Originally published March 17, 2008

With the announcement by JPMorgan Chase & Co. (JPMorgan) and the Federal Reserve regarding the purchase of The Bear Stearns Companies Inc. (Bear Stearns), it appears that the counterparties of Bear Stearns will now be able to look to JPMorgan to satisfy substantially all of their outstanding trading obligations.1 However, the speed with which Bear Stearns deteriorated has once again called attention to counterparty credit risk in OTC derivatives trades and related securities transactions (prime brokerage, repos, stock lending, etc.).

Some will take comfort not only in the fact that the combined actions of the Federal Reserve and JPMorgan averted the losses that would undoubtedly have occurred in the event of a Bear Stearns bankruptcy, but, more importantly, in the implied assurance that the government will continue to take whatever steps are necessary to avert a bankruptcy at another major bank or investment institution. Others, however, will recognize that there are limits to the government's capacity and appetite for rescuing failed financial institutions, and will pay renewed attention to measures designed to ensure that they have maximum contractual protections in the event of a credit crisis at another OTC dealer counterparty.

Below, in summary fashion, we discuss the following seven key provisions of the ISDA Master Agreements and Credit Support Annex that should be reviewed in connection with assessing your counterparty credit risk.

  1. ISDA Payment Default
  2. ISDA Additional Termination Events
  3. CSA Thresholds and Minimum Transfer Amounts
  4. CSA Independent Amounts
  5. CSA Rehypothecation Rights
  6. CSA Custodian Provisions
  7. CSA Default

Action items with respect to each of these provisions are identified.

ISDA Master Agreement Schedule

1. Payment Default. The 1992 ISDA Master Agreement provides that an Event of Default occurs if a payment default is not cured on or before the 3rd Local Business Day (LBD) after notice of the payment (or delivery) default is given. Under the 2002 ISDA Master Agreement, the cure period is reduced to 1 LBD after notice.

Action items:

  1. Review existing agreements to determine the applicable cure period. If you have 1992 agreements and the Schedule does not already shorten the cure period to 1 LBD after notice, consider amending the agreement to accomplish this.
  2. Review notice provision to be certain how you are required to give notice of an Event of Default under the ISDA and when such notice is effective.

2. Additional Termination Events (ATEs). Dealers often negotiate terms in the Schedule to ISDA Master Agreements which give them the right to early terminate outstanding transactions at a point in time before an actual counterparty default occurs (and hopefully while the user counterparty is still solvent). User counterparties can similarly seek to include as an ATE, a "credit rating downgrade" provision which would permit the early termination of the ISDA Master Agreement when the dealer counterparty is downgraded below a specified rating (but remains solvent).

Action items:

  1. Review existing agreements to determine whether there is a credit downgrade ATE applicable to the counterparty and, if so, whether it has been breached.
  2. In light of the events at Bear Stearns which retained (barely) its investment grade rating even though it was hours away from a bankruptcy filing, consider whether the rating level is high enough to offer sufficient protection – a provision tied to a credit rating downgrade below investment grade may not be triggered until it is too late.
  3. Consider amending existing agreements that do not have an ATE geared to the dealer counterparty's credit rating, to include a credit rating downgrade ATE.
  4. Consider alternative ATE triggers tied to widening spreads on credit default swaps on the dealer's unsecured debt or changes in the spread on its short term commercial paper borrowings. Both of these measures are likely to provide earlier warnings of impending counterparty credit issues.

Credit Support Annex

3. Thresholds and Minimum Transfer Amount. The only real protection against counterparty credit risk for the user counterparty's "in-the-money" positions is holding adequate collateral to cover the replacement cost of the transactions. This is precisely the protection parties seek to achieve by agreeing to two-way collateral transfers under the ISDA Credit Support Annex. Since parties are only required to transfer collateral to the extent that exposures exceed agreed upon Thresholds, it is important to continuously review those amounts:

Action items:

  1. Revisit any agreements where the dealer counterparty is not required to post collateral (e.g., has an "infinite" Threshold).
  2. Where "two-way" collateral terms have been agreed to, review your operations procedures to confirm that collateral demands are being made as often as permitted (i.e., whenever you are in an under-collateralized "in-the-money" position).
  3. Where the parties' Thresholds are greater than zero (but not infinity), consider amending the agreement to move to zero Thresholds. Alternatively, consider "laddered" Thresholds which go down to zero as the counterparty's credit rating declines. Note that the movement to zero Thresholds should occur before a counterparty's credit rating is reduced below investment grade and need not be the same as the credit ratings specified in an Additional Termination Event.
  4. Even if you have zero Thresholds, review rounding and Minimum Transfer Amounts to reduce the amount of potential unsecured counterparty exposure. Even if Minimum Transfer Amounts are appropriate in normal times for administrative reasons, you can provide that they will drop to zero upon the occurrence of certain events (e.g., credit downgrade, spike in cost of short-term borrowings or credit default swap pricing).

