that it secures only the borrower’s net obligations across the loan and the swap. While this protects Parent in the event of the lender’s insolvency (since it prevents a liquidator from demanding a gross payment under the guarantee in respect of the loan in circumstances where the borrower is in the money under the swap), it may leave the lender exposed (to the extent that the loan and swap obligations cannot be netted off) in the event of the borrower’s insolvency. 74

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Reach – what assets underpin the security? Let us assume that our base case contains a requirement for the borrower to provide a debenture and that the lender and the swap provider are now separate entities. As a preliminary matter, the ‘all monies’ and ‘payment without set-off or counterclaim’ provisions within the debenture will need amending in the same way and for the same reasons as given above with respect to the guarantee. If the swap is expressed to be a condition subsequent to the making of the loan or if the borrower’s hedging strategy contemplates a rolling programme of swaps, the ‘tacking’ provisions within the debenture may also require amendment to capture contingent borrower liabilities arising under transactions entered into after the date of its execution. Next, a security trustee will need to be interposed as a means of extending and regulating the benefit of the debenture to
for the lender and the swap provider (leading us, conveniently, to some of the intercreditor issues discussed below). Finally, the ‘odd’ nature of a swap in this context will need to be taken into account. Remember that a swap has potential to be both an asset and a liability (to the same party) at different times in its life. So, from the perspective of a swap-holding debenture-giver, the swap may on one day be an asset that underpins the debenture and on another day be a liability that is itself secured by (all other assets caught by) the debenture. A schizophrenic floater? In diagrammatic terms, this apparent paradox is summed up in Figure 4.3.

The paradox of the ‘schizophrenic floater’

Figure 4.3

Borrower

Debenture Obligations under loan agreement

Security trustee

Swap (as contingent asset to borrower) reallocates debenture cover to lending bank

Swap (as contingent liability to borrower) eats into debenture cover

Security trust

Lending bank

Swap provider

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The relevance of all this manifests itself both in the drafting of the debenture and in the phrasing of the condition precedent in the loan agreement relating to the security package to be delivered by the borrower. In both regards, the borrower is usually asked to ‘assign the hedging agreement by way of security to the security trustee’. Clearly this is an unsophisticated formulation (again, it has to be said, borne out of ignorance as to the nature of a swap) with which the borrower cannot, strictly speaking, comply. What it can do (and it is this that should be reflected in the drafting) is assign, to the security trustee (i) by way of security for its obligations under the loan agreement, its assets (including any net close-out amounts due to it by the swap provider under the swap agreement) and
or (ii) by way of security for (a) its obligations under the loan agreement and (b) any net close-out amounts due by it to the swap provider under the swap agreement, its general assets (period). Note additionally that, where the lender and the swap provider are one and the same, there is no point at all in the lender asking for the benefit of the swap to be assigned to it. Why? If the lender (qua swap provider) is in the money, the borrower has no rights to assign; and if the lender (qua swap provider) is out the money, all that the security achieves is an assignment back to the lender of something that it owes to the borrower. Yet, time and time again, swap-providing lenders insist on an assignment of this nature and, time and time again, borrowers oblige – a wasted effort, of course, against a backdrop of the lender’s contractual and
or statutory (Rule 4.90) set-off rights.

INTERCREDITOR DOCUMENTATION Some readers may be thinking that the analysis presented in this chapter is all well and good where the swap provider is itself the lender or is an affiliate of the lender, since it is in a position in both cases to influence the drafting of the loan agreement so as to ensure that, wherever its termination rights are disapplied or limited in the swap agreement, they are ‘turned back on’ in the loan agreement. Equally, it is in a position to influence whether the occurrence of an event of default leads to an acceleration of the loan and, thereby, to the existence of a termination right under the swap. But where it is unrelated to the lender or otherwise has no influence over the terms of the loan agreement (where, for example, it is the hedge provider but only a minority participant
vote-holder in a syndicate), this is not the case. In such instances, it is true that the General Rule does not operate and that the swap provider will want
need to negotiate (and will be justified in negotiating) for a much fuller suite of termination rights. It may, of course, have to accept 76

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fetters on those rights (stays on enforcement, for example), a subordination of its claims against the borrower, an inferior ranking in any security waterfall and so on – and all of these matters, as well as various other security and intercreditor issues considered in Chapter 3, will need to be addressed in an appropriate intercreditor agreement.

ANCILLARY DOCUMENTATION Board resolutions, authorities, side letters, statutory declarations and other ancillary documents relating to the deal as a whole must also be cognisant of the swap. Yet it is quite remarkable (but consistent with its overall treatment) how many times execution and other formalities relating to the swap documentation are left until the last moment or ignored altogether. If it helps to repeat it, a swap is just another credit agreement that needs to be recorded and approved as such.

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Overview Capacity and authority Suitability Reliance Reputation, regulatory and litigation risk Advisor liability

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OVERVIEW It was suggested in Chapter 2 that OTC derivatives are, from a legal and regulatory perspective, fundamentally more demanding than loan instruments. While that is true in general, the legal and regulatory issues that most commonly arise in the context of finance-linked swap arrangements may be narrowed down to a few key areas. First, for many types of borrower, questions will arise both as to the legal capacity of the borrower to enter into interest rate swap transactions (that of the swap provider is assumed) and as to the authority of its agents or employees to sign and give effect to legally binding swap contracts on its behalf. The law is not difficult in this regard, but it usually demands entityby-entity analysis. Second, OTC derivatives and ISDA documentation may be new to many participants in the finance-linked swap market. Without independent advice, therefore, such participants will be relying on the swap provider to supply a product (and a suite of documentation) that is suitable in the context of their chosen hedging strategy – all the more so if the swap provider has been instrumental in designing that strategy. Naturally, the obligation to provide a product and related documentation that is suitable, especially in the context of a ‘reliant’ borrower, imposes upon the swap provider a degree of legal and
or commercial responsibility. Abrogation of that responsibility may, at best, cause damage to the swap provider’s reputation and, at worst, expose the swap provider to regulatory censure and
or litigation. Third, as a consequence of the foregoing, the position of various advisors within typical finance-linked swap structures must also be considered. Each of these aspects is examined in the course of this chapter.

CAPACITY AND AUTHORITY Capacity Certain types of institutional borrower are unlikely to hedge their borrowings on anything other than a ‘portfolio’ basis, such is the size and diversity of their asset and liability bases. Insurance companies, the larger building societies and hedge funds, among others, are all likely to fall into this category. While questions of legal capacity are highly relevant to such entities, they are of academic interest only in the context of a book on finance-linked swaps. 81

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By contrast, ‘ordinary’ companies incorporated under the Companies Act 1985 (including limited liability SPVs), trusts, housing associations, limited partnerships and various other corporate entities (including the smaller building societies) will all, from time to time, seek to hedge particular debt liabilities with tailored interest rate swap and option products. In respect of borrowers such as these, finance-linked swap providers are likely to require, over and above the generalized representations as to capacity set out in Section 3(a) of the ISDA 1992 Master Agreement, specific assurances that are germane to the entering into of the swap. These will vary from entity to entity but may include representations as to the purpose of and intention behind the swap, compliance with and furtherance of constitutional objectives, adherence to applicable statutory provisions, authorization by and registration with relevant regulatory bodies and
or general sufficiency of assets. More often than not, the swap provider will supplement its requirement for additional representations with a request for delivery of certified copies of the borrower’s constitutional documents – be they memorandum and articles of association, trust deed, model rules, limited partnership deed, formal charter, etc. – and a legal opinion from the borrower’s lawyers. Needless to say, the swap provider should examine the relevant constitutional documents for evidence of the borrower’s capacity to enter into the swap (the fact that it is intended to hedge a specific debt obligation is often helpful – and sometimes a prerequisite – in this regard) and the relevant opinion for any unusual assumptions, reservations and qualifications. The opinion itself will usually be influential in determining the swap provider’s representation and document-delivery requirements of the borrower. Unfortunately, there are no general rules in relation to legal capacity (except, perhaps, that the more unusual the entity, the greater the degree of legal due diligence the swap provider should undertake) and there is no satisfactory substitute for consulting a specialist lawyer or text, i.e. one versed in or relating to the specific borrower type, for the applicable legal analysis. It is worth recalling that certain borrowers, notably local authorities, are unable, on account of legal incapacity, to enter into swaps (finance-linked or otherwise) at all. Others – trusts, housing associations and the less sophisticated building societies, for example – may only do so subject to a requirement to terminate or ‘reallocate’ the swap on a prepayment of the loan to which it relates. At the other end of the spectrum, the capacity of limitedliability companies to enter into finance-linked swaps is seldom called into question – a function of the permissive Companies Act regime that applies generally to contracts entered into by such entities. That fact does not, however, prevent certain swap providers – US houses in particular – from requesting, as a matter of general policy, opinions as to the legal capacity of such entities. In between these extremes lie various shades of grey. 82

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We return to some of these questions, in Chapters 6 and 7, in the specific context of housing associations and building societies.

Authority Related to the question of capacity (and usually dealt with as an ancillary consideration in any opinion given by the borrower’s lawyers) is the question of authority. As a general rule, satisfying oneself as to a borrower’s capacity to enter into a swap is a wasted exercise if the person or persons who sign the corresponding documentation have no authority from the borrower to do so. Accordingly, swap providers usually insist on receiving suitably worded and authenticated corporate resolutions and specimen signature lists. As a matter of good practice, borrowers should also insist on seeing appropriate authorizations from the swap provider. A word of caution is in order here in relation to delegated authorities. If, for example, a borrower’s board delegates authority to enter into a swap to a sub-committee – but qualifies this with a requirement that the sub-committee must first be satisfied that the swap is in the best interests of the borrower – the swap provider must, in order to complete the chain of authority, seek a resolution from the sub-committee that not only authorizes the entering into of the swap (and signature of the relevant documentation) but also attests to the sub-committee being satisfied in accordance with the terms of the authority delegated to it.

SUITABILITY Distinct from the issues of capacity and authority is the question of suitability. Often discussed as if it were only relevant to the transacting of OTC derivatives business, the principle is in fact a basic tenet of consumer rights in the financial services industry. In short, it imposes upon a seller of financial instruments a legal duty of skill and care, when dealing with an unsophisticated customer (the differing degrees of ‘sophistication’ will be examined shortly), to provide a product that is appropriate to that customer’s needs. Much of the law in this regard is appositely encapsulated in the case of Bankers Trust International plc v Dharmala Sakti Sejahtera [1996] CLC 581. This concerned a suit brought by Bankers Trust against an Indonesian company, Dharmala, for payment of a close-out amount under a series of interest rate swaps that had become heavily out the money for Dharmala. Dharmala defended itself by alleging that Bankers Trust owed it various duties, not least a duty to consider the suitability of the swaps for Dharmala 83

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(taking into account its expertise, its financial position, the availability of alternative strategies and the possible consequences of it entering into the swaps) and a duty to advise Dharmala to obtain independent advice. It also alleged that Bankers Trust had misled it as to the nature and effect of the contracts. That Dharmala failed (on all counts) can be attributed simply to the Court’s finding that, on the facts, Dharmala was a sophisticated entity, had not been misled and had been advised to satisfy itself as to the risks and outcomes implicit in the transactions. It therefore had to pay the amount owing. The case confirmed, however, that duties could arise so that, had the Court found that Dharmala was unsophisticated and
or had been misled, Bankers Trust may well have lost. The decision, therefore, is of immense significance to the finance-linked swap market where, as we have noted, practice is often misleading and the degree of sophistication on the part of many borrowers is low. Unsurprisingly, the regulatory environment reflects the legal position. The FSA’s rules on customer classification (applicable to most markets, not just those involving OTC derivatives) are encapsulated in the InterProfessional Code (applicable to ‘market counterparties’, i.e. professionals) and in the Conduct of Business Handbook (applicable to ‘intermediate’ and ‘private’ customers, i.e. semi-sophisticated and unsophisticated customers respectively), both of which are modelled on the old London Code of Conduct (itself succeeded by the new, Non-Investment Products Code). These rules require the seller, first, to get to ‘know’ its customer (which requirement includes it having an understanding of the customer’s appetite for risk); second, to classify the customer according to its sophistication; and third, to issue the risk warnings, related terms of business and other documents (if any) that are appropriate to that classification. Only then may it book and confirm the transaction. So far as the Confirmation itself is concerned, this must comply with the requirements as to timeliness of dispatch (considered under ‘Operational Differences’ in Chapter 2) and informational content, all as set out in Section 8 of the Conduct of Business Handbook. In practice, many finance-linked swap customers are likely to fall into the intermediate or private customer bracket and the compliance (as well as legal) burden on the relevant swap providers will, accordingly, be at the upper to top end of the spectrum. Interestingly, in this regard, the FSA has (under July 2002 Consultation Paper 141) entertained a welcome change to its hitherto established requirement that securitization SPVs may be classified as ‘intermediate’ customers only if they have been formally assessed by a rating agency (and must, if unrated, be classified as ‘private’ customers). The effect of this relaxation of the rating requirement is to reduce the compliance burden for swap providers in relation to a significant number of finance-linked swap arrangements. 84

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RELIANCE In the wake of Dharmala and a number of analogous cases, the OTC derivatives market took a long, hard look at itself. There is little doubt that swap providers tightened up their marketing, selling and compliance procedures. In addition, ISDA released a suite of representations, now incorporated as standard into Part 5 Schedule provisions within ISDA 1992 Master Agreements (see Part 5(2) of the model Schedule included in Annex 5), attesting to each party’s ability to understand and assume the risks of transactions entered into and to stand on its own two feet for such purposes. Commonly referred to as ‘non-reliance’ representations, the provisions were (and are) intended both to encourage parties to think about what they are doing before entering into transactions and to make it more difficult for them to assert Dharmala-type defences in litigation. It is important to note, however, that, outside of the market counterparty arena, non-reliance representations are only as good as the facts that underpin them. So if a swap provider, in relation to a given transaction, makes a material misrepresentation to its (relatively unsophisticated) counterparty – and if the counterparty relies upon that misrepresentation to its detriment – the swap provider is going to find it difficult, if not impossible, to hide behind the non-reliance representations in any litigation that ensues. Put another way, if a swap provider proffers advice, the advice must be accurate (and, as a matter of good housekeeping therefore, accurately minuted); and if, say, in the context of an unsophisticated counterparty, it is unwilling to give advice, then it must do all it can to ensure that the counterparty seeks the required advice elsewhere. A good analogy in the latter regard is the position of a wife who co-signs a mortgage over the matrimonial home as security for her husband’s business debts. No reasonable banker is going to feel comfortable with the security unless the wife has received independent legal advice, the fear (justified by a long line of case law) being that the wife will later argue that she was coerced or misled by her husband into signing the mortgage, and that the mortgage is, as a result, unenforceable. The position of a swap provider vis-à-vis an unsophisticated counterparty is comparable. Related to the foregoing is the tendency of many swap providers to view non-reliance representations as a panacea, as demonstrated by the 2002 United States Court of Appeals litigation – Caiola v Citibank N.A. The facts, in brief, are that Caiola, a wealthy individual, entered into a number of OTC equity derivative transactions with Citibank as a proxy for taking physical positions in the equity markets. Such was the size of the transactions that he had insisted at the outset (and had received oral assurances) that Citibank was to hedge its own exposure under the transactions by ‘delta hedging’, a technique involving relatively small purchases, by Citibank, of 85

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the underlying equity. Citibank later ceased delta hedging and began hedging on a fully covered basis, executing significant purchases in the physical market that, in effect, negated Caiola’s strategies in the synthetic market. Caiola blamed this change of tack by Citibank for losses that he later suffered under the transactions and sued. Citibank defended itself by pointing to a non-reliance type disclaimer, included within the ISDA documentation to which it and Caiola were party, asserting that the existence of the disclaimer precluded Caiola from relying on Citibank’s oral assurances concerning delta hedging. The court, adopting an approach that would probably be mirrored under English law, was notably unimpressed with the argument. Finally, again related to the foregoing, there exists a dogmatic adherence of swap providers to non-reliance representations even if they are not appropriate to the circumstances. As the Financial Law Panel pointed out as long ago as 1995 in its paper ‘OTC derivatives – banks’ obligations to customers’: ‘This issue [of pre-contractual misrepresentation] can, up to a point, be addressed by banks inserting in standard contracts a provision that the customer has not relied on any statements or representations made by the bank. Such solutions will only be effective, however, if they accord with the facts. If the customer does rely on the bank’s views, in circumstances which give rise to legal rights, a general exclusion clause may not protect the bank. The answer is to put in place training and compliance systems which ensure that the customer does not rely on the bank, unless it is intended that reliance should form part of the relationship’ (italics added). The point, then, is that non-reliance representations are negotiable and should be amended
qualified if the relationship between the parties demands it. They seldom are, however, as the following recent example, concerning a regional, non-bank buyer of super long-dated interest rate swaps, illustrates. The selling bank had, understandably, suggested that the swaps be cash-collateralized – on a mutual basis – under an ISDA credit support annex governed by English law. The maturity of the transactions meant, however, that the buyer did not have the expertise to calculate the quantum of cash collateral that would be due to (or owing by) it from time to time, so the bank had agreed to undertake the necessary calculations for both parties. It had also agreed to various mechanical amendments to the annex, proposed by the buyer, that were necessary to bring about the desired ‘omni-calculation agent’ functionality. Yet, constrained by policy parameters that were (are) clearly not in keeping with the legal position, it steadfastly refused to qualify its standard suite of non-reliance representations to reflect the fact that, in relation to the collateral arrangements at least, the buyer was heavily reliant on the bank. The buyer in the end relented, giving the bank a Pyrrhic victory only by telling it, at the point of signature, that it would be relying on the bank in relation to calculations under the annex. 86

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The bank, of course, would have been much better off in these circumstances agreeing exactly the extent of its responsibilities to the buyer rather than pretending that the responsibilities did not exist and
or hiding behind meaningless representations to that effect. We now turn to consider how questions of suitability and reliance are relevant to the finance-linked swap market.

REPUTATION, REGULATORY AND LITIGATION RISK Reputation risk Poor practice exposes finance-linked swap providers to the risk of damage to reputation in a number of ways, although, for reasons given in Chapters 1 and 2, the size and likelihood of occurrence of the risk varies from sector to sector. In the upper echelons of the market – i.e. in relation to big-ticket, rated, syndicated and
or debt capital markets transactions – borrowers are generally sophisticated (as well as better advised), best practice is often a matter of prescription and poor practice carries a much higher tariff in terms of reputational damage. So, the garden is rosier to begin with, swap providers are better disciplined and the risk of damage to reputation is correspondingly low. At the mid- to small-ticket end of the market, the converse is true, so poor practice abounds and the risk is high. Whether swap providers to the latter sectors are simply unaware of the poverty of practice that exists or whether they have no will to do anything about it (or both) are questions that we will leave until Chapter 10, but the answers dictate the extent to which the concerns are of real or academic interest to swap providers themselves, their internal policy makers and their regulators. In the latter regard, it is interesting to conjecture whether, by the time that Basle 2 comes into effect in 2006, continuing poor practice in the area of finance-linked swaps will be sufficient to attract a capital penalty under any of the intended new supervisory heads (in particular, that requiring banks to adopt sound practices to manage their operational, including legal, risks). How, then, does reputation risk manifest itself? In the first instance, providing a suite of documentation that neither gives the borrower a perfect economic hedge nor reflects the commercial positions agreed in the loan agreement cannot be good business practice. Second, misinforming the borrower that the documents are ‘standard form’ (and that, therefore, the borrower does not need to review them) simply compounds the error. It also sits uneasily and incongruously with standard non-reliance representations, pursuant to which the borrower says ‘I am not relying on you’ to a swap provider on whose very assurance (‘the documents are in standard form – 87

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just sign’) it is relying in signing the documents ‘blind’ and, therefore, in not reading the non-reliance representations in the first place. Third, failing to insist that the borrower seeks independent commercial and legal advice, while at the same time omitting to explain to the borrower the fundamentals of swap transactions or the key terms of ISDA documentation, is dubious customer care. Finally, regulatory censure or adverse litigation (to which malpractice may lead) is always damaging to reputation. One need only consider the position of Bankers Trust, post-Dharmala et al., to see that that is so. The only saving grace (itself of questionable value) is that most swap providers are as bad as each other, certainly where unsophisticated borrowers and small-ticket transactions are concerned. That will be of no comfort, however, to any swap provider that suffers a public backlash and
or regulatory censure.

Regulatory risk Poor practice may not only damage reputation generally but may also lead to regulatory intervention, which may in turn cause further damage to reputation. More specifically, a failure to comply with the ‘know your customer’ and other Conduct of Business rules may lead to a fine or other sanction and may also make it more difficult for the swap provider to rebut a Dharmala-type ‘the product was not suitable to my needs’ claim by an aggrieved customer. It is always useful to bear in mind, in this regard, that regulatory compliance is an accurate barometer of (and useful shield against) legal liability.

Litigation risk Given the legal risks implicit in transacting swap business, particularly vis-àvis unsophisticated counterparties, a finance-linked swap provider ought to follow some simple rules if it is to keep litigation risk to a minimum. First, it should insist that the borrower seeks independent advice in relation not only to the commercial terms of the swap but also to the contractual aspects of the documentation (and the appropriateness of both in the context of the wider loan transaction); and, if the borrower refuses, it should consider carefully whether it is right for the borrower to transact at all. Necessarily, therefore, the swap needs to be on the agenda at a very early stage of discussions. In addition, far from saying that ISDA documentation is ‘standard form’, the swap provider ought to explain that it is a highly complex suite of precedents that, especially in the context of a finance-linked swap arrangement, requires careful engineering and equally adroit review. The swap provider ought, in particular, to point out the existence and 88

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significance of the non-reliance representations and any other disclaimers contained within the documentation. Whether or not the borrower seeks independent advice, the swap provider should make clear, at the very least, that swaps ‘can go up as well as down’ (with the result that, on an early termination, the borrower may have to pay a close-out amount to the swap provider) and the significance of the fact that the loan agreement and ISDA documentation are discrete but interrelated contractual arrangements. In the latter regard, the borrower should be made aware that a default under either is likely to bring about a demand for repayment or, as the case may be, an early termination under the other (implicit in which may be a requirement for it to pay a close-out amount, as before); and that, if the borrower prepays the loan, it will, if acting rationally, want a right (and may, in any event, be compelled by law, the regulatory environment, its constitution and
or the swap provider) to close out the swap and may, as before, have to pay a close-out amount. The swap provider should also explain that, on an early termination of the swap, the relevant close-out amount may fall to be paid to the borrower. Some swap providers, disingenuously, make no mention of close-out gains and some may even hold on to them rather than pay them over. By way of recent example of what can go wrong, litigation was only narrowly averted when a small, unsophisticated, regional buy-out borrower prepaid its buy-out loan only to find, when it came to close out the related swap, that it had no contractual right to do so and that, even if the swap provider were to agree, consensually, to an early termination, it would be at a cost to the borrower. A rather embarrassed buy-out banker later admitted that he had subsequently cooked a deal with the borrower whereby he paid back some of his fees on the original loan transaction to help the borrower fund its exit from the swap. Needless to say, neither the bank nor the swap provider had advised the borrower to seek independent advice, both had said that the documents were ‘standard form’ (and so the borrower had not read them) and the borrower had no understanding at all of the implications of a close-out of a swap ahead of its contractual maturity. From a legal liability perspective, the bank could not have been in a worse position. Ironically, the banker in question had, at the time of the buy-out, just taken out a fixed rate mortgage from his building society – and so knew all about break penalties on fixed rate obligations. He had simply failed to draw the analogy to the attention of the borrower. One final point, related to the question of suitability and particularly relevant to finance-linked swaps, is worth a mention. Lending banks often couch the obligation to hedge in terms of a specified percentage of the loan principal – 70% is a common benchmark in this regard. Yet practice suggests that there is hardly ever any discussion as to why or whether this is the most appropriate figure – or indeed whether there are any appropriate 89

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figures other than 0% (equating to ‘do not hedge at all’) or 100% (equating to ‘hedge in full’). Certainly, it would be interesting to try to predict the outcome of a claim by a borrower along the lines that the 70% benchmark was an arbitrary number, imposed upon the borrower by the bank, that did not reflect the borrower’s actual hedging requirement. On any analysis, it is difficult to see what place an arbitrary number has in the context of a bank’s obligation to provide a product that is suitable for a particular borrower in a particular set of circumstances.

ADVISOR LIABILITY Hedging strategy consultants Happily, given what we have said above, it is increasingly common for dedicated hedging consultants to be employed by borrowers to advise in relation to finance-linked swap arrangements. Such consultants, be they boutique corporate finance firms or specialist advisory teams within the larger accountancy practices, have seen the growth of the finance-linked swap market as an opportunity to add value to (and thereby generate increased fee income from) the existing services that they offer to borrowers in the context of structured loan finance transactions of the sort considered in this book. In offering advice on the swap, they go a long way to allaying the concerns of the swap provider as to product suitability and reliance – after all, if someone else is advising the borrower, then it cannot blame (or blame only) the swap provider if the product is unsuitable, it cannot say that it did not understand what it was buying and it cannot say that it was relying on the swap provider for the relevant advice. It can blame the consultants, of course, but, so far as the swap provider is concerned, the non-reliance representations made to it by the borrower, for once, reflect reality. There remains a problem, however, insofar as none of these consultants is a law firm. When it comes to suitability of the swap documentation, therefore, such consultants are not really in a position to advise. What do they do in practice? The best tell the borrower to seek advice from a law firm that has the requisite degree of expertise. Some of the accountancy firms have their own legal divisions to which the borrower is likely to be referred. A limited number of consultants have made it their business to understand enough about ISDA documentation to be able to give the borrower a reasonable steer on matters such as economic and credit symmetry, prepayment, transferability and so on. So long as these latter advisors carry a reasonable level of professional indemnity cover and make explicit in their mandate from the borrower that they are not in a position to give legal advice – merely commercial pointers on the documentation – the practice seems unobjectionable, and certainly cannot be 90

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criticised in a market where sensible advice is at a premium. The worst simply perpetuate the status quo, advising the borrower to sign whatever it receives from the swap provider on the basis that it is standard form documentation. Yet, incongruously, these very same consultants negotiate extremely hard on the loan agreement and charge the borrower for advising on both sets of documentation. Needless to say, this disparity in approach perhaps makes them obvious targets for an aggrieved borrower who is looking for somebody to sue over poor advice in relation to the swap documents.

Lawyers to the borrower Many law firms that advise on small- to mid-ticket structured loan financings are in an unenviable position when it comes to the swap. It is a fact that most of them do not have the expertise to be able to cover this aspect of the transaction. Faced with a choice between expressly declining the instruction for that very reason or, much worse, accepting it but misadvising the borrower, most of them save face by acquiescing in the ‘standard form’ arguments that emanate from the swap provider, the deal bankers (and their lawyers) and the hedging consultants. The fact is, however, that acquiescing in an argument that does not hold water (and that they ought to know does not hold water) may, of itself, leave them exposed to a claim by the borrower. Those law firms that have the requisite expertise are also in a difficult position. Not only do they have to meet the ‘standard form’ argument on its head (something that will necessitate a struggle – swap providers, hitherto at least, are unaccustomed to lawyers challenging documentation that has been used many times before without question) but they will also be charged with being uncommercial and pedantic into the bargain. That should not, however, deter them from their duty to their client to seek perfectly principled amendments, of the type considered in Chapter 4, to the swap, loan, security and intercreditor documentation. As an adjunct to the foregoing, law firms are sometimes called in after a deal has completed to provide an opinion as to the borrower’s capacity and authority to enter into the swap (it is a little late by then but it happens nevertheless). An astute firm will caveat its opinion by stating that it has not been involved in negotiation of the swap documentation (or the related suite of credit documents), thereby protecting itself from the horrors that, typically, lurk within.

Lawyers to the lending bank
swap provider Similarly, the position of lawyers to the lending bank is not a happy one. As before, most do not have the expertise to be able to advise on the swap and 91

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those that do will not want to ruffle the client’s feathers (or those of its affiliated swap provider) by insisting on a quality-control role in relation to the swap documentation. In any event, outside of the big-ticket markets, lending banks and swap providers rarely invite their lawyers to tender for the swap work, such is their (tenuous) belief, noted in Chapter 1, in the accuracy and omnicompetence of their house documentation. So, as before, an unconscious subterfuge is adopted whereby all parties pretend (very well, since most of them believe) that the documentation is in good shape at the point at which it leaves the swap provider’s office. Whether that is enough to open up a liability risk to the lawyers concerned is debatable, but the potential is there.

