Execution of ISDA Master by Investment Funds

Investment funds (“IF”) entering into OTC derivatives transactions should enter into an ISDA Master Agreement (“MA”) with each of their counterparties in order to benefit from the credit risk mitigation mechanism allowed by its netting provisions.

Although this might vary with the size and creditworthiness of each IF, it is often its counterparty to the MA, i.e. a broker/dealer, that will circulate the first draft of the Schedule to the MA.

It is not uncommon for the IF negotiator to amend thoroughly this first draft, especially when the counterparty is not aware of the specific features of MA negotiations with IF counterparties.

A recurrent issue in this context pertains to the drafting of the signature blocks, or to be more specific, the accurate identification of the IF entity that will execute the MA (“Signing Entity”).

An understanding of the legal structure of the IF counterparty is required to make the right decision.

This article refers to the 2002 version of the ISDA Master Agreement.

1. What are the risks if the ISDA Master Agreement signature blocks are not properly designed ?

Under Article 3 (a) (ii) of the MA, each party represents to the other party that it has the power and authority to execute, deliver and perform under the MA. The same clause encompasses the agreements connected to the MA, including collateral documentation. Article 3 (a) (iii) contains representations relating to the absence of violation or conflicts with a party’s legal obligations, constitutional documents or applicable courts and government agencies orders.

It is important to note that the above representations are deemed repeated each time a transaction governed by the ISDA MA is entered into, which virtually means that an actively trading counterparty should at all times be compliant with its representations.

If the representations are breached, an event of default is constituted under Article 5 (a) (iv) of the ISDA MA, which allows the non-defaulting counterparty to terminate all transactions governed by the MA.

Power to enter into the MA shall be distinguished from authority to enter into the MA. The former corresponds to the capacity of the Signing Entity at stake to enter into the ISDA MA whereas the latter relates to the natural person(s) executing the agreement on behalf of the said Entity.

It results from the above that an IF entering into an ISDA MA without being properly identified on the execution page and the front page of the contract is at the mercy of its counterparty, the latter being practically authorised to ter-minate the relationship anytime it wishes to do so.

Concretely, the IF will be exposed to an unnecessary risk of early termination each time it is out-of-the-money on a net basis.

2. Which fund entity shall be a party to the ISDA MA ?

Deciding which entity of a IF’s universe shall enter into the MA involves reviewing the IF structure and documentation. This article provides guidelines applicable to French, Luxembourg and Cayman Islands IFs, which guidelines can certainly be useful for other fund structures.

Categories of IFs. Luxembourg and French IFs usually take the form of either a corporate body (this is the case for a SICAV) or a common fund (fonds commun de placement or FCP). Cayman funds can either be companies, partnerships or trusts.
In the above jurisdictions, as in many others, only IFs structured as corporate vehicles have legal personality. All other types of funds therefore have to be represented by another entity having legal personality when entering into an agreement such as a MA.

This is explicitly mentioned in Article 14 (2) of the Luxembourg UCI law dated 17 December 2010 providing that “the management company acts in its own name while indicating that it is acting for and on behalf of the FCP”.

Proposed drafting. The drafting hereunder can be used for a Luxembourg FCP: [Name of Management Company] acting on behalf of and for [name of the FCP], a Luxembourg FCP governed by the [17 December 2010 Law on UCIs].

A similar drafting will have to be adopted when a SICAV is not self-managed and requires its management company to enter into the MA on its behalf.

When the IF is structured as an umbrella fund, an ISDA is commonly signed for each sub-fund, the netting provisions being limited in scope to each segregated sub-fund.

Additionally, an investment manager might have been appointed by the management company (or the IF itself if it is a self-managed SICAV) in respect of specific sub-funds.

Those elements are taken into account in the more elaborated drafting hereunder:
[Name of Investment Manager] acting as agent of [name of the Management Company], on behalf of and for the [name of the IF], a Luxembourg [FCP][SICAV] governed by the [17 December 2010 Law on UCIs] [in relation to the sub-funds listed in Annex I (each a “sub-fund”)].

When it comes to Cayman or Irish funds adopting a trust structure, the trustee should in principle be the Signing Entity.

A drafting different from the one proposed hereupon should be adopted in order to take into account the fact that (i) the unit trust itself does not have legal personality and (ii) contrary to management companies of French or Luxembourg IFs, no statute law explicitly authorises the trustee to act “on behalf of and for the fund”.

