The expression that “a rising tide lifts all boats” may be easy to disregard in today’s “low tide” of interest rates, but investors and companies that fail to have an appropriate hedge program in place risk being flooded by unanticipated financing costs as the tide inevitably starts to rise. The Federal Reserve appears poised to continue raising its federal funds rate target in 2016. Although many factors influence long-term rates, increases in short-term rates make material increases in long-term rates more likely. Higher long-term rates in turn could expose borrowers in various market segments to considerable hardship.
Liberal underwriting standards and a proliferation of lenders have allowed equity investors, for example, to finance huge amounts and to refinance at their convenience. Corporate debt has also increased dramatically in the seven years since the financial crisis. Effectively managing interest rate risk will be of vital importance to many market participants in the months ahead.
One of the primary ways in which borrowers can mitigate interest rate risk in financing transactions is through the use of interest rate hedge agreements, which provide both borrowers and lenders with protection against escalating rates. This article raises and addresses several key issues, from both lender and borrower perspectives, including the basic types of hedging agreements, the Dodd-Frank restrictions on eligible contract participants, security and collateral considerations, including Dodd- Frank clearing and margin requirements, and bankruptcy and offset issues.
Basic types of hedge agreements
The three most common types of interest rate hedge products are rate caps, interest rate swaps and collars. The following paragraphs explain how a borrower may use these products to hedge interest rate exposure on a floating rate loan.
In a rate cap transaction, a borrower and hedge provider agree to a maximum interest rate, known as the “cap rate” or “strike rate.” If the floating interest rate index governing the underlying loan (the loan index rate), typically LIBOR, climbs above this strike rate, the hedge provider pays the borrower the excess. In exchange, the borrower pays the hedge provider a one-time fee when the agreement is signed. The result is that the borrower receives protection against any subsequent increase in LIBOR above the cap rate without surrendering the benefits of any subsequent declines in rates.
A collar transaction effectively sets both a maximum and minimum interest rate. If the loan index rate remains between the maximum and minimum rates specified in the collar (referred to as the cap strike and floor strike, respectively), the borrower neither makes nor receives payments under the collar. If the loan index rate rises above the cap strike rate, the hedge provider pays the difference to the borrower. Conversely, if the floating interest rate dips below the floor strike rate, the borrower pays the difference to the hedge provider. The borrower is thereby exposed only to the confined range of interest rate fluctuations between the cap strike and floor strike rates, and is protected in the event rates rise above the cap strike rate. In addition, although the borrower retains some of the potential benefit associated with declining interest rates, the borrower surrenders the savings that would accrue if rates were to dip below the floor strike rate. In exchange for protection in the high rate scenarios, the borrower may be required to pay the hedge provider an upfront fee, which would typically be lower than the fee required under a rate cap. In some cases the fee may be waived altogether, if the value of potential payments to the hedge provider in the low rate scenario adequately compensates the hedge provider for its potential costs in the high rate scenario.
Eligible contract participants
The Commodity Exchange Act, as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank)1, requires that any party to a swap be an “eligible contract participant” (ECP), unless the swap is entered into through an exchange (referred to as a derivatives contract market) registered with the Commodity Futures Trading Commission (CFTC). No such exchange has been registered to date, and thus it is currently unlawful for any non-ECP to be a party to a swap or even to act as a guarantor or credit support provider of swap payments.
The Commodity Exchange Act defines the term “swap” quite broadly—the term includes all three types of hedges described above. Generally, an entity is an ECP if it has total assets of at least $10,000,000, or net worth of at least $1 million if the entity is hedging commercial risk (among other possible qualifications).
This restriction on non-ECP entities is broadly interpreted to preclude enforcement of a swap if a non-ECP is a direct party to the swap, and enforcement of a guarantee or pledge supporting swap cash flows from a non-ECP guarantor or pledgor. Thus, it is critical for both borrowers and lenders to ensure that each party to the swap, and each credit support provider of swap cash flows, is an ECP at the time the swap or credit support arrangement is entered into.
In many financings, particularly where the swap provider is the same entity as, or is an affiliate of, the lender, the borrower’s obligations to make ongoing swap payments are included in the waterfall provisions in the loan agreement. In such case, the lender should conduct due diligence to determine if any of the borrowers, guarantors or pledgors do not qualify as ECPs. If there is any question regarding an entity’s ECP status, the lender should consider additional measures to ensure that non-ECP entities do not participate as a guarantor or pledgor. For example, each guarantor or pledgor should make a representation that it is an ECP, and this representation should be deemed repeated at any time a swap or guarantee/pledge is entered into.2 The parties may consider contractually excluding any non-ECP entity from the definition of guarantor or pledgor with respect to swap obligations. Borrowers may favor this approach. The Loan Syndications and Trading Association (LSTA) has published model language for such circumstances (LSTA Market Advisory).3 Another approach, more likely to be favored by lenders, would be to require certain borrower entities that qualify as ECPs to provide “keepwell” support to any non-ECP entities, the objective being to thereby convert the non- ECPs into ECPs. The LSTA Market Advisory contains model “keepwell” language as well. In addition, the lender should make certain that any non-swap guaranty that it obtains in connection with its financing is properly drafted to exclude any guarantee of swap obligations by any non-ECP guarantor.
