Interest Rate Swap Agreements

 
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By:
Jeff  Novel
1601 Elm Street
Suite 3700
Dallas, Texas 75201
(214) 777-4223
Email: 
jnovel@krcl.com
Blog: 
Lawofbanking.com
 
O
VERVIEW
 
OF
 I
NTEREST
 R
ATE
 S
WAP
 A
GREEMENT
 
What is it?
A contract between two parties to exchange cash flows at
specified intervals, calculated by reference to an index.
What is the purpose?
It provides a tool for altering the character of assets and
liabilities, fine tuning risk exposure, lowering the cost of
financing or speculating on interest rate fluctuations.
A typical use is to give a variable-rate loan the characteristics
of a fixed-rate loan.
 
 
O
VERVIEW
 
OF
 I
NTEREST
 R
ATE
 S
WAP
 A
GREEMENT
 
How does it work?
One party makes fixed rate payments on an agreed
hypothetical principal amount (“notional amount”), during a
given period and the other counterparty makes floating rate
payments.  The payments are netted at specified intervals to
determine who is “in the money.”
 
O
VERVIEW
 
OF
 I
NTEREST
 R
ATE
 S
WAP
 A
GREEMENT
 
 
Counterparty A
 
Counterparty B
 
LIBOR
 
10% Fixed Rate
 
$1 Million Notional Amount and semi annual payments
 
Assumption: LIBOR at 9% at pay period
 
Counterparty B must pay Counterparty A:
(10%-9%) * $1,000,000 * (0.5) = $5,000
 
Assumption: Libor at 11% at pay period
 
Counterparty A must pay Counterparty B:
(11%-10%) * $1,000,000 * (0.5) = $5,000
 
O
VERVIEW
 
OF
 I
NTEREST
 R
ATE
 S
WAP
 A
GREEMENT
 
Three key components:
 
1.
International Swap Dealers Association, Inc. (ISDA ) Master
Agreement
2.
Schedule to the ISDA Master Agreement
3.
Confirmation(s)
 
 
ISDA M
ASTER
 A
GREEMENT
 
Two Versions: Published in 1992 and 2002.
Includes provisions generally applicable to all swap transactions.
A few differences in the 1992 and 2002 versions:
Grace period for payment defaults shortened from three
business days to one business day.
New methodology for close-out calculations.
Introduction of a force majeure provision as a termination
event.
Introduction of a set-off provision.
Expansion of breach of agreement Event of Default to include
repudiation.
 
 
ISDA M
ASTER
 A
GREEMENT
Key Provisions
 
Preamble—
”Party A and Party B have entered and/or anticipate
entering into one or more transactions (each a “Transaction”)
that are or will be governed by this Master Agreement…
 
“Transaction” is not a defined term—The intention is that
the Master Agreement should be capable of use (with
modifications if necessary) for whatever derivative
transactions the parties choose.  Where the Master
Agreement is intended to apply, this should be specified
in the relevant Confirmation unless the parties have
agreed to another methodology to identify transactions
under the Master Agreement.
 
ISDA M
ASTER
 A
GREEMENT
Key Provisions
 
Events of Default and Termination Events (Section 5)
Slightly different consequences follow from an Event of
Default and a Termination Event, though the ultimate
effect—early termination and close-out of all affected
Transactions—is the same.
An Event of Default is one for which a party can be
regarded to be culpable.
A Termination Event may simply be suffered by, or
happen to, a party.
 
ISDA M
ASTER
 A
GREEMENT
Key Provisions
 
Events of Default (Section 5(a)
 
Failure to Pay or Deliver
—A breach of a payment or delivery
obligation which is not remedied in a three day grace period
(1 day grace period in 2002 ISDA Master Agreement).
 
Breach of Agreement
—A breach of any other obligations in
the Master Agreement which are not remedied within a 30
day grace period.
 
Credit Support Default
—Breach of a Credit Support
Document or the Credit Support Document ceases to be in
full force.
 
Misrepresentation
—Any representation, other than one of
the tax representations, is incorrect when made or repeated.
 
 
ISDA M
ASTER
 A
GREEMENT
Key Provisions
 
Events of Default (Section 5(a)
Default under Specified Transaction—
A default under other
derivative transactions executed by the parties.
 
Cross Default
—Generally relates to a default by a party with
respect to any obligation related to borrowed money (can be
modified to cover other obligations).
 
Bankruptcy
—Generally relates to insolvency proceedings.
 