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Common themes Project financings Property financings PFI financings MBO financings

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COMMON THEMES We now turn to consider finance-linked swaps in the context of several discrete yet common financing structures, in relation to which the nature of the market in which the borrower operates gives rise to special implications for the swap. In general, however, the peculiarities identified ought not to mask the essential similarities between the various structures or the continuing applicability of the analysis set out in the preceding chapters. All of the structures considered in this chapter are characterized by a multiplicity of lending and other parties, by uncertainty as to the timing and quantum of the funding requirement and by a high ratio of long-term debt to equity. These characteristics, as we have seen, have important implications for the security and intercreditor arrangements, the borrower’s hedging strategy and the sensitivity of the structure to adverse movements in interest rates. The latter feature, in turn, places a premium on the achievement of economic symmetry between the swap and its related debt obligation. Typically, borrowers within each of the structures are exposed to financial and other risks (over and above those represented by interest and currency rates) that, absent a natural hedge or other mitigant, may need to be managed with derivatives or analogous instruments. Input
output price risk, inflation risk, contractor credit risk and weather risk are just a few examples, some of which are considered in this chapter. To the extent that these other instruments afford generic protection, they require much less engineering than their interest rate or cross-currency swap counterparts. A further tendency is for the recourse of the debt provider(s) to be limited to the assets of a specific entity (typically, an SPV) or otherwise to be ringfenced to specific assets within the sponsor-borrower’s balance sheet. In such circumstances, recourse of the swap provider ought, in principle, to be similarly limited. Where the structure is rated, any formal criteria or requirements of the relevant agency relating to the swap (as well as to the wider structure as a whole) must also be respected and followed. We consider rating agency criteria and their implications for finance-linked swap documentation in Chapter 7. Additional technicalities arise where the structure is novated by the incipient SPV into a ‘real’ entity (the project sponsor, perhaps) following the construction phase of a given project or where the structure is refinanced. This chapter considers swap novation mechanics in detail, using property development loans as examples, but the reader should note that the principles are of general application to most project, leveraged and structured finance transactions. Finally, many of the structures rely for their efficacy on due performance 95

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under certain key agreements (concessions, licences, construction and service agreements, etc.) entered into by the borrower. To the extent that breach of these agreements triggers an acceleration of the loan, so the swap provider, by application of the General Rule considered in Chapter 4, will have a corresponding right to terminate the swap. But if no right to accelerate exists in favour of the lender(s), it is difficult to see the justification for such a right in favour of the swap provider. Nevertheless, many practitioners seek in these circumstances (erroneously, it is suggested) to endow swap providers with such rights in the relevant swap documentation.

PROJECT FINANCINGS In the broadest sense, each of the financings considered in this chapter can be regarded as a ‘project financing’. Yet ‘project financing’ is usually associated with large-scale infrastructure projects, often involving the extraction of natural resources, that have an international dimension and
or a degree of state sponsorship. It is in this sense that we use the term here. We consider two simplified structures, one involving bank debt and the other involving bond finance.

Bank debt From a finance-linked swap perspective, the structure set out in Figure 6.1 is little different to the arrangements considered in previous chapters. Several additional points are worth making, however. First, where the debt obligation is of long maturity, the SPV will often insist on rights to break the swap, sometimes at zero, nominal or fixed cost to itself, at pre-agreed, periodic intervals. The flexibility that this affords to the SPV, enabling it without penalty or at an agreed cost to switch out of fixed and into (lower) floating interest rates, will ordinarily be reflected in a higher-than-normal fixed rate under the swap. In passing, break rights of this nature (i.e. non-credit-related and transaction-specific) are best documented within the relevant Confirmation, making use of the Optional Early Termination provisions set out in Article 15 et seq. of the 2000 ISDA Definitions. These provisions are tailor-made for the purpose and the only real issues are to determine whether any limits are to be placed on the SPV’s rights to break (i.e. single versus multiple exercise; partial breaks versus break-in-whole only) and to ensure that, if the break is to be at fixed cost (including zero), the applicable ISDA Definition – ‘Cash Settlement Amount’ – is amended accordingly. Second, since the loan principal is likely to be required only in stages and 96

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Simplified project finance structure (bank debt)

Contractors/ licensors/ concessionnaires

Sponsor(s)

Equity

Dividends

Principal Lending banks

Project agreements

Fixed SPV

LIBOR

Figure 6.1

LIBOR

Swap provider (a lending bank?)

Security over (i) rights under project agreements (ii) net rights under swap agreement (iii) other assets Security trustee

at uncertain times, the SPV will be faced with the familiar problem of having to decide between building into the swap an accretion profile that represents its best guess of when and in what amounts drawings under the loan facility will take place, running forward rate risk in relation to undrawn portions of the loan facility (increasing the swap notional proportionately at the time of each new drawing) and locking in a series of forward rates, at the outset, using swaptions. As noted in Chapter 3, each alternative carries with it advantages and disadvantages. Presetting the accretion profile is a day 1, zero-cost strategy that nevertheless exposes the borrower to the risk of being over- or under-hedged at various points during the life of the loan. Running forward rate risk is again a day 1, zero-cost strategy, but one that exposes the borrower to the possibility of a higher fixed rate in respect of each future drawing (or to the economic equivalent of having to ‘buy in’, through a payment to the swap provider at the relevant time, the lower fixed rate locked in at the time of first drawing). The use of swaptions carries an upfront premium but – provided the SPV has a reasonable degree of confidence as to when and in what amount it intends to draw the loan – removes a great deal of the uncertainty. Note that the problems exist whether or not interest is capitalized during the construction phase of the project and that indeterminate amortization and prepayment profiles give rise to analogous difficulties at the back end of the transaction. 97

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A third and related issue stems from the lag, which characterizes many project financings, between inception of negotiations and financial close
first drawdown. Here again, the SPV (or, more accurately at the precontract stage, its sponsor) is faced with a choice between paying a premium for a swaption and running forward rate risk. If the sponsor elects to enter into (and subsequently exercises) a swaption, the resultant interest rate swap will ordinarily be novated to the project borrower at financial close. If project negotiations break down so that financial close never occurs, the sponsor will be able to recoup some or all of its premium if the swaption is in the money but otherwise will have to write it off as a sunk and irrecoverable cost. Finally, any international dimension to the debt financing arrangements will have consequences for the borrower’s hedging strategy (cross-currency risk may need to be hedged) and for the swap documentation. In the latter regard, the tax representations, process agent election and governing law
jurisdiction
immunity provisions within the ISDA 1992 Master Agreement will merit special attention and any international arbitration rules to which the debt finance agreements are subject should, for obvious reasons, be stated to apply equally to the swap.

Bond finance Bond finance, although superficially similar, differs from traditional debt finance in a number of ways that are directly relevant to the swap component of the structure. While bonds often attract a floating rate of interest, it is not unusual for them to be issued as fixed rate instruments (analogous to the fixed rate loan instruments considered in Chapter 1) and
or for them to be inflation-linked, i.e. for outstanding principal to be pegged to, say, the Retail Price Index (RPI). The bond issue in Figure 6.2 displays the latter two characteristics. Since the SPV receives the entire proceeds of the issue upfront (contrast this with the flexibility of multiple drawdowns inherent in bank loan facilities), it usually places the proceeds on deposit with a syndicate of depositee banks. Such deposits are, typically, structured to pay a sub-LIBOR return and to give the SPV reasonably free rights of access, enabling it to meet its project payment obligations as they fall due. Where, as in our example, the bonds are fixed rate and
or inflationlinked, the mismatch between the return on the deposits and modelled inflation on the one hand, and the coupon on the bonds (calculated by reference to inflation-adjusted principal) on the other, needs to be hedged via a pair of swaps – one that pays the SPV fixed in return for LIBOR and a second that pays the SPV actual inflation in return for modelled inflation. As always, the principle of economic symmetry demands that the various fixed and floating 98

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Simplified project finance structure (bond finance)

Contractors/ licensors/ concessionnaires

Sponsor(s)

Equity

Figure 6.2

Dividends

Project agreements Actual inflation

Bond proceeds Bond investors

SPV

Modelled inflation LIBOR

Fixed (⫹/⫺ inflation) Bond proceeds

Depositees

Swap providers (depositees?)

Fixed

Security over (i) rights under project agreements LIBOR ⫺ (ii) net rights under swap agreements (iii) rights against Security depositees (until trustee bond proceeds exhausted) (iv) other assets

amounts are calculated in the same manner and paid on the same dates. In particular, each time the deposit reduces, the notional on the first swap will need to reduce correspondingly, otherwise the SPV will be increasingly exposed to LIBOR. If, therefore, the timing of reductions to the deposits is uncertain, the SPV will – unless it is prepared to pay upfront for the requisite degree of ‘swaptionality’ or to meet any swap break costs as they arise – have to face the fact that, for short periods at least, there will be economic asymmetry between the deposits and the swap. Conversely, but for similar reasons, the notional on the second swap will need to accrete in line with the inflation-adjusted bond principal. An accreting notional means that the second swap provider will, potentially at least, become an increasingly large claimant in relation to the security pool. It is not uncommon, therefore, for its right to participate in that pool to be capped or for it to be obliged to terminate the swap once an agreed exposure threshold has been reached. Note that bond interest is often calculated on the basis of a year of 360 (as opposed to 365
366) days and so the day count fraction for the swaps needs a corresponding election. Happily, bond and structured deposit documentation often draws heavily on ISDA-type calculation of interest provisions – a tendency that ought, in general, to facilitate the process of achieving economic symmetry. Note also that, although bifurcation of the first swap and the deposits leads to a mechanism that is transparent (which, 99

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in turn, ought to encourage a competitive tender process in relation to rates
margins for both instruments), it is possible for the two to be combined into a derivative-embedded deposit (often referred to as a ‘guaranteed investment contract’ or ‘GIC’) that pays the SPV a single amount calculated by reference to a fixed rate net of the spread below LIBOR that the deposits would have attracted on a stand-alone basis. Certain other bond characteristics are worth mentioning in the context of the swap arrangements. First, almost all public bond issues are rated and many are also ‘wrapped’ (i.e. scheduled payments of principal and interest are ‘guaranteed’, for a fee, by a highly rated insurer, financial guarantor or other credit protection provider). As noted above, the rating process will have a prescriptive influence on both the structure and the commercial terms of the swap. Questions will also arise as to the entitlement of the swap provider to the benefit of the credit wrap. Second, public bond issues must comply with the protocols of the exchange(s) on which the bonds are listed and, in particular, with the investor disclosure requirements of the relevant listing authority(ies). Accordingly, the terms of the swap – especially the enforcement rights and ranking of the swap provider on issuer default – will usually feature prominently in the offering circular and other pre-launch documents provided to potential investors. Third, private placements and other non-public bond issues are, typically, subject to a much less prescriptive regime. In such cases, negotiation of the swap documentation is a matter of common sense that involves blending the principles discussed in Chapter 4 with the criteria applicable to rated issues. Finally, as with debt financings, any international dimension to the bond issue is likely to have implications for the borrower’s hedging strategy as well as for the terms of the swap documentation.

PROPERTY FINANCINGS Property financings (development loans in particular) are characterized by three factors that are especially relevant to the swap component of the structure. The first is the by now thematic uncertainty that is associated with the duration of, and the timing of the funding requirement within, the property development period. The second is the historic tendency for commercial property to be held for long periods of time relative to the maturities to which bankers to the property sector are prepared to lend, coupled with significant differences in risk appetite – and therefore loan margins – as between financing for the development and post-development phases. Both factors give rise to frequent debt refinancings by borrowers. The third is the importance, influenced by debt serviceability considerations as well as loanto-value strictures, that is attached by bankers to the quality of the rental 100

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covenant, the periodicity of the rental income flow and the extent to which that flow is (or is not) correlated to LIBOR. We consider each of these factors in turn before looking at a number of issues that are relevant to a particular type of property finance borrower – housing associations.

Uncertainties in the development period Anecdotally, property development loans are among the first to have been hedged through interest rate swaps. As a result, many property developers and their bankers have become highly literate when it comes to formulating hedging strategy. In the current benign interest rate environment, for example, many defer the decision of whether and in what amount to hedge until completion of the development (by which time the swap notional can be set by reference to a fully drawn loan) and, even then, postpone it indefinitely or make it conditional on floating rates breaching one or more pre-agreed thresholds. Where implementation of the hedge is postponed, all parties need to be cognisant of the fact that the finance documents will, at the point at which the swap is introduced into the structure, need to be revisited. Where, by contrast, the lender insists and
or the cash flow sensitivities demand that the borrower hedges from the outset, the usual commercial and documentation issues – as well as the inevitable and associated timing uncertainties – will, as ever, need to be addressed. Away from the interest rate arena, attention is currently being focused on the potential of weather derivatives as a means to hedge one particular uncertainty of the development period – its length. A correctly structured cold winter call option, for example, will, for an upfront premium, provide generic compensation to a construction company for e.g. contractual penalties and
or cash flow difficulties that it encounters if, say, an exceptionally harsh winter hinders its progress.

Refinancing Refinancing seems almost to be a way of life in the property loans sector, giving rise to perennial challenges for borrowers in the context of their swap arrangements. Generally, as we have noted, it is the lending bank (or an affiliate of that bank) that provides the borrower with its swap. Related to this, any security (usually a charge over one or more property assets) that the borrower gives to the lending bank in respect of the loan will be expressed to extend to the borrower’s contingent obligations under the swap. Therefore, unless the maturity of the swap and the date of refinancing of the loan are coterminous, an out-the-money borrower faces several difficulties. Most obviously, it has 101

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to terminate or otherwise release the lender or its affiliate from its remaining obligations under the swap and, in either case, pay to the lender or its affiliate the out-the-money amount. Only then will the lending bank be prepared to release its security, a release that the borrower must have in order to be able to satisfy its refinancing bankers’ own requirements for security. If the borrower terminates the swap, it faces the problem of having to go back into the market and enter into a new swap, usually with the refinancing lender or one of its affiliates, that replaces the original swap. The fact that it is out the money in respect of the original swap generally dictates that the fixed rate that it locks in through the new swap will be lower than that which it was paying under the original swap (Annex 1 explains the logic behind this). That good news is heavily tempered by the fact that it has to pay to exit the original swap. While in pure mathematical terms the exit cost ought to be equal to the discounted ‘savings’ that it makes on the lower fixed rate going forward, there will in practice be transaction costs and credit spread differentials, as between the original and new swap provider, that will leave the borrower, in holistic terms, worse off. From a practical perspective, the requirement to pay the out-the-money amount may also give the borrower a cash flow problem – one that is hardly alleviated by the fact that its effective borrowing rate for the remainder of the life of the new swap has decreased. Figure 6.3 illustrates the dilemma. A novation, whereby the original swap remains in place but the new lender (or its affiliate) is substituted for the old lender (or its affiliate), may or may Termination and replacement

Figure 6.3

Principal Original lender and swap provider

LIBOR LIBOR

Borrower

Fixed (x%)

Termination payment (swap)

Refinancing payment (loan)

Principal Refinancing lender and swap provider

LIBOR LIBOR Fixed (y%, where y⬍x)

102

Borrower

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not be a better alternative. Much depends on how the out-the-money amount is to be settled between the parties and whether or not the fixed rate applicable to the post-novation swap is to be ‘marked to market’. The first alternative is for the new swap provider to make a payment to the borrower (or, better, directly to the original swap provider on behalf of the borrower) that reflects the fact that the borrower, post-novation, will be paying to the new swap provider a fixed rate that is off (i.e. above) market. While the amount that the new swap provider will be prepared to pay for the swap and the amount that the old swap provider will expect to receive, by way of compensation for giving it up, ought to be the same, there will in practice be differences in the way that the old and new swap providers calculate the respective amounts. Those differences may leave the borrower in the position of having to make (or, in theory at least, being entitled to receive) an adjusting payment. Figure 6.4 illustrates the cash flows. Novation to new swap provider (off-market fixed rate)

Figure 6.4

Adjusting payment?

LIBOR Original swap provider

Borrower Fixed (x%)

Novation payment

Novation LIBOR

Fixed (x%)

Novatee swap provider

The second alternative (and one that at least obviates the requirement for an adjusting payment) is analogous to the arrangement illustrated in Figure 6.3. Here the borrower treats the novation as if it were terminating the old (and entering into a new) swap and simply pays the old swap provider the out-the-money amount, simultaneously agreeing with the new swap provider a lower, at-the-money, fixed rate applicable to the postnovation swap. As before, however, there are potentially adverse cash flow implications for the borrower. Figure 6.5 illustrates the difficulty. There are at least four solutions to the problem of an out-the-money swap in a refinancing context. First, as always, is for the borrower to pay, at the outset of the original loan, for zero (or nominal or fixed) exit-cost optionality. A second, cruder alternative is for it to hedge only for short periods at a 103

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Novation to new swap provider (at-the-money fixed rate) Novation payment

LIBOR Original swap provider

Borrower Fixed (x%)

Novation LIBOR

Fixed (y%, where y⬍x)

Novatee swap provider

time – accepting the forward rate risk but reducing the potential for substantial break costs on a refinancing. Whether such a strategy would, over the long run, be acceptable to the original or any subsequent lender is debatable, however. A third possibility is for it to hedge through a swap provider that is independent of the original (and any subsequent) lender. If swap provider credit concerns could be alleviated – and a ‘travelling’ intercreditor mechanism devised that would keep refinancing negotiations to a minimum – such a solution would have much to commend it. A fourth alternative, seen from time to time in the market place, requires a little flexibility on the part of both the original swap provider and the new lender. Here the original swap provider remains in place (with the new lender as swap novatee) and it is the borrower that drops out of the picture, at least so far as the swap is concerned. The borrower instead takes a fixed rate loan from the new lender (calculated as the sum of the original swap rate plus the new lender’s credit and funding costs), which the new lender uses to satisfy its (post-novation) fixed rate payment obligation to the original swap provider. Assuming that the original swap provider and the new lender have mutual swap lines (and an ISDA 1992 Master Agreement or similar) in place, there are no real issues to consider, other than negotiation of the novation agreement and the usual fixed rate loan indemnity technicalities discussed in Chapter 1. Figure 6.6 provides an illustration. Swap novations may also occur outside of a refinancing context if, as occasionally happens, the entire project is novated by the developer to the project sponsor at the end of the construction phase. Here, over and above the familiar considerations of quantification and payment of the mark to market (this time as between the outgoing developer and the swap provider), 104

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Borrower novation to new lender (fixed rate loan)

Figure 6.6

Principal Original lender & swap provider

LIBOR LIBOR

Borrower

Fixed (x%)

Fixed (x%)

Refinancing payment (loan)

LIBOR

Refinancing lender & swap novatee

Principal Borrower Fixed (x% ⫹ refinancing lender’s credit/funding costs)

several other issues arise. First, it is conceivable that the project sponsor will have a better credit rating than the developer and it is right that it should ask for that to be reflected in the credit spread applicable to the swap postnovation. Second, for similar reasons, if the intended approach is to novate the existing ISDA documentation in its entirety (i.e. Master, Schedule and Confirmation), the project sponsor ought also to seek a softening of the representations, covenants and events of default applicable to it post-novation. In passing, especially given the number of amendments likely to be required to the terms of the existing Master and Schedule to make it ‘work’ for the project sponsor, a much better approach here is for the Confirmation alone (or, more accurately, the transaction whose economic terms it evidences) to be novated and for an entirely new Master and Schedule to be put in place between the project sponsor and the swap provider to govern the transaction going forward. Finally, of course, the question of legal capacity of the project sponsor to enter into the novation agreement and any related documentation (such as the new Master and Schedule) must, as always, be considered. There are several closing points worth making. The first is that the borrower faces far less serious difficulties when its swap is in the money at the time of the refinancing. Reconsideration of the various examples given above will quickly reveal that this is so. The second is that the difficulties, like the solutions, are common to refinancings in all markets. They just happen to crop up with greater frequency in a property finance context. Third, terminations and novations of swaps may, to the extent that 105

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they crystallize contingent assets and liabilities, have tax and accounting implications that the borrower ought to bear in mind. Fourth, the eventual disposal of the underlying property asset(s) will ordinarily oblige the borrower to prepay its loan. As noted in Chapters 3 and 4, that obligation will, with correctly drafted swap documentation, also trigger a related ‘prepayment’ (i.e. close-out) of the swap and a corresponding obligation, on whichever of the parties is out the money, to settle the mark to market. Finally, ISDA’s 2002-published, standardized form of novation agreement deserves a mention. Intended to reduce novation-related documentation and negotiation time, take-up of the new agreement has been much less enthusiastic, among end-users in particular, than the swap markets had anticipated. One reason for this may be that the document is imperfect, insofar as it fails to address the questions of quantification and settlement of the mark to market (it deals only with accruals up to the novation date) and fails to provide users with a convenient means of making point-of-novation amendments to key terms of the relevant transaction(s). Put another way, while it would, with minor amendment only, be adequate to novate the swap illustrated in Figure 6.6 (since, in that example, it is only accruals up to the novation date that need catering for and the fixed rate remains the same post-novation), it would be inadequate, without significant amendment, to novate the swaps illustrated in either of Figures 6.4 or 6.5. Historically – and perhaps the only reasonable explanation for ISDA’s reluctance (in spite of representations made to it at the committee level) to break new ground in this area – swap novation agreements have never documented the mark to market and what has happened, in practice, is that novating parties – their traders in particular – have been content to disregard the strict contractual terms applicable to the novation and to settle the mark to market by oral
side agreement. From the perspective of legal integrity, this is a curious and dubious state of affairs and, while perhaps justifiable as a practice in the inter-bank market, it is not at all helpful in an end-user context. An April 2003 practice note – ‘ISDA Statement on Consent Requirement for Transfer of Transactions’ – issued by ISDA’s Trading Practice Committee addresses some, though by no means all, of these issues, while the User’s Guide published concurrently with the novation agreement is more or less silent on the subject.

Rental income The importance of the rental income stream to the viability of many property finance structures cannot be overstated. So far as the credit quality of the rental covenant is concerned, credit default swaps may represent an obvious risk mitigant, particularly where institutional or other large corporate lessees are concerned. Closer to home, the broad principle of economic symmetry 106

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demands that the rental stream (which will be relied upon in many structures to service the borrower’s fixed rate payment obligation under the interest rate swap that hedges the underlying loan) is, in terms of the timing of its receipt, reflected as closely as possible in the payment dates under the swap. Ideally, in fact, the swap payment dates should post-date the rental receipt dates by a day or so, thereby building in a degree of tolerance in respect of late rental payments. Figure 6.7 provides a diagrammatic illustration. Rental receipt timing issues

Figure 6.7

Principal Lending bank & swap provider

LIBOR LIBOR Fixed (t1)

Borrower

Rental income (t1– 5?)

Lessee

Where the lessee has periodic break rights under the lease, the borrower will be exposed (to the ongoing fixed leg of the swap) if the lessee breaks but the borrower is unable to re-let the property, either at all or except at a lower rental than that prevailing prior to the break. Zero
fixed cost exit optionality operating in favour of the borrower on each lease break date will, albeit for a premium, help to mitigate these risks. A further structural issue, implicit in certain property financings, arises where rental uplifts are linked to an inflation index – e.g. RPI – and capital repayments on the loan are linked to an assumed rate of growth in respect of that index. This exposes the borrower to the additional risk (i.e. over and above its interest rate risk on the loan) that RPI will grow at a rate that is less than the assumed rate, leaving it with a funding shortfall so far as capital repayments on the loan are concerned. By entering into a second derivative – an RPI income swap – the borrower can mitigate both risks. Needless to say, drafting of the respective swap Confirmations, the loan agreement and (to the extent negotiable) the relevant lease requires skill and thought if the borrower is to avoid timing and
or basis mismatches between the various receivables and payables. With six payment streams to consider, that is no mean feat. Figure 6.8 illustrates the various cash flows. The economic facets of the structure set out in Figure 6.8 may be replicated by embedding the RPI income swap into a fixed rate loan instrument. Whether, as some lenders argue, that results in a contractual arrangement that is simpler, and therefore more attractive to a borrower, is open to question. It is true that derivative-embedded loans require less documentation than finance-linked swap arrangements but, as we observed in Chapter 1, they also lack transparency, are inseparable from the host obligation and give rise to numerous complexities so far as borrower indemnities are concerned. 107

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Interest rate and RPI income swaps in a property finance context

Figure 6.8

Principal Lending bank LIBOR (⫹ assumed RPI-linked capital repayments)

LIBOR Borrower

Interest rate swap

Fixed

Fixed RPI Swap provider(s)

Rental income (⫹ RPI-linked uplift)

Lessee

RPI income swap

Floating RPI

In addition, it is perhaps disingenuous of fixed rate lenders to say that ISDA documentation is overly complex when derivative-embedded instruments merely camouflage – rather than remove – the complexities. The truth is that a borrower is often just as exposed to close-out costs under a fixed rate loan as it is under a finance-linked swap. Under the latter, however, the exposure is much more obvious and ascertainable. The debate will not be resolved here but it does bring us, conveniently, to the subject of derivatives entered into by housing associations.

Housing associations Housing associations are not-for-profit organizations whose general purpose is the provision of housing accommodation. The vast majority are incorporated as industrial and provident societies under the Industrial and Provident Societies Act 1965, are regulated by the FSA and, in the case of housing associations having their registered offices in England, are registered with the Housing Corporation – as registered social landlords (‘RSLs’) – under the Housing Act 1996. Some housing associations are charities or charitable trusts, in relation to which any or all of the Charities Act 1993, the Trustee Act 2000, the consent of the Charity Commissioners and internal constitutional limitations will be relevant to the question of their capacity to enter into finance-linked swaps. Most RSLs adopt as their opening constitution a set of model rules recommended by the Housing 108

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Corporation, whose consent (as well as the acknowledgement of the FSA) is required to any subsequent change to those rules. Practical guidance on the ability of RSLs to enter into derivatives is set out in Housing Corporation Regulatory Circular 99
05 (that, together with Housing Corporation Regulatory Circular 99
04, replaces the former regime encapsulated in Housing Corporation Circular 11
95). Circular 99
05 stipulates that RSLs governed by standard model rules may only enter into interest rate and
or RPI-linked derivatives that are embedded into loan instruments. In practice, therefore, such RSLs are confined to fixed rate, capped rate or RPI-linked loans, to which the issues considered in Chapter 1 – particularly those relating to break cost indemnities – are highly relevant. An RSL may (using model forms of amendment recommended by the Housing Corporation) apply to the Housing Corporation for a ‘narrow’ or ‘broad’ change to its rules. Application for a ‘narrow’ rule change is relatively painless and, once completed, enables the RSL to enter into finance-linked caps. Application for a ‘broad’ rule change requires the RSL to satisfy the Housing Corporation that it is well versed in derivatives and in treasury management and control. If it can do that, it may be authorized to enter into a broad range of finance-linked swaps, caps, collars and swaptions. Note, in this regard, that Circular 99
05 uses the terms ‘loan instruments that incorporate derivatives’, ‘free-standing derivatives’ and ‘speculation’ to mean, respectively, ‘derivative-embedded loans’, ‘finance-linked derivatives’ and ‘pure stand-alone derivatives’ as those terms are used in this book. In all cases, aggregate derivative notional amounts must not at any time exceed the lower of the RSL’s borrowing limit (as set out in its rules) and its aggregate variable rate borrowings (including contractually committed but undrawn amounts) from time to time. In general, only £-denominated derivatives are permitted and the RSL’s governing body (or a duly authorized sub-committee established under its rules) must formally consider and resolve that each derivative entered into – whether embedded or financelinked – is in the best interests of the RSL. If the RSL does not have the requisite expertise (i.e. if, for all intents and purposes, the RSL is anything other than a broad rule change RSL), its governing body must additionally consult a suitably qualified and authorized advisor. Speculation (i.e. through pure stand-alone derivatives as that term is used in Chapter 1) is not permitted at all. Implicit in the foregoing is that the RSL must, on a loan prepayment, terminate any related swap (and bear the costs, if any, of such termination) unless it is able formally to ‘reallocate’ the swap to a specific liability elsewhere in its balance sheet. In light of the foregoing, document delivery obligations, additional representations, early termination rights and obligations and (to the extent not dealt with in the related loan agreement) additional events of default 109

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appearing within the relevant swap documentation should be couched accordingly. RSLs that have the flexibility to enter into both derivative-embedded loans and finance-linked derivatives must, inevitably, weigh up the advantages and disadvantages of each before deciding which is most appropriate to their circumstances. Whichever structure they adopt, however, there is no escaping the principles discussed in the preceding chapters of this book. It is noteworthy and encouraging, in this regard, that Circular 99
05 requires RSLs to pay particular attention, when entering into finance-linked derivatives, to the principle of economic symmetry, the possibility of break costs, the need for legal and regulatory compliance, the need for tax advice and the need to consider counterparty creditworthiness. If there is a criticism of the Circular, it is that it does not mention anywhere the importance of achieving credit symmetry or the technical issues that arise in relation to transferability of and security for finance-linked derivative exposures. Nor does it make explicit the obligation, on a loan prepayment, to terminate or ‘reallocate’ any related swap or the sanctions that flow generally from a breach of the applicable legal and regulatory environments.

PFI FINANCINGS PFI financings, being merely a specialized form of project finance, are characterized by structures not dissimilar to those illustrated in Figures 6.1 and 6.2. Under these, governmental and other authorities engage private sector contractors – usually via SPVs funded by the loan or debt capital markets – to embark upon long-term, capital-intensive, infrastructure projects ranging from hospitals and motorways to court houses and waterworks. Floating rate funding within such structures is often hedged with a finance-linked swap. Figure 6.9 provides a simplified illustration. Unlike most of the structures considered up to this point, practice relating to PFI financings is subject to a high degree of prescription in the form of recently published Office of Government Commerce (‘OGC’) Guidance, entitled ‘Standardisation of PFI Contracts – General Issue 3 (Revised, 2002)’. This ‘Primary Guidance’, as we shall refer to it, is intended to reduce negotiating time and to ensure consistency of approach and pricing across comparable PFI projects. In order to appreciate its significance for the swap component of such projects, however, it is first necessary to understand how the Primary Guidance evolved.

Evolution of the Primary Guidance A first and predecessor edition of the Primary Guidance was published in July 1999 under the auspices of the Government’s PFI Treasury Taskforce. 110

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Simplified PFI finance structure (bank debt)

Figure 6.9

Authority

Project agreement

Sponsor(s)

Dividends

Construction, services, etc. agreements

Equity Principal Lending banks

Sub-contractors, service providers

Fixed SPV

LIBOR

LIBOR

Swap provider (a lending bank?)

