Legal Aspects of Derivatives - Essay Example

 Abstract Derivative products are being very widely used in the present age to hedge against corporate business risks and many of the world’s largest companies use these products. Some of the business risks for which derivatives may be used include exchange rate or interest rate fluctuations, commodity and equity prices as well as the risks associated with lending. Swaps are contractual agreements between two parties usually made under a specified law which require both the parties to exchange cash flows based on interest rates, exchange rates or the prices of indexes. Equity swaps involve exchanging cash flows based on rates of return of a stock market index or two stock market indexes. Equity index swaps are used by institutions to gain exposure to stock markets where governments have created high entry costs. Whatever the motive for using derivatives and swaps, it is important to be able to understand the legal aspects of the contracts related to derivatives. Because swaps and derivatives are very widely used internationally, the International Swaps and Derivatives Association or ISDA was formed in order to encourage the prudent use of privately negotiated derivative business. The overall trading relationship between parties to derivative transactions is now mostly governed by a standard ISDA Master Agreement which is designed to be governed by either New York Law or English Law. Collateral agreements can be made under English Law, Japanese Law or New York Law, although if a party to the contract becomes insolvent, the insolvency laws of the country of incorporation will apply. It is important for those dealing with derivatives to understand the legal aspects of such agreements. In this brief paper, an attempt is made to study such legal aspects through a hypothetical case involving a derivative agreement between two parties. Introduction It is important to be able to understand the legal aspects of derivatives agreements because derivatives are increasingly being used by businesses to hedge against corporate business risks, including risks associated with international operations, exchange rate or interest rate fluctuations, commodity and equity prices as well as the risks associated with lending. The International Swaps and Derivatives Association, ISDA, was formed with a view to encourage the prudent global use of privately negotiated derivative agreements and this body has made it possible for participants to relatively easily enter into such agreements through the use of its standardised ISDA Master Agreement which is designed to be governed under either English Law or New York Law. Collateral agreements can be made under English Law, New York Law or Japanese Law. However, if a party to the contract becomes insolvent, the insolvency laws of the country in which the party was incorporated will apply. A swap agreement is basically an agreement between two parties to exchange cash flows. Such cash flows may be determined on the basis of interest rates, exchange rates or the prices of indexes or commodities. Equity Index Swaps are widely used these days in order to gain exposure to markets in which governments have created a high entry cost. However, because swaps and derivatives have come to be very widely used, it is important to understand their legal aspects. In this paper, an attempt has been made to understand the legal issues behind derivatives and swaps through the use of a hypothetical case. This hypothetical case is presented below, along with the explanations for issues raised in the case. The Hypothetical Legal Case Involving Derivative and Swap Agreements BDCS a French bank has decided to enter the market in derivatives especially with corporate entities in Eastern Europe and South America. Advise BDCS as to the legal issues which would affect its credit exposure in the event of the insolvency of one of its corporate counterparties in respect of its derivative portfolio on the basis that it has signed an ISDA Master Agreement (Multi Currency Cross Border) 2002 under English law. What rights would BDCS have if it has entered into swaps from its Paris office with the Argentine office of BNT, a Mexican incorporated bank, and subsequently, the Argentine government were to impose a moratorium on all foreign currency payments? Assume documentation under an ISDA Master under English law. BDCS has bought a credit default swap from BMB to cover its loans to SVB. IT is understood that SVB is being restructured for purposes of internal reorganisation. What rights if any, would BDCS have against BMB and what are its duties in order to obtain payment under the credit derivative assuming 'Publicly Available Information' is specified in the credit default swap confirm? BDCS is also keen to reduce risk exposure by using 'mark to market' collateralisation structures based on netted exposure of derivatives transactions. What legal steps should BDCS undertake