It is indeed impossible to act “on behalf” of an entity having no legal personality.

Therefore, the following drafting can be retained:

[Name of the Trustee], as trustee of [name of the IF]…

In the event that the trustee has delegated its investment management powers to another entity such as an investment manager or manager, this entity should be the Signing Entity, but the trustee should acknowledge the Master MA.

3. Consequences of the agency relationship created

As seen above, an agency relationship between the Signing Entity and the IF is created. Possibly several agencies are created between the several links of the delegation chain.

This has consequences, as the “No Agency” representation and warranty set forth in Section 3(g) of the MA should be opted out in Part 4 [(l)] of the Schedule in order to avoid a misrepresentation.

Hence, because the parties are not acting on a principal to principal basis, the well-functioning of close-out netting is likely to be affected, which risk should be addressed in the documentation.

An agency letter can therefore be addressed by the Signing Entity to the Counterparty of the IF providing a series of undertakings, representations and warranties mainly stipulating that the Signing Entity will enter into transactions under the MA only if the IF assets under its control are sufficient to ensure that the IF can perform its obligations under the Agreement. The said agency letter will be enclosed to the ISDA MA.

The agency risk might however be considered non material when:

(i) the agency between the management company and the IF is a statutory agency relationship such as for Luxembourg IFs; and/or when

(ii) Part 3(b) of the Schedule include the provision of copies of the investment management agreement and/or sub-investment management agreements to the counterparty, which provision should be covered by Section 3(d) Representation.
The contractual documentation of the management delegation chain should indeed contain provisions alleviating the agency risk at stake, thanks to clauses imposing the exercise of reasonable care and skill.

 

Depositary, Custodian, Trustee: Their Respective Roles Towards Investment Funds

If it is pretty clear what the role of the manager of an investment fund consists of, things become slightly more disorientating when other entities involved in fund structures are considered. One may ask what are the respective roles assumed by a Depositary, a Custodian and a Trustee, and what are the possible relations between them.

The same word may correspond to several types of functions and activities, depending on which jurisdiction and type of investment funds we are talking about. This post reflects my experience in handling Luxembourg, French, Irish, BVI, Cayman and Hong Kong funds’ work: my comments may therefore not be relevant to US funds (clarifications thereof are welcome!):

1. Depositary / Custodian

In a nutshell, the Depositary is a “Super-Custodian”, or more accurately a “Central Custodian”. A Depositary could choose to assume all the functions of a Custodian, although in practice it makes sense to delegate some functions to Sub-Custodians (see below). On the opposite, a Custodian may not assume all of a Depositary’s functions.

A Depositary generally has three functions:

(1) the preservation of the assets of the fund (the depositary holds the title of the assets when they are transferable instruments such as equities, or operates as a mere book-keeper complementing a Prime-Broker’s job when it comes to derivatives);

(2) the day-to-day administration of the assets of the fund (the depositary receives the income produced by the assets);

(3) the control of the funds’s operation (compliance with investment policies, notably proper creation/redemption/cancellation of the units/shares issued to the investors)

So what is the difference between a custodian and a Depositary? Well, a Depositary is a regulated bank holding a licence allowing it to operate as a Depositary, which may choose to delegate part of its functions to a Sub-Custodian.

A Depositary holds the title of the assets of the funds (unlike a Sub-Custodian), national laws may require that a fund appoints a Depositary (e.g. UCITS funds and most of continental Europe’s non-regulated funds such as Luxembourg’s SIFs shall appoint a Depositary located in their own jurisdiction, although this may change with UCITS IV introducing a passport for Depositaries) which is held liable, together with the manager, for the supervision of the fund’s business, and potentially vicariously liable for the functions it has delegated to a Sub-Custodian.

Such delegation to a Sub-Custodian often occurs when the manager wants to invest in markets where the Depositary does not operate or operates under a separate entity (this is “Global Custody”). There are of course rules to be observed when structuring a delegation, which notably implies the performance of due diligence and ongoing monitoring by the Depositary. As Sub-Custodians are governed by their national laws, the rules on asset segregation and re-hypothecation may vary widely.

2. Trustee / Custodian

Trustees only exist in jurisdictions where Trust Law applies, that means English common law jurisdictions. There are no Trustees involved in continental Europe’s funds.