Security over (i) rights under project, construction and service agreements (ii) net rights under swap agreement Security (iii) other assets trustee

This did not contain anything of substance on interest rate hedging. In April 2000, the OGC assumed responsibility for the Primary Guidance and soon afterwards engaged Partnerships UK plc (‘PUK’) to begin the task of redrafting it. During 2002, on the back of numerous discussion drafts, a revised document was published. This was later supplemented by a separate paper – ‘Guidance on Certain Financing Issues in PFI Contracts’ – that we shall refer to as the ‘Supplementary Guidance’. For present purposes, it is instructive to compare certain aspects of the discussion draft that immediately preceded the Primary Guidance with the version that was ultimately published. In particular, whereas the former included separate chapters on, respectively, ‘Using the Capital Markets for Finance’ (originally, Chapter 34) and ‘Interest Rate Risk and Hedging’ (originally, Chapter 35), the published document has moved what was Chapter 34 into Section 2 of the Supplementary Guidance and has dispensed altogether with what was Chapter 35. At the same time, it has retained a number of ad hoc, hedging-related comments that appeared (outside of Chapters 34 and 35) in the discussion draft. 111

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Section 2 of the Supplementary Guidance Section 2 of the Supplementary Guidance (‘Using the Capital Markets for Finance’) is, for all intents and purposes, identical to Chapter 34 of the discussion draft that immediately preceded the published version of the Primary Guidance. It contains a useful introduction to the bond markets that, reminiscent of the discussion on project financings at the beginning of this chapter, considers, among other things, whether to hedge bond-originated deposit proceeds with discrete interest rate
RPI-linked derivatives or via a GIC. It does not, however, go into any detail so far as the swap arrangements are concerned. While Section 2.11.5 notes, for example, that ‘the [bond proceeds] swap counterparty may wish to be secured’, it goes on to say only that ‘the actual swap security arrangements for the swap will vary from project to project’. It omits to mention the resultant intercreditor implications. Similarly, while Section 2.11.7 advises authorities to note that the bond proceeds swap ‘will be documented by way of a modified ISDA Master Agreement so that the terms will be based on a standard form document’, it does not say what those modifications should be. Nor does it mention the role of the Confirmation or the importance of achieving symmetry between the swap and deposit terms. To its credit, the same Section does point out that ‘the [swap] documentation should provide clearly for the outcome should the swap be broken’ and later, at Section 2.12.2, suggests that ‘swap breakage is to be included in the definition of Senior Debt for the purposes of compensation on termination’. We will return to the significance of these latter points shortly.

Old Chapter 35 As noted above, what was Chapter 35 of the pre-publication draft of the Primary Guidance has vanished altogether. According to sources at PUK, a last-minute decision was taken to withdraw it on the grounds, first, that the subject matter was too specialized to sit within the main body of the Primary Guidance (and so, like the section on Capital Markets, deserved to be treated in supplementary fashion) and second, that the entire text was in need of further research and drafting. According to the same sources, a supplement on interest rate hedging is an agenda item for PUK that may make its appearance in 2003
4. The observations that follow (all, it is to be remembered, relating to a chapter that did not make it into publication) are intended to assist that process. Encouraging is the chapter’s recognition that the hedge needs to be included as a discussion item early on in the project and that various hedging instruments (including pre-drawdown swaptions and long-term swaps with 112

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break rights) are available to contractor borrowers. Equally encouraging is its discussion on strategy and, in particular, on timing, pricing and implementation of the hedge. There are also insightful observations, such as ‘interest rate risk and its management should not be an after-thought’ and ‘the skills required to provide expert advice on interest rate hedging strategy and execution will not always be found within the firm chosen to provide all other aspects of financial advice’. Certainly, all of these themes are consistent with the findings and recommendations set out in this book. Where the chapter is less helpful, however, is in relation to the more technical aspects of integrating a finance-linked swap into a PFI structure. There is, for example, no mention of the concepts of economic or credit symmetry, no discussion of the implications of a prepayment or transfer of the loan or the swap, only cursory references to security
intercreditor issues and closeout costs, and no reference at all to legal or regulatory considerations. In particular, the statement that ‘both sides of [the] swap are carried out using standard form ISDA documentation’ is unhelpful and inaccurate when read in the light of earlier chapters of this book. It is hoped that PUK will address these shortcomings in the relevant supplement in due course.

Ad hoc hedging considerations within the Primary Guidance Oddly, the Primary Guidance retains several references to interest rate hedging that now seem out of place following the withdrawal of old Chapter 35. The paragraphs on the requirement to calculate swap breakage costs in accordance with ISDA-based Second Method
Market Quotation methodology, set out at Section 34.2.1, and on interest rate hedging in a refinancing context, set out at Section 35.4.4, are cases in point. As before, it is hoped that PUK will rationalize these sections within the relevant supplement in due course.

Guidance on termination and refinancing A large part of the Primary Guidance is taken up with the question of what happens if either the authority or the contractor defaults on their respective obligations under the project agreement or if the parties wish to refinance the project. We consider each in turn. Termination

The Primary Guidance deals with the consequences of three principal (and a number of subsidiary) types of termination event: authority default, authority voluntary termination and contractor default. In relation to the first two, the Primary Guidance requires the authority to make a payment to the contractor that, broadly, ensures the contractor’s exit from the project at zero cost and with a degree of compensation for lost profits. A large part of 113

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the payment will, therefore, comprise the amount of project-incurred debt that is outstanding at the relevant time. In relation to contractor default (including insolvency), the Primary Guidance takes an understandably different approach. Here the authority is required to pay compensation that reflects the market value of the project at the relevant time (which may be zero). Lender concerns in this regard are mitigated, to an extent, by rights to step into (and back out of) the shoes of the defaulting contractor, so as to continue or bring to an end the project according to its viability. What is important for our purposes is the treatment of the related swap on the occurrence of any of these termination events. While, as noted above, neither old Chapter 35 nor the Primary Guidance contains anything of relevance, there are some clues within the Supplementary Guidance. How helpful these are is a matter of debate, since the Supplementary Guidance governs, from a hedging perspective, only those costs that arise from a break of the swap that hedges the deposit proceeds of debt capital market financings. Nevertheless, it is a starting point. Implicit in Sections 2.11.7 and 2.12.2 of the Supplementary Guidance, in particular, is the suggestion that, on a termination of the project (for anything other than a contractor default), the swap should be broken and the relevant break cost
gains taken into account for the purposes of calculating the amount of compensation payable by the authority to the contractor. There are, however, many unanswered questions here. First, in whose hands should the power to terminate the swap reside – the contractor, the lenders and
or the swap provider? And should such termination rights not be tempered to reflect the election of an authority to pay compensation over time (as contemplated by Section 21.5 of the Primary Guidance)? Second, why does Section 2.12.2 of the Supplementary Guidance seem to differentiate between break costs (to be added to the amount of senior debt for the purposes of determining the amount of authority compensation payable) and break gains (simply to be paid back to the contractor – why not, for consistency with the definition of ‘Senior Debt’ at pages 17 and 18 of the Primary Guidance, deducted from the amount of senior debt)? Related to this, how is the break cost component of any authority compensation payment to be routed out of the contractor’s and into the swap provider’s hands? Similarly, how are break gains received by the contractor from the swap provider to be apportioned between the various parties? In either case, how are the relevant break amounts to be calculated? In this regard, there is no reference to methodology or quantum (both of which, it is suggested, ought to mirror what is in the swap documentation) in any of the model ‘compensation on termination’ provisions suggested by the Primary Guidance. What, additionally, is intended to happen to the swap on a contractor default and
or following a lender step-in or subsequent step-out? Who, for example, is to pay the swap provider post-step-in? 114

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Last, but not least, how is the lack of legal capacity that prevents local authorities from entering into swaps to be squared with the obligation on such authorities to compensate PFI contractors for swap break costs? Is it simply enough to say that, once a swap has been terminated, the amount payable represents a liquidated damages claim, the payment of which is within the legal capacity of local authorities? Or is a swap contract to be construed as a ‘form of finance’ legitimized by Section 1(2)(b) of the Local Government (Contracts) Act 1997, itself specifically aimed at allaying concerns of the private finance sector in relation to transactions entered into with local authorities? Or is there something else? It is curious that there does not appear to be a single line of discussion on this particular issue anywhere in the literature, not even in the extensive ‘Guide to the Local Government (Contracts) Act 1997’, published in 1998 under the auspices of the Public Private Partnership Programme, that otherwise provides an indepth analysis of the workings of the new act. Again, it is to be hoped that PUK will tackle these issues head on in its forthcoming supplement. Refinancing

Refinancing of PFI structures is dealt with in Chapter 35 of the Primary Guidance (new Chapter 35, that is, not the old Chapter 35 discussed above), as supplemented by a further guidance note, ‘Calculation of the Authority’s Share of a Refinancing Gain’, issued by the OGC on 31 July 2002. These, together, provide that any financial benefits arising out of a refinancing must, as a general rule, be shared between the project investors and the authority – subject to various exemptions, one of which relates to the ongoing swap arrangements. Section 35.4.4 of the Primary Guidance, in particular, suggests that if the contractor can lock in lower fixed rates under a new swap contract post-refinancing, it is exempt from sharing that ‘gain’ with the authority so long as (a) in circumstances in which the new swap is intended to be included as a compensation item following a future authority default or voluntary termination, the authority consents to that inclusion; (b) the contractor bears all interest rate risk going forward (other than, presumably, any break cost implicitly assumed by the authority under (a) above); and (c) the ongoing project cost to the authority is calculated on the basis of market (presumably, floating) rates of interest (that cost to be adjusted, as appropriate, to take account of the contractor hedging some, but not all, of the forward interest rate risk implicit in the remaining term of the project). But here, as before, there are some unanswered questions, not least the issue of what is to happen to the existing swap arrangements on a refinancing – an issue that, as we saw in the context of property refinancings, throws up 115

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as many technical difficulties as it does possible solutions. It is to be remembered, in this regard, that a borrower can lock in a lower fixed rate at the point of refinancing (exactly the situation contemplated by Section 35.4.4) only by doing one of two things – either terminating and replacing the original swap or novating and adjusting it. In either case, it must make an appropriate mark-to-market payment to the original swap provider. Nowhere is this explicit in the OGC guidance papers, although there is an acknowledgement, in paragraph 2.23 of a PFI refinancing update report released by the Comptroller and Auditor General on 7 November 2002, of ‘evidence that some authorities are insufficiently aware of the issues’. Having said that, the update report itself does not once mention the sharing of swap gains and again, therefore, the issue ought perhaps to be addressed by PUK in its forthcoming supplement.

MBO FINANCINGS The final section of this chapter is concerned with swaps that are linked to the debt component of management buy-out transactions, although the principles discussed are of equal relevance to most leveraged acquisition finance and private equity transactions, including ‘public to privates’. A typical MBO finance structure is illustrated in Figure 6.10. Aside from endemic poor practice so far as the hedge is concerned (witness the fact that much of the anecdotal evidence offered in Chapters 1 to 5 owes its existence to the MBO markets), there are three factors that Typical MBO finance structure

Figure 6.10

Equity providers Equity Dividends Acquisition monies

Principal Lending bank(s)

Newco/ borrower LIBOR

LIBOR

Swap provider(s)

116

Fixed

Vendor Shares/assets

100%

Target/target assets (post-acquisition)

100%

Target/target assets (pre-acquisition)

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differentiate MBO financings from the other structures considered in this chapter. The first is that a relatively high number of MBO transactions fail to complete. Most are highly leveraged, which makes for nervousness in general and also contributes to a reluctance on the part of all parties to make concessions in negotiation. Public to privates are additionally vulnerable to failure of the relevant bid for want of acceptances. Unsurprisingly, then, the swap is often expressed to be a condition subsequent to drawdown of the loan and, for this reason as much as the sense of relief that greets a successful completion, the related ISDA documentation is generally subjected to little or no scrutiny. Second, certain of the larger private equity houses are party to Memoranda of Understanding (‘MoUs’) with various UK lending banks that seek to standardize the intercreditor position between such houses
banks in relation to co-funded acquisition finance transactions. Although MoUs are stated to be non-legally binding and are generally subject to the caveat that the principles espoused in them may not be applicable to larger and
or syndicated and
or multi-layered transactions, they are nevertheless highly persuasive. Indeed, they are often ‘adopted’ in the context of transactions co-funded by private equity houses that are not party to MoUs of their own. It is remarkable, then, that nowhere in any of the MoUs that are current in the market is there any discussion of or provision for swap-related credit exposures arising under hedged MBO financings. As observed in Chapters 3 and 4, a comprehensive intercreditor agreement ought, in relation to the swap as much as any other component of the structure, to contain provisions dealing with ranking, subordination and priority of claims, voting and enforcement rights, security for net amounts payable by the borrower, redistribution of net amounts payable to the borrower and so on. Even basic intercreditor arrangements of the type contemplated by MoUs cannot (but nevertheless do) ignore all of these considerations. The third factor is the question of ‘financial assistance’ under s151 et seq. of the Companies Act 1985 that complicates the picture for a great many (share-based) MBO transactions. A detailed consideration of the law in this regard is beyond the scope of this book and the reader who is unfamiliar with the difficulties (or the ‘whitewash’ procedure that, for private limited companies at least, offers a solution) is referred to Chapter 11 of Maurice Dwyer’s Private Equity Transactions, listed in the bibliography, for a comprehensive analysis. For those to whom the law is familiar, we concentrate on three simple structures to illustrate some of the financial assistance issues that arise in relation to the swap.

Lending bank and swap provider as same entity The simplest case arises where the lending bank and the swap provider are 117

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the same entity and the target company provides security for the borrower’s obligations under both the loan and the swap. Figure 6.11 provides an illustration. Figure 6.11

Financial assistance: lending bank and swap provider as same entity Principal Lending bank & swap provider

LIBOR LIBOR

Newco/ borrower

Fixed 100%

Security

Target

There is little doubt that the security given by target in Figure 6.11 constitutes financial assistance. Accordingly, the statutory declaration of target’s directors, the net assets letter of target’s auditors and, to the extent required, any special resolution of target (together, the ‘supporting papers’) ought, in detailing the nature and principal terms of the financial assistance, to make reference to both the loan and the swap. As obvious as this seems, the swap (particularly where it is a condition subsequent to the drawing of the loan) is sometimes – particularly in small-ticket transactions – not referred to at all. Practitioners will, if questioned in this regard, usually point out that the borrower gives to the lending bank (qua swap provider) an express indemnity for swap termination costs in the loan agreement and that the security is in any event ‘all monies’ – so, the argument goes, as long as the security is correctly whitewashed and as long as the loan agreement is itself referred to in the supporting papers, the lending bank has good security for its exposures under both the loan and the swap. There are, however, several difficulties with this line of reasoning. First, it is circular to argue that omitting to refer to the swap is unproblematic provided that the security is correctly whitewashed when the supporting papers are missing the very detail – a reference to the swap – that is required to make the whitewash correct in the first place. Second, if the ‘all monies’ argument holds water, why detail anything at all in the supporting papers? Third – and related to the first two points – omitting to refer to the swap sits uneasily with dicta of Mummery J. in Re SH & Co. (Realisations) 1990 Ltd [1993] B.C.C. 60 to the effect that practitioners should, in cases of doubt as to what level of 118

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detail to include in the supporting papers, err on the side of caution. Fourth, as noted in Chapter 4, the inclusion of swap break indemnities in loan agreements is duplicative and illogical. Since such indemnities are bound eventually to disappear if best practice in relation to finance-linked swaps is followed, there will be nothing for proponents of the argument to hang their hats upon. Taking all these points into account, it is difficult to see any case for omitting to refer to the swap in the supporting papers. Even if the swap is a condition subsequent, it should be referred to contemplatively in the supporting papers. This (assuming that the security documentation is correctly drafted) has nothing to do with the eight-week (maximum) window period between the entering into of the supporting papers and the giving of the financial assistance – as imposed by s158 of the Companies Act 1985 – and everything to do with good practice of the sort outlined above.

Lending bank and swap provider as different entities Where, as illustrated by Figure 6.12, the lending bank and the swap provider are different entities, the analysis is even more compelling, insofar as the loan agreement in the two-party scenario is highly unlikely to contain break indemnities in favour of the swap provider. It is therefore difficult, in such circumstances, to see any argument in favour of incomplete supporting papers. Financial assistance: lending bank and swap provider as different entities

Figure 6.12

Principal Lending bank

Newco/ borrower LIBOR

Security trustee

LIBOR

100% Fixed

Swap provider

Target

Security

‘Indirect’ security structures A gloss on the two-party scenario is where the lending bank and the swap provider are affiliated and an ‘indirect’ security structure of the sort encountered in Chapter 3 is employed. Figure 6.13 provides an illustration. 119

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Financial assistance: ‘indirect’ security structure

Counter-indemnity Lending bank Guarantee (of borrower’s obligations under swap)

Newco/ borrower Guarantee (of swap provider’s obligations under swap) 100%

100%

Swap provider

Security (for loan and for counterindemnity)

Target

Here, if properly drafted, the supporting papers ought to refer not only to the loan and the swap but also to the counter-indemnity given by the borrower in favour of the lending bank relating to the latter’s guarantee in favour of the swap provider. In practice, a duplicative and illogical approach is taken in relation to the counter-indemnity, which often appears both in the loan agreement and as a Part 3 document delivery item within the relevant ISDA Schedule. That duplication does not, for reasons already given, support an argument for omitting to refer to the counter-indemnity in the supporting papers. Having concluded our survey of common finance-linked swap arrangements, we now turn to consider, in Chapters 7 and 8, a number of specialized applications.

120

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Overview Purpose of swap Illustrative structures Rating agency approaches and criteria Significance for swap documentation Significance for swap providers

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OVERVIEW This chapter examines two specialised but prevalent forms of linked swap arrangement – repackagings and securitizations. As noted in previous chapters, such transactions tend to be big-ticket, highly engineered and subject to a material degree of prescription in the form of rating agency criteria. We consider various illustrative structures, compare the broad approaches and criteria of the leading rating agencies in relation to the swap component of such structures and explore the significance of the approaches and criteria for both the swap documentation and the related swap provider(s). We begin, however, by making some general observations on the purpose of the swap and, related to that, the role of the swap provider within a typical arrangement. For the most part, the analysis that follows focuses on the interest rate and
or cross-currency components of the relevant structure. This is deliberate. Credit default and total rate of return swaps – as employed in several of the structures – are a specialist subject in their own right (indeed are treated as such by the rating agencies) and do not properly belong in a book on dayto-day hedging instruments. Accordingly, they and their related criteria are considered in passing only. In addition, much of the analysis in Chapters 3 and 4 of this book is, to the extent not explicitly
implicitly addressed by the rating agency criteria, applicable by analogy to the structures considered in this chapter. We do not repeat that analysis here but the reader will do well to keep it in mind.

PURPOSE OF SWAP Hitherto, the role of the swap has been simply to alter the properties of one or more cash flows, most commonly from a floating into a fixed rate of interest, from one currency into another or from a floating into a fixed rate of inflation – in each case within structures that have necessitated one or, at most, two swaps. In repackaging and securitization transactions, by contrast, each swap serves one or both of two additional purposes (considered below) and the number of swaps employed varies according to the homogeneity or otherwise of the underlying assets. If these pay in different currencies and
or by reference to different interest rate sources, for example, a separate swap may be required in respect of each asset, and even if the assets are capable of being grouped into classes, each of the classes will usually require its own swap. 123

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As for the additional purposes, the first of these is to act as a smoother in respect of unpredictable and
or ‘lumpy’ cash flows generated by the underlying assets. Smoothing is achieved both by requiring the relevant SPV to make payments under the swap only on or after scheduled payment dates with respect to such assets (and only then in an amount that does not exceed what it has actually received) and by ensuring that it receives payments under the swap (or, if the swap provider is in default of those, under any related guarantee) in good time to meet its payment obligations to investors. These two mechanisms are often supplemented by a liquidity feature that obliges the swap provider to continue to pay under the swap even though the underlying assets have paid late (or insufficiently or not at all) and even though the SPV cannot, as a result, meet its own payment obligations to the swap provider. Unless, however, the transaction has been structured in such a way that credit risk on the underlying assets resides with the swap provider, this feature is not open-ended. Aggregate permitted shortfalls will usually be subject to a cap and the SPV will ordinarily be under an obligation to reimburse the swap provider in respect of accrued shortfalls, together with interest, on the next following (or, occasionally, next following but one) payment date following their occurrence. The second additional purpose of the swap is to serve as credit enhancement. Credit enhancement is implicit in the smoothing and liquidity features considered in the previous paragraph but it also manifests itself in other ways. The fact that the swap provider is rated and
or guaranteed by a rated entity (one or the other is generally a prerequisite of the rating agencies) is in itself a form of credit enhancement, particularly insofar as the SPV’s rights against the swap provider form part of the security package entered into by the SPV for the benefit of investors. In respect of its own rights against the SPV, the swap provider will expect to be positioned favourably (preferably at or above the ranking of senior noteholders) in any security or payment waterfall. The usual exceptions are if it is itself in default or if it is downgraded (its subordination in these instances protecting noteholders in respect of out-the-money amounts due by the SPV to it on an early termination of the swap or a novation of the swap to a higher rated provider) or if commercial or regulatory considerations necessitate an inferior ranking. Along with other creditors in the waterfall, the swap provider will be required to enter into appropriate limited recourse and non-petition covenants that effectively ring-fence the liabilities of the SPV. It will usually also be subject to an obligation, if it (or any guarantor of it) is downgraded during the life of the transaction, to post collateral, provide a guarantee (or a replacement guarantee) or, as noted above, procure a novation of the swap to a suitably rated third party, in each case on terms reasonably acceptable to the SPV and approved by the note trustee and the rating agencies for the deal. Since none of these enhancements is of value if the swaps (and any 124

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related guarantee) are unenforceable, local legal opinions will be required that address not only enforceability but also pari passu ranking, withholding tax (on which more later) and conflict of law concerns. Just as the purpose of the swap varies in repackaging and securitization transactions, so does the role of the swap provider. In a great many repackagings, for example, the swap provider not only takes centre stage in arranging the deal but also fulfils a variety of calculation and other agency functions on behalf of the SPV, particularly where the SPV is little more than a name in a register or a plate on a wall. Similarly, where the swap is syndicated or put out to tender, it is helpful for a ‘lead’ provider to be able to co-ordinate the tender process, marshal the other providers, harmonize the inevitable inconsistencies that exist between their house precedents and work with the relevant agencies to ensure a conformed and rating-compliant approach to the swap documentation. A final and important difference between swaps in a repackaging and securitization context and those examined in earlier chapters is the fact that, under the former, the investor base is invariably a disparate group that is entirely unrelated to the swap provider. It is this factor more than any other that explains why rating agency criteria applicable to repackaging and securitization transactions are as they are and why the General Rule considered in Chapter 4 is not the most appropriate means of documenting swaps that are linked to such transactions. While certainly there exist more than passing similarities between the two methodologies, the rating agency criteria are necessarily different insofar as they have to strike a balance between investor concerns to ensure continuity of the swap and swap provider concerns to be able to terminate the swap in certain circumstances – concerns, as we have seen, that are much more easily addressed where the swap provider and lender are one and the same or are closely affiliated.

ILLUSTRATIVE STRUCTURES A detailed analysis of the commercial and legal influences that underpin repackaging and securitization transactions (as well as their constituent documentation) is beyond the scope of this book and what follows is intended only to put the interest rate and cross-currency swap components of the various structures into context. If there is a point for the reader to take away, it is that the swaps, even though they operate behind the scenes, are an important feature of repackaged and securitized notes; and that the noteholder, as a result, has a legitimate interest in the rights (in particular, the termination rights) of the swap provider and the SPV under the same. Where the notes are rated (as is the case for most securitizations and the majority of repackagings), 125

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rating agency criteria serve usefully to delineate those rights. Where the notes are unrated, the onus is on investors and their advisors to scrutinize the relevant prospectus for unusual or prejudicial swap terms and to modify their investment decision accordingly. It goes without saying that rating agency criteria serve as a useful benchmark for unrated transactions.

Repackagings Repackagings evolved in the mid-1980s as a securitized variant of asset swaps – a generic class of financial instruments that enabled the cash flows from a given security to be ‘repackaged’ into a synthetic asset possessing greater investor appeal. Under a typical asset swap, an investor would buy a security – by definition, one that it did not want – the coupon on which would then be swapped out for a customized interest rate and
or currency profile that it did want (‘real’ securities having that same profile being, by definition, unavailable to it). Typically, the security seller and swap provider would be the same entity and the two transactions would be marketed and sold to the investor as a complete package. Figure 7.1 sets out the basic structure. Basic asset swap structure

Figure 7.1

Purchase monies Security

Coupon

Investor

Security Coupon equivalent

Security seller/ swap provider

Desired/ synthetic coupon

Asset swaps suffered several drawbacks. First, they presupposed that the investor had legal capacity (and was otherwise permitted) to transact derivatives. Second, the existence of an asset transaction on the one hand and a swap transaction on the other exposed the investor to two sets of credit risk as well as the burden of having to mark to market, account for and discern tax treatment across two separate instruments (this was long before hedge accounting under IAS 39). Third, asset swaps were inherently illiquid. If it was to be traded, the entire structure had to be unbundled, i.e. the asset had to be sold to the new investor and, unless the original swap provider was prepared to agree to a novation, the swap had to be broken by the original investor and entered into afresh between the new investor and a different swap provider – with attendant credit transference and break cost implications in both cases. Not surprisingly, asset swaps attracted limited interest in the private investor market and were (and still are) seldom seen outside of the inter-bank market. 126

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If one stops to think about these arguments, it is apparent that they are analogous to the very same drawbacks that have occupied us throughout this book in relation to liability swaps. Conceptually, there is no difference between a swap that hedges a loan and a swap that repackages an asset – except, perhaps, that asset swap investors are, almost by definition, sophisticated and well advised and, further, have a choice as to whether or not to enter into the arrangement. Finance-linked swap investors (i.e. borrowers), on the other hand, may be unsophisticated and have little choice to the extent that the entering into of the swap is a condition precedent (or subsequent) to the drawing of the loan. These conceptual similarities suggest that the principles espoused in the earlier chapters of this book with respect to liability swaps ought to apply equally to asset swaps. In relation to the structure set out in Figure 7.1, for example, a degree of engineering to the swap documentation seems almost inevitable – both to ensure economic symmetry between the coupon received on the security and the ‘coupon equivalent’ payable under the swap and to give the investor certain additional termination rights analogous to those accorded to borrowers in respect of liability swaps. In the latter regard, it is suggested that the investor ought at the very least to have an express right to unwind the swap transaction in contemplation of a sale of the underlying security and
or following a prepayment or default by the underlying issuer. Whether approaches to asset swap documentation have ever been consistently this scientific is doubtful and it is not unusual to see asset swaps documented as if they were stand-alone transactions. Yet, in principle, it is difficult to see why this should be so. Repackagings, by contrast, possess virtually none of the impediments traditionally associated with asset swaps. They achieve the same economic end, i.e. the repackaging of one income flow into another that is more marketable, but do so in a way that leaves investors holding ‘real’ securities that are liquid and tradable and that have the capacity to be listed and rated as well as cleared and settled through institutional clearing systems. Adopting conventional note issuance and securitization technology, they work as follows. The arranger – itself invariably the swap provider – establishes a bankruptcy-remote SPV, usually offshore, for the purpose of issuing notes that possess the desired coupon characteristics. The SPV uses the proceeds of the issue contemporaneously to purchase (usually from the market via the arranger) the underlying assets – these serve additionally to collateralize the SPV’s obligations to investors – the income from which is swapped out to give the SPV the cash flow necessary to service its coupon payment obligations under the notes. Figure 7.2 provides an illustration of a simplified repackaging structure employing a $
EUR cross-currency swap. From an investor perspective, the structure works very well. The investor holds a liquid instrument and has been spared the negotiating burden, 127

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Simplified repackaging structure ($
EUR)

Figure 7.2

Subscription monies ($) Investors

$ Principal SPV

EUR principal EUR coupon equivalent

$ Coupon

Swap provider/ arranger

$ coupon equivalent EUR purchase monies

EUR coupon

Security trustee

Underlying assets

Market

ongoing payment and settlement administration duties and credit and closeout risks associated with conventional asset swaps. It retains credit risk on the underlying issuer(s) and is indirectly exposed if and to the extent that the arranger defaults on its obligations under the swap, but otherwise is party to a much more satisfactory arrangement. Equally, the arranger benefits from the administrative flexibility and economies of scale that typify large-scale, proprietary note issuance and securitization programmes. These benefits – as well as speed of execution generally and the ability to ‘brand-leverage’ the product – can be further exploited if the arranger employs a multiple issuance or multiple issuer structure. Under the former, a single SPV is established as before but it issues multiple series of notes (as opposed to a single, stand-alone issue). Figure 7.3a provides an illustration. Multiple issuance structure

Figure 7.3a

Assets/Swap #1

Issue # 1

Firewall Assets/Swap #2

SPV

Issue # 2

Firewall Assets/Swap #3

128

Issue # 3

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Under the latter, a separate SPV is established for individual issuances but a common and global documentary framework is employed. Figure 7.3b provides an illustration. Multiple issuer structure