to ensure as far as possible that its risk reduction methodology is enforceable in law? Legal Issues Affecting BDCS Credit Exposure in the Event of the Insolvency of its Counterpart By entering into a swap or derivatives agreement with counterparts in Eastern Europe and South America under English Law, BDCS is in effect exposing itself to being considered as a creditor party under the laws of Eastern Europe or South America in the event of the insolvency of its partners. Even though the ISDA Master Agreement is governed under the English Law or the Common Law of Contracts as it is known in many jurisdictions which were former colonies of the Crown of England, the ISDA Master Agreement is not bound by English Law in the event of an insolvency of one of the partners. Thus, in the event of insolvency of its partners, BDCS will have to deal with the governments of Eastern Europe or South America in which its partners were incorporated. Different countries have different laws and procedures for administering insolvent companies. Some countries, such as England or other Commonwealth countries, have insolvency laws which are favourable to the creditors, however, other countries have laws which are not so favourable to those who are creditors of the insolvent companies. Because insolvency cases will be dealt with by authorities or courts in the country of incorporation of the insolvent partner, therefore, BDCS can only have its claims heard by courts of these countries and their laws may not be favourable. Also, the governments of such countries may have currency restrictions in force which can make it difficult for BDCS to recover any amounts owed to it by its insolvent partners. The remaining assets of any insolvent partners which have been incorporated in Eastern Europe or South America may also be held in the countries of incorporation which may have unstable economies with high inflation and a constant devaluation of the local currency. Thus, BDCS may only be in a position to recover a small proportion of any amounts owed to it by its insolvent Eastern European or South American partners and it may only be possible to do this after litigation in local courts in the country of incorporation of the insolvent partner. Those who have entered into a swap or derivatives agreement will only be concerned about a default if there are assets involved which are owed to them. Hence, a considerable amount of time may be involved before which any relief may be available from courts in the country of incorporation of the insolvent partner and this may deteriorate the cash flow situation of BDCS. It is also possible that there may be a moratorium on the removal of any assets or property of an insolvent partner which is subject to statutory management from the country of incorporation. In practice, however, an insolvent partner may terminate the derivative agreement prior to declaring bankruptcy (Allen & Overy) and (Hudson). The Rights of BDCS in the Event of a Moratorium by the Government of Argentina If the government of Argentina were to place a moratorium on all foreign exchange payments from Argentina, then this situation will be handled by the force majeure clause of the ISDA Master Agreement. The force majeure clause was added to the ISDA Master Agreement in 2002 and is a part of section 5(b) (ii) of the 2002 agreement. A force majeure situation may be defined as a situation in which a party to the Master Agreement is incapable of discharging its obligations under the agreement as a result of an act of God or the act of a state or government. Even though the partner with which BDCS entered into an agreement is the Argentine office of a Mexican incorporated bank, the action of the government of Argentina is enough for the force majeure clause to take effect. It is also necessary for a waiting period of eight days to have elapsed prior to the force majeure clause becoming effective. It is, however, expected that the party to the agreement i.e. the Argentine office of the Mexican incorporated bank will try to overcome the hurdles associated with the foreign exchange payments restrictions imposed by the government of Argentina, perhaps through recourse to its head office or by using other means at its disposal. However, the party is not expected to take a loss when attempting such efforts. The party affected by the force majeure or the BDCS bank is considered by law to be the Affected Party and it is this party which determines the Close - out Amount which has to be paid for an agreement which has been terminated by the force majeure clause. However, it is possible that some fall back clauses may have been incorporated into the Master Agreement to deal with such contingencies and these clauses will be valid prior to a force majeure situation occurring. In the event of a force majeure situation occurring, either party is allowed to terminate the agreement, however, only the affected party or the BDCS bank is allowed to