Merger Without Assumption
—Merger where the surviving
party fails to assume obligations under the Master Agreement
or related documents.
 
ISDA M
ASTER
 A
GREEMENT
Key Provisions
 
Termination Events (Section 5(b))
Determine which party is the “Affected Party.”
 
Illegality
—A party cannot legally perform its payment or
delivery or other material obligations under the Transactions or
Credit Support Documents.
 
Tax Events
—Relates to any action or proceeding brought by a
tax authority, or a Change in Tax Law which requires that
payments from one party to the other be grossed-up.
Tax Event on Merger
—Relates to a merger or similar
reorganization which would require one party to gross up
payments to the other.
 
Credit Event Upon Merger
—Surviving or transferee entity is
materially less creditworthy than the “Affected Party”
immediately before the action.
 
ISDA M
ASTER
 A
GREEMENT
Key Provisions
 
Early Termination (Section 6)
Following Event of Default
Automatic Early Termination occurs day before Termination Event; or
Non-defaulting Party has the right to terminate by designating an
Early Termination Date within 20 days of notice.
Following a Termination Event
Depends on whether one or both parties are an “Affected Party”
One Affected Party (Illegality, Tax Event, or Tax Event Upon Merger) =
20 days to resolve for Affected Party / 30 days to attempt to resolve
for other party (Does not apply for Illegality in 2002 ISDA).
Two Affected Parties = 30 days to resolve.
If solutions fail, or for any other event, an Early Termination Date
may be designated by not more than 20 days’ notice.
 
ISDA M
ASTER
 A
GREEMENT
Key Provisions
 
Early Termination (Section 6)
Following designation for Event of Default or Termination
Date:
The agreement will terminate on the designated date, whether
or not the relevant Event of Default or Termination Event is still
continuing; and
The obligation to make further payments or deliveries with
respect to the “Terminated Transactions” will end and be
replaced by an obligation to pay the close-out amount.
As soon as practicable following the occurrence of an Early
Termination Date, the close out amount must be calculated
under the close-out netting provisions on Section 6(e).
 
ISDA M
ASTER
 A
GREEMENT
Key Provisions
 
Payments on Early Termination
The net amount of the value of future obligations under the
1992 Agreement is determined by either “Market Quotation”
or “Loss.”  This is selected in the Schedule.
Market Quotation involves gathering quotes for replacing the
transactions from leading dealers in the relevant market.
Loss involves calculating the amount which the calculating party has
lost or gained as a result of the termination.
The payment depends on the payment method chosen:
First Method—If the close-out calculations show that the net balance
is in favor of the defaulting party, no payment is required by the non-
defaulting party.  This is rarely used and there is doubt in some
jurisdictions whether it is effective.
Second Method—Provides for full two-way payments on default, 
i.e.,
a non-defaulting party is required to make a payment .
 
 
ISDA M
ASTER
 A
GREEMENT
Key Provisions
 
2002 ISDA Master Agreement
“Market Quotation” and “Loss” are replaced with “Close-Out
Amount.”
Determined in good faith to produce commercially
reasonable result.  It is the amount of the losses incurred
in replacing or providing the economic equivalent to the
Terminated Transaction.
The Determining Party will consider:
Quotations from third parties
Relevant market data supplied by third-parties
Internal information of the same type used in the regular
course of business.
May consider any loss or costs incurred as a result of
terminating, liquidating or re-establishing any hedges.
 
S
CHEDULE
 
TO
 ISDA M
ASTER
 A
GREEMENT
 
Customizes the parties’ contractual arrangement by reflecting any
deviations from the standard language of the ISDA Master
Agreement and specific terms negotiated by the parties.
Items typically addressed in the Schedule include:
The calculation of payments on early termination;
Events that constitute additional events of default or
termination events;
Cross-collateralization;
Representations and agreements to deliver documents;
Non-reliance and independence of obligations; and
Risk disclosures.
 
C
ONFIRMATIONS
 
The Master Agreement and Schedule provide a framework for the
transaction.  They do not provide the financial / pricing terms of
individual deals.
The confirmation provides these details:
Trade date and effective date.
Termination date
Notional amount
Fixed and floating rate payers and rates
Reaffirms non-reliance, that the parties are capable of
assuming the risks of the transaction and that the parties do
not have a fiduciary relationship.
 
