Corporates of all sizes may need to enter into International Swaps and Derivatives Association, Inc. (ISDA) agreements for a variety of reasons, such as to hedge floating rate interest rates or to cover off FX exposures. This article highlights a number of the issues for treasurers, in-house counsel and key stakeholders to consider before entering into negotiations with their bank group, including how to structure the agreement, comply with regulatory requirements and plan for key developments such as benchmark reform.
Documentation and structure
For any over-the-counter (OTC) derivative trades (i.e. derivatives that are negotiated and traded directly between two parties, without going through an exchange or other intermediary), an ISDA agreement will be required, comprising:
- A master agreement prepared by the ISDA – a pre-printed framework document that itself is not negotiated or amended;
- A schedule to the master agreement – this amends the terms of the master agreement;
- Credit support documents (optional) – in order to provide collateral or security for a trade or trades (typically in the form of ISDA’s Credit Support Annex or a parent company guarantee); and
- A confirmation – a short-form document that contains the economic details of a particular trade.
Having this framework in place prior to trading should be a key priority for any business requiring access to derivative products. To ensure adequate contractual protection, the documentation will need to be tailored to the type of trading that is envisaged, whether it is a one-off trade or a template for a number of different types of trading. For instance, there is tailored wording and definitions that can be incorporated – ISDA has produced specific definitions, wording and supplemental protocols for the majority of trading areas, such as equity derivatives and FX and currency options.
For corporates, it may also be the case that they wish or are required by their banking group to enter into derivatives that are linked directly to their banking facilities, e.g. to hedge against a floating rate interest rate under an underlying loan (Finance-linked ISDAs). With Finance-linked ISDAs, specific consideration will need to be given in the framework as to how the loan and derivative trade should inter-relate (e.g. how terminations and crossdefault will apply). A related point is benchmark reform and the proposed cessation of LIBOR in 2021, a mismatch between the loan and the ISDA agreement with regards to fallbacks could have undesirable economic consequences. ISDA is currently going through a consultation process on benchmark reform complemented by the 2018 Benchmarks Supplement, which allows firms to agree interim fallback arrangements should a benchmark cease to exist before the benchmark fallbacks are implemented.
Another key point to consider right at the outset is the relevant counterparty and its jurisdiction of incorporation. Aside from being comfortable with the insolvency risk of the counterparty, the jurisdiction in which the counterparty is registered may have knock-on effects for the requirements of the ISDA agreement and the approach to drafting. There are a number of protocols and/or modules produced by ISDA that may need to be adhered to in order to comply with local regulatory requirements, or representations that ought to be given. To give just a couple of illustrations of this point, see the article in this publication by Marc A. Horwitz as well as the section on tax below. There is an ISDA-supported service called Markit ISDA Amends that enables adherence to certain ISDA protocols, with further information available at ihsmarkit.com.
It is therefore important to ensure that you seek local law advice at the drafting stage.
Similarly, the choice of entity that you pick to enter into the trade will also drive a number of points in the ISDA agreement. For example, if you need flexibility for upcoming or potential changes to your company structure, this will need to be catered for in the transferability provisions.
As alluded to above, regulatory requirements will need to be reflected in the drafting of the ISDA Agreement and will vary from jurisdiction to jurisdiction. A primary concern for a number of large corporates with operations in Europe will be compliance with the EU’s European Market Infrastructure Regulation (EMIR), requiring all OTC derivative trades to be reported to a trade depository. Most banking institutions offer to provide EMIR reporting on a corporate’s behalf, but this will often require entering into the bank’s standalone form of agreement which typically provides that the banking institution will do this free of charge but without accepting any liability. Alternatively, relevant language can be built into the ISDA agreement at the outset so that EMIR reporting is adequately addressed.
There are a number of common tax issues that can arise and be affected by language in the ISDA agreement, these include:
- Withholding tax on payments;
- Obligations to report payments to the relevant tax authorities; and
- Restrictions on the payer obtaining tax relief (deduction) for payments.
The tax provisions and representations may need to be added to or amended for a number of reasons. For example, due to the flexible manner in which entities can designate their tax classification in the US through the Internal Revenue Service, it may not be clear that the counterparty is in fact a branch of a US parent. Without specific US tax representations in the ISDA agreement, US withholding tax could apply to trades entered into with such an entity.
It is therefore important to carefully scrutinize the counterparty’s company structure and ensure that relevant tax advice is sought before agreeing the terms of any ISDA agreement.
The derivatives market has been a core focus of attention worldwide, particularly in the aftermath of the 2008 financial crisis. Moving forward, there are a number of planned developments that may have significant ramifications for all companies entering into derivative contracts. Benchmark reform mentioned above is certainly one of these, but in addition:
Brexit: Very much a moving target for the market at the moment, derivatives could be particularly affected by developments as they continue to unfold (at the time of writing, Brexit will occur on October 31, 2019 without a deal yet in place). In October 2018, ISDA produced a paper on the possible effects of a no-deal Brexit, with a number of regulatory consequences in focus. ISDA also helpfully update a set of FAQs relating to Brexit – the January 22, 2019 edition is available at isda.org.
Initial Margin: In September 2019 and 2020, phase-ins of initial margin requirements will pick up pace, the threshold requirement for posting initial margin will drop significantly (from a threshold of aggregate average notional amount of non-cleared derivatives of EUR2.25 trillion down to EUR8 billion in September 2020). This will affect more than 1,000 new companies and add to the documentation and operational requirements needed for those affected. ISDA have created a new platform called ISDA Create in an attempt to add automization to this process.
Smart contracts: ISDA are actively looking at what parts of the derivatives contractual framework can be automated and changed into component parts for representation as functions before then combining these functions into templates for use with particular products. ISDA Create is one example of this and legal guidelines have now been published by ISDA at isda.informz.net
Ensuring that a suitable framework for derivatives trades is in place before any trading occurs is essential. This article, which does not even touch on the common points of negotiation in the ISDA agreement itself, highlights that guidance should be obtained from relevant experts – from tax professionals to lawyers with country-specific know-how. Our derivatives team, also comprising tax and regulatory support as well as covering the key financial centers, have a breadth and depth of knowledge to advise on one-off trades, programs with multiple bank counterparties and ongoing compliance issues.