present the Close – out Amount. When the event of force majeure affects payment obligations under a credit support document, only the non- affected party or the Argentine office of the Mexican bank is allowed to terminate the agreement. Because the Mexican incorporated bank has not been declared insolvent, therefore in the event that the Argentine office of the bank cannot meet its obligations related to the Close – out amount, BDCS can attempt legal action against the bank under English Law. The English Law of contracts will not reduce the amount of the indebtedness of the Mexican Bank, but the Affected Party or the BDCS bank can choose to accept anything in lieu of the amounts owed to it by the Argentine office of the Mexican bank (Allens Arthur Robinson), (Street) and (Hudson). Rights and Duties of BDCS in order to obtain Payment under the Credit Derivative A credit default swap is a transaction in which one party, in this case the SVB, will pay a single fixed amount or a periodic fixed amount or floating amount determined with reference to a specified notional amount, in this case the amount of the loan to SVB to BDCS until the loan is completely paid off. BMB in this scenario acts as a credit protection seller and it will commence payments to BDCS of either a fixed amount or an amount determined with reference to the value of the BDCS loans to SVB on the occurrence of a specified credit event such as bankruptcy or a payment default by SVB to BDCS. Hence, BMB is in effect acting as an insurer to the loans which BDCS has extended to SVB and its insurance obligations commence when and if SVB is unable to continue with it’s agreed upon obligations to repay its loans. Obviously, BMB is not going to undertake its loan insurance obligations unless there is a periodic financial payment to it by BDCS which has purchased the loan insurance. Hence, the most likely arrangement which will exist between BDCS and BMB is that BDCS will periodically pay BMB a portion of the loan amount which SVB is paying to it on a periodic basis. Hence, it is the duty of BDCS to continue to pay the proportion that has been agreed to be paid to BMB for as long as SVB is paying it’s agreed upon amount as the repayment of its loan from BDCS. If, for some reason, there is a default by SVB or SVB has been declared to be insolvent, then it is the duty of BDCS to inform BMB about this fact and it will then be the right of BDCS to require that BMB commence its duties as a loan insurer and start its agreed amount cash flow payments to BDCS because SVB has defaulted. BDCS will also be required to keep BMB informed about the publicly available information about SVB when confirming the receipt of payments from SVB to BMB. The agreements that will have been made between BDCS, SVB and BMB are swap agreements because they require periodic exchange of cash flows between the parties. These agreements are contract arrangements and will have been made under some widely acceptable law, possibly English Law and can be challenged in a court under the said law or English Law in the event that a party is not fulfilling its contractual obligations. BDCS can sue SVB in the event of a default under the English Law or in the country where SVB has been incorporated in the event of it being declared insolvent. BDCS will be required to keep BMB informed about the performance of the loan and can also sue BMB in case of any breach of its contract, under English Law (Allan & Overy) and (Hudson). BDCS and the ‘Mark to Market’ Collateralisation Mark to market collateralisation refers to the situation in which securities have been pledged as collateral for a loan which has been extended by a bank. These securities have a fluctuating market value which changes on a daily basis depending on the market value of the securities which have been pledged. Marketable securities, bonds, national saving certificates, oil reserves or even gold may be used as collateral to seek a loan. In the event of a mark to market collateralisation situation, it is important that banks ensure that the mark to market collateral position is reviewed periodically, preferably with a maximum of once every six months in order to reflect the market value of a loan. The party which has been granted a loan may be required to post additional security if the price of the already posted security is inadequate to cover the loan amount. In determining the amount of securities that are required to be posted, haircuts are applied to the market value of various types of collaterals and a 99% value of the security may be used to calculate the collateral amount instead of 100%. Banks must also have the right to cease the collateral in the event of a default from the counterparty without interference from courts. Guarantees may also be required from third parties such as governments, other banks, guarantees from parents or associates of the company with a stronger financial position etc. Banks use technique