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All too often in financing transactions the strategy – and documentation – to be employed by the borrower in hedging risks under the loan are left until the last minute and are given insufficient thought. In this article we consider the issues which lenders and swap providers need to consider in the context of the borrower’s hedging, and the risks of failing to pay these issues enough attention.
There are two key risks which are commonly hedged in the context of a loan agreement: interest rate risk and currency risk. In both cases, the swaps will almost invariably be governed by industry standard derivatives documentation published by the International Swaps and Derivatives Association, Inc. (ISDA). The ISDA documentation will usually consist of an ISDA Master Agreement (the relationship-level document between the borrower and swap provider – this may already be in place prior to the financing transaction and may be being used for other derivatives transactions) and a Confirmation (the trade-specific document which sets out the economic terms of the hedging transaction).
As an alternative, it is possible to avoid the need to negotiate and sign an ISDA Master Agreement by including what is known as “pre-ISDA” wording into the Confirmation. However, swap providers should ensure that they understand the implications of taking this route as it can affect their rights and, in some circumstances, offer them less protection than a full ISDA Master Agreement.
The terms of the swap itself must be given careful consideration. These issues should be considered at the same time as negotiation of the loan arrangements (rather than as an afterthought). We have set out below the key issues which need to be dealt with.
(a) The economics of the swap need to match the loan, particularly in relation to any potential amortisation of the loan (whether scheduled or unscheduled). Over- or under-hedging the loan can create risks for borrower, lender and swap provider and should be avoided.
(b) For similar reasons, the swap and loan documentation should usually “stand and fall together”. This means that the events of default should match across the two arrangements. Since the loan is usually the more heavily negotiated document, it is common for the standard events of default in the ISDA documentation to be switched off and replaced with a cross-acceleration to the loan agreement. However if there is any circumstance in which the loan agreement may fall away prior to the swap, the parties must make sure that the ISDA events of default then resume.
(c) The swap constitutes a contingent credit exposure for both borrower and swap provider which may at any time be either an asset or a liability of either party. This has several implications for the loan and security documentation:
- if the borrower is “in-the-money” at any time (i.e. the swap constitutes an asset for the borrower) and the lender is not the same person as the swap provider, the benefit of the swap should form part of the lender’s security package;
- if the borrower is “out-the-money” at any time (i.e. the swap constitutes a liability for the borrower) and the lender is the same person as the swap provider, the lender/swap provider needs to ensure that the borrower’s exposure under the swap is covered by the security package: it needs to form part of the secured liabilities;
- if the lender and swap provider are the same person and there is an intercreditor arrangement in place (i.e. there is also a junior lender in the structure) the lender/swap provider should ensure that the borrower’s exposure under the swap is included in the lender’s priority; and
- consideration should be given to whether the mark-to-market of the swap should be taken into account in calculating the borrower’s compliance with indebtedness and loan-to-value covenants and whether this should only be the case where the borrower is “out-of-the-money” or also where it is “in-the-money”.
This is just a flavour of some of the issues which need to be considered by lenders and swap providers when a borrower is entering into hedging arrangements. The most important point is that both lenders and swap providers should take advice from derivatives lawyers and should do so as early as possible in the process of negotiating the loan documentation. Failure to address the points highlighted above can in fact lead to the hedging arrangements exacerbating, rather than mitigating, the risk profile of the transaction from the lender’s perspective.
If you would like more information about this topic, please contact Emma Ashworth