Turbulent and illiquid markets have led to an increase in disputes between counterparties to derivatives contracts over the posting of collateral. These disputes can entail demands for tens of millions of dollars worth of collateral and underscore the liquidity risks posed by OTC derivatives transactions. In such disputes, a “documentation disadvantage” can prove fatal. (See Box: Avoiding “Documentation Disadvantages” in Valuation Disputes.) Some of these disputes have already led to litigation and we now have the first judicial decision involving the dispute provisions of the 1994 ISDA Credit Support Annex (“CSA”). Unfortunately, although the District Court’s decision in VCG Special Opportunities Master Fund Limited v. Citibank, NA, is correct in its result, it further muddies the waters for parties attempting to work out disagreements over collateral under the CSA. However, the case is an important reminder to end-users of the need to understand and exercise the dispute rights they currently enjoy under Paragraph 5 of the CSA, and should encourage end-users to become involved in ISDA’s current initiative to reexamine these important contractual rights.
“Bad Facts Make Bad Law”
The VCG Fund litigation was based on the completely erroneous premise that a confirmation specifying an Independent Amount relieved the VCG Fund of any further obligation to post additional collateral under the CSA.1 The VCG Fund suffered the most avoidable “Documentation Disadvantage” of all; it failed to read and understand what it had agreed to when it executed the CSA. The CSA is designed to facilitate the movement of collateral between parties based on changes in each party’s “Exposure” to the other party.2 “Exposure” is often described as the “mark-to-market” value of the outstanding trade(s), although that is not the precise definition employed in the CSA.3 Independent Amounts, on the other hand, are specified amounts that are typically added to the Exposure calculation in determining a party’s obligation to post collateral. Thus, if the mark-to-market value of the trades between Party A and Party B is determined to be $2 million in favor of Party A (the “in-the-money party”) and the Independent Amount applicable to Party B (the “out-of-the-money party”) is $1 million, Party B would be obligated to deliver $3 million in collateral to Party A.4 VCG Fund claimed that it was entitled to rescission based upon its understanding that it had assumed no “risk of daily mark-to-market movement in the value of the reference obligation.” Even the most cursory understanding of the CSA would refute that assumption. As Judge Jones aptly observed in rejecting the rescission claim: “[I]t appears that the instant case presents a circumstance where VCG, a sophisticated hedge fund, simply failed to review carefully the terms of the parties’ agreement.”
Had Judge Jones simply decided the case based on the unambiguous and indisputable reading of the CSA, the decision would not merit further comment. But Judge Jones went considerably further in her refutation of VCG Fund’s claims. First, she argued that whatever inconsistency may have existed between the confirmation and the CSA was “waived” by VCG Fund when on several occasions the Fund agreed to post collateral to Citibank even though it believed it was not required to do so. Judge Jones’ decision in this regard fails to even acknowledge the “no waiver” provision in the underlying ISDA Master Agreement which explicitly states that a “failure or delay in exercising any right, power or privilege in respect of this Agreement will not be presumed to operate as a waiver….”5 Certainly the right to resist a demand for collateral under the CSA, which when executed becomes part of the single ISDA Master Agreement, is a “right, power, or privilege in respect of” the Master Agreement. The implications of Judge Jones’ decision could be grave. Although in the instant case there was only one transaction at issue, it is common for parties to have tens or hundreds of transactions governed by a single Master Agreement/CSA. It is not unreasonable for a party to temporarily forgo disputing a legal issue with respect to a single transaction when a decision to pursue the matter could result in termination of all outstanding transactions with the counterparty. Such a decision should not forever bar the party from asserting its legal rights. This is precisely the point of the “no waiver” provision in the ISDA Master Agreement.
Second, Judge Jones ruled that VCG Fund could not challenge Citbank’s demand for collateral based upon its Exposure determination because it failed to dispute Citibank’s claim in the manner provided in Paragraph 5 of the CSA. This is somewhat surprising since VCG Fund claimed, albeit incorrectly, that it was not required to post any collateral other than the Independent Amount specified in the confirmation. Thus, it really didn’t matter what Citibank determined its Exposure to be under the contract. Although there were allegations in the complaint regarding Citibank’s determination of Exposure, this was not the essence of VCG Fund’s legal claim. Consider, for example, a collateral dispute that might arise in another context. Certainly, one should not have to pursue the dispute rights of Paragraph 5 if the claim were that collateral need not be delivered because an Event of Default or Potential Event of Default has occurred with respect to the party demanding collateral.6 However, even where Exposure valuations are at issue, the opinion could adversely impact current market practice. It is routine market practice for parties to informally work out valuation disputes without necessarily going through the formalities of the Paragraph 5 provision on each and every occasion. Parties should not be discouraged from such informal activities for fear that they may be waiving their right to contest a valuation.