L
ITIGATION
 I
SSUE
 # 1
Prepayment penalties and the closeout fee
 
Issue—The note or loan agreement states that there is no
prepayment penalty and the borrower claims the closeout fee is a
prepayment penalty.
Case law—
Thrifty Oil Co. v. Bank of Am. Nat’l Trust and Sav. Ass’n, 
322 F.3d
1039, 1042 (9th Cir. 2003) (loan and swap agreement create
separate obligations)
BKB Properties, LLC v. Suntrust Bank, 
453 Fed. Appx. 582, Nos. 09-
6260, 10-5065 (6th Cir. July 12, 2011) (a prepayment penalty and
termination fee are separate obligations).
American Infoage, LLC v. Regions Bank, 
No. 8:13-cv-1533-T-23TGW,
2014 WL 4794748 (Sep. 25, 2014) (elimination of prepayment
penalty in loan agreement did not eliminate obligation to pay
termination fee under the swap agreement).
Solution—Double-check the language in the note and loan
agreement.
 
L
ITIGATION
 I
SSUE
 # 2
The Closeout Fee
 
Issue—The borrower did not know of the existence or understand
the extent of the Closeout Fee.
Schedules typically include language stating: “
It is important
to realize, that should you liquidate the swap contract prior to
maturity, you may realize a significant financial gain or a
loss.”
The borrower cannot understand how high a Closeout
Fee may be based on the Swap Agreement.
Solution—Provide hypothetical gains or losses that might be
realized under various interest rate scenarios and liquidation
strategies.
 
L
ITIGATION
 I
SSUE
 #3
Calculation of the Closeout Fee
 
Issue—The borrower is uncertain how the Closeout Fee was
calculated.
Section 6(c)(ii) of the ISDA Master Agreement provides that
upon an early termination, no further payments are due
under the Swap Agreement apart from those calculated
under Section 6(e).
Section 6(e) substitutes prior payment obligations with
the requirement to pay a new net amount which takes
into account the following elements: (i) the value of
future obligations owed by each party to the other under
outstanding Transactions; and (ii) the value of unpaid
amounts which have already accrued and are owed
between the parties.
Solution—Provide clear calculations and choose the “Second
Method.”
 
L
ITIGATION
 I
SSUE
 #4
Violation of the Bank Holding Company Act
 
Issue: Was the Swap Agreement coupled with a loan in a manner
that violated the Bank Holding Company Act?
The Bank Holding Company Act (12 U.S.C. 
§ 1972) is directed
at tying arrangements by banks that require bank customers
to accept or provide some other service or product or to
refrain from dealing with other parties in order to obtain the
bank product or service they desire.
There is a potential violation where (1) the banking practice in
question was unusual in the banking industry; (2) an anti-
competitive tying arrangement existed, and (3) the practice
benefits the bank.
Solution—Review policies to confirm how Swap Agreements are
being offered to customers.
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An interest rate swap agreement is a contract between two parties to exchange cash flows at specified intervals, allowing for risk management and altering the characteristics of assets and liabilities. By making fixed and floating rate payments, parties can hedge against interest rate fluctuations and customize their financing options. Key components include the ISDA Master Agreement and its versions, outlining provisions for swap transactions.


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  1. I INTEREST NTEREST R RATE O OVERVIEW VERVIEW AND ATE S SWAP AND L LITIGATION ITIGATION I ISSUES WAP A AGREEMENTS GREEMENTS: : SSUES By: Jeff Novel 1601 Elm Street Suite 3700 Dallas, Texas 75201 (214) 777-4223 Email: jnovel@krcl.com Blog: Lawofbanking.com

  2. OVERVIEWOF INTEREST RATE SWAP AGREEMENT What is it? A contract between two parties to exchange cash flows at specified intervals, calculated by reference to an index. What is the purpose? It provides a tool for altering the character of assets and liabilities, fine tuning risk exposure, lowering the cost of financing or speculating on interest rate fluctuations. A typical use is to give a variable-rate loan the characteristics of a fixed-rate loan.

  3. OVERVIEWOF INTEREST RATE SWAP AGREEMENT How does it work? One party makes fixed rate payments on an agreed hypothetical principal amount ( notionalamount ), during a given period and the other counterparty makes floating rate payments. The payments are netted at specified intervals to determine who is in the money.