Assets/Swap #1

SPV # 1

Assets/Swap #2

SPV # 2

Assets/Swap #3

SPV # 3

Figure 7.3b

Issue # 1

Common note programme

Issue # 2

Issue # 3

The two techniques may also be combined into a multiple issuer
multiple issuance structure. Figure 7.3c provides an illustration. Multiple issuer
multiple issuance structure Assets/Swap #1

Figure 7.3c

Issue # 1A

Firewall Assets/Swap #2

Issue # 2A

SPV A

Firewall Assets/Swap #3

Issue # 3A Common note programme

Assets/Swap #4

Issue # 4B

Firewall Assets/Swap #5

SPV B

Issue # 5B

Firewall Assets/Swap #6

Issue # 6B

Where multiple series of notes are issued out of the same SPV, a key legal concern is to ensure an effective segregation of the underlying assets as 129

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between different series of notes. In the benign legal environment that characterizes many offshore jurisdictions, that challenge is usually overcome by means of limited recourse and non-petition covenants (so called ‘firewalls’) entered into between the SPV and investors. One particular advantage of multiple issuer and
or issuance structures is that a pro-forma ISDA Master Agreement and Schedule can be agreed at the outset and incorporated by reference into each subsequent Confirmation (ordinarily, of course, it is the Confirmation that is incorporated by reference into the ISDA Master). Each Confirmation will need to identify the issuer and the issuance and, for reasons that hark back to the discussion on pre-Master Confirmations in Chapter 4, Section 1(b) of the pro-forma will need to be amended to ensure that, in the event of any inconsistency, it is the pro-forma (and not the Confirmation) that prevails – but otherwise the practice has much to commend it. It is an efficient means of documenting such structures and has the added benefit that a periodically updated, generic legal opinion in respect of the pro-forma will satisfy much of the rating agency’s requirement for ongoing legal due diligence. A notable exception arises in the context of multiple issuance structures, in relation to which the rating agencies will usually want to reexamine the payer and payee tax representations on the occasion of each and every issuance. An extension of the basic asset swap
repackaging structure is the repackaged credit-linked note. Two broad categories of transaction are identifiable, both of which combine credit default or total rate of return swaps with conventional repackaging technology to synthesize an asset whose income as well as credit risk profile is consistent with investor objectives. Under both categories, the SPV takes the credit risk implicit in a portfolio of underlying assets and repackages it as exposure to a third party – either the credit swap provider itself or a named reference entity. The investor’s motivation in either case is to acquire credit exposure that is otherwise unavailable to it in the cash market and
or to achieve a return above that obtainable from a direct investment in or loan to the relevant credit swap provider
reference entity. Figures 7.4a, b and c illustrate three typical structures. For simplicity, these omit the interest rate or cross-currency swap(s) that may, as in the conventional asset swap
repackaging transactions considered earlier, be necessary to reprofile the cash flows generated by the underlying assets. Under the first structure (Figure 7.4a), the SPV pays to the credit swap provider an amount equal to periodic principal and coupon received on the underlying assets in exchange for an enhanced LIBOR flow that it uses to service the coupon on the notes. At maturity, the swap provider makes a par payment to the SPV (used by the SPV to redeem the notes) and receives the underlying assets (or their sale or liquidation proceeds) in return. Credit risk on the underlying assets resides with the credit swap provider while investors run credit risk on the credit swap provider in respect of the maturity payment. 130

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Repackaged credit-linked note: exposure to credit swap provider (forward sale/total rate of return structure) Subscription monies Investors

Figure 7.4a

Principal & coupon SPV

LIBOR ⫹

LIBOR ⫹

Credit swap provider

Par payment at maturity Purchase monies

Principal & coupon

Underlying assets

Market

Under the second structure (Figure 7.4b), the SPV receives a periodic fee from the credit swap provider for writing credit protection in the latter’s favour on a named reference entity (which may or may not be the issuer of the underlying assets). Principal and coupon on the underlying assets, together with the fee from the credit swap provider, are paid via the SPV to investors, giving them, as before, an enhanced return. On the occurrence of a credit event with respect to the reference entity, the SPV liquidates the underlying assets and makes a compensating payment to the credit swap provider (based on the post-default value of specified obligations of the Repackaged credit-linked note: exposure to named reference entity (credit default structure) Subscription monies Investors

Figure 7.4b

Fee Credit swap provider

SPV (Net) principal & coupon & fee

Contingent payment

Principal & coupon

Underlying assets

Purchase monies

Market

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reference entity), the balance – if any – being paid over to investors. In the absence of a credit event, investors receive back their principal in full. Their risk, in this instance, is on the underlying assets as well as the reference entity (if not itself the issuer of those assets). Repackaged credit-linked note: exposure to named reference entity (total rate of return structure)

Figure 7.4c

Payment at maturity Subscription monies Investors

Principal & coupon Credit swap provider

SPV RE-linked coupon

RE-linked coupon Principal & coupon

Underlying assets

Purchase monies

Market

Under the final structure (Figure 7.4c), investors receive, via the SPV, a coupon that reflects the cost of funding of a named reference entity. The credit swap provider, in return, receives periodic payments equal to principal and coupon received on the underlying assets. At maturity, the credit swap provider and the SPV effect a cash settlement that reflects any increase or decrease in the value of specified obligations of the reference entity between inception of the transaction and its maturity. In turn, investors receive back from the SPV their original principal plus
minus the amount of the cash settlement. Investors to this structure run credit risk on each of the underlying assets, the reference entity and the credit swap provider. Needless to say, more complicated variants on these themes exist – repackagings based on credit spread, tenor mismatch, basket and
or first-todefault swaps are all good examples. However, since the principles are the same whatever the intricacies of the structure, no more time need be spent on hybrid arrangements here.

Securitizations Securitizations differ from repackagings insofar as they are, in general, structurally more intense and possess ‘real-world’ characteristics – real borrowers 132

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looking to raise real funds for a real purpose. The latter feature becomes most apparent when one considers that many of the structures considered earlier in this book – property and project financings, for example – readily lend themselves to securitization techniques; not something that can easily be said of repackagings. We look briefly at loan securitizations, both real and synthetic, as being reasonably representative of the genre. Traditional loan securitization involves the sale of loan assets by an originator to an SPV. The SPV issues notes to finance their purchase and uses the income generated by the assets to service its payment obligations to noteholders, whose claims against the SPV are secured on, among other things, the assets purchased. Interest rate risk, currency risk and ‘payment lumpiness’ are swapped out in the normal way, while super-senior noteholders may benefit additionally from a ‘deposit swap’ arrangement, pursuant to which an amount equal to their subscription is paid over to a highly rated swap counterparty at note issuance and repaid at note maturity – thereby effectively guaranteeing the return of their principal. The attractions of securitization to the originator range from cost and diversification of funding benefits to improved capital returns and ratios and the divestment of risk. The appeal to noteholders is equally varied – the notes are secured, transferable and largely originator-risk independent and may offer returns in excess of those available from equivalently rated non-asset-backed securities. The sale of assets that underpins traditional loan securitizations gives rise to various legal and structural complexities. Although the details need not concern us here, those complexities have, over recent years, focused attention on synthetic structures whose motivation is the same – the transfer of economic risk in a portfolio of loans for funding, capital and
or risk management purposes – but whose methodology is entirely different. Under a synthetic, there is no sale. Instead, the underlying assets remain on the originator’s balance sheet and their economic risk is transferred to a third party by means of a sub-participation or a credit derivative. Where the originator additionally requires funding, this can (contrary to the views of a minority in the market) be achieved using collateralized or funded variants on the same theme. Figure 7.5 illustrates, in simplified form, a template structure for achieving a funded loan securitization (whether by real or synthetic means). For the interested reader, a comprehensive analysis of the various alternatives implicit in the diagram can be found in either of the Hudd
Voisey
Carne or Walker articles on real vs. synthetic loan securitization, both listed in the bibliography. In relation to the swap documentation generally – whether relating to a repackaging or a securitization – several points can usefully be made. First, where the structure permits and there are limited numbers of interest rate, cross-currency and credit swaps to consider, it may be possible to integrate 133

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Template funded loan securitization structure

Figure 7.5

Swap provider

Interest rate and/or cross-currency swaps Sale/sub-participation/ credit-linked note Loan originator

Notes SPV

Purchase/funding/ subscription monies

Subscription monies

Investors

Principal & interest

Principal & interest Principal & interest (post-securitization) Loan assets

Security

Security trustee

the cash flows into a single Confirmation. Whether integrated or not, the principles of economic symmetry and smoothing demand that the SPV always receives in advance of, and in an amount at least equal to, what it has to pay out. Second, the central provisions of any credit derivative component of the structure – the extent and sensitivity of credit events, the means for determining their occurrence, the timing and method of valuation of reference assets for settlement purposes, etc. – will, notwithstanding the existence of ISDA credit derivatives definitions, be the subject of intense scrutiny by all parties (not least, the rating agencies). As noted earlier, separate criteria exist to offer guidance and prescription in this regard. Finally, the relevant Master Agreement and Schedule will also come under examination. Whether it relates only to interest rate or cross-currency swaps – or additionally masters one or more credit derivative transactions – its form and content will, in practice, follow the broad swap agreement criteria to which we now turn.

RATING AGENCY APPROACHES AND CRITERIA A rating addresses the ability of an obligor to make full and timely payment of its obligations. Repackaging, securitization and analogous transactions are 134

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characterized by several factors that jeopardize this ability. Legal risk aside, a typical SPV can perform only to the extent that the assets that it owns and the swaps to which it is party pay in accordance with their terms. In the case of the swaps, it is not only the credit rating of the swap provider (or its guarantor) that is a relevant consideration; the sensitivity of the swap agreement to withholding taxes and early termination is equally important. It is this dependency and these sensitivities – as well as a general appreciation of the importance of swaps to the integrity of repackaging and securitization transactions – that are behind the criteria that we are about to consider. While the criteria are similar in substance, they are not identical. Nor are they mandatory – reflecting the fact that rating is more art than science – or perfect. In the latter regard, for example, Standard & Poor’s (S&P) criteria make the common mistake of confusing Specified Transactions (relevant to Default under Specified Transaction) and Transactions (relevant to Failure to Pay or Deliver). As noted in Chapter 4, Specified Transactions and Transactions are mutually exclusive and it is therefore wrong for the criteria to assert that a default under a Specified Transaction gives rise to a termination right ‘whether or not the [Specified Transaction] is a part of the current agreement’. Implicitly, a Specified Transaction cannot be ‘a part of the current agreement’ – a fact explicitly recognized by ISDA in its 2002 successor to the 1992 Master Agreement. We now look briefly at the approaches and criteria of the three principal agencies before turning to a detailed examination of the implications of these for swap documentation and related swap provider(s).

Standard & Poor’s S&P’s swap agreement criteria are contained in a single, undated document listed in the bibliography. The criteria are stated to apply to all asset-backed securities transactions (including repackagings and securitizations) that are swapped out using interest rate or cross-currency swaps documented under the ISDA 1992 Master Agreement. The use of other forms of swap agreement (including the 1987 predecessor to the ISDA 1992 Master Agreement) is not precluded provided that the criteria are respected. The rating that S&P assigns to a transaction varies according to whether the structure is swap-dependent or swap-independent. Swap-dependent structures are further divided into those that are collateral-dependent and those that are collateral-independent. The categories equate, in broad terms, to structures (all, for these purposes, assumed to be structurally and legally robust) in respect of which investors run credit risk on both the swap provider (or its guarantor) and the underlying assets
collateral (in which case the overall rating is ordinarily the lower, but sometimes a blend, of the respective ratings), solely on the swap provider (or its guarantor) or solely on 135

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the underlying assets
collateral. Figure 7.6 provides an overview of the various approaches. Figure 7.6

S&P approaches to rated transactions Rated transactions (legal/structural risk assumed to be zero)

Swap-dependent

Collateral-dependent (rating ⫽ lower/blend of that of swap provider and that of collateral)

Swap-independent (rating ⫽ that of collateral)

Collateral-independent (rating ⫽ that of swap provider)

Since most transactions are collateral-dependent, the criteria set out in detail the amendments that S&P would expect to see made to the ISDA 1992 Master Agreement in respect of such transactions. Guidelines in respect of collateral-independent and swap-independent transactions are also included. Separate, January 1999 and May 2000 publications (again, listed in the bibliography) prescribe minimum rating and credit support requirements for interest rate and cross-currency swap providers in the context of rated transactions.

Moody’s Investors Service Where S&P’s approach to the rating of repackagings and securitizations is prescriptive, Moody’s is holistic. A source at Moody’s put it this way: ‘We are generally non-prescriptive; we look at the risks and, if they are substantial, we seek to remove or model them and assign a rating accordingly.’ Nevertheless, two relevant Moody’s papers exist, dated May and October 2002, both of which are listed in the bibliography. Between them, these stipulate minimum rating and credit support requirements for interest rate and cross-currency swap providers, discuss swap break cost implications (both generally and in the context of downgrade-triggered novations and defaulttriggered replacements) and examine the problems associated with swaps that hedge assets having indeterminate amortization and prepayment profiles – all reminiscent of discussions, albeit in a slightly different context, earlier in this book. Like the S&P criteria, the two papers suggest various amendments to ISDA documentation when used in the context of rated asset-backed securities transactions. 136

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Fitch Fitch publishes no formal criteria relating to interest rate or cross-currency swaps in a structured
rated finance context. In practice as well as according to a source at the agency, the approach that it adopts is broadly consistent with that of S&P.

SIGNIFICANCE FOR SWAP DOCUMENTATION We begin with a survey of S&P’s comments on and required
recommended amendments to the ISDA 1992 Master Agreement when used in the context of collateral-dependent transactions. Where Moody’s approach is different or supplementary, the text notes this. References to Sections are to Sections of, and capitalized terms have the meaning given to them in, the ISDA 1992 Master Agreement.

Netting (Section 2(c)) S&P allows netting of payments in respect of stand-alone issues and across notes of the same series. Settlement netting across notes of different series or that is impracticable due to international time differences is not permitted. Paying agent systems and operational limitations may in any event preclude the practice.

Deduction or Withholding for Tax (Section 2(d)) As a preliminary matter, S&P requires Section 2(d)(i)(4) to be amended so that the obligation of a party to gross up is in respect of all withholding taxes, i.e. not merely Indemnifiable Taxes. As to whether a party should be required to gross up at all, the criteria differentiate between existing (i.e. those that apply at the time the transaction closes) and future withholding taxes. In respect of existing withholding taxes, if (i) imposed on the SPV’s payments, S&P expects the swap provider to receive net; and if (ii) imposed on the swap provider’s payments, S&P requires the swap provider to gross up for each withholding. It also requires the terms of any guarantee or other credit wrap of the swap provider’s obligations to be extended accordingly. In respect of future (or increased) withholding taxes, S&P is prepared (since its ratings do not generally address change of tax law risk) to entertain a number of different risk allocation mechanisms. Pursuant to these (i) both parties may be required to gross up; (ii) the swap provider alone may be required to gross up; (iii) both parties may be permitted to pay net; and
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(iv) the swap provider may be permitted to terminate. The first of these alternatives is viable only if there is a reasonable expectation that the SPV will have sufficient funds available to it. Where (exceptionally, given the limited cash flow of most SPVs) that is the case, the swap provider will be permitted to terminate only if the SPV fails to gross up or if it (the swap provider) is prepared to make a termination payment to the SPV that enables the SPV to redeem the notes. The amount of the termination payment in the latter instance will be calculated as the note redemption amount less the sale proceeds of the underlying assets
collateral (adjusted for swap break costs
gains) and Section 6(e) will need to be amended accordingly. In all other cases where the swap provider has a withholding taxrelated termination right, it will terminate (and the direction and size of the termination payment will be calculated) in the normal way. S&P will in all circumstances require a legal opinion that confirms whether withholding taxes arise under current law and whether any legislation is pending that would give rise to such taxes in the future. How easy it is to opine on whether or not something is ‘pending’ is debatable, however. More generally, S&P will require the prospectus and other investor-facing documents relating to the issue to disclose the nature and extent of the tax risk, particularly where the swap provider is excused from grossing up or has a termination right following the imposition of a withholding.

Representations (Section 3) S&P’s general approach to SPV representations is that they exist for due diligence purposes only and that, even if they are allowed to remain in the documentation, their breach (unlikely as it is in the context of a bankruptcy-remote vehicle) should not give rise to an Event of Default or to a right in favour of the swap provider to terminate. S&P will entertain exceptions on a case-by-case basis, although there may be knock-on ramifications for the overall rating. With the exception of the payer and payee tax representations at Sections 3(e) and 3(f), S&P regards swap provider representations as otiose on the grounds that the SPV will, assuming the swap provider remains solvent and continues to pay, wish to terminate the swap only if the wider transaction is itself unwound. While there is some logic to this approach and even though it is hard to imagine that a rated and reputable swap provider might ever be in material breach of the standard Section 3(a) to (d) representations, the lack of termination rights in favour of the SPV following a swap provider misrepresentation is at least questionable. In relation to the tax representations, of course, the conundrum disappears to the extent that their breach does not give rise to a termination right under an unadulterated ISDA 1992 Master Agreement in any event. That said, the veracity of the tax represen138

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tations will need addressing in the relevant tax opinion(s) and the (nontermination) consequences of their breach will need dovetailing into whichever of the tax risk allocation mechanisms considered above is adopted for the structure.

Agreements (Section 4) The approach here is identical to that applicable to representations. It is therefore legitimate for the SPV to be required to enter into the various covenants and agreements under Section 4 provided that breach of these does not give rise to an Event of Default or a right in favour of the swap provider to terminate. Exceptions may be entertained on a case-by-case basis. In relation to the covenant to pay stamp taxes at Section 4(e), S&P may require the relevant tax opinion to confirm the existence or otherwise of such taxes and will want to be satisfied that the SPV has the ability to meet any that are identified. A swap provider breach of covenant is treated in the same manner as a swap provider misrepresentation (so may, as before, lead to a questionable outcome in certain circumstances – consider in particular a swap provider failure to deliver documents pursuant to Section 4(a)(ii)). Moody’s approach to Sections 3 and 4 is subtly different. On the SPV side, it requires the representations and agreements to reflect the reality that most SPVs have limited management and are therefore not in a position to make representations or satisfy ongoing covenant obligations (unless, perhaps, a reputable servicing party is appointed to act on their behalf). Accordingly, Moody’s generally requires them to be deleted (at least with respect to the SPV). Where they are permitted to remain (whether on the SPV or the swap provider side, or both), their breach may result in an early termination of the swap only if a third party, such as the note trustee, determines that to allow the swap to continue would materially prejudice the interests of investors or other secured creditors (including the swap provider).

Events of Default (Section 5(a)) and Termination Events (Section 5(b)) In broad terms that in part reflect the thought processes discussed above, the only Events of Default and Termination Events that S&P regards as prima facie acceptable (for both parties) are Failure to Pay or Deliver, Bankruptcy, Merger Without Assumption and Illegality. Moody’s opening position is much more conservative, being (on the SPV side) limited to Failure to Pay or Deliver and Illegality. In relation to the various events, the three Local Business Day grace period applicable to Failure to Pay or Deliver is usually removed, the Bankruptcy definition is amended to carve out technical or 139

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structural default (e.g. on deeply subordinated SPV debt) and Merger Without Assumption is amended to carve out the transfer by the SPV of its assets to the relevant security trustee
custodian. Moody’s points out additionally that, in relation to multiple issuance structures, care needs to be taken to ensure that default under one
a limited number of (but not all) series of notes does not trigger a Bankruptcy under Section 5(a)(vii)(2) (inability to pay debts as they become due) and further queries whether the grace period under Section 5(a)(vii)(4) (the purpose of which is to give a party time to dismiss a frivolous or vexatious winding-up petition) is sufficient at 30 days. The latter concern may be more imaginary than real insofar as most SPVs are structured to be bankruptcy-remote. Nevertheless, Moody’s overall preference is for Bankruptcy to be disapplied with respect to the SPV and, at the very least, for the provision to be amended in the various manners suggested above. S&P will allow its ‘starting list’ to be extended to Tax Event and Tax Event Upon Merger (if this is consistent with the tax risk allocation mechanisms considered earlier) as well as, with respect to the swap provider only, Credit Support Default (where the swap provider is guaranteed) and Credit Event Upon Merger (where there are legitimate concerns in that regard). Additional Termination Events will rarely be permitted except to the extent that they are consistent with the deal, do not override security trustee discretions and are not otherwise addressed by the structure. It is not unreasonable, for example, for the swap provider to require termination rights where the notes are prepaid (in part) or mandatorily redeemed (in whole) or where the security trustee takes enforcement action. These latter events are ordinarily couched as Additional Termination Events (rather than Events of Default) for two principal reasons, both a consequence of the way in which the termination provisions within the ISDA 1992 Master Agreement are themselves drafted. First, where the SPV has issued a series of notes – each series being swapped out using one or more swaps specific to that series – it is much easier to provide for seriesspecific terminations by making an appropriate amendment to the Section 14 definition of ‘Affected Transactions’. But, since Affected Transactions have meaning only in the context of Additional Termination Events, that rules out describing the underlying events as Events of Default. Second, early terminations pursuant to Additional Termination Events will, by deeming both parties to be ‘Affected Parties’ for the purposes of Section 6(e)(ii)(2), be effected at mid-market rather than, from the SPV’s perspective, the wrong side of the bid : offer spread. This sleight of hand is usually complemented by a stipulation that, for Section 6(b)(iv)(2) purposes, the SPV is the sole Affected Party – thereby leaving designation of the relevant Early Termination Date in the hands of the swap provider. 140

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Early Termination (Section 6) S&P is comfortable for both the SPV and the swap provider to have termination rights, whether following the occurrence of an Event of Default or a Termination Event, provided that Automatic Early Termination (which, it is to be noted, relates only to a limited number of limbs of the Bankruptcy provision – both the S&P and Moody’s criteria erroneously suggest that it applies to all Events of Default) is stated not to apply. Although not addressed explicitly in the criteria, Additional Termination Events are, in practice, usually bifurcated in the manner considered in the previous paragraph so as to make the swap provider the arbiter of the termination decision while at the same time ensuring that the swap is terminated at mid-market. So far as the measure and method of calculating the termination payment are concerned, earlier (1993) S&P criteria had insisted upon the election of, respectively, Loss and First Method (primarily to spare SPVs from having to make termination payments to defaulting swap providers). Recent recognition of the pricing and transferability benefits that come from the election of Second Method and Market Quotation has, however, prompted a change of approach. As a result, either of the two Methods will now be accepted and, while in relation to measure there is a preference for Market Quotation (falling back to Loss, in accordance with conventional ISDA 1992 Master Agreement methodology, if a Market Quotation cannot be obtained), Loss may also be elected – especially where the swap is highly structured and
or by its nature illiquid. More generally, S&P will require the ranking of the swap provider (where itself in the money, of course – where out the money, the point is academic) on an early termination to be reflected in the swap documentation. S&P’s view, consistent with the discussion on payment and security waterfalls earlier in this chapter, is that a pari passu ranking with investors will, in most circumstances, be appropriate but that, where the underlying collateral or the swap provider itself is in default, a ranking, respectively, above and below investors will be permitted
expected. Moody’s, on the other hand, has a strong preference for the ranking of the swap provider in the payment
security waterfall to be less generous, e.g. below note interest
above note principal (preserving investor liquidity) or even below both note interest and note principal (preserving investor capital as well as investor liquidity), and will entertain a pari passu ranking only where it is the SPV that is in default.

Transfer (Section 7) For reasons already considered in Chapters 3 and 4 in the context of borrower-security providers, S&P will allow Section 7 to be amended to 141

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enable the SPV to assign to the relevant trustee, by way of security, its rights against the swap provider. S&P will also allow the Section to be amended in contemplation of a novation of the swap to a suitably rated novatee on, for example, a downgrade of the original swap provider. The Transfer to Avoid Termination Event provisions of Section 6(b)(ii) may be retained provided that, in the case of a transfer by the swap provider, the transferee has a rating equal to or above that of the original provider.

Miscellaneous (Section 9) S&P will require Section 9(b) (Amendments) to be supplemented with a provision to the effect that no amendment to the swap documentation is effective unless S&P has approved it in advance and in writing. In practice, the note
security trustee will insist on the provision being supplemented in identical fashion with respect to it.

Offices; Multibranch Parties (Section 10) S&P requires the multibranch provisions to be disapplied with respect to both the SPV and the swap provider. In practice, this means that swap providers to rated transactions may enter into the relevant swaps only at a head office level (since entering into them at a branch level will necessitate the branch itself being a principal to the agreement – this is the effect of the S&P stipulation; it makes designation of the branch as an Office impossible – and the result of this, on a strict interpretation, is that the SPV loses the benefit of the Section 10(a) representation that would otherwise have been made to it, in respect of transactions entered into with the branch, by the relevant head office). In passing, this last point is of general application and is frequently missed by counterparties to branch swap providers that purport to enter into ISDA documentation at a principal : principal level.

Other considerations We round up our summary with a brief look at collateral-independent and swap-independent structures as well as at some of the additional criteria that S&P and the other agencies require to be met in all swap agreements, regardless of the nature of the structure. Collateral-independent structures

A collateral-independent structure is one where the swap provider pays to the SPV regardless of the performance of the underlying assets
collateral. Put another way, collateral risk resides with the swap provider and investors look solely to the rating of the swap provider for comfort that the SPV (and, 142

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in consequence, they) will be paid out in full. Figure 7.4a (considered earlier in this chapter) provides an illustration of a collateral-independent structure, albeit in the context of a credit (as opposed to interest rate
cross-currency) swap. Since the swap provider to such structures carries greater risk, it is deserving of greater protection. As a result, S&P is prepared to cede to it a wider range of Events of Default and Termination Events than for collateraldependent structures. Separately, the Section 6(e) amount payable on an early termination will, for by now familiar reasons, require amending so that the amount that the swap provider pays to the SPV equals the note redemption amount less the sale proceeds of the underlying collateral (adjusted, as before, for swap break costs
gains). Swap-independent structures

A swap-independent structure is one in respect of which the swap is provided as a straightforward accommodation to investors and the rating of the swap provider is neither a sole nor supporting rating in the way that it is for swap-dependent structures. As a result, on a swap provider default under a swap-independent structure, investors may choose between unwinding the structure and allowing it to continue on an unswapped basis. In general, S&P is prepared to entertain a range of Events of Default and Termination Events that is wider still than those allowed under collateral-independent structures. In return, it requires the Section 6(e) close-out amount to be deemed zero on an early termination (logical if the structure is to be truly independent of the swap) and alerts investors to the market risk to which they may be exposed following an early termination by affixing an ‘r’ symbol to the rating. Additional criteria

Many of the additional criteria that S&P and the other agencies expect swap agreements to meet were considered at the beginning of this chapter. Pari passu ranking and enforceability of swap provider
guarantor obligations, efficacy of choice of law elections, swap provider non-petition and limited recourse covenants and the requirement for local law legal opinions are just some examples. Other provisions that are commonly inserted into relevant Schedules (even though not expressly required by the criteria but sensible for reasons given in Chapter 4) are limitation on scope, non-reliance representations, change of account restrictions, conformity of Termination Currency and removal of Potential Event of Default. Where the swap contains a liquidity feature, Section 2(a)(ii) must additionally be amended in contemplation of the fact that payments by the SPV may, from time to time, be made after their due date. Other amending or supplementary provisions will almost certainly be required on a case-by-case basis. Finally, it is not 143

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unusual, on account of the amount of engineering that they typically require, for the relevant Confirmations to be pre-drafted and appended to the related Schedule in anticipation of their execution.

SIGNIFICANCE FOR SWAP PROVIDERS A difficulty that faces arrangers of structured transactions is a natural investor preference for triple-A-rated investments, on the one hand, and a limited number of triple-A-rated swap providers on the other. Fortunately, pragmatism prevails and the rating agencies are, in the context of vanilla interest rate and cross-currency swaps at least, prepared to accord triple-A status to structures in respect of which the swap provider is rated below triple-A (and is not otherwise guaranteed by an entity that is itself rated triple-A). In broad terms, the way that this is achieved is through the (lower-rated) swap provider agreeing to post, with the security trustee, collateral for the ongoing mark to market (either on a day-1 basis or promptly following its downgrade) or to procure a novation of the swap(s) to a higher-rated provider (again, promptly following its downgrade). The amount of any collateral haircut, the periodicity of the posting obligation, the size of any credit and de minimis thresholds and the type and quality of eligible collateral will be matters for discussion on a case-by-case basis between the arranger, the swap provider and the rating agency(ies). Collateral will ordinarily (and logically) be posted under an ISDA credit support annex, will be in the same currency as that of the note issue and should be supported by an opinion confirming the trustee’s rights to the collateral in the swap provider’s insolvency. As a final matter, the rating agencies will rate structures to which the swap provider is a triple-A-rated ‘derivative product company’ provided that a volatility buffer is posted with the security trustee that protects investors against adverse market movements between the date of termination of the swap (should it be terminated early) and its replacement (by the SPV) in the market. The defining features of derivative product companies, the additional circumstances that bring about an early termination of swaps entered into by them and the logic behind the requirement for a volatility buffer will be considered in greater detail in Chapter 8, to which we now turn for an examination of a number of further specialized applications.