The description above of typical hedge agreements could be read to suggest that the use of these agreements would eliminate the borrower’s interest rate risk. A more accurate view would be that the borrower entering into a hedge agreement has merely exchanged interest rate risk for another risk: counterparty risk. The borrower’s counterparty risk is the risk that the counterparty, i.e., the hedge provider, will fail to perform its obligations under the hedge agreement. If the hedge provider defaults on its obligations, the borrower generally is required under the loan documents to obtain a replacement interest rate hedge agreement. In the case of a rate cap, however, the borrower will have paid the hedge provider at closing. In this circumstance, not only would the borrower have to pay a second time for a hedge agreement that it had already purchased, but the replacement cost may far exceed the cost for the original hedge if interest rates have risen in the interim.4
A borrower may minimize counterparty risk by negotiating certain additional terms into the hedge agreement. One way of minimizing counterparty risk is to require the hedge provider to post margin in an amount equal to the value of the hedge agreement; the concept is that, upon a default by the hedge provider, the borrower would be able to use the collateral it is holding to purchase a new hedge agreement to cover the remaining term of the original hedge agreement. Another approach would be to obligate the hedge provider to replace itself, i.e., cause a new hedge provider to enter into a hedge agreement with the borrower covering the remaining term of the original hedge. A third approach would be to require the hedge provider to supply a guaranty from a creditworthy entity, often an affiliate of the hedge provider. In some cases the parties negotiate that these remedies would be required only if the hedge provider’s credit ratings drop below specified thresholds. These provisions generally protect the lender as well as the borrower, because they minimize the risk that the borrower will have to incur an additional expense to acquire a replacement hedge agreement. Some lenders require borrowers to include these provisions in their interest rate hedge agreements.
Mandatory clearing; margin for uncleared swaps
Under the Commodity Exchange Act, as amended by Dodd-Frank, all swaps identified by the regulators as capable of being cleared (generally, “standardized” swaps), and to which a clearing exception does not apply, must be cleared through a registered swap clearinghouse. To date, the regulators have identified interest rate swaps and certain credit default swaps as subject to this mandatory clearing requirement. Clearing adds a layer of complexity and cost to hedging transactions. Among other things, the clearinghouses require daily margin calls of all customers. As a result, many borrowers will want to avail themselves of an “end user exception” to ensure that their hedge transactions are not subject to mandatory clearing.
The Commodity Exchange Act requires that each party to an uncleared swap post margin (collateral) to its counterparty. The US banking regulators and the CFTC have published margin rules which will be phased in over a period beginning in September of this year. These rules also contain exceptions for certain end-users.
Many corporate borrowers, and most real estate borrowers, will be eligible for exceptions from these clearing and margin requirements. Certain funds and others in the financial sector, however, may not be eligible. Lenders should conduct due diligence to confirm the availability of any such exceptions.
A default by a borrower under a loan agreement with respect to which a hedge agreement is in place will typically trigger a cross-default under the related Master Agreement. Similarly, an event of default under the hedge agreement, particularly an event of default that results in an early termination of the hedge, is typically an event of default under the loan agreement. Hedge providers often propose a broad cross-default provision which may reference defaults by affiliates (broadly defined) of the borrower in respect of separate financial obligations to the hedge provider (or its affiliates) above a certain threshold amount and defaults by affiliates under separate hedge agreements with the same provider. The parties can negotiate which parties should be included in the crossdefault provisions as so-called “Specified Entities,” and which parties should be excluded. If the hedge provider and the lender are not affiliates, then the lender would prefer the list of “Specified Entities” to be as limited as possible. If the hedge provider and the lender are affiliates, however, then they would prefer a broader list of “Specified Entities.”