  4. OVERVIEWOF INTEREST RATE SWAP AGREEMENT LIBOR Counterparty A Counterparty B 10% Fixed Rate $1 Million Notional Amount and semi annual payments Assumption: LIBOR at 9% at pay period Assumption: Libor at 11% at pay period Counterparty B must pay Counterparty A: (10%-9%) * $1,000,000 * (0.5) = $5,000 Counterparty A must pay Counterparty B: (11%-10%) * $1,000,000 * (0.5) = $5,000

  5. OVERVIEWOF INTEREST RATE SWAP AGREEMENT Three key components: 1. International Swap Dealers Association, Inc. (ISDA ) Master Agreement Schedule to the ISDA Master Agreement Confirmation(s) 2. 3.

  6. ISDA MASTER AGREEMENT Two Versions: Published in 1992 and 2002. Includes provisions generally applicable to all swap transactions. A few differences in the 1992 and 2002 versions: Grace period for payment defaults shortened from three business days to one business day. New methodology for close-out calculations. Introduction of a force majeure provision as a termination event. Introduction of a set-off provision. Expansion of breach of agreement Event of Default to include repudiation.

  7. ISDA MASTER AGREEMENT Key Provisions Preamble Party A and Party B have entered and/or anticipate entering into one or more transactions (each a Transaction ) that are or will be governed by this Master Agreement Transaction is not a defined term The intention is that the Master Agreement should be capable of use (with modifications if necessary) for whatever derivative transactions the parties choose. Where the Master Agreement is intended to apply, this should be specified in the relevant Confirmation unless the parties have agreed to another methodology to identify transactions under the Master Agreement.

  8. ISDA MASTER AGREEMENT Key Provisions Events of Default and Termination Events (Section 5) Slightly different consequences follow from an Event of Default and a Termination Event, though the ultimate effect early termination and close-out of all affected Transactions is the same. An Event of Default is one for which a party can be regarded to be culpable. A Termination Event may simply be suffered by, or happen to, a party.

  9. ISDA MASTER AGREEMENT Key Provisions Events of Default (Section 5(a) Failure to Pay or Deliver A breach of a payment or delivery obligation which is not remedied in a three day grace period (1 day grace period in 2002 ISDA Master Agreement). Breach of Agreement A breach of any other obligations in the Master Agreement which are not remedied within a 30 day grace period. Credit Support Default Breach of a Credit Support Document or the Credit Support Document ceases to be in full force. Misrepresentation Any representation, other than one of the tax representations, is incorrect when made or repeated.

  10. ISDA MASTER AGREEMENT Key Provisions Events of Default (Section 5(a) Default under Specified Transaction A default under other derivative transactions executed by the parties. Cross Default Generally relates to a default by a party with respect to any obligation related to borrowed money (can be modified to cover other obligations). Bankruptcy Generally relates to insolvency proceedings. Merger Without Assumption Merger where the surviving party fails to assume obligations under the Master Agreement or related documents.

  11. ISDA MASTER AGREEMENT Key Provisions Termination Events (Section 5(b)) Determine which party is the Affected Party. Illegality A party cannot legally perform its payment or delivery or other material obligations under the Transactions or Credit Support Documents. Tax Events Relates to any action or proceeding brought by a tax authority, or a Change in Tax Law which requires that payments from one party to the other be grossed-up. Tax Event on Merger Relates to a merger or similar reorganization which would require one party to gross up payments to the other. Credit Event Upon Merger Surviving or transferee entity is materially less creditworthy than the Affected Party immediately before the action.

  12. ISDA MASTER AGREEMENT Key Provisions Early Termination (Section 6) Following Event of Default Automatic Early Termination occurs day before Termination Event; or Non-defaulting Party has the right to terminate by designating an Early Termination Date within 20 days of notice. Following a Termination Event Depends on whether one or both parties are an AffectedParty One Affected Party (Illegality, Tax Event, or Tax Event Upon Merger) = 20 days to resolve for Affected Party / 30 days to attempt to resolve for other party (Does not apply for Illegality in 2002 ISDA). Two Affected Parties = 30 days to resolve. If solutions fail, or for any other event, an Early Termination Date may be designated by not more than 20 days notice.

  13. ISDA MASTER AGREEMENT Key Provisions Early Termination (Section 6) Following designation for Event of Default or Termination Date: The agreement will terminate on the designated date, whether or not the relevant Event of Default or Termination Event is still continuing; and The obligation to make further payments or deliveries with respect to the TerminatedTransactions will end and be replaced by an obligation to pay the close-out amount. As soon as practicable following the occurrence of an Early Termination Date, the close out amount must be calculated under the close-out netting provisions on Section 6(e).