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8 Specialized applications

Swaps linked to debt capital market instruments Share scheme hedges Swaps with AAA-rated derivative product companies Accrual swaps Building society applications Private client applications

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SWAPS LINKED TO DEBT CAPITAL MARKET INSTRUMENTS Corporate borrowers regularly look to the debt capital markets as a supplement
complement to traditional bank funding and are often able to issue at prices and for maturities that compare favourably to those under bilateral and syndicated loan arrangements. A variety of structures is available, ranging from short term commercial paper (CP) programmes to much longer-dated notes issued out of medium term note (MTN) programmes. Issuances are frequently swapped out using finance-linked swaps.

CP programmes CP programmes are analogous to many of the structures considered in Chapter 7, the swap serving to transform the cash flows on assets owned by the issuer so as to give holders of the CP a desired coupon profile. Figure 8.1 illustrates a simple programme that gives the issuer $ funding serviced by EUR revenue streams. Simple CP programme

Assets/ Collateral

Figure 8.1

Periodic EUR

EUR revenue

Swap provider

Issuer $ Coupon equivalent $ Principal

$ Coupon

CP holders

CP programmes, whether structured as unsecured funding lines or secured warehousing arrangements, tend to be rated and the rating agency criteria considered in Chapter 7 are generally applicable. The S&P criteria, in particular, include a discussion on the necessity for and means of achieving economic symmetry (specifically in a CP context) that is on all fours with much of the analysis set out in Chapters 3 and 4.

MTN programmes Issues out of MTN programmes and analogous debt capital market instruments are structurally similar to CP, although security is rare and the role of 147

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the swap is limited to giving the issuer fixed rate funding (or, in the case of a fixed rate MTN issue, floating rate funding) – occasionally, by means of a cross-currency swap, in a different currency to that of the original issue. There is nothing paradoxical, incidentally, in an issuer issuing at a fixed rate and then swapping it into floating, albeit that it is not something that a fixed rate borrower from a bank would ever be likely to do. MTN programmes cater for fixed rate issues specifically to tap the fixed income investor market and because it is much easier for the issuer to swap out the relevant cash flows than it is to ask individual investors to do so. Figure 8.2 provides a simplified illustration of a fixed rate MTN issue swapped into floating. Illustrative fixed-to-floating rate MTN issue

Figure 8.2

Principal Noteholders

LIBOR Swap provider

Issuer Fixed

Fixed

Programme documentation

The illustration in Figure 8.2 is based on a 15-year (swapped out for 10), subordinated, listed and rated note issue that was recently undertaken by a major UK financial institution out of an existing MTN programme. Given the size, term and status of the issue and the fact that the respective lawyers to the issuer and to the programme dealers (one of which was the swap provider) were major UK law firms, one would expect the swap documentation to have been tailored accordingly. In fact, it displays (what follows is an analysis of the swap documentation as executed) a number of shortcomings. The first is a discrepancy between the Fixed Rate Day Count Fractions specified, respectively, in the Confirmation for the swap and in the Pricing Supplement for the note issue (each of which, in all other respects, is economically identical to the other). That for the swap is expressed to be ISDA’s ‘30
360’ (unadjusted) and that for the note is expressed to be ISMA’s ‘Actual
Actual’ (essentially a 365-day measure). The inconsistency leads to a periodic windfall gain for the issuer insofar as the fixed amount that it receives under the swap is greater (since it is calculated by reference to a smaller divisor – the length of the year) than that which it has to pay on the notes. Since the swap provider is itself a noteholder, it may suffer – unless the basis mismatch is absorbed or counter-hedged by it at the institutional or portfolio level – to the extent of the difference. The difference itself is material. According to Moles and Terry (1997), a 360-day year increases the 148

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amount of annual interest by a factor of 1.013889 when compared with a 365-day year. Now whether, on account of the volume of business that it undertakes and
or the likely fragmentation that exists between its fixed and floating income divisions, the swap provider ever picks up or even cares about the discrepancy is a moot point. What is evident is that the note prospectus in question is permissive of both day count fractions and that the issuer would have been indifferent to a conforming amendment. In addition, had the discrepancy been ‘the other way round’, the issuer would have been horribly compromised. The second and perhaps more serious discrepancy arises in relation to the credit provisions within the respective swap and note documentation. Neither is tailored and the issuer and the (non-swap providing) noteholders are, as a result, structurally exposed to the extent that the swap provider enjoys more sensitive or extensive termination rights under the swap than exist with respect to the notes. The converse is also true. To give just two from a number of examples, the grace period for failure to pay under the notes stands at 14 days, whereas in relation to the swap it is the customary (pre-2002 ISDA Master, that is) three. Similarly, the borrowed monies cross-default threshold is much lower under the notes than it is under the swap and
but the swap provider enjoys an extended cross-default regime by virtue of the Default under Specified Transaction provisions of the ISDA 1992 Master Agreement. It is to be remembered, in this vein, that the issuance was subordinated. There is, therefore, an argument that the claims of the swap provider (qua swap provider, not merely qua noteholder) ought similarly to have been subordinated, not only to the issuer’s general creditors but also for the purposes of alignment with other noteholders. Not one of these points made its way to the negotiating table. Instead, the swap was ‘lumped in’ with the issuer’s stand-alone transactions under an untailored ISDA 1992 Master Agreement and the principled alternative of employing scope-restricted (and suitably tailored) swap documentation was ignored. The final oversight is the absence of a right in favour of the issuer to terminate the swap should it redeem the notes early (e.g. consequent upon a tax gross-up), leaving it exposed to market risk in respect of its post-redemption payment obligations under the swap. It would be wrong, here, for the issuer to assume that the swap provider will agree to a consensual early termination following an early redemption of the notes. In the first instance, the 10-year term of the swap means that the swap provider is likely to have hedged it on a back-to-back basis and will be constrained to the extent that its back-toback counterparty is itself unwilling to agree to a break. Second, even if the swap provider is willing to accommodate the issuer, the amount of the break cost (or gain) will be at the swap provider’s discretion (instead of being calculated in accordance with standard Section 6(e) ISDA methodology – which, to a savvy and insistent issuer, means mid-market under 149

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Section 6(e)(ii)(2)(A)). In this regard, providing for prepayment-consequent break rights with respect to some but not all transactions under a given ISDA Master is easily achieved by designating the applicable transactions as ‘capital market-linked’ or similar in the relevant Confirmation(s), building into the Schedule the desired termination characteristics (usually through the Additional Termination Event elective at Part 1(h)) and segregating the transactions for early termination designation purposes through an appropriate cross-amendment to the Section 14 definition of ‘Affected Transactions’. By any standard, these discrepancies and omissions are difficult to understand. How is it that they occurred? In this instance, the issuer’s lawyers pitched for the swap work but were told that it would be done in-house by the issuer’s treasury department; the dealers’ lawyers (debt finance, not derivatives, experts) either were unaware of the swap (it appeared nowhere on the note issuance closing agenda), overlooked the subordination and intercreditor questions altogether or rationalized them on the basis that the swap would be adequately documented, in-house, by the swap provider (itself a major City financial institution); and the rating and listing agents were similarly unaware of the swap or regarded it as a post-issuance matter, between the issuer and the swap provider, that did not affect the issuance’s rating or prejudice the listing of the notes. The result, however – and one which takes us all the way back to Chapters 1 and 2 – is a swap, documented ‘remotely’ from the wider deal, that exposes the borrower and its lenders to a wholly avoidable degree of ongoing credit, liquidity and structural risk. The episode is good evidence that poor practice in the finance-linked swap arena extends to the highest echelons of the debt and debt capital markets.

SHARE SCHEME HEDGES Share scheme hedges are only tangentially relevant to the subject matter of this book. They are, however, interesting in their own right and give rise to several ‘symmetry’ issues that are no different, in principle, to those considered in the context of debt financings and related interest rate and cross-currency swaps. The idea behind a share scheme is simple. By granting to key employees options on the shares of the company for which they work (or periodically rewarding them with discounted shares; the concept is similar), the relevant employees are incentivized to work harder – since the harder they work, the higher the company’s share price (at least in the long run) and the more valuable their options and rewards. While the current bear market and recent instances of companies ‘lowering the bar’ to keep incentives in the money have done little to advance the economic case for such schemes, many companies continue to operate them in one form or another. 150

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The ‘problem’ with share schemes is that the more successful they are (in terms of moving the share price up), the more expensive they become for the company, since at some point, it has to deliver highly priced shares (or effect a corresponding cash settlement) to relevant employees. In short, the company is exposed to its own forward share price. One way that it can manage this exposure is to enter into equity derivatives – forward contracts and
or options on its own shares – that, in effect, put a cap on the forward risk. A prerequisite to such hedges, whether entered into directly by the company or by the trust vehicle out of which – for a variety of legal, tax and accounting reasons – share schemes are typically run, is that there is sufficient liquidity in the underlying share to enable the hedge provider (without significantly moving the share price) to forward- or delta-hedge its own exposure under the hedge contract(s). As a result, a derivatives-based solution is likely to be viable only for FTSE 250(!) companies. Smaller companies are compelled to consider alternative strategies, such as rolling purchases of shares by the trust vehicle (preferably at troughs, as opposed to peaks, in the share price cycle) and
or periodic (but necessarily dilutive) new issues. Figure 8.3 provides a simple illustration of a typical share scheme structure and related hedge and counter-hedge. Illustrative share scheme and related hedge
counter-hedge

Figure 8.3

PLC

Funding/indemnity agreement Cash/shares Market

Counterhedge

Hedge provider

Trustee Option premia/ settlement payments

Trust deed

Employees

Share scheme hedges give rise to numerous legal and documentation complexities. From a legal perspective, payments made by the company to the trust vehicle under the funding
indemnity agreement (used by the trustee to meet its premium or forward settlement obligations to the hedge provider; and in turn by the hedge provider to fund purchases of the company’s shares) have all the ingredients of unlawful financial assistance under s151 et seq. Companies Act 1985. The company must, therefore, be able to avail itself of the ‘larger purpose’ exemption at s153(1), show that it falls within the specific share scheme exemption (underpinned by a sufficiency of net assets
reserves 151

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test) at s153(4)(b) and s154 or demonstrate (using complex arguments that are beyond the scope of this book) that there is no breach of s151 in the first place. Usually, s153(4)(b) is the first ‘port of call’ in this regard. Additionally, the capacity and authority of the trustee to enter into the hedge must be investigated and the hedge provider must be mindful of close period restrictions, insider dealing and listing rules and other corporate law and governance considerations in relation to the open market and
or forward purchases of the company’s shares that underpin its counter-hedge. For their part, the company and the trustee will each have legitimate concerns as to the creditworthiness of the hedge provider; and the company, in particular, will want assurances (usually embodied within a commitment letter) that the hedge provider will manage the process of putting on and taking off its counter-hedge in a confidential and incremental manner – so as not to alert the market to the company’s strategy or unduly disturb the share price. At the documentation level, the contract between the hedge provider and the trustee will invariably be documented on ISDA terms, making use of the 1996 ISDA Equity Derivatives Definitions (or their forwards-inclusive 2002 reincarnation). Several points are worth making in this regard. First, it is almost impossible to achieve anything other than approximate economic symmetry between payments and
or deliveries required to be made by the trustee to employees, on the one hand, and receipts under the hedge, on the other, by reason of the fact that employee share scheme entitlements are, by necessity, imbued with a high degree of optionality. Put another way, employees have wide discretion as to when and in what amounts to exercise their rights – behaviour that cannot be predicted (other than by statistical approximation and interpolation) nor, as a result, exactly mirrored under the hedge contract. All that can reasonably be achieved is broad correspondence between the exercise dates, periods and (cash vs. physical) settlement provisions applicable to, respectively, the scheme and the hedge; and between the expected quantum of the company’s forward exposure (taking into account the size of the scheme, relevant award parameters, likely employee attrition rates and outside factors, including change of law, that may affect the value of entitlements or the share price during the scheme period) and the size of the hedge. Second, of relevance to physically settled transactions in particular, ISDAbased equity derivatives documentation contains standard fallbacks and
or deferral mechanisms that address the possibility that the hedge provider is unable, at the relevant time, to meet its settlement obligations to the trustee (whether on account of illiquidity in the underlying share, market disruption generally or applicable close period trading restrictions). These fallbacks and mechanisms should, wherever possible, be structured in such a way as to leave the trustee unaffected, i.e. in a position to meet its ongoing settlement obligations to employees. 152

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Third, both the scheme and the hedge documentation will inevitably contain provisions that aim to preserve economic equivalence following, for example, a split, consolidation or other reclassification of the shares; and that provide for adjustment, acceleration or termination of outstanding obligations following the occurrence of corporate events as diverse as change of control, merger, de-listing, nationalization and insolvency (all of which materially affect the company’s share price). Again, it is essential to achieve as great a degree of conformity between the respective sets of documentation as is possible. Where significant basis risk of the kinds considered above is identified, it is usually eliminated through amendments to the trust deed relating to the scheme rather than through amendments to the hedge documentation. Adopting the latter solution passes the basis risk to the hedge provider (and so will be unacceptable to it if its intention is to counter-hedge by means of a back-to-back derivative), whereas the former eliminates it altogether. In passing, basis risk of this kind arises in many other equity-linked contexts. A good example is a hedge entered into by a building society (considered further below) to cover its exposure under an equity-linked retail investment product. Here again, care should be taken to minimize documentary basis risk (between the terms of the equity derivative and the terms relating to the investment product) to the greatest extent possible. As well as being used to hedge ‘direct’ trustee obligations to share scheme beneficiaries, equity derivatives may be structured to protect against ‘indirect’, scheme-embedded obligations to provide loan funding in respect of employee share purchases (and
or to meet employee tax liabilities crystallized as a result of such purchases) and against National Insurance liabilities payable by the company, under certain types of scheme, on employee gains. Here, however, the question of unlawful financial assistance looms mightily since there is considerable doubt whether company
trustee obligations of an indirect nature are within the ambit of the s153(4)(b) exemption considered earlier.

SWAPS WITH AAA-RATED DERIVATIVE PRODUCT COMPANIES Derivative product companies (DPCs) were developed in the early 1990s to enable relatively low-rated swap providers to transact a wider range of derivatives business at better spreads and with a greater number of (increasingly credit-conscious) end-users and other counterparties. A limited number of DPCs continue in existence today as highly rated subsidiaries of major financial institutions. Their ability to enter into derivative transactions under a triple-A banner (that, up to a point, is independent of the parent’s 153

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own rating) is, or at least was in the 1990s, seen as more efficient than the alternative of the parent undertaking the business itself and ‘dragging up’ the rating, on a transaction-by-transaction or counterparty-by-counterparty basis, either through ongoing collateralization of the mark to market or the ‘buying in’ of a guarantee or other form of credit enhancement from a highly rated credit support provider. Subsequent advances in collateral management, ISDA’s work in bringing about a standardization of collateral documentation and moves towards the establishment of multilateral collateral clearing and settlement systems have, while not rendering DPCs otiose, done little to advance the economic case for their existence. Most DPCs are of the ‘enhanced’ variety. They are, in other words, bankruptcy-remote (eliminating the risk of parental insolvency), well capitalized (hence the rating) and largely market risk-independent (all transactions in the book being laid off on a back-to-back basis – usually with the parent – on a fully (net) collateralized basis). ‘Unenhanced’ DPCs, by contrast, rely for their rating on the balance sheet strength of an external entity (e.g. a parental guarantor, unlimited liability shareholder or joint venture partner) and, as with enhanced DPCs, on the elimination of market risk through back-to-back transactions with that or another entity. Unenhanced DPCs are vulnerable to rating downgrades of the supporting entity(ies) to the extent that their own rating suffers (as is likely) a corresponding diminution. Enhanced DPCs may be further divided into ‘fixed capital’ and ‘dynamic capital’ structures. Fixed capital structures are, by definition, capitalinefficient (the book must grow to fill – and is ultimately constrained by – capital headroom in the DPC) but have the advantage that they are conceptually simple, being no different, in principle, to ‘ordinary’ triple-A vehicles. Dynamic capital structures, on the other hand, achieve an efficient alignment of capital (and parental collateral) with the size, composition and volatility of the book and are more prevalent as a result. A final distinction may be drawn between ‘continuation’ and ‘termination’ structures. Under a continuation structure, a parental insolvency or downgrade will lead to the DPC closing the book to new business and unwinding (and replacing in the market, usually with a predesignated, rated entity) all back-to-back transactions entered into with the insolvent
downgraded parent – the intention being that the book should then be left to run off naturally. The presupposition here, of course, is that the book is broadly balanced in the first place and that pricing, credit and other differentials relating to the unwind and replacement processes are minimal, so that net replacement costs to the DPC are at or close to zero. From a counterparty perspective, continuation structures carry the obvious attraction that they leave the counterparty’s hedging arrangements undisturbed. Under termination structures, most of which are dynamically capitalized, 154

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the occurrence of a parent and
or DPC-related trigger event will lead to an automatic termination of all transactions on both sides of the book, i.e. not only back-to-back transactions entered into with the DPC’s parent but also underlying transactions entered into with its counterparties. From a credit and liquidity perspective, there ought to be few concerns provided, first, that the DPC is (as is almost certain to be the case) sufficiently capitalized and
or collateralized in respect of net amounts due to it (on whichever side of the book); second, that it holds a volatility buffer sufficient to cover market risk during the unwind period; and third, that early termination payables are structured to fall due a day or so after receipt of early termination receivables. Termination structures not only have significant implications for the underlying swap documentation (the early termination provisions, in particular, need amending to accommodate the additional trigger events) but also give rise to a greater or lesser degree of commercial prejudice to affected counterparties. Although termination of the relevant transactions will, as an accommodation to such counterparties, be effected at mid-market, that is of little comfort to, for example, a corporate borrower (on the other end of a finance-linked swap with a DPC) that has to replace the transaction, in what is likely to be a disrupted market, at bid. For this reason, S&P alerts counterparties to the market risk to which termination structures expose them by affixing a ‘t’ symbol to the rating. Moody’s and Fitch take a contrasting view, assigning to the DPC a straight triple-A rating on the grounds that the rating is intended only to address the likelihood of DPC default and that what happens procedurally (post-default) is of academic concern only.

ACCRUAL SWAPS It is fair to say that the global trend towards marking to market has spelled the end for the practice (known as ‘accrual accounting’) of ignoring contingent exposures under swap instruments and concerning oneself, instead, only with accruals up to the next payment date. Having said that, accrual swaps remain conceptually legitimate and relevant in certain specialized contexts, notably tax-based financings, in relation to which contingent exposures are an anathema that needs to be engineered out of the structure. Figure 8.4 provides an illustration. The starting point to an understanding of Figure 8.4 is a necessity (usually motivated by tax considerations) on the part of the lessee to pay a fixed (as opposed to variable) rental for the use of a given asset – an asset purchased by the lessor with fixed rate funding provided by the lending bank – even if its actual desire (usually motivated by the existence of LIBORcorrelated revenue streams) is to pay a variable (or floating) amount. Where 155

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Illustrative accrual swap structure

Figure 8.4

Loan Principal Lessor Fixed Principal LIBM LIBOR

Lending bank & swap provider

Fixed (rental)

Lease

Fixed Lessee LIBOR Swap

this is the case and where the bank has funded itself in the LIBM, it makes sense for the lessee and the bank to swap the unwanted fixed flows into floating. Thereafter, the fixed amounts simply move round in a circle (from lessee to lessor to bank to lessee) and the only ‘real’ market risk in the entire structure is that of the bank in relation to break costs on its funding (which can be picked up, in the normal manner, through indemnity provisions built into the loan agreement). What is key, therefore, is that the transaction documentation should provide for a simultaneous termination of the lease, the loan and the swap in the event that the structure needs, for whatever reason, to be unwound ahead of its stated maturity. The swap documentation, in particular, must be further amended to ensure that the early termination amount (calculated in accordance with Section 6(e) in the case of the ISDA 1992 Master Agreement) is expressed to be zero or is otherwise consistent with early unwind amounts (i.e. over and above simple accruals) payable under, respectively, the lease and the loan.

BUILDING SOCIETY APPLICATIONS As noted at various points in this book, building societies enter into derivatives for two unsurprising purposes: first, to hedge (by means of linked instruments) risks that are associated with specific assets or liabilities; and second, to manage (by means of portfolio transactions) more general balance sheet risk. The law governing the capacity of building societies to enter into derivatives (as enshrined in the Building Societies Act 1986 (as amended)) is not 156

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difficult. Broadly, if a society believes that a derivative transaction, being one of a narrow class of instruments contemplated by the Act, is entered into for hedging purposes, then that transaction is within its capacity. Third parties are, moreover and as a general rule, protected by provisions that preserve the enforceability of the transaction, notwithstanding that it amounts to a contravention of the Act and notwithstanding that it is outside the capacity of the society. Interesting side issues arise by virtue of certain regulatory constraints imposed by the FSA. These constraints – analogous to those considered in Chapter 6 in the context of housing associations – are set out in Chapter 4 (Financial Risk Management) of the FSA’s Interim Prudential Sourcebook for Building Societies. This subjects societies, according to their level of sophistication, to one of five different supervisory approaches: administered, matched, extended, comprehensive and trading. In broad terms, an administered approach society cannot enter into derivatives of any description (even simple derivative-embedded products, such as fixed rate mortgages, are off limits), whereas a matched approach society may enter into linked arrangements, such as interest rate and equity index swaps, that are referable to specific items within the society’s balance sheet. An extended approach society may additionally enter into portfolio transactions (effectively enabling it to take a view on interest rates), provided that it routinely marks the transactions to market and stress tests them in the context of different interest rate scenarios. A comprehensive approach society operates on what can be described as an ‘extended plus’ basis. A trading approach society – one that exists at the top end of the sophistication spectrum – may additionally enter into stand-alone transactions (in respect of securities, not derivatives), enabling it to undertake, subject as before to appropriate control parameters, a limited range of own account securities trading. In relation to linked transactions, the general considerations set out in Chapters 3 and 4 are relevant by analogy and a well-advised society will focus, in particular, on the achievement of economic symmetry between individual swaps, on the one hand, and the balance sheet items that they are intended to hedge, on the other. Express termination rights on an early redemption or repayment of the underlying asset or liability will also merit inclusion in the swap documentation. This is clearly necessary in relation to transactions entered into by a matched approach society (since a failure to terminate the swap side of a hedged transaction will lead to it holding an unmatched position going forward) but is perhaps less obvious in the context of transactions entered into by extended, comprehensive or trading approach societies. Here, however, unless the relevant society is able formally to ‘reallocate’ the swap to a specific item within its balance sheet or to make the case for its retention as a portfolio transaction, it will have to 157

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terminate it. As has been noted in various other contexts, it is no argument to say that the swap provider will agree to a consensual early termination in these circumstances – it may not and, even if it does, the time and cost of (or gain following) the early termination will be entirely a matter of discretion. Contractual prescription is therefore the only principled solution.

PRIVATE CLIENT APPLICATIONS Two common private client applications bring our survey to a close. The first arises in an interest rate context and is a function of the increasing tendency with which unincorporated term loan borrowers (such as sole traders and partnerships) borrow at floating rates and swap into fixed (rather than take out the economic equivalent of a fixed rate loan). Here, several points deserve mention. In general, the sophistication level of such borrowers (and, it has to be said, their lending bankers) is at the very low end of the register. Accordingly, none of the issues considered in Annexes 1 and 2 or Chapters 3 and 4 is understood and, as a result, the commercial risks to the borrower (as well as the reputation, regulatory and litigation risks to the lender) are at their most acute. At the same time, the ticket size is at its lowest and the temptation to sell the ISDA documentation to the client as ‘standard form’ (in order to keep costs down) is at its highest. The fact that ISDA documentation is not drafted for use in anything other than an inter-bank (or bank to corporate end-user) context also gives rise to difficulties. What, for example, does ‘Credit Event Upon Merger’ mean in relation to an individual – marriage to a person who is impoverished?! Fortunately, many of these technical absurdities disappear if a General Rule approach to the swap is adopted. In the end, however, there is no real substitute for a line-by-line analysis of the documentation to iron out nonsensical provisions. The second application arises in the more sophisticated (as well as bigger ticket and better advised) market that surrounds high net worth individuals. It is not uncommon for such individuals to seek to protect the capital value of, enhance the yield from or take advantage of tax arbitrage opportunities in their equity holdings from time to time – employing, in the case of holdings that comprise liquid and listed shares, a range of vanilla and structured equity derivatives (as well as a variety of repo and stock-lending techniques) specifically tailored for the purpose. As with the share scheme hedges considered earlier in this chapter, the key concern of the individual will be to minimize the effect of standardized disruption and fallback provisions within the derivative documentation so as to preserve, to the fullest extent possible, the continuity and efficacy of the underlying strategy. 158

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Who manages? Managing the borrower Managing the lender
syndicate Managing the swap provider Managing the rating agencies Operational issues and timing Cost Post-drawdown issues and restructuring the deal

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WHO MANAGES? The answer to the question ‘Who manages the swap aspects of financelinked swap arrangements?’ varies according to the size and structure of the wider transaction. At the big-ticket end of the market, responsibility usually falls to the arranger (whether or not itself a
the swap provider) and, where the swap is syndicated, a ‘lead’ provider may also be appointed to manage the other providers. The management process will necessitate agreeing and conforming the swap documents – both inter se and with the other transaction documents – and co-ordinating the related swap tender, implementation and document execution processes. Where the transaction is rated and
or negotiation of the swap documentation is entrusted to external counsel, the comments and concerns of the respective agencies and lawyers must also be factored in. Any other interested parties – accountants, pricing and strategy consultants, regulators, etc. – need similarly to be involved. At the small-ticket end of the market, there may be no formal management at all. As we have seen, the swap pricing, implementation and documentation processes often bypass the core transaction altogether and, particularly in a ‘condition subsequent’ environment, are a mere afterthought to drawdown. In between these extremes, it ordinarily falls to the borrower’s lawyers, acting in concert with the borrower’s accountants and other strategy consultants, to take the lead in extracting draft swap documents from the relevant provider(s) and in negotiating the same with that
those provider(s).

MANAGING THE BORROWER The key to managing the borrower (by which, for present purposes, we mean both it and its non-lawyer consultants) is proactivity and timeliness. In general, the borrower needs to be made aware, as early as possible in the negotiating process, that the swap – from a commercial, legal and documentation perspective – is as important as any other component of the transaction. It needs, therefore, to have any ‘standard form’ arguments that have been drummed into it by the lender
swap provider drummed back out of it and to be given an introduction to the architecture and broad substance of ISDA documentation as well as to the commercial ramifications of entering into swap transactions. In particular, it needs to understand that swaps give rise to credit exposures and that these, in a finance-linked context, are relevant to the financial covenants and security package given in relation to the loan. 161

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It also needs to appreciate the cost
gain (and attendant tax and accountancy) implications of a break or transfer of a swap ahead of its contractual maturity. From a swap documentation perspective, the borrower needs further to understand the rationale that underpins the goals of economic and credit symmetry and the amendments that are necessary to the relevant swap and loan documents to achieve these. It needs to think carefully about the representations that it is being asked to give to the swap provider, in particular the representations as to its capacity and authority, the tax representations (breach of which, it is to be remembered, by reason of anything other than a change in tax law or a swap provider failure to provide relevant tax documents will, under the ISDA 1992 Master Agreement, lead to the borrower having to gross up but with no right to terminate) and the non-reliance representations (which, as we have noted, may or may not reflect the facts). It needs also to consider who, on prepayment of the loan, is to have a corresponding break right under the swap (i.e. both it and the swap provider or it alone) and to agree with the swap provider what is to happen to the swap on a transfer of the loan. As noted in earlier chapters, many of these matters go to the heart of the borrower’s future cash flows and it is not enough for the swap provider to ask the borrower simply to rely on its bona fides or forward commerciality in such respects. Contractual prescription is the only principled solution. Finally, the borrower should be encouraged to agree hedging strategy as early as possible with the lender and the swap provider (and to copy the relevant strategy document to its lawyers) and should be primed in relation to its document delivery obligations – corporate authorities, incumbency certificates, tax forms, etc. – with respect to the swap. Much of the foregoing is best raised at the initial scope and fee-quote meeting between the borrower and its lawyers. Ideally, a derivatives lawyer should be present at that meeting to press home the case for inclusion of the swap in the job specification. If the borrower remains unconvinced, the engagement letter that goes out to the borrower should make explicit that the need for review of the swap component of the transaction has been explained to the borrower and
but that the borrower has declined to commission the relevant advice. Where the law firm engaged in relation to the loan does not have the requisite expertise to advise on the swap, that fact (as well as the need for the borrower to seek the relevant advice elsewhere) should, in accordance with applicable Law Society Professional Conduct Rules, be explained to the borrower and made clear in the relevant engagement letter.

MANAGING THE LENDER
SYNDICATE To the extent that the syndicate arranger
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swap arrangements – as is generally the case for big-ticket loan transactions – little management will be required. Swap-related comments on the loan, security and intercreditor documents, received from the borrower and its lawyers, from fellow syndicate members and
or from the swap provider(s), are increasingly the norm and can expect to be factored into the negotiating process in the usual manner. The only real difficulty is to ensure that the loan and swap negotiations move in tandem, a goal that is made easier if there is only one swap provider and
or if lender and swap provider are one and the same. The same cannot always be said of transactions in the mid- to small-ticket loan markets. Here, the challenge for the borrower’s legal team will often be to ‘sell’ to the lender and its lawyers the required amendments to the loan and related documents – amendments that either or both may be unaccustomed to ‘buying’. The key to success in this regard is for the borrower and its lawyers to present a united front to the lender and its lawyers and for the swap-related comments to be included in the first (as opposed to second, third, fourth, etc.) round of borrower comments on the loan agreement. Where the swap is a condition subsequent to the making of the loan and a decision is taken to defer consideration of any swap-related comments until the time that the swap is transacted, the lender(s) should be asked to enter into a commitment, preferably in writing, to revisit the loan and related documentation at the relevant time.