4. Independent Amounts. Dealer counterparties are more likely than user counterparties to insist upon additional collateral (in the form of Independent Amounts) to insure that they hold collateral that exceeds their exposure to the user counterparty. This poses serious credit issues for user counterparties because upon the bankruptcy or insolvency of a dealer counterparty, the user counterparty would likely be in a general creditor position to the extent that it has overcollateralized its obligations to the dealer counterparty.

Action items:

  1. If you have agreed to Independent Amounts, review agreements to determine whether you have one or more of the following protections in the event the financial condition of the dealer counterparty deteriorates:
  1. Independent Amounts are reduced to zero when (and for as long as) the dealer counterparty's credit condition fails to meet certain objective credit criteria (e.g., credit ratings test, pricing on short-term debt, credit default swap pricing);
  2. The dealer counterparty's right to rehypothecate collateral (including Independent Amounts) under Para. 6(c) is terminated when its credit condition fails to meet specified objective credit criteria;
  3. The dealer counterparty is required to hold collateral through a third party custodian when its credit condition fails to meet specified objective credit criteria.

5. Rehypothecation. If a counterparty is entitled to rehypothecate collateral (essentially to use collateral it is holding as part of its own business assets) under Para. 6(c), the counterparty posting that collateral will have general creditor exposure to the party holding its collateral to the extent that its exposure to the counterparty exceeds the amount of collateral it has posted. Aparty can find itself in this excess collateralized position, for example, when the market moves in its favor and it has not yet requested and received the return of its excess collateral.

Action items:

  1. Where rehypothecation rights are granted, clarify the provisions of Para. 6(c) to make clear that such rights cease upon the occurrence of an Event of Default or Additional Termination Event with respect to the party holding collateral.
  2. Consider whether a higher standard than is reflected in Additional Termination Events (typically credit rating downgrades) should be applied to rehypothecation rights. For example, an ATE may be tied to a credit downgrade below investment grade. Rehypothecation rights should arguably terminate before that downgrade threshold is breached.

6. Custodian for Collateral. A party is typically permitted to hold collateral itself or with related parties so long as no Event of Default has occurred and is continuing. In the event the party holding collateral becomes insolvent there is a risk that the assets being held as collateral will be part of the estate of the insolvent party. This is avoided if collateral is held through a creditworthy third party Custodian.

Action items:

  1. Review CSA agreements to determine when a Secured Party is required to hold collateral through an unrelated third party Custodian. Consider requiring a third party Custodian when the credit position of the counterparty has deteriorated according to specified objective standards, even if an Event of Default or Additional Termination Event (i.e., a Specified Condition which has been defined for this purpose to include an ATE) has not yet occurred.
  2. Review CSA agreements to ensure adequate standards (e.g., size and credit ratings) and custodial terms are specified for third party custodians.

7. Failure to Deliver Collateral. The ISDA CSA (1994 NY agreement) provides that an Event of Default under the CSA will occur of a party fails to make a collateral transfer when due if the failure continues for 2 LBDs after notice of the failure is given. In most new agreements the cure period for failure to deliver collateral is reduced to 1 LBD after notice.

Action items:

  1. Review existing agreements where the cure period has not been reduced from 2 to 1 LBD after notice, consider amending the agreement to provide for the shorter cure period.
  2. Review notice provision to be certain how you are required to give notice of an Event of Default under the CSA and when such notices are effective.
  3. Review CSA dispute resolution provision (Para. 5) to determine delays that may arise if counterparty disputes a demand for the transfer of collateral.

Footnotes

1. Attached hereto is the executed Guaranty Agreement entered into by JPMorgan in connection with its acquisition agreement with Bear Stearns (Acquisition Agreement). In general, the Guaranty Agreement seeks to provide a JPMorgan guaranty of the liabilities of Bear Stearns and specified subsidiaries of Bear Stearns incurred in connection with borrowings and capital markets activities (including swaps, repos and securities lending) in existence as of March 16, 2008 or incurred during the Guaranty Period. The Guaranty Period extends through the date on which the Acquisition Agreement is terminated or the Closing Date as defined in the Acquisition Agreement. Although further review of the Acquisition Agreement will be required to determine the scope of one specified exception, it appears that the JPMorgan guaranty is intended to continue to apply even if the acquisition of Bear Stearns is not consummated. Counsel should be consulted with respect to the application of the Guaranty Agreement to particular circumstances.

© 2008 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.