The Trustee is the legal owner of the fund’s assets and owes a fiduciary duty to the investors i.e. the beneficial owners of the fund’s assets. Its role is very similar to the control function assumed by a Depositary: there is no Depositary when there is a Trustee, but there is a Custodian. The Trustee’s roles consist of:

(1) holding control over the asset of the fund that were entrusted to him by the investors ;

(2) making sure that the investment policies provided in the Trust Deed and the laws governing the fund are observed by the investment manager ; and

(3) ensuring that the assets are segregated from the manager’s assets.

The Custodian exercises a direct control over the assets of the scheme and has the main mission to hold, safeguard and operate them in accordance with the managers’ investment decisions.

Although the respective roles of Trustee and Custodian shall be clearly distinguished, in some jurisdictions the Law authorises one single entity to assume both roles, such entity being thus referred to as the “Trustee/Custodian”.

Summary:

Trustee = control only

Custodian = custody only

Depositary = custody (frequent delegation) + control

ISDA Mode d’Emploi (4): Etude des Clauses – Résiliation et Conséquences: (a) Events of Default

Les cas de défaut (“Events of Default”) sont importants puisque la partie qui n’est pas en défaut est autorisée, lorsqu’ils surviennent, à désigner une date (“Early Termination Date”) à laquelle l’ensemble des Transactions sont résiliées.

En sus des cas de défaut listés en 5 (a), l’ISDA 1992 crée en 5 (b) une autre catégorie de défauts appellés Termination Events. La survenance d’un Termination Event autorise une des parties ou les deux parties à résilier certaines ou l’ensemble des Transactions, mais il y a de plus une obligation pesant sur la partie à l’égard de laquelle le Termination Event se produit de notifier cette survenance à l’autre partie. Les Termination Events sont donc plus “dangereux” pour la partie en défaut, qui se doit d’être transparente. De plus, relativement à certains Termination Events, la partie affectée par l’évènement a une obligation de moyen de transférer les Transactions affectées afin d’éviter la survenance du Termination Event. Les Termination Events seront étudiés par le menu dans le prochain post.

Events of Default – Section 5 (a)

De nombreux Events of Default ont été révisés dans l ‘ISDA 2002, et je détaille ces changements dans les développements consacrés à chaque Event.

1. Failure to Pay or Deliver

Un délai de grace de 3 Local Business Days (définition en Article 14 de l’ISDA) est accordé pour tout défaut de paiement ou de livraison afférent à une Transaction, et à l’issue de ce délai un Event of Default est caractérisé. L’ISDA 2002 ramène ce délai de grace à 1 Local Business Day, et un délai de grace d’1 Local Delivery Day s’applique aux obligations de livraison, c’est à dire, par exemple, à la livraison de valeurs mobilières (et non de liquidités) venant en règlement d’une Transaction. La définition de Local Delivery Day diffère de la définition de Local Business Day en ce qu’elle admet que la livraison d’actifs tels que des valeurs mobilières peut être rendue impossible en raison de perturbations affectant les systèmes de règlement qui ne sont pas sous le contrôle de la partie devant effectuer la livraison. On pense par exemple à des difficultés rencontrées par un sous-dépositaire.

2. Breach of Agreement

Un délai de grace de 30 jours s’applique en cas d’irrespect ou de non exécution de toute obligation stipulée dans l’ISDA 1992, et à l’expiration de cette période un Event of Default est qualifié. L’ISDA 2002 écarte le délai de grace lorsqu’une partie dénonce ou conteste la validité de l’ISDA 2002 ou d’une Confirmation.

3. Credit Support Default

Un tel Event est charactérisé (1) lorsqu’une partie ou un Credit Support Provider manque à ses obligations prévues par tout Credit Support Document (tout éventuel délai de grace devant être pris en compte) ou (2) lorsque de tels Credit Support Documents sont résiliés, arrivent à expirations ou cessent d’avoir force obligatoire avant que l’ensemble des obligations prévues dans le cadre des Transactions auxquelles ils se rapportent n’aient été honorées, et en l’absence de consentement de l’autre partie, ou (3) lorsqu’une partie dénonce ou conteste la validité du Credit Support Document.

4. Misrepresentation

J’ai déjà abordé ces stipulations ici en traitant des representations.

5. Default Under Specified Transaction

J’ai brièvement abordé ce concept ici. Essentiellement, cette stipulation permet un défaut croisé (“Cross-Default“, voir (6) ci-dessous) limité dans son étendue aux dérivés conclus entre les contreparties à l’ISDA 1992 ou à  leurs Credit Support Providers ou Specified Entities, s’il y en a. Ceci implique que si l’une de ces parties fait défaut sur l’un des types de dérivés contenus dans la définition de Specified Transactions (voir ci-dessous), en prenant compte des délais de grâce, l’autre partie peut se prévaloir d’un Event of Default sous l’ISDA 1992.