Borrowers are cautioned to consider carefully the implications of broadly defining the category of Specified Entities that may trigger a cross-default under a hedge agreement. Consider, for example, a situation in which a particular borrower and its affiliates have numerous loans and associated interest rate swap agreements with a particular lender. If the cross-default provisions of the agreements governing the swap transactions refer to affiliates of each borrower, the lender may be permitted to terminate all of the swap agreements (or, worse for the borrower, be permitted to choose which swaps to terminate and which to leave in place) upon a single event of default by a single affiliate under a single swap agreement. In turn, as noted above, the termination of each swap agreement by the hedge provider would likely trigger an event of default under the related loan documents. Borrowers should take special care to negotiate the cross-default provisions in order to avoid the potential for one underperforming business or property to trigger an avalanche of cross-defaults on “out of the money” hedges and, by extension, on the related loans. In addition, borrowers should note that courts have held certain cross-affiliate set-off provisions to be unenforceable in bankruptcy proceedings.5
Treatment in bankruptcy
The US Bankruptcy Code generally protects parties to swap agreements from the potentially catastrophic effects that could arise from the failure of a financial institution with significant exposure to derivatives. The Bankruptcy Code exempts swap agreements from:
- Operation of the automatic stay
- The right of the bankruptcy trustee to assume or reject executory contracts
- The prohibition on ipso facto clauses making bankruptcy an event of default
- Limitations on set-off rights
These “safe harbor” provisions have been expanded to cover a wider range of financial products and eligible participants. The overall effect of these provisions is to permit a party to a hedge agreement to terminate the agreement, offset and net out any payment obligations owed under the agreement (including the netting of termination values or payment amounts across multiple transactions between the same counterparties) and apply any margin collateral held in respect of those obligations notwithstanding the bankruptcy of the hedge counterparty—all without having to obtain permission from the court.6
The filing of a bankruptcy petition will trigger an event of default that can be used by the counterparty as a basis for terminating the hedge agreement and exercising its offset and netting rights. The terms of those rights may become particularly important, as they could have a significant impact on the financial value of the hedge transaction both in and outside of a bankruptcy.
Banks, however, are not US Bankruptcy Code eligible entities. The Federal Deposit Insurance Act (FDIA)7 would govern the insolvency (or conservatorship) of certain banks, while state law would govern the insolvency/ conservatorship of other banks. The FDIA affords hedge counterparties rights that are somewhat similar to those available to hedge counterparties under the US Bankruptcy Code, yet differences do exist. For example, under the FDIA, a hedge counterparty must observe a one-businessday stay before exercising its right to terminate a hedge contract with a bank in receivership or conservatorship, and in the case of a conservatorship, certain insolvencyrelated events cannot be used to trigger a termination or other remedies.8 This stay provides an opportunity to transfer the “good” assets (including swaps, to the extent the FDIC wants to keep them in place) to a solvent entity while leaving the “bad” assets behind in the insolvent entity.
Dodd-Frank provides an alternative framework for restructuring certain non-bank financial institutions (including non-bank affiliates of banks) deemed capable of jeopardizing the economy. Through an “orderly liquidation authority” (OLA) procedure, each applicable counterparty must observe a one-business day stay before exercising its right to terminate a transaction with an OLA-eligible insolvent entity (similar to the FDIA provision described above).9
On October 11, 2014, ISDA announced that 18 major global financial institutions (G-18) agreed to sign a new ISDA Resolution Stay Protocol, which has been developed in coordination with the Financial Stability Board to support cross-border resolution and reduce systemic risk. The protocol imposes a 48-hour stay on cross-default and early termination rights within standard ISDA derivatives contracts between protocol adherents in the event one of them is subject to resolution action in its jurisdiction. The stay is intended to give regulators time to facilitate an orderly resolution of a troubled bank. Although this protocol is not currently binding on parties other than the G-18 firms, regulators might eventually require a much broader group of market participants to adhere to the protocol.10
Certain offset rights may have a significant negative effect on the value of a hedge agreement. For example, a “disguised walk-away” provision provides that a nondefaulting counterparty has no obligation to pay a derivatives settlement amount to a defaulting party unless all liabilities of any kind then owing by the defaulting party and its affiliates to the non-defaulting party and its affiliates have first been paid.
Although one can argue about the intrinsic fairness of such a provision outside of a bankruptcy, consider its impact once a bankruptcy has been filed. If the hedge provider is an affiliate of the bankrupt borrower’s mortgage lender (as is often the case), the effect of the provision is to permit the hedge provider to argue that it has no payment obligations under the hedge agreement (even where the hedge is “in the money” for the borrower) unless the mortgage loan is paid in full, notwithstanding the existence of the bankruptcy case.
Such provisions, however, may not be enforceable in an insolvency or conservatorship proceeding. For example, the FDIA explicitly provides that such a provision is not enforceable against an institution in default that takes federally insured deposits.11 As noted above, not all banks are regulated by the FDIA and courts applying state law have been divided on this issue.12 As a result of the uncertainty surrounding enforceability, most hedge providers have eliminated walkaway clauses from their hedge agreements. Nonetheless, given their potentially harsh result, borrowers would be well served to remain vigilant on this point and eliminate onerous offset provisions from their agreements.
Hedges in connection with real estate financings
The discussion above is applicable to borrowers and lenders in a variety of industries. Other considerations can arise when the borrower is a real estate investor. Those issues are not addressed in this article.
Interest rate hedge agreements are complex and should be entered into only after receiving advice from qualified counsel. The topics discussed in this article are some of the more important issues of which borrowers and lenders should be aware when working with hedge agreements. Bearing these points in mind will help ensure that one is not taking on unforeseen risks when attempting to manage one’s exposure to interest rate fluctuations.
This article is based in part on an article co-authored by the author, Gary A. Goodman, a partner in Dentons, and Malcolm K. Montgomery, a partner at Shearman & Stearling LLP. The author gratefully acknowledges their contributions. Any errors in this article are the sole responsibility of the author.