such as break trade laws / termination clause, i.e. they have a mutual contract whereby they can exit from the trade in the event of any type of default on the part of borrower. All documentation used in collateralized transactions and for documenting on-balance-sheet netting, guarantees, and credit derivative must be binding on all parties and must be legally enforceable in all relevant jurisdictions. Banks must have properly reviewed all the documents and should have appropriate legal opinions to verify such, and ensure its enforceability. Stipulating the conditions in advance for an adequate transfer of information lays the foundation for an appropriate monitoring of credit risk and for assessing the potential need for adjustments to non-price terms or the application of termination provisions. The time that it will require to liquidate securities should be considered when deciding on the haircuts that need to be applied to the security value that has been pledged in the contract. Covenants should ensure that banks are made aware of adverse financial developments and are able to press for adjustment well before the time when cessation of the relationship is appropriate (Bank for International Settlements) and (India Info Online). The legal process that is involved in the liquidation of securities in the event of a default should be well understood and documented. The clauses should include any holding periods involved. An outright transfer mechanism may be deemed to be more appropriate. Documenting the agreement is important and ISDA Master Agreements and Credit Support Annexe may be useful. New York Law, Japanese Law or English Law may be the governing law, depending on where the securities which have been pledged are located. The collateral taker must have unrestricted use of the securities received as collateral until it is time to return them to the collateral giver. The Credit Support Documentation should also be enforceable in the counterparty’s home jurisdiction. A pledge granted by an English counterparty may require registration with the UK registrar of companies. It may be appropriate to charge custody costs to the party which has pledged securities. Third party custodians such as centralised collateral management services may be used and all valuations for collateral purposes should be accompanied by a legal disclaimer (International Swaps and Derivatives Association, ISDA). Case Law Related to Derivatives and Swap Agreements In the system of English Law, the law of contracts has gradually evolved into its present form after very many case judgements and legal opinions. However, it is not the law of contracts alone which is of importance in cross border swap and derivative agreements, but rather its peculiar application to the contracts related to derivatives and swaps. Similarly, the law of insolvency that has an impact on the law related to swaps and derivatives is not just the law of England, but rather the laws of the very many countries in which companies which were party to swap or derivatives agreements were incorporated and which have since then become insolvent. Thus, for insolvency related cases, there are very many opinions from all over the world which is derived from very many legal systems. Hence, the English Case Law component is mostly applicable to the Master Agreements and their Annexes which may be used. Over the years, the International Swaps and Derivatives Association, ISDA has moulded its Master Agreements in light of the Case Law which has been produced as a result of court cases involving English Law or the Law of New York. The most recent changes to the Master Agreement took place in 2002, when the force majeure clause was introduced into the Master Agreements along with clauses related to close – out Amount, grace period and set – off clause. English Law cases have not dealt with insolvency, but rather have dealt with the concept of Loss as a result of a party to the Master Agreement deviating from its obligations. Some of the important cases under English Law which have had a bearing on the understanding of the concept of Loss include Australia and New Zealand Banking Group v Societe Generale which has given a more settled meaning to the concept of Loss. A number of cases under English Law have highlighted that fact that in the old Master Agreements, Market Quotation could somehow produce unreasonable results. Examples of such court cases under English Law include Peregrine Fixed Income Limited v Robinson Department Store plc and Enron Australia Finance Pty Limited (in Liquidation) v Integral Energy Australia. These cases have influenced the ISDA to replace the choice of Market Quotation and Loss in the 2002 Master Agreement with Close – out Amount, which is a single payment measure. Hence, the good thing about ISDA Master Agreements and their latest amended forms is that ISDA constantly changes these Master Agreements and associated documentation to reflect the