L’ISDA 2002 contient des stipulations plus élaborées, qui distinguent quatre situations, qui constituent chacune un Event of Default:

(i) Défault sous une Specified Transaction ou un credit support arrangement (sauf défaut de livraison), en prenant en compte les délais de grâce, résultant en (a) une liquidation de, (b) une accélération des obligations (“Acceleration”) sous, ou (c) une résiliation anticipée de cette Specified Transaction.

(ii) Un défaut de paiement relativement à une Specified Transaction, les délais de grâce ou exigences de notification étant pris en compte. En l’absence de délais de grâce ou d’exigences de notification applicables, le défaut de paiement doit durer 1 Local Business Day pour constituer un Event of Default.

(iii) Défaut de livraison relativement à une Specified Transaction ou tout credit arrangement y associé, lorsqu’un tel défaut entraîne une Acceleration de l’ensemble des trades.

(iv) Toute dénonciation ou mise en cause de la validité d’une Specified Transaction ou de tout credit arrangement y associé, confirmé ou fait par écrit.

La définition de Specified Transaction est souvent discutée par les parties: Default Under Specified Transaction est plus sévère que Cross Default puisque celui-la n’est pas limité par un montant-seuil.

Dans l’ISDA 1992, la définition de Specified Transaction est la suivante:

“Specified Transaction” means, subject to the Schedule, (a) any transaction (including an agreement with respectthereto) now existing or hereafter entered into between one party to this Agreement (or any Credit SupportProvider of such party or any applicable Specified Entity of such party) and the other party to this Agreement (or any Credit Support Provider of such other party or any applicable Specified Entity of such other party) which is a rate swap transaction, basis swap, forward rate transaction, commodity swap, commodity option, equity or equity index swap, equity or equity index option, bond option, interest rate option, foreign exchange transaction, cap transaction, floor transaction, collar transaction, currency swap transaction, cross-currency rate swap transaction, currency option or any other similar transaction (including any option with respect to any of thesetransactions), (b) any combination of these transactions and (c) any other transaction identified as a SpecifiedTransaction in this Agreement or the relevant confirmation.

Lorsqu’elle n’est pas amendée dans la Schedule, cette définition couvre l’ensemble des dérivés OTC passés entre les parties, y compris les transactions passées sous d’autres contrats que l’ISDA en question, ce qui inclut les autres ISDA mais aussi les Long Forms. Lorsque la phrase “any other entity” remplace “and the other party to this Agreement” (en gras dans la définition ci-dessus), le domaine de Specified Transaction devient beaucoup plus vaste: danger ! On remarque également que la définition utilise le terme de “Specified Entity“, étudié dans mon précédent post. Si la définition de Specified Entity est laissée vierge dans la Schedule, pas de problème. Mais les parties peuvent tenter d’amender Specified Entities afin de faciliter l’usage de Default Under Specified Transaction, qui, rappellons-le, est bien pratique puisqu’il n’y a pas de seuil. Souvent, Specified Entity sera défini comme suit: “Affiliates in relation to Party A and B“.

L’ISDA 2002 complète essentiellement la liste des produits contenus dans la définition de Specified Transaction pour y inclure les dérivés de crédit, les dérivés climatiques, les forwards sur valeurs mobilières ou matières premières, les prêts de titres et les repos, plus une clause-balais couvrant les “transactions conclues actuellement sur le marché et leurs futures variantes“. On notera que l’ajout de CDS et de repos est souvent pratiqué dans la définition de l’ISDA 1992. On a pu critiquer l’ajout des repos, dont les système de règlement est considéré comme peu fiable. Egalement, l’ISDA 2002 prend la précaution de préciser que Specified Transaction ne couvre pas les Transactions, c’est à dire  que Specified Transaction ne s’applique qu’aux transactions documentées par un autre instrument juridique que l’ISDA en question. Cette précision utile – L’ISDA 1992 était ambigu sur ce point – est accompagnée de l’ajout d’un (2) à l’Event of Default dénommé Breach of Agreement (dénommé désormais “Breach of Agreement ; Repudiation of Agreement” en (5) (a) (ii)) qui inclut désormais la dénonciation de Transactions qui, rappelons-le, entraîne la caractérisation d’un Event of Default sans délai de grâce.