  14. ISDA MASTER AGREEMENT Key Provisions Payments on Early Termination The net amount of the value of future obligations under the 1992 Agreement is determined by either MarketQuotation or Loss. This is selected in the Schedule. Market Quotation involves gathering quotes for replacing the transactions from leading dealers in the relevant market. Loss involves calculating the amount which the calculating party has lost or gained as a result of the termination. The payment depends on the payment method chosen: First Method If the close-out calculations show that the net balance is in favor of the defaulting party, no payment is required by the non- defaulting party. This is rarely used and there is doubt in some jurisdictions whether it is effective. Second Method Provides for full two-way payments on default, i.e., a non-defaulting party is required to make a payment .

  15. ISDA MASTER AGREEMENT Key Provisions 2002 ISDA Master Agreement MarketQuotation and Loss are replaced with Close-Out Amount. Determined in good faith to produce commercially reasonable result. It is the amount of the losses incurred in replacing or providing the economic equivalent to the Terminated Transaction. The Determining Party will consider: Quotations from third parties Relevant market data supplied by third-parties Internal information of the same type used in the regular course of business. May consider any loss or costs incurred as a result of terminating, liquidating or re-establishing any hedges.

  16. SCHEDULETO ISDA MASTER AGREEMENT Customizes the parties contractual arrangement by reflecting any deviations from the standard language of the ISDA Master Agreement and specific terms negotiated by the parties. Items typically addressed in the Schedule include: The calculation of payments on early termination; Events that constitute additional events of default or termination events; Cross-collateralization; Representations and agreements to deliver documents; Non-reliance and independence of obligations; and Risk disclosures.

  17. CONFIRMATIONS The Master Agreement and Schedule provide a framework for the transaction. They do not provide the financial / pricing terms of individual deals. The confirmation provides these details: Trade date and effective date. Termination date Notional amount Fixed and floating rate payers and rates Reaffirms non-reliance, that the parties are capable of assuming the risks of the transaction and that the parties do not have a fiduciary relationship.

  18. LITIGATION ISSUE # 1 Prepayment penalties and the closeout fee Issue The note or loan agreement states that there is no prepayment penalty and the borrower claims the closeout fee is a prepayment penalty. Case law Thrifty Oil Co. v. Bank of Am. Nat l Trust and Sav. Ass n, 322 F.3d 1039, 1042 (9th Cir. 2003) (loan and swap agreement create separate obligations) BKB Properties, LLC v. Suntrust Bank, 453 Fed. Appx. 582, Nos. 09- 6260, 10-5065 (6th Cir. July 12, 2011) (a prepayment penalty and termination fee are separate obligations). American Infoage, LLC v. Regions Bank, No. 8:13-cv-1533-T-23TGW, 2014 WL 4794748 (Sep. 25, 2014) (elimination of prepayment penalty in loan agreement did not eliminate obligation to pay termination fee under the swap agreement). Solution Double-check the language in the note and loan agreement.

  19. LITIGATION ISSUE # 2 The Closeout Fee Issue The borrower did not know of the existence or understand the extent of the Closeout Fee. Schedules typically include language stating: It is important to realize, that should you liquidate the swap contract prior to maturity, you may realize a significant financial gain or a loss. The borrower cannot understand how high a Closeout Fee may be based on the Swap Agreement. Solution Provide hypothetical gains or losses that might be realized under various interest rate scenarios and liquidation strategies.

  20. LITIGATION ISSUE #3 Calculation of the Closeout Fee Issue The borrower is uncertain how the Closeout Fee was calculated. Section 6(c)(ii) of the ISDA Master Agreement provides that upon an early termination, no further payments are due under the Swap Agreement apart from those calculated under Section 6(e). Section 6(e) substitutes prior payment obligations with the requirement to pay a new net amount which takes into account the following elements: (i) the value of future obligations owed by each party to the other under outstanding Transactions; and (ii) the value of unpaid amounts which have already accrued and are owed between the parties. Solution Provide clear calculations and choose the Second Method.

  21. LITIGATION ISSUE #4 Violation of the Bank Holding Company Act Issue: Was the Swap Agreement coupled with a loan in a manner that violated the Bank Holding Company Act? The Bank Holding Company Act (12 U.S.C. 1972) is directed at tying arrangements by banks that require bank customers to accept or provide some other service or product or to refrain from dealing with other parties in order to obtain the bank product or service they desire. There is a potential violation where (1) the banking practice in question was unusual in the banking industry; (2) an anti- competitive tying arrangement existed, and (3) the practice benefits the bank. Solution Review policies to confirm how Swap Agreements are being offered to customers.

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