In recent years, there have been a number of financial asset portfolio sales in the Australian market. These have primarily been in relation to consumer and corporate receivables (such as the recent GE and Esanda transactions), but have often included related derivative arrangements within the sale portfolio.
We are now seeing a trend towards divestment of stand-alone derivative portfolios. This is primarily as a result of increasing capital charges being required with respect to some derivative positions. This opens up an opportunity for non-prudentially regulated entities – such as managed funds – to invest directly in this asset class.
The nature of derivative arrangements is such that there are a number of issues that require consideration beyond those typically considered in general receivables sale arrangements. A due diligence review of the derivative arrangements will be required at the commencement of the transaction, in order to assess the impact of these matters. The primary issue that will need to be assessed through the due diligence review is the manner in which the derivative interests are to be transferred. The transfer may be effected by way of novation or assignment, or where there are restrictions on transfer, it may only be possible to deal with the economics of the transaction by way of a sub-participation. The outcome of the due diligence, and of course the parties' commercial requirements, will drive the transaction structure. It is therefore important to correctly structure and scope the due diligence at the commencement of transaction planning Set out below are some of the primary issues that need to be considered as part of any derivatives portfolio sale.
Restrictions on assignment
(a) ISDA master agreement restrictions
As most derivatives have bilateral payment obligations (ie. each party has rights and obligations in respect of payments – as opposed to loans where the lender usually has rights to receive payments, but limited obligations to make any payment beyond the initial draw), it is likely that in most instances, novation will be the preferred approach for dealing with a derivative position. This will require the relevant counterparty to each derivative to be party to a novation agreement.
If however only assignment of rights under the derivatives arrangements is proposed, then the restrictions contained in the ISDA master agreement need to be considered. These include a restriction on assignment without consent (subject to various limited care-outs).
The upshot of this is that consent of the counterparty is likely to be required in respect of any dealing with derivative arrangements.
The ISDA schedule should also be reviewed to confirm whether the provisions in the ISDA master agreement have been modified, and whether there are other bespoke restrictions imposed on dealing with the derivative positions. These may sometimes be contained in other documents, such as facility, security and project documents. As an example, State consent may be required in respect of derivatives referencing PPP transactions.
The scope and extent of the required consents will be a key consideration for the overall transaction structure and timeline.
(b) "Credit event upon merger"
Consideration of the credit event upon merger regime under the ISDA master agreement is required.
Broadly speaking, this regime restricts certain transfers to "materially weaker" entities. Where the counterparty is from a financially strong group, there may have been amendments made to the trigger of what constitutes a "materially weaker" entity – sometimes by reference to credit rating changes. While in the normal course this is unlikely to cause any issues, it is important to confirm the position as part of the due diligence documentation review.
Where the derivatives are part of broader secured financing arrangements, a key consideration for the incoming counterparty will be to ensure that it obtains an appropriate position in the security structure.
Some security structures require a nomination procedure to be followed in order for the borrowing group, and often the relevant security trustee, to acknowledge that the derivative arrangements form part of the secured money. It will be important to follow these mechanical provisions carefully.
It is also necessary to assess whether any necessary execution by the security trustee or agent will be provided "as of right" – as opposed to the security trustee or agent being required to seek consent from other parties (such as the broader financier group). This is an important issue as obtaining consents may have an impact on timing and introduce further scope for leverage/negotiation.
If the derivatives arrangements are part of broader financings by multiple financiers across a corporate group, there may well be restrictions on early termination of the derivatives, even following default or other termination scenarios being triggered. These will likely be documented in the intercreditor arrangements, or possibly the facility agreement. As this may represent a significant restriction on the rights of the incoming counterparty, it will be important for the incoming counterparty to carefully assess these restrictions.
It will obviously be a key requirement that there be confidence in the valuation process documented in the sale agreement as between all applicable parties.
Where possible, it is often useful to undertake various dry runs of the valuation protocols, to order to iron out process and input issues.
One issue that can arise is what happens in the event of disagreement on the final position. After cascading through the management structure of each relevant party, a tie breaker is typically required. This is often reference to an independent expert. However, if the trades are bespoke, it may be difficult to obtain agreement as to which parties have the appropriate expertise and are sufficiently independent in the market.
It is likely to be useful to raise this issue early in the negotiation process.
Purchaser specific issues
It will be necessary to carefully consider the identity of the incoming derivative counterparty. Some of the issues for consideration include:
- AFSL – does the incoming entity have an appropriate financial services licence (or take the benefit of an appropriate exemption)
- restrictions on mandate/approvals and counterparty ratings – are there any mandate restrictions (such as under applicable trust documentation or internal restrictions, which limit the type, quantum of trades, rating of counterparty etc), or internal approvals required prior to proceeding with the transactions
- "house" ISDA requirements – is it acceptable to take the ISDA on its current terms, or are amendments required to reflect required "house" positions for the incoming entity, particularly on issues such as termination events, cross default thresholds and the like
- overall limits as against counterparties – does the incoming derivative counterparty have any internal limits for counterparties that need to be considered, or which would otherwise restrict the incoming derivative counterparty from taking the full position under the derivative arrangements
- rating – does the incoming derivative counterparty have any rating requirements (or as noted above, any credit event upon merger implications)
- reporting/delegation – do any appropriate derivatives reporting and delegation arrangements need to be put in place between the incoming derivative counterparty and the counterparty
- registration as a foreign company/tax – to the extent that the incoming derivative counterparty is not otherwise operating in the Australian market, are there broader issues to be considered – tax, registration as a foreign company etc, and
- how are the derivatives arrangements to be structured and booked from the incoming derivative counterparty's point of view – are any additional internal issues required to be addressed?
Increased capital charges required against derivative positions are likely to lead to some banks divesting certain of their derivative positions. This will open up opportunities for managed funds to invest directly in existing derivative portfolios. Thorough due diligence review is required in order to correctly structure any such acquisition.