6. Cross Default

Dans ce cas, il s’agit d’un défaut d’une partie, son Credit Support Provider ou une Specified Entity, relativement à des fonds empruntés (définis par le terme “Specified Indebtedness“), lequel défaut (i) excède un montant-seuil déterminé (c’est le “Threshold Amount” figurant en Partie 1 de la Schedule), et (ii) a pour conséquence de rendre exigible ou potentiellement exigible ladite Specified Indebtedness avant la date de paiement prévue initialement. Cross Default est généralement activé dans la Schedule lorsque l’ISDA intervient en couverture d’un prêt: il y aura alors Cross Default en si un cas de défaut est caractérisé sous un contrat de prêt ou sous un accord sur le fondement duquel des fonds sont avancés. Deux types de négociations interviennent fréquemment quant à Cross Default:

(a) La définition de Specified Indebtedness fait l’objet de négociations dans la mesure où elle détermine la portée de Cross-Default. Plus la définition de Specified Indebtedness est large, plus il est facile d’atteindre le Threshold Amount, celui-ci étant calculé sur une base agrégée de l’ensemble des cas de défaut d’une partie, de ses Credit Support Providers et de ses Specified Entities.

La définition de Specified Indebtedness, qui est la même dans l’ISDA 2002 que dans la version de 1992, est la suivante:

“Specified Indebtedness” means, subject to the Schedule, any obligation (whether present or future,contingent or otherwise, as principal or surety or otherwise) in respect of borrowed money.

Il s’agit donc bien des emprunts, et de tous les emprunts. Une controverse existe ainsi quant à l’inclusion des dépôts bancaires dans la notion de “borrowed money“. Quoiqu’il en soit, de nombreuses contreparties bancaires tentent d’exclure les dépôts de la définition de Specfied Indebtedness, afin d’éviter de se retrouver en défaut sous ISDA par le truchement de la claude de Cross Default si par hasard elles avaient des difficultés à restituer les dépôts à leurs clients. De telles clause limitatives utilisent des  notions de force majeur ou de moratoire gouvernemental pour limiter la portée de “borrowed money“. D’une manière générale, les amendement apportés dans la Schedule tendent a à affiner la définition de Specified Indebtedness, afin, par exemple, d’exclure les emprunts intra-groupes, cad avec les Credit Support Providers et les Affiliates, ou de préciser que les retards dus à des problèmes administratifs ne doivent pas être pris en compte.

(b) Cross Default devient Cross Acceleration. Certaines contreparties considèrent que l’effet “binaire” de la clause de Cross Default est trop sévère. Elles préfèrent ne pas caractériser un défaut sous ISDA en cas de simple défaut affectant un Specified Indebtedness: elle préfèrent que pour caractériser un défaut sous ISDA la partie qui subit le défaut relativement à une Specified Indebtedness ait pris des mesures afin de recouvrer ses créances et résilier le contrat-tiers. Le défaut sous ISDA est donc conditionné par l’action de la partie tierce, c’est la “Cross Acceleration“. Cet adoucissement de Cross-Default est généralement concédé à une contrepartie ayant les reins solides, et s’accompagne de l’exigence (sous forme d’une representation spécifique) que celle-ci applique l’adoucissement avec toutes ses contreparties.

7. Bankruptcy

Ainsi que suggéré par le titre, cette clause définit différentes situations de banqueroutes, insolvabilités et autres sources de joie profonde. Dans les cas où une dissolution (“winding-up“) ou mise en redressement est prononcée, un délai de grâce de 30 jours est prévu afin de permettre de renverser la situation avant qu’un Event of Default ne soit constitué. De même, un délai de 30 jours est accordé lorsqu’une tierce partie prend possession d’un actif. L’ISDA 2002 réduit drastiquement ce délai de grâce puisqu’il est ramené à 15 jours, et se trouve même réduit à néant lorsque la dissolution ou mise en redressement est initiée par un régulateur ou une entité officielle ayant un pouvoir juridictionnel ou quasi juridictionnel à cet effet.

8. Merger Without Assumption

Ceci correspond aux situations où une partie ou un Credit Support Provider fusionne avec, ou transfère tout ou une part substantielle de ses actifs à une autre entité, et que l’entité résultant de cette fusion/transfert n’est pas en mesure de faire face aux obligations de la partie originale telles que stipulées dans le Master ISDA 1992 en question, ou que les bénéfices du Credit Support document ne peuvent s’appliquer aux obligations de l’entité cessionnaire.

