Living on the hedge – Don't let your hedging agreement cost you - Fund Management/ REITs

Hedging agreements are an integral part of many loan transactions so it's surprising that so many market participants fail to give them the attention they deserve.

Typically drafted using industry standard ISDA documentation, there seems to be an assumption that they are too complicated and esoteric to deal with, even though there have been many instances where this has proven to be a costly oversight for either the hedging bank or the borrower. The recent English law decision of Barnett Waddington Trustees (1980) Limited v The Royal Bank of Scotland PLC [2015] EWHC 2435 (Ch) is a good example of this where the bank's actual cost of its back-to-back arrangements were not accurately reflected in the hedging agreement.

Parties to hedging agreement cannot live on the edge with their hedging agreements. The diligence that applies to other finance agreements has to extend to hedging. Always rigorously analyse and negotiate your position and keep in mind these four simple points to ensure your hedging agreement doesn't cost you down the track. If you follow these, your agreement will function as intended and won't undermine the hours and hours of work that has gone into the commercial deal itself.

ONE SET OF EVENTS OF DEFAULT TO RULE THEM ALL

Integration is critical and one of the easiest ways to secure integration with the other documents is to ensure that the events of default (EODs) in the underlying loan agreement align with the EODs set out in the ISDA Master Agreement. This is a standard approach that should be acceptable to hedging banks that are also acting as lenders in the deal. The idea is that, other than for a limited set of circumstances, the termination of the hedge in a default situation should trigger solely from an EOD or acceleration under the hedged loan agreement. This is usually achieved by disapplying the relevant EOD in the schedule to the ISDA Master Agreement and then either:

drafting an additional EOD linking to the clause that specifies the EODs under the loan agreement; or
tailoring a new Additional Termination Event (which allows for greater flexibility as to the consequences and procedures following such defaults) to link to those EODs or to acceleration under the loan agreement.

A common exception to disapplying all EODs is the "Failure to Pay or Deliver" event of default. There is no reason to include it in the hedging agreement if failure to pay is expressly specified as an EOD in the hedged loan agreement. However, in many instances, it is overlooked by the lawyers drafting the loan agreement. As such, it is left as a stand alone EOD in the hedging agreement.

DON'T OVER-HEDGE

Borrowers should never be obliged to hedge more than they need to, and the process to adjust hedging should be agreed up front. Include a mechanism in the hedging agreement to ensure that the amount being hedged is adjusted as required so that there is no over-hedging (for example, if a prepayment or cancellation is made by the borrower under the loan agreement). The typical approach is to deem a portion of your transaction as an "Affected Transaction", where the value of that portion equals the amount that the principal amount outstanding of the loan reduces. An Additional Termination Event should be specified in relation to those Affected Transactions.

The hedging bank may require that the borrower compensate it for any re-hedging/break fees under this arrangement. This is not usual, but carefully consider the scope and nature of such expenses as, following the Waddington decision, banks may request the borrower to cover break costs and other re-hedging fees and expenses that are strictly internal costs of the bank.

Other Additional Termination Events include, as noted above, terminating the hedging agreement due to acceleration of the principal outstanding under the loan agreement or terminating the hedge if the hedge provider is no longer a lender under the loan agreement.

DON'T INADVERTENTLY BREACH STANDARD ISDA PROVISIONS

ISDA Master Agreements have a large number of interconnected and very specifically defined terms. Inadvertent breaches of the documents may occur unless they are clearly understood by borrowers. For example, ensure that the credit support provided under the hedging agreement is not drafted too broadly. Hedge providers will usually require that the Credit Support Documents match the security documents provided in connection with the loan agreement and that the Credit Support Providers match the obligors/security providers under the loan agreement. It is important that it should not be cast any wider that necessary. In addition, the litigation representation under section 3(c) of the ISDA Master Agreement extends to Credit Support Providers. Also, obtain consent from the hedging bank under section 7 (the transfer provisions) of the ISDA Master Agreement to the granting of security interests over the ISDA Master Agreement by the Borrower to any security trustee/agent.

CASHFLOW IS KING

Finally, ensure that the payment and cashflow mechanics under any confirmation work seamlessly with your loan agreement. This is more than just a theoretical risk, as we have seen transactions with operational issues where the cash flow has not been integrated throughout all the elements of the transaction. Some things to watch out for, for example, are:

Does the timing of payments match up with the obligations under the loan agreement?
Is the same definition of Business Day used across the loan and hedging documents?
Are the rates set the same way across the documents and are negative interest rates handled consistently (in other words, is any interest rate floor provision drafted consistently throughout the transaction documents)?

CONCLUSION

These are a sample of things that are often overlooked, but should be considered by borrowers and their counsel when negotiating any hedging agreement. There may be other issues that would need to be considered, depending on the particular circumstances of the transaction. In any event, it is important that borrowers give hedging agreements the same attention and scrutiny that are given to other financing or transaction documentation, in particular how they integrate with and "speak" to the underlying loan arrangements.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.


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