latest thinking arising out of the latest case laws, legal opinions presented by governments as well as regulatory authorities and concerns expressed by companies (Highnam). Changes reflected in the Master Agreement are the complexities of using the modern instruments of swaps and derivatives within the meaning of contracts. Trying to quote and present old cases which have shaped the broader English Law of Contracts is not very relevant to the modern situation for swaps and derivates, because such cases have already had an impact on the accepted Law of Contracts. If there is a desire to investigate the evolution of case law related to the English Law of Contract, then (Street) or (Veermesch) may be consulted, however, such attempts will be relevant to the general Law of Contracts and not the Private Contract Law of Swaps and Derivatives. Conclusion With the increasing use of derivatives and swaps in international financial arrangements, it is important to have standardised legal agreements and methods of operation. The International Swaps and Derivatives Association has done a lot of work to enhance the use of derivatives in international finance and its legal documents as well as opinions are now very well accepted all over the world. These can be safely resorted to when considering the use of derivatives as financial instruments. References / Bibliography 1. Allen & Overy. “AN INTRODUCTION TO THE DOCUMENTATION OF OTC DERIVATIVES "TEN THEMES" Allen & Overy. May 2002. July 30, 2005. https://www.isdadocs.org/educat/pdf/ten-themes.pdf 2. Allen & Overy. “An Introduction to the Documentation of OTC Derivatives”. Allen & Overy. 2002. July 30, 2005. https://www.isdadocs.org/educat/pdf/documentation_of_derivatives.pdf 3. Baker & McKenzie. “Documentation of OTC Derivatives under the ISDA Master Agreement: A Primer for Corporate Council & Treasury”. Baker & McKenzie. 2004. July 28, 2005. http://www.bakernet.com/NR/rdonlyres/923702A4-DA33-4050-B249-FD7605FF0885/0/SwapsPractice_asof11Sept04.pdf 4. Bank for International Settlements. “Sound Practices for Banks Interaction with Highly Leveraged Institutions”. Bank for International Settlements. 1999. July 30, 2005. http://www.bis.org/publ/bcbsc123.pdf 5. Bergman, William J et al. “Netting, Financial Contract and Banks: The Economic Implications”. Federal Reserve Bank of Chicago. Retrieved: July 28, 2005. From: http://sba.luc.edu/research/wpapers/030812.pdf 6. Castagnino, John P. “Derivatives: The Key Principles”. Richmond. 2004. July 28, 2005. http://www.richmondlawtax.com/pdf/Sample%20Content%20Derivatives%20II%201904501311.pdf 7. Dubofsky, David A and Thomas W. Miller, Jr. “Derivatives: Valuation and Risk Management”. Oxford University Press. 2003 8. Highnam, Tom. (2002). 2002 ISDA Master Agreement. FindLaw Australia. 2005. July 30, 2005. http://www.findlaw.com.au/articles/default.asp?task=read&id=8578&site=GN 9. Hudson, Alistair. “The Law of Financial Derivatives”. Sweet and Maxwell. 2002. July 28, 2005. http://www.globallawreview.com/lawoffinder.html 10. India Info Online. “Credit Risk Management”. India Info Online. 2004. July 30, 2005. http://www.indiainfoline.com/bisc/ari/cred.pdf 11. International Swaps and Derivatives Association, Inc. ISDA. “EU Insolvency Regulation: Position Paper for ISDA on the Treatment of Set – Off”. ISDA. 2004. July 28, 2005. https://www.isdadocs.org/speeches/pdf/Faxroom.pdf 12. International Swaps and Derivatives Association, Inc. ISDA. “Financial Transactions in Insolvency: Reducing Risk through Legislative Reform”. ISDA. 1996. July 28, 2005. https://www.isdadocs.org/speeches/pdf/FinancialTransinInsolvency.pdf 13. International Swaps and Derivatives Association, Inc. ISDA. “Guidelines for Collateral Practitioners”. International Swaps and Derivatives Association, Inc. ISDA. 2004. July 30, 2005. http://www.angelfire.com/nt2/swaps/Swap%20Collateral.pdf 14. International Swaps and Derivatives Association, Inc. ISDA. “The Financial System and Major Operational Disruption”. ISDA. 2003. July 28, 2005. http://www.hm-treasury.gov.uk/media/CEC/15/ISDA_response240403.pdf 15. Mokal, Rizwaan Jameel. “Corporate Insolvency Law Theory and Application”. Oxford University Press. 2005. July 28, 2005. http://www.oup.com/us/catalog/general/subject/Law/BusinessLaw/?pr=10&pf=0&ss=author.asc&sf=all&sd=asc&view=usa&ci=0199264872 16. Morner, Anna. “Swaps and Netting: Some Recent Developments”. The London Institute of International Banking, Finance & Development Law. 1997. July 28, 2005. http://iibf.law.smu.edu/swaps.pdf 17. Robinson, Allens Arthur. “2002 ISDA Master Agreement”. Allens Arthur Robinson. March, 2003. July 28, 2005. http://www.aar.com.au/pubs/pdf/baf/fobafmar03.pdf 18. Street, Thomas A. “The History and Theory of English Contract Law” Beard Books. 1999. July 28, 2005. http://www.beardbooks.com/the_history_and_theory_of_english_contract_law.html 19. Veermesch, R.B and K. E. Lindgren. “Business Law of Australia”. Butterworths. 1987. Read More