MANAGING THE SWAP PROVIDER Many swap providers are increasingly cognisant of the issues that arise in the context of finance-linked swap arrangements and are prepared, as a result, to adopt a General Rule-type approach to the drafting of the Schedule and to work to achieve economic symmetry between the Confirmation and the loan. In relation to such providers, key issues will be to ensure timely agreement with the borrower and its lender(s) on hedging strategy, production – if at all possible – of a term sheet relating to the swap, early dissemination of a draft Schedule and Confirmation and inclusion of the swap in the completion agenda relating to the wider transaction. Where there is more than one swap provider, the borrower will do well to insist upon the appointment of a lead provider with which it may conduct negotiations concerning the swap documents and with which the syndicate arranger
lenders may communicate in relation to security and intercreditor arrangements affecting the swap provider group as a whole. Where the swap(s) is
are additionally put out to tender, the tender process itself will need to be factored into the time line leading up to completion. 163

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Occasionally, a sophisticated borrower will come up against an unsophisticated swap provider (by which we mean a provider that is wedded to stand-alone swap documentation – even in a finance-linked context – and
or that is itself the lender but is, along with the lawyers acting for it, content to see the swap bypass the deal in the manner described earlier). All that the borrower and its lawyers can reasonably do in these circumstances is to go through the same process as for a sophisticated provider and make principled amendments to the swap documentation. As always, the key to success is presenting a united front to the provider from the very outset of negotiations. If the provider remains intransigent, the borrower has little choice but to go elsewhere or sign up to flawed documentation. Neither is a satisfactory outcome.

MANAGING THE RATING AGENCIES Matters are relatively straightforward so far as management of the rating agencies is concerned. The key to a satisfactory result is for the designers of the structure and the originators of the related swap documentation to keep in mind the criteria discussed in Chapter 7, to provide draft documentation to the agencies that is timely and reflects those criteria and to raise with the agencies as soon as possible any issues that make compliance with the criteria difficult or impossible. As noted in Chapter 7, each rated deal is different and demands a different approach. Rating analysts understand this and are prepared to derogate from the criteria where the structure demands or permits. They do, however, demand openness in return. So if, to give some examples, there is a structural problem that cannot be engineered out, one or more of the relevant legal opinions reveals a tax, enforceability or other legal difficulty, or the rating of the swap counterparty is below par, these matters need raising with the relevant analysts. If a solution can be found, all well and good; if not, the deal may have to be aborted, relocated to a different jurisdiction or the deficiencies in it reflected in the final rating.

OPERATIONAL ISSUES AND TIMING The operational and timing aspects of finance-linked swap arrangements are discussed in detail in the early chapters of this book. From a management perspective, key (and related) issues are (i) the Confirmation-generation process and (ii) the timing of the entering into of the swap
drawing down of the loan. 164

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Confirmation generation at the big-ticket end of the finance-linked market reflects the understanding that exists within that market of the importance of achieving economic symmetry. In other words, a draft of the Confirmation will be circulated for comment early on in the process – if all is working well, in tandem with a draft of the Schedule – and responsibility for its preparation will be a matter for the swap provider’s legal (as opposed to back-office) team. By the time that the Confirmation comes to be signed, therefore, all that will be missing from it is the fixed rate and it will otherwise be in a form and substance that reflect the wider transaction. By contrast, responsibility for Confirmation generation at the mid- to small-ticket end of the finance-linked market invariably lies with the swap provider’s back office. There is no legal input (either from the swap provider or the borrower) and the back-office personnel in many instances do not know that the swap is hedging a particular loan obligation (let alone have sight of, or the ability to interpret, the related loan agreement). So the Confirmation, as well as being produced in response to an underlying deal ticket after the swap has been traded, bears no relation to the loan agreement that it is supposed to hedge. How is this to be managed? From the borrower’s perspective, all that can reasonably be done is for it and its lawyers to insist that a draft of the Confirmation is produced for it to comment upon. The earlier the request is made, the better, if only to assess the lender’s familiarity with ISDA documentation and to avoid situations where the lender or its lawyers offer up, in response to the request, a copy of the ISDA 1992 Master Agreement, a copy of an unadulterated Schedule to an ISDA 1992 Master Agreement or a copy of the template Confirmations at the back of the 1991 or 2000 ISDA Definitions booklets! These are real-life occurrences – indicative of some of the gaps in knowledge that have yet to be filled in significant sectors of the finance-linked swap market. From a timing perspective, the ideal is for the borrower verbally to agree the fixed rate for the swap, then to sign the swap, loan and other documents and only then to issue the relevant drawdown notice – the cumulative result being a swap and a loan drawing that are effective on the same date. In practice, it may not be possible to achieve as fine a degree of contemporaneity as this, in which case the borrower and its lawyers need to think about the various problems that may arise and to manage those accordingly. By way of example, a common temptation is for the borrower to lock in a favourable fixed rate under the swap before the conditions precedent applicable to the related loan have been met. If the borrower finds subsequently that it cannot meet these (so cannot draw the loan), it will need to be able to break the swap, preferably at zero cost. Agreement to this effect needs to be reached with the swap provider before the swap is entered into.

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COST Fees for review of the swap documentation will have to be discussed early on with the borrower but need not be an obstacle. As we shall observe in Chapter 10, the fact that the terms of the loan agreement drive the vast majority of the commercial and credit provisions applicable to the swap means that the review process can, with the will of all parties, be concluded quickly and (extremely) cheaply relative to aggregate fees for the wider transaction.

POST-DRAWDOWN ISSUES AND RESTRUCTURING THE DEAL Once the swap has been concluded and the loan drawn down, there will be little for the borrower to worry about – assuming that the lawyers have done their respective jobs properly and that the fact pattern on which the loan was originally predicated does not change. It is only when the fact pattern changes that there can be complications – where, for example, the borrower wishes (or is required) to prepay the loan or to reschedule its loan repayment obligations; where lenders exercise their step-in rights or rights to assign the loan; where the borrower wishes to novate its rights and obligations (including those relating to the swap) to a third party; where the security or intercreditor arrangements change; or where the swap provider merges, is downgraded or becomes insolvent. The swap, in such circumstances, may need to be broken or replaced, the amortization profile reset, the ongoing fixed rate adjusted and
or a mark-tomarket payment made to
by the borrower. In all cases, additional swap documentation is likely to be required, whether in the form of a novation and
or amendment agreement relating to the original swap documentation or a new Master ! Schedule ! Confirmation altogether. Amending documentation relating to the wider transaction may also be necessary. The services of a derivatives lawyer will invariably be required to assist the loan restructuring team in these respects.

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10 Conclusions

What constitutes best practice? Barriers Drivers A vision for the future

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WHAT CONSTITUTES BEST PRACTICE? Best practice in relation to swaps linked to rated transactions is, to a large extent, codified in the criteria considered in Chapter 7. The hedge component of PFI transactions is subject to a lesser degree of (less sophisticated) prescription in the form of the OGC guidance papers considered in Chapter 6. Otherwise, barring limited analysis in a handful of sector-specific publications, there is no practitioner text – and certainly nothing from ISDA or the LMA – on the subject of finance-linked swap transactions. That puts the analysis set out in Chapters 3 and 4 – comprising a ‘General Rule’ approach to the Schedule, an adherence to the principle of economic symmetry in relation to the Confirmation and inter-cognisance between the transaction documents as a whole – in the invidious position of being the only detailed summary of discernible practice in the field. Chapters 5 to 9 supplement, vary or qualify that analysis, necessarily, but the foundations are laid in those two chapters. Whether the analysis is correct, i.e. whether it amounts to accepted or acceptable practice, is an altogether different question, to which we return in closing. First, we consider the various barriers and drivers that exist (at the macro- and micro-level) to stymie or, as the case may be, catalyze the achievement of better, if not best, practice.

BARRIERS Professional denial Professional denial manifests itself in a variety of ways: ‘standard form’ arguments prevail; debt finance practitioners behave as if derivatives were a discrete and unrelated product area; derivative practitioners readily insert swaps, unengineered, into structured finance transactions; and reticence, incredulity and hostility greet proposals for change. These factors, as well as perpetuating the status quo, greatly hinder the establishment of a forum for better practice of the sort advocated later in this chapter. What they do not explain is why good practice has not ‘trickled down’ from the sophisticated to the vanilla end of the market – a reasonable question, to which there are several interrelated answers. First, although the derivatives market remains relatively young, it has grown and permeated the debt markets at an extraordinary rate – far too quickly, in fact, for good practice to keep up. Not surprisingly, then, 169

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resource within the swap-providing community has been directed at the ‘sharp’ end of the market and the rest has had to make do. Cost and ‘horsesfor-courses’ considerations are an additional factor – nobody is going to instruct the best law firms in the land to advise on a vanilla swap into a small-ticket loan transaction – resulting in a bifurcation of professional expertise that serves only to perpetuate poor practice at the lower end of the market. This, in turn, is compounded by the fact that few private practice derivative lawyers regularly act for end-users against swap providers – let alone on small-ticket transactions – and fewer still can claim to have worked extensively on both sides of the derivative : debt divide. The result is that a great many vanilla finance-linked swap transactions continue to be discussed in unprincipled fashion at both ends – swap provider and end-user – of the negotiating table, and the market ends up none the wiser. Second, ISDA documentation is, justifiably for the most part, viewed by significant sectors of the market as sacrosanct. As derivatives doyen Jeff Golden remarked in The Lawyer (20 February 2003): ‘This [the new 2002 Master Agreement] is a piece of paper which people philosophically put [great] confidence in – it’s a social phenomenon.’ But a high confidence level is one thing – blind faith another. As Golden would be the first to point out, the documentation was originally (and remains) drafted to provide the inter-bank market with a convenient, legally robust, credit risk-reducing and capital-efficient vehicle through which to transact vanilla, stand-alone derivatives. Whenever, therefore, employed in an end-user, cross-border, exotic and
or structured (including finance-linked) context, it has to be tailored to suit. This requirement to ‘cut the cloth’, so to speak, is well understood at the sophisticated end of the market but is obscured in all other sectors by the reverence in which the documentation is held – a dogma that looks decidedly misplaced when one considers that not one provision of any of the ISDA 1987, 1992 and 2002 Master Agreements is drafted in contemplation of finance-linked transactions. Third, and finally, the fact that bank lending and swap departments are, in general, geographically, economically and culturally disparate (and are further divided, intra-department, by product line) means that communication in relation to finance-linked swap transactions is inherently poor. This, in turn, reinforces the unwillingness (or, as the case may be, lack of appreciation of the need) to look for a solution and this, in turn, means that policy, precedents and practice remain misaligned. Many law firms organize themselves in a similar manner, i.e. as if debt and derivative instruments were unrelated practice areas, further compounding the problem. Professional denial is undoubtedly the most significant of all barriers to better practice in the finance-linked swap market. The phenomenon is aggravated by the fact that there is very little evidence to date, in the public arena at least, that malpractice has resulted in any material degree of 170

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prejudice to those party to finance-linked arrangements. Perhaps this is not surprising when one considers that the finance-linked swap market is little more than 10 years old, i.e. younger still than the stand-alone derivatives market that spawned it. What is key, however, is that the potential for prejudice exists and that increasing numbers of debt finance and derivative professionals are willing to admit, privately at least, that current practice is nowhere near where it should be.

Organizational inertia Professional denial means that, for many, the finance-linked swap market is not ‘broken’, so does not need ‘fixing’. Organizational inertia, on the other hand, implies that even those who recognize the defects will be disinclined to take action until the case for doing so becomes overwhelming. The drivers considered later in this chapter may convince the doubters but, for the moment, it is a fact that the organizational implications of raising competency and service levels in relation to finance-linked swap transactions – in terms of policy, procedure, resource, training, structure and short-term profitability – represent a significant, additional barrier in their own right.

Cost At a macro-level, there is no doubt that it will be a costly exercise if the swap and loan-providing communities are to bring about the changes suggested by this book. At the very least, precedents will have to be revisited and originating, operations and legal
documentation personnel (as well as external advisors) retrained accordingly. There may be funding and back-to-back hedging implications, too, in a blanket policy of insulating borrowers from interest rate basis risk and transferring it, instead, to the lender and
or the swap provider. Whether these are relevant considerations, when viewed in the context of the drivers considered below, is open to debate. At the transactional level, a similar argument applies. The key economic and credit provisions applicable to finance-linked swap transactions are subservient to, indeed take their lead from, corresponding provisions of the loan agreement. Negotiation of the swap documentation is therefore reduced from the ‘conventional’ to the ‘technical’ (at least so far as provisions relating to the borrower are concerned). The low marginal cost implicit in undertaking this exercise, when compared with the high marginal utility (as evidenced by the drivers considered below) that results from it, may present an insuperable economic argument to those detractors who would contend that engineering the swap, in the context of small- and medium-ticket loan transactions, unnecessarily increases the borrower’s costs. In absolute terms, the increase is modest; but when viewed relatively or from the perspective of economic utility, it is insignificant. 171

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In short, cost considerations probably represent an illusory, rather than real, barrier to progress.

DRIVERS Commercial imperative Commercial imperative means different things to different parties. To the borrower, it means achieving as near perfect a hedge as is possible and ensuring that concessions made at the level of the loan agreement are not undermined by conflicting provisions in the swap agreement. To the lender and the swap provider, it means reaching an acceptable compromise from an intercreditor and security perspective. The fact that these imperatives exist, coupled with increasing sophistication among end-users in general, means that the onus is on lenders and swap providers to deliver quality documentation that has a high degree of commercial and structural integrity. The weaknesses in some of the ‘barrier’ arguments considered earlier merely reinforce this requirement.

Reputation
regulatory
litigation risk As Chapter 5 points out, poor practice by lenders and swap providers in the finance-linked arena gives rise to the potential for significant damage to reputation, regulatory penalty (including, possibly, the imposition of an operational charge under Basle 2) and
or adverse litigation. That potentiality ought to be a sufficient driver in its own right. Taking a contrary view and arguing that the risk is minimal on account of the lack of verifiable or public incident is flawed since it ignores the embryonic state of the market, the existence of widespread private misgivings and the adage – never more apposite to the financial markets than today – that prevention is better than cure.

Hedge accounting It is too early to predict how end-users will position themselves to take advantage of their ability to hedge account under IAS 39. What is certain, however, is that those who do will be compelled to focus more keenly than ever on the achievement of structural and economic symmetry as between the hedging and the hedged instrument, with obvious and attendant implications for the integrity of finance-linked swap documentation.

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FpML FpML (Financial products Mark-up Language) is a recent, ISDA-driven initiative that promises, through developments in information highway technology, to bring a new level of automation and operational efficiency to the Confirmation-generation and -exchange processes. While FpML is aimed first and foremost at the inter-bank market and although the quality of individual Confirmations will continue to depend on the accuracy of informational input, the efficiencies achieved may mean that resource can be reallocated to improving the integrity of Confirmations in a finance-linked swap context.

A VISION FOR THE FUTURE Outside of the rarefied world of rated deals, the paucity of debate and practitioner guidance in relation to finance-linked swap transactions means that many of the ideas in this book, however principled, have yet to gain widespread or formal currency in the market. There is a groundswell of opinion in isolated quarters, certainly, but nothing more than that. More critically, an acceptance of what amounts to best practice is unlikely to come about through the dogged efforts of individual practitioners – the task is simply too great. As Chapters 1 and 2 point out, significant numbers of interest rate and cross-currency swap transactions are finance-linked, yet poor practice is endemic. This unhappy coalescence suggests that accepted best practice is likely to remain elusive unless it is pinned down by debate and consensus, among derivative as well as debt finance practitioners, within a high-level, cross-market forum established for that purpose. The imperative for such a forum is increasingly compelling and a collaborative undertaking between ISDA and the LMA would, in relation to the UK debt markets at least, seem an obvious vehicle through which to channel efforts. It is with a proposal for a forum of this nature that this book concludes. As to what its objectives should be, a triumvirate of goals presents itself: the settling of market-standard finance-linked swap documentation; the drafting of market-standard provisions for insertion into swap-hedged loan, security and intercreditor documentation; and the dissemination of appropriate memoranda of understanding and practice notes in relation to both. It is hoped that this book will form the bedrock from which those aspirations might grow.

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Annexes

Annex 1 Economic fundamentals and dynamics of interest rate swap transactions Annex 2 Nature and architecture of ISDA documentation Annex 3 Documentation and deal checklists Annex 4 Model term sheet Annex 5 Model finance-linked swap Schedule Annex 6 Model finance-linked interest rate swap Confirmation (short-form) Annex 7 Model finance-linked interest rate cap Confirmation (long-form) Annex 8 Epilogue – ISDA 2002 Master Agreement

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ANNEX 1

Economic fundamentals and dynamics of interest rate swap transactions

What follows is a series of related and sequential questions, the answers to which offer an insight into the economic fundamentals and dynamics of interest rate swap transactions. The material is not difficult and is presented in such a way as to give anyone approaching interest rate swaps for the first time a grasp of the basic principles. The only prerequisites are an intuitive disposition and a general understanding of interest calculations. Financial engineers and other purists dismayed by the simplicity of the treatment are reminded that it is aimed at beginners. Throughout, the expression ‘interest rate swap’ is shortened to ‘IRS’.

WHAT IS AN IRS? An IRS is a contract of a given duration under which two parties agree to make a series of payments to each other (hence the term ‘swap’), the amount of each payment being calculated by reference to (or derived from, hence the generic term ‘derivative’) an underlying rate of interest (hence the reference to ‘interest rate’). Typically, one of the parties (the fixed rate payer) will pay by reference to a fixed rate of interest and the other (the floating rate payer) by reference to a floating (i.e. variable) rate of interest. The payments that arise are not payments of interest in the conventional sense (they cannot be, since neither party makes a payment of loan principal to the other at any stage of the contract), they are simply contractual commitments that happen to be calculated by reference to fixed and floating rates of interest. As to how the amounts are determined, the best place to start is by thinking of a loan on which interest is payable at periodic intervals – quarterly, say. Ignoring repayments of principal for the time being, the amount that the borrower is required to pay to the lender at the end of each quarter is calculated as the product of (i) the loan principal; (ii) a specified ‘day count fraction’, being the number of days in the quarter divided by the number of 177

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days in the year; and (iii) the agreed rate of interest (which may be fixed or floating). Under an IRS, the calculation is the same, save for two important differences. First, as there is no loan principal (an IRS is not a loan, albeit that it does give rise to credit risk), it is necessary to substitute item (i) of the equation with a ‘notional’ amount that serves the same purpose, i.e. acts as a multiplicand for items (ii) and (iii). Second, both parties under an IRS are required to make the relevant payments (under a loan, it is only the borrower) and the respective amounts that they pay are almost always asymmetric. Why? Because one of them is paying by reference to a fixed and the other by reference to a floating rate of interest. For the payments to be identical, the floating rate and the fixed rate for the quarter would have to be the same. That, as we shall see, is an unlikely occurrence. The payment flows arising under a typical IRS – having, let us suppose, a notional amount of £100 million, a five-year term, quarterly LIBOR as the applicable floating rate and a fixed rate of 5% p.a. – are illustrated in Figure A1.1. Payment flows under a typical IRS

Figure A1.1

Quarterly LIBOR over 5 years on £100m notional Floating rate payer

Fixed rate payer Quarterly 5% p.a. over 5 years on £100m notional

Where amounts payable under an IRS fall on the same date and are in the same currency, it is common for the parties to agree to ‘net-settle’ the two payments, i.e. for the smaller amount to be deducted from the larger amount and for the difference to be paid over by the party with the larger original obligation. Net settlement is administratively efficient and reduces settlement risk. The only limiting factor is the ability of the parties to ‘manage’ the payments, from an operational perspective, on a net basis. For banks and other large buyers and sellers of IRSs, this is generally not an issue and net settlement is often extended to same-date
same-currency payments arising under multiple IRSs between two given parties.

WHY ENTER INTO ONE? There are, essentially, only two reasons for entering into an IRS. The first is for the purposes of asset and
or liability management (i.e. ‘hedging’) and the second is to speculate. 178

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IRS as an asset
liability management tool Quarterly LIBOR

Quarterly LIBOR Floating rate payer/investor

IRS provider Fixed

Quarterly LIBOR Bond (5 year; £100m)

Figure A1.2

Fixed rate payer/borrower Fixed

Quarterly LIBOR Loan (5 year; £100m)

Consider the diagram in Figure A1.2. It is identical to Figure A1.1 save that an IRS provider – such as a bank – has been interposed between the floating rate payer and the fixed rate payer, each of which is also party to an independent contract (a five-year, £100 million bond that pays quarterly LIBOR, in the case of the floating rate payer; and a five-year, £100 million loan costing quarterly LIBOR, in the case of the fixed rate payer). Suppose that the investor fears that interest rates will fall over the life of the bond and wants to lock in a fixed rate of return. Suppose, on the other hand, that the borrower fears the opposite and wants to fix its interest costs over the life of the loan. In such circumstances, it makes perfect sense for each of them to enter into the respective contracts with the IRS provider to hedge against an interest rate fall or, as the case may be, an interest rate rise. Put another way, since the respective LIBOR flows cancel out, the investor ends up with the economic equivalent of a fixed income bond and the borrower ends up with the economic equivalent of a fixed rate loan. As to why the investor and the borrower require the services of an IRS provider at all (it will usually take a ‘cut’ out of the payment flows on one or both sides of the transaction), there are several reasons, all to do with the fact that the investor and the borrower are unlikely to transact (or to want to transact) directly with the other. First, they may not know that the other exists. The IRS provider thus performs a classic intermediation service by bringing them together. Second, even if they do know of the existence of the other, it is unlikely that their IRS requirements will be identical. What the IRS provider will do, in practice, is provide a tailored IRS contract to each of them, taking both contracts into its trading book (a book that is actively managed so that it remains, when viewed from the perspective of all IRS contracts within it, in broad equilibrium). Third, the parties are unlikely to want to trade with each other for credit risk and confidentiality reasons. Here again, the IRS provider offers an intermediated solution that addresses both concerns. 179

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A reasonable question is why the investor does not simply buy a fixed rate bond or why the borrower does not enter into a fixed rate loan. The answers are unsurprising. From the investor’s perspective, fixed rate paper on the issuer’s name may simply be unavailable in the market. Equally, the borrower may (for reasons considered in Chapter 1) be unable to find a lender willing to offer it a fixed rate loan. Remove the independent contracts from Figure A1.2 (i.e. return to Figure A1.1) and, absent a positive correlation between LIBOR and the parties’ respective income
expenditure flows, each IRS is nothing more than a bet on future interest rates – speculation, in other words.

WHERE DOES THE FIXED RATE COME FROM? The answer to this question is fundamental to an understanding of IRS dynamics. Reconsider Figure A1.1. Neither party, acting rationally, is going to enter into the IRS unless what it expects to pay and what it expects to get back in return is, over the life of the IRS and on a discounted to present value basis, equal. Why else would either party enter into the contract? The difficulty is working out what the actual amount is going to be, since nobody has a crystal ball and nobody can predict exactly how floating rates are going to behave over the next five (to take our example) years. And without knowing what floating rates are going to do, it is impossible, as we shall see, to calculate the fixed rate. The key to resolution of this conundrum is something called the forward curve. This represents the market’s best guess, based on all available benchmarks (including relevant economic and political indicators, prices and rates applicable to fixed income investments and general market sentiment), of where floating rates are likely to be at any point over a given period. In illiquid and
or niche markets, the forward curve is a highly subjective construction that differs wildly from institution to institution (and getting it ‘right’, therefore, can lead to a significant competitive advantage). In liquid and transparent markets (such as the interest rate markets), the forward curve is, except in times of extreme volatility, not a matter of controversy. It is, then, possible to plot a forward interest rate curve that (based on today’s information) gives an objectively verifiable measure of where future interest rates are expected to be. If we trust the forward curve (and there is actually little choice), we are half way to working out the fixed rate. Why? Because if we know the floating rate for each quarter over the term of the IRS, we can also work out the aggregate amount payable by the floating rate payer over that same term. Since that amount, a priori, has to equal the aggregate amount payable by the fixed rate payer over that same term, we can derive the fixed rate. This outcome is demonstrated diagrammatically in 180

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Deriving the fixed rate from the forward curve

Figure A1.3

LIBOR i same area

x%

5 year swap rate

0

0

5 yrs

t

Figure A1.3, which shows an upward sloping, five-year forward curve for £ LIBOR. Intuitively (a mathematical demonstration would also be possible), the reader can see that the fixed rate is simply the rate that ensures that the area below the forward curve (representing floating rate ‘interest’) and the area below the horizontal line (representing fixed rate ‘interest’) are, over the term of the IRS, the same. The fixed rate is also called the swap rate. Swap rates for IRSs of different maturities or calculated by reference to different floating rates of interest (i.e. in addition to £ LIBOR) are published daily in leading financial papers around the world, are quoted by banks on request and are also available, real-time, on the screen pages of publishers of financial information such as Reuters and Bloomberg.

HOW DOES CREDIT RISK ARISE UNDER AN IRS? When two parties enter into the IRS, they do so at a fixed rate that, ignoring credit spreads and funding costs, ensures (based on the forward curve) that the discounted present value of their respective aggregate payment obligations, over the term of the IRS, is identical. To use the jargon, the IRS is, on the day that it is entered into, ‘at the money’. As we have seen, however, the forward curve is based on today’s (or even, in times of extreme volatility, this minute’s) information. By tomorrow (or even later in the day), that information will almost certainly have changed. As a result, the forward curve will be different – it may move up or down, 181

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become inverted, less or more steep and so on. It may even lose its shape altogether. Every time the forward curve moves, the amount that the floating rate payer expects to have to pay to the fixed rate payer, over the residual term of the IRS, changes relative to the amount that it expects to receive. If the floating rate payer expects to receive more, it is said to be ‘in the money’ (i.e. to have contingent credit exposure on the fixed rate payer) to the extent of the difference. The fixed rate payer in such circumstances is said to be ‘out (of) the money’ (i.e. to have a contingent payment obligation to the floating rate payer) to that same extent. If the floating rate payer expects to receive less, it is said to be out (and the fixed rate payer is said to be in) the money, again to the extent of the difference. The relevance of all this becomes apparent if one considers what happens when an IRS, for whatever reason (most critically, the insolvency of one or other of the parties), is terminated ahead of its contractual maturity. In such circumstances, the contingent exposure (and corresponding obligation) under the IRS is best crystallized – otherwise an in-the-money party risks seeing its exposure rise and rise over time – leaving the out-the-money party having to make a termination payment. Returning to our borrower, what is the significance to it of an early termination of the IRS? If it is the borrower that is insolvent, an in-the-money amount represents a debtor that the borrower’s liquidator will seek to realize in the normal way; and an out-the-money amount represents a claim in respect of which the IRS provider will prove in the borrower’s liquidation. While the IRS provider may suffer a loss in respect of that claim, its book (managed, as noted earlier, on a portfolio basis) will not be unduly disturbed. If, on the other hand (and unusually, given its likely creditworthiness), it is the IRS provider that is insolvent, the borrower’s problem is two-fold: first, its loan is now ‘unhedged’; and second, it may not recover all (or any) of the in-the-money amount that is due to it from the IRS provider (if indeed, as we shall assume for the time being, it is the borrower that is in the money at the relevant time). In the case of the IRS provider’s insolvency, the borrower will, if acting rationally, want to go back into the market and re-hedge, at the original fixed rate, with a different IRS provider. But the original fixed rate will now be ‘off-market’, i.e. will be below the prevailing fixed rate (it is this very fact that leads to the borrower being in the money in the first place) and so the replacement IRS provider will want to be compensated to the extent of the difference. In very crude terms (that are discernible intuitively as well as mathematically), the amount of that compensation will be the same amount that is due to the borrower from the original IRS provider – and so the borrower will, typically, on-pay that amount to the replacement IRS provider, re-hedging itself at the original fixed rate in the process. If, as is more likely 182

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however, the borrower fails to recover the full amount from the original IRS provider, it will have to (i) make up the difference itself (when entering into the new IRS with the replacement provider); (ii) enter into a replacement IRS that is ‘at market’ (i.e. at the higher fixed rate); or (iii) buy, from the replacement provider, whatever fixed rate is available in exchange for the amount that it receives from the original IRS provider. If, finally, the borrower is out the money when the original IRS provider becomes insolvent, it will probably enter into a new, off-market IRS with a replacement provider, as before, but this time will use the compensation amount that it receives from the replacement provider to meet its termination payment obligation to the original IRS provider.