That said, in light of Judge Jones’ decision, if there is a dispute regarding the determination of Exposure or the value of existing Posted Collateral, the disputing party is certainly well advised to pursue its rights under Paragraph 5, summarized below, or to take steps to preserve those rights while less formal dispute resolution activities are in process. Unless modified in Paragraph 13, the Paragraph 5 dispute rights may be invoked only by providing notice to the other party no later than the close of business on the Local Business Day following the receipt of a demand for collateral. In brief, Paragraph 5 requires the disputing party to post the undisputed amount, allows some time for the parties to work out their differences, and then, if the dispute is not resolved, requires the Valuation Agent to determine Exposure by “seeking four actual quotations at mid-market from Reference Market-makers for purposes of calculating Market Quotation….” If such quotations are available, the dispute is resolved by taking the average of the quotations obtained. If no quotations are available for a particular Transaction, “then the Valuation Agent’s original calculation will be used for that Transaction.”
The mechanism in Paragraph 5 for resolving valuation disputes under the CSA is the only alternative dispute resolution mechanism embedded in the standard ISDA documentation. Otherwise, the parties are left with the choice of either satisfying the counterparty’s demand or litigating the dispute, and litigation generally entails the risk that one of the parties will be found to be in default with respect to all outstanding Transactions. The Paragraph 5 mechanism works best where either party (i.e., whichever party is demanding the transfer of collateral) can be the Valuation Agent. In some cases, the dealer counterparty insists upon being the Valuation Agent in all circumstances, and this materially reduces the benefit of the provision to the end-user party. The reason for this is that the dealer, as sole Valuation Agent, both controls and conducts the polling process and has the clear right to fall back to its initial calculation if no quotations “are available.”
ISDA’s Initiative to Reexamine Dispute Resolution Under the CSA
ISDA has set in motion a process designed to reexamine the dispute resolution mechanism currently employed in the CSA. We understand that the reexamination is the result of several issues that have emerged regarding experience with Paragraph 5 disputes:
- First, there is concern that the process may be invoked to unduly delay the delivery of collateral and that this exposes parties to inappropriate counterparty credit risk.
- Second, there is concern that the mechanism does not clearly address the situation where both parties believe that they are “in-the-money” and are entitled to demand collateral. (Given current market volatility and illiquidity, this scenario is apparently arising with some frequency.)
- Third, there also seems to be concern that the concept of seeking “actual quotations at mid-market” needs to be rethought because dealers typically provide bid/offer quotes and not “mid-market” quotes. Moreover, the entire notion that dealers are willing and have the capacity to provide quotes for this purpose is open to question.
- Fourth, some apparently believe that the derivatives dealer should always be the Valuation Agent and, accordingly, may seek elimination of the current default provision of the existing Paragraph 13 that provides that the Valuation Agent will be whichever party is demanding the transfer of collateral. As noted above, this change would materially undermine the value of the dispute provision for end-users.7
- Fifth, some have suggested that disputes regarding determinations of Exposure and the value of Posted Collateral should be decided by an independent third party. Others believe that all collateral determinations should be made by an independent third party, such as is presently the case with respect to exchange traded derivatives, so that disputes are eliminated.
All of these issues, and undoubtedly others, will be addressed in the pending ISDA initiative. The ISDA Board of Directors, which consists solely of dealer institutions, has committed to the Federal Reserve Bank of New York that it will review existing margin dispute language and recommend alternative and improved approaches by April 30, 2009.
Avoiding “Documentation Disadvantages” in Valuation Disputes
- Read and thoroughly understand the terms of the collateral agreement.
- Resist designation of the counterparty as sole Valuation Agent in Paragraph 13 (or in the confirmation to a particular trade).
- Resist language requiring the posting of Independent Amounts to a counterparty when you are “in-the-money” by more than the Independent Amount.
- Resist efforts to delete or undermine the dispute rights provided in Paragraph 5 of the CSA.
- Where a specific transaction poses particular valuation issues (e.g., where the trade is highly structured and illiquid), discuss and agree up front on a fair methodology for valuing the trade for collateral purposes or upon a mechanism for submitting valuation disputes to knowledgeable (and willing) third parties.
- Exercise your Paragraph 5 dispute rights when there is a valuation issue or take steps to ensure that those rights are preserved if you agree to less formal resolution of valuation issues.
- Let ISDA know that you are keenly interested in its pending review of existing dispute resolution provisions and want any proposed changes to be even-handed in their treatment of dealers and end-users. Letters can be addressed to:
ISDA Collateral Committee
One Bishop Square
London E1 6AD
ISDA members can participate in ISDA’s Dispute Resolution Working Group. Contact Katie Arnold at ISDA for further information (KArnold@ISDA.org).