In the last three issues of Business Law Quarterly, we have had articles on the ISDA Master Agreement and the Schedule. This article is about the Credit Support Annex (CSA) to the Schedule to the Master Agreement. The CSA is a “credit support document” for purposes of the Master Agreement. In fact, it is a security agreement under which each party grants a security interest to the other party in order to secure the granting party’s obligations in respect of any Transactions.
Security interests in personal property in the United States are generally governed by the Uniform Commercial Code and this is true with the CSA, but because the CSA is designed for use all over the world, it doesn’t refer to the UCC and instead states that the secured party has all rights and remedies available to a secured party under applicable law with respect to the collateral, including the right to liquidate collateral.
For many types of personal property collateral, such as accounts receivable, inventory and equipment, the secured party does not take possession of the collateral. To do so would be impractical and also impede the debtor’s operations. But when collateral is required in respect of a swap transaction, the parties typically prefer that the collateral be cash or cash equivalents or other easily valued and readily marketable securities. Security interests in such types of collateral are generally perfected by obtaining “control” either through possession (pledgor delivers (or posts)) the collateral to secured party) or by a tri-party “account control agreement” with the broker or other securities intermediary which holds the securities (either in actual physical form or as the book entry owner).
The security interest under the CSA will cover only the collateral which the granting party posts. A party is required to post collateral when it has “Exposure” above an agreed required minimum level. Either party to an ISDA Master Agreement may have to put up collateral at some point if there is a CSA as part of the contract.
The CSA itself is a form document in which the text of paragraphs one through 12 is mandated. Changes and modifications that are agreed upon by the parties are set forth in paragraph 13 which is titled Elections and Variables. Paragraph 13 is also where amounts (such as the level of Exposure required in order to trigger the obligation to post collateral) and other information needed to complete the earlier provisions is set forth.
The main issues for the parties to negotiate in the CSA are:
- What obligations are secured? Is it just the Transactions under the Master Agreement, or are additional obligations to be included, such as obligations to repay loans under a loan agreement between the parties?
- What kinds of collateral will be acceptable? As noted, usually the collateral must be readily marketable, such as U.S. Treasury obligations and highly-rated publicly traded corporate debt. Cash may also be used.
- How will collateral be valued? Typically, there is a slight discount for anything other than cash. Thus, T-bills may be valued at 99 percent of current market value; corporate bonds at 98 percent and so forth. This provides the secured party with a small cushion protecting against fluctuations in value which may occur from time to time.
- What is the minimum Exposure requirement which must exist in order for a party to have to provide collateral? Not uncommonly, collateral is not required until the amount by which one side is out of the money has reached an agreed upon level which is significant, such as $10,000.
- Conversely, once collateral has been posted, what is the minimum “Return Amount” in order to require release of the excess? For example, if a party posted $100,000 of collateral, how much would Exposure have to decline to in order to require a return of some of the collateral? Since the parties don’t want to be shuffling collateral back and forth very often, Exposure often has to be reduced by $10,000 or more before there is a right to get collateral back. So, when Exposure reached $100,000, a party posted that much collateral. When Exposure drops back to less than $90,000, collateral worth $10,000 is released.
- Who will be the “Valuation Agent” that makes the valuation determinations as to Exposure in order to decide if more collateral must be delivered or some may be released? If one of the parties is a bank or other financial institution, it usually wants this role, at least in part because it is better qualified and prepared to make such determinations.
- Who will hold any posted collateral? One possibility is that one party delivers collateral to the other to be held, but in some circumstances one or both parties may want to designate a “Custodian” to hold any collateral that they have to put up.
- If collateral is to be held by a Custodian, who will that be? Usually, it is required to be a bank or trust company with substantial assets. If there is a Custodian, it will have to enter into a control agreement sufficient to give the secured party “control” over the collateral to the extent required by the UCC.
- Who pays the Custodian if there is one? Typically, the party that wants a Custodian gets to pay for it.
- What use may a party make of collateral that the other party has put up? Can the party getting collateral re-hypothecate it? Or sell it? Remember that collateral is usually cash or publicly traded debt securities, and that the party holding collateral is “in the money” and would be entitled to be paid if the Transaction being collateralized were to be terminated, so it is not unreasonable for a party holding collateral to want to be free to use it.9 Where there is a Custodian, however, this usually doesn’t apply.
- Does the party holding collateral have an obligation to pay interest in respect of posted collateral? If so, at what rate? If cash is posted, the party which has the ability to use the cash is generally expected to pay a market rate of interest on the amount held. If interest bearing securities are posted, the parties can agree that the owner (the party putting up the collateral) is entitled to all interest payments from the securities.
The Events of Default under the Master Agreement are applicable to the CSA. In addition, paragraph 7 of the CSA states that an Event of Default will exist under Section 5(a)(iii)(1) of the Master Agreement if any of three circumstances should occur:
- Failure to post collateral, transfer collateral or pay interest when due which failure continues for two business days;
- Failure to comply with any restrictions placed upon the use of collateral by a party which failure continues for five business days; or
- Failure to comply with any of the other provisions of the CSA which failure continues for thirty days.
If an Event of Default occurs with respect to a party, the other party will have the right to exercise remedies. In this case, that means terminating the affected Transaction(s), foreclosing upon the collateral and using the proceeds to pay itself any early termination amounts which it is owed. In addition, the CSA contains provisions which are found in most security agreements providing for payment of costs and expenses incurred by the secured party in liquidating collateral after default and payment of default interest on overdue amounts and these claims can also be paid out of foreclosure sale proceeds.