HOW IS THE CREDIT RISK THAT ARISES UNDER AN IRS (I) QUANTIFIED AND (II) MANAGED? Quantification of the credit risk that arises under an IRS is illustrated diagrammatically in Figure A1.4, which compares an IRS in respect of which there is no termination (other than at contractual maturity) and an IRS in respect of which there is a break during the third quarter of its term. If the IRS runs to maturity (as illustrated by the arrows above the time line in Figure A1.4), the parties will have made their respective payments to each

Contingent vs. scheduled payments under an IRS contract

No default/break during term

Floating

Floating

Floating

Fixed

Fixed

Fixed

Figure A1.4

etc.

time line 1 4

0 Default/break during 3rd quarter

1 2

Floating

Floating

Fixed

Fixed

3 4

net accrual (‘A’) break/ last scheduled default date payment date

5 years

MTM (‘M’)

scheduled maturity

M ⫹Ⲑ⫺ A ⫽ termination payment

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other as originally contemplated by the terms of the IRS contract. The fact that the borrower may have ended up paying more, in aggregate, than it has received under the contract is irrelevant – even though the fixed rate under the contract was calculated in contemplation of payables and receivables being the same – since the stated objective (fixing the borrower’s loan interest costs) has been achieved. The unconvinced reader should consider the position of a fixed rate mortgage borrower who, with the benefit of hindsight, would have done better by borrowing at variable rates. Most such borrowers merely shrug, acknowledging that the ‘extra’ interest was simply the price that they had to pay for interest rate certainty. If, on the other hand, the IRS is broken ahead of maturity, a termination amount will, as we have noted, be payable. In Figure A1.4, the zigzag (below the time line) represents an early termination on a date in the third quarter of the term of the IRS. The termination amount in respect of that date is calculated as the aggregate of the ‘mark to market’ (‘MTM’ for short and described in Figure A1.4 as ‘M’) and an accrual amount (described in Figure A1.4 as ‘A’). The MTM is the net present value of the remaining receivables
payables under the contract between the termination date and the scheduled maturity date (calculated by reference to the then current forward curve) and the net accrual is the difference between the fixed and floating amounts due in respect of the period from the then last scheduled payment date under the IRS up to the date of its termination. The futurity of performance that is implicit in IRS contracts and the possibility that one or other of the parties to them may fail to perform its obligations means that the credit exposures that arise, while contingent, need to be risk managed. It is not uncommon, therefore, for one or both of the parties to insist that the other’s obligations to it are secured in some way, either through the provision of cash or other liquid collateral, a guarantee by a better quality credit (e.g. a parent company) or some other form of security. Collateralization generally goes hand in hand with IRS contract documentation (such as the ISDA 1992 Master Agreement) that provides for positive and negative exposures – arising between the same parties but across different IRS (and
or other derivative) transactions – themselves to be netted on an early termination. Close-out netting is not to be confused with payment settlement netting of the sort considered earlier in this Annex. The latter is operationally driven. The former is motivated by credit risk reduction concerns and demands, as a result, IRS documentation that is robust enough to ensure ‘survival’ of the termination and netting provisions on the insolvency of one or other of the parties. As an important sequitur, robustness of this nature enables IRS and other derivative transactions to be both collateralized and, in the case of regulated IRS providers, capitalized on a net, as opposed to a gross, basis. 184

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WHAT IS THE SIGNIFICANCE OF THESE PRINCIPLES IN A FINANCE-LINKED SWAP CONTEXT? Figure A1.5 illustrates various credit scenarios in the context of a loan that is hedged with a finance-linked IRS (where both loan and IRS are provided by the lending bank). IRS fundamentals applied in a finance-linked swap context

Lending bank & swap provider

Figure A1.5

Loan exposure Borrower Contingent swap exposure

The loan exposure in Figure A1.5 is always positive so far as the lending bank is concerned (and always negative so far as the borrower is concerned). There are, however, three possibilities so far as the IRS is concerned: (i) it increases the lending bank’s exposure (where the lending bank is in the money); (ii) it decreases the lending bank’s exposure (where the lending bank is out the money); or (iii) it leaves the lending bank’s exposure unchanged (on those rare occasions when the IRS is at the money). Each of these possibilities needs to be contemplated in the loan and IRS documentation entered into between the lending bank and the borrower (and much of this book is devoted to discussing the intricacies of doing just that). To give just two examples of relevant considerations, the lending bank will want to ensure that any security that it receives from the borrower extends beyond the loan to secure, additionally, contingent exposures arising under the IRS. The borrower, on the other hand, will want a contractual right, on an early termination of the IRS, to set off any amounts owing (but not paid) to it under the IRS against amounts that it owes under the loan.

ANYTHING ELSE I SHOULD KNOW? The principles outlined above apply to most derivative contracts. Some derivatives are, admittedly, ‘odd’. Under premium-paid option contracts, for example, only one party (the option buyer) can ever be in the money and only one party (the option seller) can ever be out. Under cross-currency 185

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swaps, there is a mutual exchange of principal. Under some IRS contracts, both parties pay by reference to a floating rate of interest (albeit different inter se). Fundamentally, however, all these contracts share the same essential characteristics.

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ANNEX 2

Nature and architecture of ISDA documentation The 1992 ISDA Master Agreement (Multicurrency-Cross Border) is a globally accepted precedent (although other master agreements exist) for the documentation of swap and other derivative transactions. It is referred to in this Annex as the ‘1992 Master’. The 1992 Master adopts a three-part ‘Master Agreement’, ‘Schedule’ and ‘Confirmation’ format that is common to most derivatives markets documentation. The Master Agreement consists of 18 pre-printed pages that set out the legal relationship between the two parties and the terms that are likely to be common to all transactions between them. Its provisions detail general transactional obligations and include representations, events of default, settlement and close-out netting provisions and the methodology to be followed on an early termination. Various administrative matters are also addressed. Where, as is invariably the case, the parties wish to tailor or skew the provisions of the Master Agreement to suit their circumstances (and, in particular, to reflect differences in their respective credit standings), they do so through the Schedule that is attached to (and that effectively amends the standard provisions of) the Master Agreement. With the Master Agreement and Schedule in place, the parties are ready to do business. All that remains – unless, as discussed in Chapter 4, the relevant transaction has been entered into and confirmed on a pre-Master basis – is for the economic terms of the transaction (i.e. who pays what to whom and when) to be agreed. Often (though less so in a finance-linked swap context) this is done over the telephone and the oral agreement so reached is then ‘confirmed’ by way of written Confirmation. Since most of the relationship and credit provisions relating to the transaction have already been agreed in the overlying Master Agreement (as amended by the Schedule), each Confirmation can (certainly in relation to vanilla transactions) be very brief, typically consisting of a few pages only. The Master Agreement, Schedule, each transaction and its related Confirmation are expressed to form a single agreement between the parties. This has several advantages. Not least, it means that the parties need only sign up to one Master Agreement and Schedule (although, for reasons 187

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considered in Chapter 4, this is not always true in a finance-linked swap context). Thereafter, they can enter into as many transactions as they wish under the umbrella of that Master Agreement and Schedule and, since they need only to agree economic terms, individual transactions can be documented and concluded cheaply and quickly (again, not always true in a finance-linked context). The ‘single agreement’ concept is also extremely helpful in reinforcing the close-out netting analysis considered in Annex 1. It is to be remembered, however, that the utility of close-out netting in a finance-linked swap context is marginal insofar as there is, typically, only ever one transaction outstanding under the ‘Master’ Agreement (a misnomer in such circumstances, of course, but not one that should undermine the case for using the 1992 Master as a convenient starting point for the documentation of finance-linked swaps). The ease of documenting transactions under the 1992 Master is further facilitated by the existence of various ISDA-published definitions booklets. The booklet the ‘1991 ISDA Definitions’ – and its successor, the ‘2000 ISDA Definitions’ (and related Annex) – contains, inter alia, standard definitions for a variety of floating rates and currencies, sets out numerous bases and fallback provisions for calculating fixed and floating rate payments under interest rate swap and similar transactions and includes pro-forma Confirmations that can be used to record such transactions. The specimen Confirmations included in Annexes 6 and 7 are based on such pro-forma. Other definitions booklets exist to facilitate the documentation of a range of more complex derivative products. By incorporating (through the Confirmation) the relevant definitions into the overall agreement, the parties may conveniently refer to a range of pre-defined terms for the purposes of recording complex economic concepts within individual Confirmations. The 1992 Master is thus a convenient vehicle for the documenting of swap and analogous transactions, particularly where these are entered into independently of any other commercial relationship between the parties (indeed, the 1992 Master – and the predecessor terms and agreements out of which it evolved – was only ever conceived and drafted with ‘independent’ transactions in mind). Where, however, transactions contemplated under a 1992 Master are in some way connected to another transaction, such as a loan, special considerations exist. It is these special considerations that form the subject matter of this book.

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ANNEX 3

Documentation and deal checklists See Chapters 3 to 9 for in-depth commentary.

DOCUMENTATION CHECKLISTS (These assume swap provider and lender are same entity or affiliated.) Swap documentation

■

■

■

Loan documentation

■

■

■

■

■

■

■

■

Decide between scope-restricted ISDA documentation and ‘long-form’ Confirmation Decide between pre-Master and contemporaneously executed Confirmation Follow ‘General Rule’
Chapters 3 and 4 approach to drafting of Schedule and Confirmation Ensure definition of swap reflects adopted documentation structure (see above) Ensure definitions of ‘permitted indebtedness’, ‘permitted security interest’ and ‘permitted disposal’ are cognisant of swap Ensure definition of ‘finance document’ does not lead to unintended override of entrenched provisions in swap documentation Ensure ‘application
source of funds’ provisions and feeder
security account mechanics are cognisant of swap Amend ‘fixture period’ provisions to reflect Designated Maturity under swap Amend prohibitions on borrower set-off to permit set-off against swap provider Consider financial covenants in light of scheduled and contingent payments due to
from borrower under swap Carve out swap from covenant not to enter into off-balance sheet financing arrangements

189

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■

■

Security documentation

■

■

■

■ ■

Build in borrower breach of swap agreement as additional EOD Amend failure to pay interest so that no EOD where caused by swap provider non-payment Consider mandatory prepayment, default interest, transfer, notice, EMU accession, governing law and other provisions from general conformity to swap documentation perspective Consider whether benefit of security is to extend to swap provider (if other than lender) and structure accordingly Ensure definition of ‘charged assets’ embraces contingent amounts due to borrower under swap (where lender and swap provider are different entities) Consider limiting ‘secured obligations’ to net borrower obligations under loan and swap Amend tacking provisions where appropriate Amend prohibitions on borrower (or thirdparty security provider) set-off to permit set-off against swap provider

Intercreditor documentation

■

Draft to reflect agreed intercreditor position (see below)

Ancillary documentation

■

Ensure all ancillary documents are cognisant of swap

PRE-DEAL
DEAL CHECKLISTS Lender
borrower pre-deal considerations

■

■

■

■

190

Formulate and agree hedging strategy (borrower with help of hedging consultants as necessary); embody strategy in term sheet Consider borrower tax and accounting implications of loan and swap Consider and agree net settlement mechanic (i.e. Fixed
LIBOR under swap vs. LIBOR
LIBOR under loan
swap) Consider borrower’s ability to mark to market swap for financial covenant compliance purposes (where applicable)

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Annex 3 ■

■

Swap provider (if lender) pre-deal considerations

■ ■

■

■

■

Agree consequences (if any) for swap on lender transfer of loan Consider policy
credit restraints in context of transfer to avoid termination event provisions within swap documentation As above; in addition: Agree swap documentation structure with borrower (see above) Consider and agree extent of swap break rights (i.e. over and above those following mandatory or voluntary prepayment of loan), including right to break if conditions precedent to drawdown of loan not satisfied; borrower to negotiate for break at mid-market (if not zero cost) Consider capacity and authority, reliance and regulatory constraints in relation to borrower Provide draft Confirmation and Schedule to borrower
borrower’s lawyers at earliest opportunity

Swap provider (if affiliated to lender) pre-deal considerations

■

As above; in addition formalize intercreditor position with lender

Swap provider (if syndicate member) pre-deal considerations

■

As above; in addition: Consider appointing lead
co-ordinating
fronting entity (if more than one swap provider in syndicate) for tender and documentation negotiation purposes Agree intercreditor position (consider swap provider’s sharing obligations; set-off rights; voting rights
subservience to majority lender decisions; unilateral termination rights; structural and contractual subordination; stepout obligations; security enforcement rights and ranking) Consider appointing loan facility agent as swap calculation agent

■

■

■

General deal considerations (all financings)

■

■ ■

Consider principles of economic and credit symmetry Consider security and intercreditor issues Consider loan prepayment and transfer issues 191

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Project financings (additional considerations)

■

■

■

■ ■

■

Property financings (additional considerations)

■ ■

■

Address rental receipt timing issues Consider inflation swap where rental uplifts are linked to actual inflation and loan capital repayments are linked to assumed inflation Consider Chapter 6 alternatives on refinancing

PFI financings (additional considerations)

■

Refer to OGC Guidance papers and Chapter 6 commentary

MBO financings (additional considerations)

■

Bear swap in mind when considering applicable MoU Ensure whitewash of target security
indemnities is cognisant of swap

Repackagings and securitizations (additional considerations)

■

■

■

■

■

192

Pay special attention to desirability of zero
fixed cost entry and exit swaptionality Decide between bond proceeds deposit swap and GIC Cap swap provider rights to security pool (in relation to accreting swap for inflation-adjusted bond principal) Address cross-border issues Consider applicable listing and
or rating agency criteria Consider entitlement of swap provider to credit wrap

Amend swap documentation to ensure rating agency-compliant (amendments to include: smoothing, liquidity and credit enhancement features; limited recourse and non-petition covenants; additional
replacement collateral triggers; bespoke tax risk allocation mechanisms; limitations on ambit and effect of representations, agreements, events of default and termination events) Obtain (and periodically update) rating agency-required local law legal opinions Construct firewalls between (and consider pro-forma Schedule for use with) multiple
programme issuances Consider and document credit derivative component of structure separately, in accordance with applicable rating agency criteria

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Debt capital market issues (additional considerations)

■

■

■

Pay special attention to principles of economic and credit symmetry Double-check to ensure swap documentation contains express issuer break rights on early redemption Consider applicable listing and
or rating agency criteria

DPCs (additional considerations)

■

Pay attention to DPC termination rights – especially where DPC is of ‘terminating’ variety

Housing associations (additional considerations)

■

Consider alternative of fixed
capped rate loan Double-check to ensure swap is compliant from legal and regulatory perspective On prepayment of loan, ensure swap is terminated or reallocated

■

■

Double-check to ensure swap is compliant from legal and regulatory perspective On prepayment
early redemption of related loan
asset, ensure swap is terminated or (if FSA-permitted) reallocated

Building societies (additional considerations)

■

Accrual swaps (additional considerations)

■

Amend Section 6(e) to achieve zero cost break on unwind of larger structure

Individuals (additional considerations)

■

Pay special attention to questions of reliance and suitability Eliminate residual (i.e. post application of ‘General Rule’) absurdities from swap documentation

■

■

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ANNEX 4

Model term sheet (Relating to base case considered in Chapter 4.)

LOAN Lender

:

[

]

Borrower

:

[

]

Guarantor

:

Parent (for net obligations across loan and swap)

Principal Amount

:

£100m amortizing by £10m per annum on each anniversary of drawdown

Drawdown Date

:

2 January 2003

Final Repayment Date

:

31 December 2012

Interest Basis

:

Quarterly LIBOR (payable on usual quarter days by reference to Telerate Page 3750) ! Margin ! MLAs

Margin

:

[

Covenants

:

[Usual lender-required covenants including financial covenants to be agreed]

Events of Default

:

[Usual lender-required events of default including Borrower breach of swap agreement]

Other Provisions

:

To include: ■

■

■

194

] b.p.

Borrower and Guarantor set-off rights in respect of swap no EOD where failure to pay interest caused by lender non-payment under swap usual prepayment obligations (prepayment rights to be agreed)

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notices to be cross-copied to Guarantor

Transfer

:

To be considered
agreed in context of swap arrangements

Governing Law

:

English

Swap Provider

:

Lender

Counterparty

:

Borrower

Guarantor

:

As for loan

Notional Amount

:

As for Principal Amount under loan

Effective Date

:

As for Drawdown Date under loan

Termination Date

:

As for Final Repayment Date under loan

Floating Rate

:

Quarterly LIBOR (same days, day count and rate source as under loan)

Fixed Rate

:

[5.125]%

Spread

:

None

Documentation

:

ISDA 1992 (modified) to include:

SWAP

■ ■ ■

■

■

■

■

restriction on scope non-reliance provisions disapplication of all Counterparty EODs bar Section 5(a)(i) additional Counterparty EOD (lender acceleration under loan agreement) Counterparty and Swap Provider ATE (prepayment of loan) notices to be cross-copied to Guarantor general conformity to loan agreement

195

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ANNEX 5

Model finance-linked swap Schedule (Relating to base case considered in Chapter 4.)

(Multicurrency-Cross Border)

ISDA

® International Swaps & Derivatives Association, Inc. SCHEDULE to the Master Agreement dated as of [

between

][

[LENDING BANK] (“Party A”)

], 200[ ]

and

[BORROWER] (“Party B”)

Part 1. Termination Provisions. (a) “Specified Entity” means in relation to Party A for the purpose of:Section 5(a)(v), not applicable; Section 5(a)(vi), not applicable; Section 5(a)(vii), not applicable; Section 5(b)(iv), not applicable; and in relation to Party B for the purpose of:Section 5(a)(v), not applicable; Section 5(a)(vi), not applicable; Section 5(a)(vii), not applicable; Section 5(b)(iv), not applicable. (b) “Specified Transaction” will have the meaning specified in Section 14 of this Agreement.

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(c) The “Cross Default” provisions of Section 5(a)(vi) will apply to Party A and will not apply to Party B. If such provisions apply:“Specified Indebtedness” will have the meaning specified in Section 14 of this Agreement
1. “Threshold Amount” means, with respect to Party A, [

]
2.

(d) The “Credit Event Upon Merger” provisions of Section 5(b)(iv) will apply to Party A and will not apply to Party B, (e) The “Automatic Early Termination” provisions of Section 6(a) will not apply to Party A and will not apply to Party B. (f) Payments on Early Termination. For the purpose of Section 6(e) of this Agreement:(i)

[Market Quotation]3[Loss]4 will apply.

(ii) The Second Method will apply. (g) “Termination Currency” means GBP. (h) Additional Termination Event will apply. The following shall constitute an Additional Termination Event:Pursuant to [Clause [ ]] of the [Facility Agreement], Party B [prepays][is required to prepay] all or part of the [Advance[s]] under the [Term Loan Facility]
5. For the purpose of the foregoing Termination Event, [both]
6 parties shall be Affected Parties. In the case of a partial prepayment of such
1

Bank to consider carve-out for general (i.e. other than borrower) deposits. Borrower to consider expansion for ‘true’ third party derivatives.
2 Bank to stipulate, borrower to consider. If borrower is itself a depositor with bank, build in zero threshold in respect of borrower deposits.
3 Elect if the finance-linked swap is to be hedged on a portfolio basis.
4 Elect if the finance-linked swap is to be hedged on a back-to-back basis.
5 The intention here is to enable the borrower (and perhaps also the bank) to bring about an early termination of the finance-linked swap on a prepayment of the loan. The drafting will need to be conformed to the precise prepayment terms of the loan and should embrace voluntary as well as mandatory prepayment events.
6 If the right to terminate on a prepayment is to operate only unilaterally (most usually, in favour of the borrower), the provision should be amended accordingly; but the borrower should note that this may, without a corresponding amendment to Section 6(e), shift the termination basis from mid-market to bid. 197

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[Advance[s]], the foregoing Termination Event shall entitle [the relevant party] to terminate the [Transaction]
7 rateably i.e. in the same amount as the amount of the partial prepayment.

Part 2. Tax Representations. (a) Payer Representations. For the purpose of Section 3(e) of this Agreement, Party A will make the following representation and Party B will make the following representation:It is not required by any applicable law, as modified by the practice of any relevant governmental revenue authority, of any Relevant Jurisdiction to make any deduction or withholding for or on account of any Tax from any payment (other than interest under Section 2(e), 6(d)(ii) or 6(e) of this Agreement) to be made by it to the other party under this Agreement. In making this representation, it may rely on (i) the accuracy of any representations made by the other party pursuant to Section 3(f) of this Agreement, (ii) the satisfaction of the agreement contained in Section 4(a)(i) or 4(a)(iii) of this Agreement and the accuracy and effectiveness of any document provided by the other party pursuant to Section 4(a)(i) or 4(a)(iii) of this Agreement and (iii) the satisfaction of the agreement of the other party contained in Section 4(d) of this Agreement, provided that it shall not be a breach of this representation where reliance is placed on clause (ii) and the other party does not deliver a form or document under Section 4(a)(iii) by reason of material prejudice to its legal or commercial position. (b) Payee Representations. For the purpose of Section 3(f) of this Agreement, neither Party A nor Party B will make any representations.

Part 3. Agreement to Deliver Documents. For the purpose of Sections 4(a)(i) and (ii) of this Agreement, each party agrees to deliver the following documents, as applicable:(a) Tax forms, documents or certificates to be delivered are:None.
7

This assumes that there will only ever be one Transaction outstanding under the Agreement (see ‘Scope’ in Part 5 below). If more than one Transaction is contemplated, the provision will need to be amended accordingly. 198

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(b) Other documents to be delivered are:Party required to Form
Document
deliver document Certificate

Date by which to be delivered

Party A
8

On or before the execution of this Agreement and thereafter promptly upon written request

Evidence of the authority of each person executing any document on its behalf in connection with this Agreement

Covered by Section 3(d) Representation Yes




Part 4. Miscellaneous. (a) Addresses for Notices
9. For the purpose of Section 12(a) of this Agreement:Address for notices or communications to Party A:Address:

[

]

Attention:

[

]

Telex No.:

[

] Answerback:

Facsimile No.: [

[

]

] Telephone No.: [

]

Electronic Messaging System Details:

[

]

Address for notices or communications to Party B:Address:

[

]

Attention:

[

]

Telex No.:

[

] Answerback:

Facsimile No.: [

[

]

] Telephone No.: [

]

Electronic Messaging System Details:

[

]

8

Party B documents (including e.g. a requirement for a legal opinion as to capacity and authority) may be included here or as c.p.’s to the related loan agreement. The latter approach avoids duplication. 9 See Chapter 4 for a discussion of various alternatives here. 199

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(b) Process Agent. For the purpose of Section 13(c) of this Agreement, neither party A nor Party B appoints a Process Agent. (c) Offices. The provisions of Section 10(a) will not apply to this Agreement. (d) Multibranch Party. For the purpose of Section 10(c) of this Agreement, neither Party A nor Party B is a Multibranch Party. (e) Calculation Agent. The Calculation Agent is Party A, unless otherwise specified in a Confirmation in relation to the [relevant] Transaction. (f) Credit Support Document. Details of any Credit Support Document:With respect to Party A: None. With respect to Party B: [detail Parent guarantee]. (g) Credit Support Provider. Credit Support Provider means:With respect to Party A: None. With respect to Party B: Parent. (h) Governing Law. This Agreement will be governed by and construed in accordance with English law. (i)

Netting of Payments. Subparagraph (ii) of Section 2(c) of this Agreement will apply to [any][the] Transaction.

(j)

“Affiliate” will have the meaning specified in Section 14 of this Agreement
10.

Part 5. Other Provisions
11
. 1.

Scope No Transaction may be entered into under this Agreement unless it is for the purpose of hedging all or part of Party B’s interest rate liabilities under the [Term Loan Facility].

2.

Relationship between Parties Each party will be deemed to represent to the other party on the date

10

Check for conformity between Section 3(c) of the Agreement (material litigation with respect to Affiliates) and any corresponding provisions of the related loan agreement.
11 See Chapter 4 for a general discussion in relation to Part 5 provisions in a finance-linked swap context. 200

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on which it enters into [a][the] Transaction that (absent a written agreement between the parties that expressly imposes affirmative obligations to the contrary for that Transaction):(a) Non-reliance. It is acting for its own account, and it has made its own independent decisions to enter into that Transaction and as to whether that Transaction is appropriate or proper for it based upon its own judgment and upon advice from such advisers as it has deemed necessary. It is not relying on any communication (written or oral) of the other party as investment advice or as a recommendation to enter into that Transaction; it being understood that information and explanation related to the terms and conditions of a Transaction shall not be considered investment advice or a recommendation to enter into that Transaction. No communication (written or oral) received from the other party shall be deemed to be an assurance or guarantee as to the expected results of that Transaction. (b) Assessment and understanding. It is capable of assessing the merits of and understanding (on its own behalf or through independent professional advice), and understands and accepts the terms, conditions and risks of, that Transaction. It is also capable of assuming, and assumes, the risks of that Transaction. (c) Status of parties. The other party is not acting as a fiduciary or as adviser to it in respect of that Transaction. 3.

Limitation on Default Sections 5(a)(ii) to (viii)
12 inclusive shall not apply to Party B. In their stead, the following Event of Default shall apply to Party B: Pursuant to [Clause][ ] of the [Facility Agreement], Party A declares the [Facilities][Advance(s)] to be repayable on demand or requires repayment of the [Facilities][Advance(s)] under the [Term Loan Facility]
13.

4.

Set-Off The following shall be added as Section 6(f):“(f) Set-Off. Any amount (the “Early Termination Amount”), payable to one party (the Payee) by the other party (the Payer) under Section 6(e), in circumstances where there is a Defaulting Party or one

12

Ensure all disapplied Events of Default exist, in one form or another, in the related loan agreement. Insert, as necessary, additional provisions to conform the grace period within Section 5(a)(i) to its counterpart within the related loan agreement.
13 Conform to precise default declaration provisions within the related loan agreement. 201

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Affected Party in the case where a Termination Event under Section 5(b)(iv) has occurred, will, at the option of the party (“X”) other than the Defaulting Party or the Affected Party (and without prior notice to the Defaulting Party or the Affected Party), be reduced by its set-off against any amount(s) (the “Other Agreement Amount”) payable (whether at such time or in the future or upon the occurrence of a contingency) by the Payee to the Payer (irrespective of the currency, place of payment or booking office of the obligation) under any other agreement(s) between the Payee and the Payer or instruments(s) or undertaking(s) issued or executed by one party to, or in favour of, the other party (and the Other Agreement Amount will be discharged promptly and in all respects to the extent it is so set-off). X will give notice to the other party of any set-off effected under this Section 6(f). For this purpose, either the Early Termination Amount or the Other Agreement Amount (or the relevant portion of such amounts) may be converted by X into the currency in which the other is denominated at the rate of exchange at which such party would be able, acting in a reasonable manner and in good faith, to purchase the relevant amount of such currency. If an obligation is unascertained, X may in good faith estimate that obligation and set-off in respect of the estimate, subject to the relevant party accounting to the other when the obligation is ascertained. Nothing in this Section 6(f) shall be effective to create a charge or other security interest. This Section 6(f) shall be without prejudice and in addition to any right of set-off, combination of accounts, lien or other right to which any party is at any time otherwise entitled (whether by operation of law, contract or otherwise).” 5.

Notification of Default Each party agrees that, so long as it has or may have an obligation under this Agreement, it will notify the other party immediately upon the occurrence of an Event of Default or, to the extent that the notifying party is aware of the same, of a Potential Event of Default
14.

6.

Third Party Rights Nothing in this Agreement is intended to confer on any person any right to enforce any term of this Agreement which that person would not have but for the Contracts (Rights of Third Parties) Act 1999.

14 Check for conformity to parallel notification provision in related loan agreement. Consider cross-copying notifications (to borrower) to Parent.

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7.

Additional Definitions Where used in this Agreement, “[Facility Agreement]” means the [Facility Agreement] dated [ ] (as amended, transferred or novated from time to time) and made between Party A and Party B. Terms defined in the [Facility Agreement] and used but not defined herein have the same meaning as given in the [Facility Agreement].

8.

EMU The parties agree that the occurrence or non-occurrence of an event associated with economic and monetary union in the European Community will not have the effect of altering any term of, or discharging or excusing performance under, this Agreement or [the] [any] Transaction, give a party the right unilaterally to alter or terminate the Agreement or [the] [any] Transaction or, in and of itself, give rise to an Event of Default, Termination Event or otherwise be the basis for the effective designation of an Early Termination Date
15.

9. Transfer [

]
16

10. Other bank-required provisions [

]


15

Check for conformity to parallel EMU provisions in related loan agreement. Consider and document the intention of the parties vis à vis the swap on a transfer of the related loan to a third party and
or, where applicable, as a security item. NB All footnotes are author’s.
16

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ANNEX 6

Model finance-linked interest rate swap Confirmation (short-form) (Relating to base case considered in Chapter 4.) [Letterhead of Lending Bank] [Date] [Name and Address of Borrower] Dear

: Finance-linked Interest Rate Swap Transaction Our ref: [ ]

The purpose of this letter (this “Confirmation”) is to confirm the terms and conditions of the Transaction entered into between us on the Trade Date specified below (the “Transaction”). The definitions and provisions contained in the 2000 ISDA Definitions, as published by the International Swaps and Derivatives Association, Inc., are incorporated into this Confirmation. In the event of any inconsistency between those definitions and provisions and this Confirmation, this Confirmation will govern. This Confirmation constitutes a “Confirmation” as referred to in, and supplements, forms part of and is subject to, the ISDA Master Agreement dated as of [date], as amended and supplemented from time to time (the “Agreement”), between [Lending Bank] (“Party A”) and [Borrower] (“Party B”). All provisions contained in the Agreement govern this Confirmation except as expressly modified below.

