Hedging is a feature of most real estate finance transactions. Where that is the case, the facility agreement (or sometimes a separate intercreditor agreement) will usually set out in some detail:
- certain restrictions on the hedge counterparty's exercise of its termination and certain other rights under the hedging agreements; and
- the extent of the hedge counterparty's rights as a secured creditor of the obligors.
But when the LMA published its recommended form of real estate finance facility agreement (the REF Agreement) earlier this year, it acknowledged that there is no consensus in the market on what these hedging terms should be.
So despite the publication of the REF Agreement, the position of the hedge counterparty in real estate finance transactions is likely to continue to be subject to significant negotiation.
Hedging in real estate finance transactions: background
The position of the hedge counterparties in the REF Agreement reflects, at least to an extent, a “traditional” approach. This assumes that a hedge counterparty will always also be a lender. As a result, although a hedge counterparty’s stand-alone position is weak, it can use its voting rights as a lender to protect its position on an institutional basis.
That approach began to fall out of favour in real estate finance transactions in the middle of the last decade, driven in part by the increase in the syndication and securitisation of real estate finance loans. Swaps desks became more alive to the need to look after themselves, rather than taking a purely passive role. That more assertive approach has not gone away, sometimes even when the hedge counterparty is likely to remain as a lender.
The REF Agreement: key points for hedge counterparties to consider
Voting rights on enforcement.
The hedge counterparty has no voting rights on enforcement: the security agent takes instructions solely from the majority lenders. This is different from the position under the LMA intercreditor agreement for leveraged finance transactions (the LMA IC Agreement). Under the LMA IC Agreement, following a permitted close-out, the security agent takes instructions from the "Majority Senior Creditors". This takes into account any close-out amounts the obligors owe to the hedge counterparties.
A hedge counterparty is only able to close out a hedging transaction in the following circumstances without the consent of the agent:
- to avoid over-hedging following a prepayment of a loan;
- if it becomes illegal for the borrower to perform its obligations under the hedging transaction;
- if the agent has accelerated the loans; or
- if the borrower has repaid the loans in full.
The REF Agreement acknowledges that the parties may wish to consider widening this. In the LMA IC Agreement, hedge counterparties are also able to close out:
- if the borrower becomes insolvent or subject to insolvency proceedings; or
- following a Tax Event, Tax Event upon Merger or a Force Majeure Event (as those terms are defined in the ISDA Master Agreements).
Hedge counterparties in real estate finance transactions may argue that they should have at least similar rights.
Rights to withhold hedging payments.
Under the REF Agreement, a hedge counterparty may not suspend making a hedging payment unless the borrower has made a payment default under the hedging transaction. As the Court of Appeal's recent decision in Lomas v. JFB Firth Rixson has confirmed, the ISDA Master Agreement allows a party to suspend making periodic payments if the other party is in default.
The lenders' position in the REF Agreement is understandable: they do not want a hedge counterparty to force them into acceleration or other enforcement action by suspending hedging payments. But should a hedge counterparty have to make hedging payments even though an event of default other than non-payment (e.g. insolvency) is continuing in respect of the borrower? It may argue that if it is "out of the money" and suspends periodic payments because of a borrower default, the lenders should rely on their right to accelerate the loan and then force it to close out.
Voting rights on amendments and waivers.
The hedge counterparty has no vote on an amendment or waiver of the terms of the finance documents unless it “relates to [its] rights and obligations”. To avoid argument about the types of amendments and waivers this would cover, hedge counterparties may want the agreement to set out certain entrenched rights and reserved matters, such as releases of security. A hedge counterparty should also note that the REF Agreement only allows it to make "administrative or mechanical" changes to the swap documents without majority lender consent.
Ability to transfer.
The REF Agreement provides (in square brackets) that any new hedge counterparty must also be a lender. Hedge counterparties may prefer to have a wider pool of potential transferees.
Consistency with ISDA Master Agreement.
Various terms (e.g. some indemnities and the notice provisions) of the REF Agreement apply between the borrower and the hedge counterparty that overlap with equivalent terms in the ISDA Master Agreement. Hedge counterparties should ensure there is no inconsistency between the facility and hedging agreements.
The REF Agreement is likely to streamline negotiations on many aspects of real estate finance transactions. But, unfortunately, drawn-out negotiations on hedging (often within the same financial institution) are unlikely to be a thing of the past.
Law stated as at 28 June 2012