Given the turmoil in the financial markets, it is now more crucial than ever for hedge funds and other market participants to consider the following six key points when negotiating ISDA® Master Agreements with dealer counterparties.
1. Net Asset Value Related Termination Triggers
Most dealers insist on a variety of net asset value ("NAV") related termination provisions in their ISDA Master Agreements so they can "pull the plug" on their hedge fund counterparties if the hedge fund's NAV declines below a certain dollar amount or by a certain percentage. These provisions may include (a) declines by certain specified percentages of the hedge fund's NAV over periods of one, three or twelve months; (b) a decline below a specified NAV dollar amount; (c) a specified NAV percentage decline below the hedge fund's highest historical year-end NAV; or (d) an increase above a specified ratio of the dealer's net exposure to the fund relative to the fund's NAV. However, based upon the hedge fund's market strategy, redemption policies or other applicable factors, certain of these events may occur even when the hedge fund is operating profitably or as anticipated. For example, the dealer needs to understand when redemptions should be included or excluded in the NAV calculation or when, due to certain nonrecurring events, the hedge fund's highest historical NAV is an unrealistic benchmark. Hedge funds should also consider including a ratingsbased termination event applicable to the dealer so that the fund has the right to terminate its outstanding trades if its dealer counterparty experiences financial distress.
2. Change in Investment Manager and Investment Guidelines Termination Events
Most dealers seek to insert a provision into an ISDA Master Agreement permitting the dealer to terminate its trades with its hedge fund counterparty if the hedge fund either (a) replaces its investment manager or (b) changes its investment guidelines or core fund documents. From the fund's perspective, these provisions may be overly broad because a new investment manager may be just as qualified as, or even more qualified than, the investment manager being replaced. Similarly, changes in a fund's investment strategies or core documents may not be detrimental to the dealer and, in fact, may provide the dealer with increased security regarding the fund's ability to meet its obligations to the dealer.
3. Delivery of Financial Information
ISDA Master Agreements require that each party deliver to the other certain specified documents, including financial information. Because hedge funds' financial statements are not publicly available, a dealer will normally require the hedge fund to deliver annual and quarterly financial statements as well as monthly NAV reports within specified time periods. The hedge fund needs to ensure it is not agreeing to an overly aggressive timetable for the delivery of financial information, particularly when financial statements require approval by, or input from, persons unrelated to the hedge fund or located in foreign jurisdictions.
While the standard ISDA Master Agreement cross-default provision requires that the default occur pursuant an agreement or instrument in respect of borrowed money, many dealers seek to expand their cross-default protection against hedge fund counterparties to include defaults arising from derivatives transactions. Careful drafting of these provisions is essential because there may be a legitimate dispute as to the amount owed and even as to which party is required to make the net payment in a derivatives transaction.
5. Collateral Provisions
Most dealers are not willing to incur any unsecured exposure with respect to their hedge fund counterparties but, conversely, expect their hedge fund counterparties to deal with them on an unsecured basis up to a specified exposure threshold amount. This collateral threshold disparity may (or may not) be appropriate when the ISDA Master Agreement was first entered into, but hedge funds should consider requesting ratings-based collateral thresholds applicable to the dealer so that the dealer's collateral terms will be subject to change if the dealer's credit ratings decline.
Hedge funds should also be concerned about the conditions precedent to the collateral delivery and return obligations contained in the New York law-governed ISDA Credit Support Annex ("CSA"). Paragraph 4(a) of the CSA relieves a secured party of its obligation to return collateral to the pledgor if the pledgor defaults or otherwise suffers a specified adverse event. This means that a dealer secured party could determine not to close-out its derivatives positions with the fund based on a default or other specified event with respect to the fund, yet still retain collateral it otherwise would be required to return to the fund pledgor based on the derivatives portfolio's mark-tomarket valuation.
6. Other Agreements Between the Dealer and the Hedge Fund
A hedge fund's derivatives trading relationship with a dealer may also extend to prime brokerage services, portfolio margining and repurchase and securities lending transactions. If so, the documentation required by the dealer would consist of, in addition to an ISDA Master Agreement, the agreements covering these other relationships. Whether other agreements between the dealer and the hedge fund are already in place when the ISDA Master Agreement is being negotiated or the ISDA Agreement is just one of a number of agreements being negotiated at the commencement of a new dealer relationship, the consistency among similar provisions in all the agreements must be evaluated and a determination made as to which provisions will govern when there are inconsistencies. Nothing is gained by the hedge fund if, for example, its carefully drafted provisions in the ISDA Agreements are nullified by provisions in a prime brokerage agreement.
Traditionally, most hedge funds have negotiated their ISDA Master Agreements defensively; they try to limit the circumstances that could allow their dealer counterparty to close-out trades due to a default or termination event. While hedge fund counterparties face special challenges when negotiating against highly rated dealers, they should seek to avoid overly broad provisions that can expose them to unnecessary default scenarios. In addition, in the context of today's volatile markets, where "even the mighty have fallen," all derivatives market participants need to consider that the creditworthiness of any counterparty may seriously, unexpectedly and rapidly deteriorate, and they may need to negotiate all their trading agreements with a new set of assumptions.