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The terms of the particular Transaction to which this Confirmation relates are as follows: General Terms: Notional Amount:

For the first Calculation Period, £100,000,000 and, for each Calculation Period thereafter (each such Calculation Period being one that begins or ends on or between any pair of dates as set out in column A of the Appendix hereto), the amount as set out in column B of the Appendix hereto opposite the relevant pair of dates as set out in column A of the Appendix hereto

Trade Date:

[

Effective Date:

2 January 2003
2

]
1

Termination Date: 31 December 2012
3, subject to adjustment in accordance with the [Modified Following
4] Business Day Convention Fixed Amounts:

1
2


3


4


5


6

Fixed Rate Payer:

Party B

Fixed Rate Payer Payment Dates:

[[ ]
5 and thereafter] Every 31 March, 30 30 June, 30 September and 31 December
6 from

This will often, in a finance-linked swap context, be the same date as the Effective Date. If the swap is a c.p. to the making of the loan, insert the drawdown date. If the swap is a c.s. to the making of the loan, insert the (post-drawdown) date on which the swap is intended to become effective. As a general rule, the Termination Date ought to coincide with the final repayment date of the loan. Where that is not the intention (i.e. where the borrower wishes to hedge for a period that is shorter or, in limited circumstances, longer than the loan term), the applicable Termination Date should be inserted. This should be cross-checked for conformity to the business day convention in the loan agreement. Most (but not all) UK loan agreements adopt ‘Modified Following’ as the relevant convention i.e. non-business days move forward to the next available business day unless that falls in the next following calendar month, whereupon they move back to the first preceding business day. It will be necessary to specify the first payer payment date with respect to the swap where, as is often the case, the effective date of the swap does not itself fall on one of the quarterly (or, as the case may be, six-monthly or annual) interest payment dates under the loan. The template as drafted assumes quarterly interest payment dates under the loan (to which the payment dates under the swap should be conformed). The template will need amending to reflect loan agreements in respect of which interest payment periodicity is other than quarterly. 205

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and including 31 March 2003 to and including the Termination Date, subject to adjustment in accordance with the [Modified Following
7] Business Day Convention Fixed Rate:

5.125%

Fixed Rate Day Count Fraction:

Actual
365 (Fixed)
8

Floating Amounts: Floating Rate Payer: Party A Floating Rate Payer [[ ] and thereafter
9] Every 31 March, Payment Dates: 30 June, 30 September and 31 December
10 from and including 31 March 2003 to and including the Termination Date, subject to adjustment in accordance with the [Modified Following
11] Business Day Convention



7

[Floating Rate for initial Calculation Period:]

[[ ]%] OR [Linear Interpolation shall
12 apply]

Floating Rate Option:

[“LIBOR”, meaning that the rate for the relevant Reset Date will be determined by the Calculation Agent on the basis of (a) the rate of the offered quotation for Sterling deposits that appears on the display designated as “Page 3750” on the Telerate Service (or such other page or service as may replace it for the

See footnote 4. This should be cross-checked for conformity to the day count convention in the loan agreement. Most (but not all) UK loan agreements assume a 365 day year, but the treatment of leap years may differ from agreement to agreement. An ‘Actual
365’ designation pushes the day count out to 366 days in a leap year, whereas an ‘Actual
365 (Fixed)’ designation ignores leap years for day count purposes.
9 See footnote 5.
10 See footnote 6.
11 See footnote 4.
12 Where the period between the Effective Date and the first Fixed
Floating Rate Payer Payment Date is less than the Designated Maturity, the relevant ‘stub’ rate will need to be inserted here or a means to determine that rate (e.g. Linear Interpolation) will need to be specified.
8

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purpose of displaying London interbank offered rates of prime banks for Sterling deposits) at or about 11.00 am on the first day of the relevant Calculation Period for a period of the Designated Maturity; or (b) if no such display rate is available, the rate per annum at which Party A was offering deposits in Sterling in an amount comparable with the relevant Notional Amount to leading banks in the London interbank market for a period of the Designated Maturity at or about 11.00 am on the first day of the relevant Calculation Period [; or (c) [add in any alternative interest fallback provisions from the loan agreement]]
13] Designated Maturity:

Three
14 months

Spread:

None

Floating Rate Day Count Fraction:

Actual
365 Fixed
15

Reset Dates:

The first day of each Calculation Period
16

Compounding:

Inapplicable

Account Details
17: Account for payments to Party A:

13


14


15
16


17

Sort Code [ ] with [ A account number [ ]

] Bank favour Party

This is an example only of the type of rate source provision that customarily appears in loan agreements and that ought to be replicated in the Confirmation if (floating) interest rate symmetry is to be achieved. The template as drafted assumes quarterly interest periods under the loan. The template will need amending to reflect loan agreements in respect of which interest payment periodicity is other than quarterly. See footnote 8. This should be cross-checked for conformity to interest fixing dates under the loan agreement. Calculation Periods under swaps generally run from payment date to payment date. As long, therefore, as (i) the payment dates under the swap and loan are identical and (ii) rate fixing under the loan occurs on loan interest payment dates, the template will work as drafted. If Floating Amounts under the swap and interest amounts under the loan are to be net-settled, the Account Details will need to reflect those arrangements (and, specifically, the fact that Party B is required only to pay Fixed Amounts to Party A). 207

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Account for payments to Party B:

Sort Code [ ] with [ B account number [ ]

Business Days:

London
18

] Bank favour Party

Please confirm that the foregoing correctly sets forth the terms of our agreement by executing the copy of this Confirmation enclosed for that purpose and returning it to us. Yours sincerely, [Lending Bank] By: ........................................... Name: Title: Confirmed as of the date first above written: [Borrower] By: .............................................................. Name: Title: [Statement as to Lending Bank’s FSA authorisation] APPENDIX

18

208

Column A Relevant Dates

Column B Notional Amount (£)

Effective Date to 31 December 2003 1 January 2004 to 31 December 2004 1 January 2005 to 31 December 2005 1 January 2006 to 31 December 2006 1 January 2007 to 31 December 2007 1 January 2008 to 31 December 2008 1 January 2009 to 31 December 2009 1 January 2010 to 31 December 2010 1 January 2011 to 31 December 2011 1 January 2012 to 31 December 2012

100,000,000 90,000,000 80,000,000 70,000,000 60,000,000 50,000,000 40,000,000 30,000,000 20,000,000 10,000,000

This should be cross-checked for conformity to the business day definition under the loan agreement. NB All foootnotes are author’s.

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ANNEX 7

Model finance-linked interest rate cap Confirmation (long-form) (Same parameters as base case considered in Chapter 4.) [Letterhead of Cap Seller] [Date] [Name and Address of Cap Buyer] Dear

: Finance-linked Interest Rate Cap Transaction Our ref: [ ]

The purpose of this letter (this “Confirmation”) is to confirm the terms and conditions of the Transaction entered into between [Cap Seller] (“Party A”) and [Cap Buyer] (“Party B”) on the Trade Date specified below (the “Transaction”). The definitions and provisions contained in the 2000 ISDA Definitions, as published by the International Swaps and Derivatives Association, Inc., are incorporated into this Confirmation. In the event of any inconsistency between those definitions and provisions and this Confirmation, this Confirmation will govern.


This Confirmation supplements, forms part of and is subject to the 1992 ISDA Master Agreement (Multicurrency-Cross Border) (the “ISDA Form”) as if we had executed an agreement in such form (but without any Schedule except for the election of English law as the Governing Law and Pounds Sterling as the Termination Currency and provided further that, in relation to Party B only, Sections 5(a)(ii) to (viii) inclusive and Section 5(b)(iv) of the ISDA Form shall be disapplied and replaced by an Additional Termination Event, being the acceleration by Party A pursuant to clause [ ] of the [Facility Agreement] dated on or around [ ] entered into between Party A and Party B of any of the facilities described therein, with Party B as the Affected Party in relation to such Additional Termination Event
1), on the Trade Date of the Transaction. In the event of any incon
1

A more favourable formulation (from the cap buyer’s perspective) is to provide that, once the cap buyer has paid the applicable premium, the cap seller cannot terminate even if the related loan is accelerated. 209

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sistency between the provisions of the ISDA Form and this Confirmation, this Confirmation will govern. The terms of the particular Transaction to which this Confirmation relates are as follows: General Terms: Notional Amount:

For the first Calculation Period, £100,000,000 and, for each Calculation Period thereafter (each such Calculation Period being one that begins or ends on or between any pair of dates as set out in column A of the Appendix hereto), the amount as set out in column B of the Appendix hereto opposite the relevant pair of dates as set out in column A of the Appendix hereto

Trade Date:

[

Effective Date:

2 January 2003

Termination Date:

31 December 2012, subject to adjustment in accordance with the Modified Following Business Day Convention

]

Fixed Amounts: Fixed Rate Payer:

Party B

Fixed Rate Payer Payment Date:

[ ], subject to adjustment in accordance with the Modified Following Business Day Convention

Fixed Amount:

GBP [premium]

Floating Amounts: Floating Rate Payer: Party A Cap Rate:

210

5.125%

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Floating Rate Payer Payment Dates:

Every 31 March, 30 June, 30 September and 31 December from and including 31 March 2003 to and including the Termination Date, subject to adjustment in accordance with the Modified Following Business Day Convention

Floating Rate Option:

[“LIBOR”, meaning that the rate for the relevant Reset Date will be determined by the Calculation Agent on the basis of (a) the rate of the offered quotation for Sterling deposits that appears on the display designated as “Page 3750” on the Telerate Service (or such other page or service as may replace it for the purpose of displaying London interbank offered rates of prime banks for Sterling deposits) at or about 11.00 am on the first day of the relevant Calculation Period for a period of the Designated Maturity; or (b) if no such display rate is available, the rate per annum at which Party A was offering deposits in Sterling in an amount comparable with the relevant Notional Amount to leading banks in the London interbank market for a period of the Designated Maturity at or about 11.00 am on the first day of the relevant Calculation Period [; or (c) [add in any alternative interest fallback provisions from the loan agreement]]]

Designated Maturity: Three months Spread:

None

Floating Rate Day Count Fraction:

Actual
365 Fixed

Reset Dates:

The first day of each Calculation Period

Compounding:

Inapplicable

Calculation Agent:

Party A

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Account Details: Account for Sort Code [ ] with [ payment to Party A: Party A account number [

] Bank favour ]

Account for Sort Code [ ] with [ payments to Party B: Party B account number [

] Bank favour ]

Business Days:

London

Other Provisions: Payer Tax Representations:

For the purpose of Section 3(e) of the ISDA Form, Party A will make the following representation and Party B will make the following representation:It is not required by any applicable law, as modified by the practice of any relevant governmental revenue authority, of any Relevant Jurisdiction to make any deduction or withholding for or on account of any Tax from any payment (other than interest under Section 2(e), 6(d)(ii) or 6(e) of the ISDA Form) to be made by it to the other party under the ISDA Form. In making this representation, it may rely on the satisfaction of the agreement of the other party contained in Section 4(a)(iii) of the ISDA Form and the accuracy and effectiveness of any document provided by the other party pursuant to Section 4(a)(iii) of the ISDA Form, provided that it shall not be a breach of this representation where reliance is placed on the foregoing and the other party does not deliver a form or document under Section 4(a)(iii) of the ISDA Form by reason of material prejudice to its legal or commercial position.

Non-reliance:

212

Each party represents to the other party on the Trade Date of the Transaction that:-

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(a) Non-Reliance. It is acting for its own account, and it has made its own independent decisions to enter into the Transaction and as to whether the Transaction is appropriate or proper for it based upon its own judgment and upon advice from such advisers as it has deemed necessary. It is not relying on any communication (written or oral) of the other party as investment advice or as a recommendation to enter into the Transaction, it being understood that information and explanations related to the terms and conditions of the Transaction will not be considered investment advice or a recommendation to enter into the Transaction. No communication (written or oral) received from the other party shall be deemed to be an assurance or guarantee as to the expected results of the Transaction. (b) Assessment and Undertaking. It is capable of assessing the merits of and understanding (on its own behalf or through independent professional advice), and understands and accepts, the terms, conditions and risks of the Transaction. It is also capable of assuming, and assumes, the risks of the Transaction. (c) Status of Parties. The other party is not acting as a fiduciary for or an advisor to it in respect of the Transaction. Document Delivery Obligations:

Each party agrees to deliver to the other, on or before the date of execution of this Confirmation, evidence of the authority of the person executing this Confirmation on its behalf.

213

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Please confirm that the foregoing correctly sets forth the terms of our agreement by executing the copy of this Confirmation enclosed for that purpose and returning it to us. Yours sincerely, [Cap Seller] By: ............................................. Name: Title: Confirmed as of the date first above written: [Cap Buyer] By: ............................................. Name: Title: [Statement as to Cap Seller’s FSA authorisation] APPENDIX Column A Relevant Dates Effective Date to 31 December 2003 1 January 2004 to 31 December 2004 1 January 2005 to 31 December 2005 1 January 2006 to 31 December 2006 1 January 2007 to 31 December 2007 1 January 2008 to 31 December 2008 1 January 2009 to 31 December 2009 1 January 2010 to 31 December 2010 1 January 2011 to 31 December 2011 1 January 2012 to 31 December 2012

214

Column B Notional Amount (£) 100,000,000 90,000,000 80,000,000 70,000,000 60,000,000 50,000,000 40,000,000 30,000,000 20,000,000 10,000,000

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ANNEX 8

Epilogue – ISDA 2002 Master Agreement

The ISDA 2002 Master Agreement (released January 2003) is, in many respects, a radically different document to its 1992 predecessor. In very broad and general terms, it brings about, for stand-alone derivatives, a significant reduction in credit tolerances and a concomitant increase in default sensitivity, as well as a host of other substantive changes. The ramifications for finance-linked transactions are much less dramatic. This, as ever, is because the credit and other provisions applicable to financelinked swap transactions are, following a ‘General Rule’ approach to the swap documentation, subservient to those in the related credit agreement. As a result, from the borrower’s perspective at least, it is almost academic whether the swap is documented under the new or the old Master. From the swap provider’s perspective, of course, the opposite is true – and it will, so far as the credit provisions applicable to it are concerned, go about negotiations in the ‘normal’ way. Paul C. Harding’s Mastering the ISDA Master Agreements (1992 and 2002), due to be published November 2003, is a sensible point of reference for the swap provider in this regard. There are, however, several facets to the new Master that are directly relevant to finance-linked swap transactions. These are as follows (references to Sections and Parts being to Sections and Parts of the new Master and its Schedule).

ABSENCE OF LITIGATION (Section 3(c)) The new Part 5(k) elective, that enables parties to delineate the scope of the Section 3(c) Absence of Litigation representation, is a handy reminder of the need to conform the representation to any corresponding representation made by the borrower in the related credit agreement (or, if there is none, to disapply it altogether).

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FORCE MAJEURE EVENT (Section 5(b)(ii)) ‘Force Majeure’ is an entirely new Termination Event that supplements and amends the existing Illegality provisions of the old Master. In broad terms, a party that, by reason of the occurrence of a Force Majeure Event or an Illegality, is precluded from performing its obligations under the new Master enjoys a ‘waiting period’ of between three and eight business days before that non-performance occasions an Event of Default. The smart approach, where finance-linked swap transactions are concerned, will be to ensure that this waiting period is reflected in both the failure to pay interest and cross default provisions of the related credit agreement. Borrower liquidity, particularly within rated transactions, will also need to be considered, as will the relationship between the waiting period and the unwind period in ‘terminating’ DPC structures.

PAYMENTS ON EARLY TERMINATION (Section 6(e)) The new Master does away with ‘First Method’ and blends ‘Market Quotation’ and ‘Loss’ into a single ‘Close-out Amount’. This means that the question of whether a finance-linked swap provider hedges on a back-toback or portfolio basis is academic, since the new measure is flexible enough to accommodate either strategy.

SET-OFF (Section 6(f)) The fact that bilateral, contractual set-off provisions are included in the main body of the new Master (under the old, they were typically included as an additional Part 5 provision) merely strengthens the case for disapplication of any prohibitions on borrower set-off in the related credit agreement.

TRANSFER (Section 7) In drafting the new Master, ISDA’s Documentation Committee took note of, but declined to implement, a suggestion that an elective be built into the Schedule to facilitate the giving of consent, by swap providers to their finance-linked swap counterparties, to the assignment of borrower rights under the Master for security purposes. This apparent unwillingness to grasp the nettle is yet another example of how much work there is to be done 216

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before the documentation of finance-linked swaps is accepted as a discipline that is distinct from (and that demands a bespoke solution when compared with) the documentation of stand-alone transactions.

NON-RELIANCE REPRESENTATIONS (Part 4(m)) The fact that the new Master includes these representations as an elective reinforces the arguments set out in Chapter 5 – namely that reliance is a question of fact to be judged on a case-by-case basis. Swap providers that convert to the new Master, glibly switching the representations ‘on’ as a house-standard position, are, regrettably, missing the point. In summary, the new ISDA 2002 Master Agreement alters very few of the arguments or conclusions in this book. In fact, if anything, it makes even more compelling the case for a separate document for use in a finance-linked swap context. Where the new Master will have an impact, undoubtedly, is in the world of stand-alone transactions and in relation to the OGC Guidance papers considered in Chapter 6 as well as the rating agency criteria considered in Chapter 7, all of which will need updating to take account of the changes heralded by it.

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Bibliography Arrowsmith, Prof. S (2001) Public Private Partnerships & PFI, Sweet & Maxwell. Comptroller and Auditor General (7 November 2002) PFI refinancing update. Das, S. (1994) Swaps and Financial Derivatives. 2nd edition, IFR Publishing. Das, S. (1999) Credit-linked Notes: Structured Notes (Parts One and Two) Issues 110 and 111, Financial Products. Das, S. (1999) Credit-linked Notes: Repackaged Note and Repackaging Vehicles (Parts One and Two) Issues 113 and 115, Financial Products. Dwyer, M. (2002) Private Equity Transactions, Sweet & Maxwell. Financial Law Panel (1996) OTC derivatives – banks’ obligations to customers. Gooch, A. C. and Klein, L. B. (1993) Documentation for Derivatives. 3rd edition, Euromoney Publications. Goris, P. (September
1994) ‘Derivative product subsidiaries: the counterparty’s view’, Journal of International Business Law. Harding, P. C. (2002) Mastering the ISDA Master Agreement. (1st edition), Pearson Education. Henderson, S. K. (September
1997) ‘Derivatives law as a niche area is dead’, Journal of International Business Law. Housing Corporation Regulatory Circulars 99
04 and 99
05. Hudd, D., Voisey, P. and Carne, B. (September 1998) ‘Loan securitisation and risk transfer’, The IRS Legal Guide to Securitisation. Hughes, M. (April 1999) ‘Areas of legal risk in sovereign-linked credit derivatives’, Journal of International Banking and Financial Law. International Swaps and Derivatives Association, Inc. User’s Guide to the 1992 ISDA Master Agreements. 1993 edition. Lambert, M. and Burnand, L. (November 2001) ‘Non-vanilla hedging structures for property companies’, Vol. 1, No. 4, Briefings in Real Estate Finance. Lindrup, G. and Godfrey, E. (2001) PFI Manual, Butterworths. Loan Market Association, British Bankers’ Association and The Association of Corporate Treasurers (updated November 2001) User’s Guide to the Recommended Form of Primary Documents. Mannix, R. (May 1999) ‘Repackaging: the key structures in the Euromarket’, International Financial Law Review. 219

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Moles, P. and Terry, N. (1997) The Handbook of International Financial Terms, Oxford University Press. Moody’s Investors Service (21 May 2002) Swaps in European Term Securitisations. Moody’s Investors Service (23 October 2002) Rating Thresholds of Hedge Counterparties in CDO Transactions. Multiple authors (June 1996) ‘Let’s rip apart those triple-A subs’, Euromoney. Office of Government Commerce Guidance (revised 2002) Standardisation of PFI Contracts – General, Issue 3. Office of Government Commerce (July 2002) Guidance on Certain Financing Issues in PFI Contracts. Public Private Partnership Programme (1998) A Guide to the Local Government (Contracts) Act 1997. Sarwal, A. K. (1989) KPMG International Handbook of Financial Instruments and Transactions, Butterworths. Standard & Poor’s (undated) Global Synthetic Securities Criteria (including revised Swap Agreement Criteria). Standard & Poor’s (6 January 1999) New Structured Finance Interest Rate and Currency Swap Criteria Broadens Allowable Counterparties. Standard & Poor’s (6 January 1999) ‘AAAt’ Swaps Approved in Structured Finance Transactions. Standard & Poor’s (19 May 2000) Swap Counterparty Requirements Expanded for Interest Rate Swaps. Vinter, G. D. (1998) Project Finance – A legal guide. 2nd edition, Sweet & Maxwell. Walker, G. (2002) ‘Interest rate hedging – getting the ISDA documentation right’, BVCA Technical Bulletin. Walker, G. (February 2002) ‘Mortgage loan securitisation: stay real or go synthetic?’, Mortgage Finance Gazette. Yescombe, E. R. (2002) Principles of Project Finance, Academic Press.

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Accrual swaps, 155–156 Advisor liability, 90 hedging strategy consultants, 90–91 lawyers to the borrower, 91 lawyers to the lending bank/swap provider, 91–92 Ancillary documentation, 77 Asset swaps, basic structure, 126 compared to liability swaps, 127 compared to repackagings, 126–128 documentation of, 127 drawbacks of, 126 Authority, 83 Back-to-back swaps, 3, 8, 10 Basis risk, 37, 171 in debt capital markets context, 148–149 in share scheme hedging context, 153 Basle 2, operational charge under, 87, 172 Best practice, barriers to, 169–172 cost, 171–172 organizational inertia, 171 professional denial, 169–171 drivers behind, 172–173 commercial imperative, 172 FpML, 173 hedge accounting, 172 reputation, regulatory, litigation risk, 172 what constitutes, 169 Borrower, managing the, 161–162 self-hedged, 5 Building society applications, 156–158

Capacity, 81–83 Confirmations, finance-linked swap, 67–70 delivery, 64 long-form Confirmations, 51–52, 55–57, 209–214 pre-Master Confirmations, 52–55 short-form Confirmations, 52, 204–208 Cost, of project managing finance-linked swaps, 166 as a barrier to better practice, 171–172 Credit derivatives, in project finance context, 95 in property finance context, 106 in rated transaction context, 123, 130–134 Credit symmetry, general, 40–42 tailoring Schedule to achieve, 58–67 Currency risk, exposure to, 3 Debt capital market instruments, 147–150 commercial paper programmes, 147 medium term note programmes, 147–150 Derivative product companies, generally, 153–155 in context of rated transactions, 144 Documentation, checklists, 189–193 considerations, 51–77 loan and swap, differences between, form, 20–21 scope, 22 substance, 20 221

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ISDA, nature and architecture of, 187–188 Economic differences between loans and swaps, 17–20 Economic symmetry, 34–40 key dates, 38 loan interest, 34–35 loan principal, 37–38 notional amount, 37–38 rate
rate source, 38–40 settlement, 40 swap payments, 35–37 tailoring Confirmation to achieve, 67–70 Equity derivatives, as example of stand-alone derivative, 6 used by building societies, 153, 157 used by private clients, 158 used to hedge share scheme exposures, 151–153 Financial assistance, in context of MBO financings, 116–120 in context of share scheme hedges, 151–153 Finance-linked swaps, characteristics of, 3–5 current market practice, 12–14 comparison, 5–10 with fixed rate loans, 7–9 with other finance-linked derivatives, 10 with stand-alone derivatives, 5–6 significance of ISDA 2002 Master Agreement for, 215–217 derivative product companies, 216 early termination, payments on, 216 force majeure event, 216 litigation, absence of, 215 non-reliance representations, 217 OGC guidance, 217 rating agency criteria, 217 set-off, 216 transfer, 216 size and shape of market, 10–11 structural formats, 11–12 Fixed rate loans, compared to finance-linked swaps, 7–9 222

financial covenants within, 9 used by housing associations, 108–110 break-indemnities for, 8–9 security for, 9 FpML, 173 GICs, in PFI context, 112 in project finance context, 99–100 Hedge accounting, 34, 172 Hedging strategy, 29–33 caps, collars, options 30 influences on, 29 implementation of, 33 pricing, 33 swaps, 29 swaptions, 31–32 timing, 32–33 risks in non-contemporaneous hedging 32 trigger clauses, 33 term sheet model, 194–195 need for, 33, 163 size of hedge generally, 29 in suitability context, 89–90 Housing associations, 108–110 Inflation derivatives, in housing association context, 109 in PFI context, 112 in project finance context, 98–99 in property finance context, 107–108 Intercreditor concerns, 44–47 borrower, 46–47 implications for documentation, 41–42, 76–77 lending bank(s), 45–46 addressed through memoranda of understanding, 117 subordination, 149 swap provider, 44–45 Interest rate swaps, break indemnity provisions for, 8–9, 118–119 collateralisation of, 62, 86, 144, 154, 184 close-out netting applied to, 25, 26, 184, 188

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comparison with loans, 17–26 significance of differences, 26 credit risk under, 181–185 how arising, 181–183 managing the, 183–184 quantifying the, 19, 183–184 significance of, 185 deriving the fixed rate under, 180–181 meaning of, 177–178 motivation behind, 178–180 payments under, 177–178 settlement netting under, 178 ISDA documentation, general, 12, 14, 21–24, 35–40, 51–70 in a finance-linked swap context, additional termination event, 60 addresses for notices, 61 affiliate, 63 agreement to deliver documents, 61 automatic early termination, 59–60 calculation agent, 62 change of account, 67 conformity of termination events
other substantive provisions, 66–67 credit event upon merger, 59 credit support document/provider 62 default, cross, 59 limitation on, 64–66 notification of, 66 ‘general rule’, 58 et seq. governing law, 62 netting of payments, 62–63 non-reliance, 64 offices
multibranch party, 62 payments on early termination, 60 path and format, 51–57 process agent, 62 scope, 63–64 specified entity, 58 specified transaction, 58 tax representations, 61 termination currency, 60 in a rated transaction context, see Rating agencies nature and architecture of, 187–188 Legal considerations,

authority, 83 capacity, 81–83 contra proferentem rule, 53 enforceability, 24–25 close-out netting, 20, 25, 56, 184, 188 reliance 64, 85–87, 217 suitability, 83–84 Lender, managing the, 162–163 position of, 18 Linear interpolation, in context of stub periods, 38–39 Litigation risk, 88–90 Loan documentation, 70–73 application
source of funds, 72 covenants, 72–73 default events, 73 definitions, 70–71 euro conversion provisions, 73 fixed rate, 8–9 financial covenants, 42, 72–73 loan payments, 72 LMA, 11–12, 20–21, 36–37, 39, 173 permitted indebtedness
security interest/disposal 42, 71 sharing, 73 MBO financings, 116–120 Model finance-linked interest rate cap Confirmation (long-form), 209–214 Model finance-linked interest rate swap Confirmation (short-form), 204–208 Model finance-linked swap Schedule, 196–203 Model term sheet, 194–195 Operational issues, 22–24, 164–165 Over-the-counter derivatives market origins, 17 size of, 17 PFI financings, 110–116 primary guidance, evolution of, 110–111 refinancing, guidance on, 113–116 supplementary guidance, 112 termination, guidance on, 113 Portfolio transactions, 3, 5–6, 223

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Post-drawdown issues, 166 Prepayment, 43–44 Private client applications, 158 Project financings, 96–100 bank debt, 96–98 bond finance, 98–100 Project managing finance-linked swap arrangements, 161 et seq. Property financings, 100–110 development period, in, 101 housing associations, 108–110 refinancing of, 101–106 rental income, 106–108 Rated transactions, purpose of swap within, 123–125 role of swap provider within, 125 Rating agencies, 134–137 criteria, approaches underpinning, 134–137 applied to, collateral-dependent structures, 137–142 collateral-independent structures, 142–143 swap-independent structures, 143 significance for swap documentation, 137–142 additional criteria, 143–144 agreements, 139 deduction or withholding for tax, 137–138 default events, 139–140 early termination, 141 miscellaneous, 142 netting, 137 offices; multibranch parties, 142 representations, 138–139 termination events, 139–140 transfer, 141–142 significance for swap provider, 5, 144 Fitch, 137 managing the, 164 Moody's Investors Service, 136 Standard & Poor's, 135–136 Reallocate, requirement to, by building societies, 157–158 224

by housing associations, 109 generally, 29, 43 Refinancing, alternatives for swap, novation, 102–104 ISDA novation agreement, 106 at-the-money, 104 off-market, 103 in tandem with fixed rate loan, 105 termination and replacement, 102 in a property finance context, 101 et seq. in a PFI context, 115–116 process, managing the, 166 Registered social landlords, 108–110 Regulatory environment, generally, 84 breach of, 88 Regulatory risk, 88 Reliance, 85–87 Repackagings, 126–132 basic structure, 128 merits of, 127–128 multiple issuance, 128 multiple issuer, 129 repackaged credit-linked notes, 130–132 Reputation risk, 87–88 Restructuring, considerations in, 166 Securitizations, 132–134 traditional, 132–134 synthetic, 133–134 Security documentation, 73–76 designation, 74 floating charge, peculiarities of, 75–76 reach, 75–76 scope, 74 Security issues, 44–47 borrower, 46–47 indirect security structures, generally, 44–45 in MBO context, 119–120 lending bank, 45–46 marshalling, doctrine of, 45 swap provider, 44–45 Share scheme hedges, 150–153

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Stand-alone derivatives, compared to finance-linked swaps, 5–6 Structural formats, 11–12 Stub periods, see Linear interpolation Suitability, 83–85, 89–90 Swap provider, managing the, 163–164 significance of rating agency criteria for, 144

Swaptions, 31–32 zero cost, 38, 96–97 Syndicate, managing the, 162–163 Transferability, 47 Weather derivatives, in property finance context, 101 legal nature of, 25

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