ISDA: A User’s Manual (2) – Structure of the ISDA Documentation

The (1992 or 2002) ISDA master agreement is the central document to the ISDA suite of documents. A fundamental principle of the documentation’s structure is the single agreement principle. Another feature of the documentation is the hierarchy it establishes between its different elements, which may recall … the Matrioshkas, the Russian egg-shaped dolls that fit inside one another. Who said that ISDA can’t be fun ?!

This is best understood through considering the different elements in the documentation:

Master & Schedule. The 1992 ISDA comprises a pre-printed standard form document for the first eighteen pages. It attaches to it a schedule (the “Schedule”), which contains credit and other transaction-specific provisions and elections, which are individually tailored for the particular circumstances of each case. The Schedule allows the parties to amend the ISDA standard form: the provisions of the Schedule will therefore be negotiated by the parties. The Schedule specifies which provisions of the standard form shall be activated, disactivated or amended (in this case the amendments will be fully displayed in the Schedule). The parties may also choose to include some new clauses such as those extracted from the 2002 ISDA : if the ISDA standard may be compared to a rough stone block, the Schedule may be seen as the sculptor’s chisel.

Confirmations. The ISDA Master and Schedule comprise an agreement pursuant to which individual trades are entered into. These trades or Transactions are recorded in Confirmations. There shall be one Confirmation for each Transaction, being noted that a Master Confirmation may be used by the parties in order to define the generic terms applicable to an homogenous category of Transactions entered into in the framework of one specific ISDA. For instance, the Master Confirmations are used for the most standardised OTCs such as some equity derivatives and credit default swaps. Where a Master Confirmation is used, a Transaction Supplement, which is a fairly succinct document, is drawn up for each specific Transaction covered by the said Master Confirmation.

Furthermore, there are two types of Confirmations: the Long Form and the Short Form. A Long Form Confirmation is purported to be entered into by the counterparties that did not yet enter into an ISDA for example because the volume of OTC transaction between themselves does not justify it, or because they did not have the time to do so. A Long Form Confirmation contains some provisions reproducing an ISDA, which makes it … longer than a conventional Confirmation, i.e. a Short Form.

Single Agreement. The set of documents described above (Standard ISDA + Schedule + Confirmations/Transaction Supplements) form part of a single agreement, as stipulated in Article 1 (c) of the ISDA Master:

Single Agreement. All Transactions are entered into in reliance on the fact that this Master Agreement and all Confirmations form a single agreement between the parties (collectively referred to as this “Agreement”), and the parties would not otherwise enter into any Transactions.

It shall be noted that the Credit Support Annex (“CSA”) is also part of the said single agreement. This is however not the case for a Credit Support Deed, which consists of a separate guarantee.

Before moving on to consider some of the other elements of the documentation, it is useful to consider the benefit of this single agreement principle in the context of systemic risk and the risk reducing nature of netting. A number of Transactions may be entered into between the parties to an ISDA Master. As the exposures of the parties under each of these Transactions in effect comprise a single agreement with the relevant ISDA Master, this enables the parties on the occurrence of default to net exposures under all of these Transactions in accordance with the provisions of the ISDA Master. This reduces the risk of cherry picking and minimises systemic risk.

Close-Out Netting. The essence of this netting, which is referred to as “close-out netting” in the jargon, is that, on the occurrence of certain defaults, which entitle the parties to terminate some or all of the trades, the trades are terminated and valued, with the result that a net amount is due by one party to the other. This netting operates as described in the Bank A/B example, taking into account trades in the money and out of the money, such that the previous individual obligations of the parties under the different trades are, on termination, replaced by one single net amount due by one party to the other.

The netting provisions are contained in Section 6(e) of the 1992 ISDA and will considered in more detail in further posts, together with an additional broader contractual right of set-off, which is often incorporated into the Schedule to the 1992 ISDA and which now forms part of the preprinted part of the 2002 ISDA.

Governing Law. The governing law of the 1992 ISDA is generally UK or US. However, where two counterparties from the same country are involved, it is not unusual to apply this country’s law and to submit to the jurisdiction of the local courts by express provision in Part 5 of the Schedule. The French counterparties use a French documentation, the FBF documentation, instead of the ISDA. Similar “national” documentations can be found in Germany and in the People’s Republic of China.

Legal Opinions. As mentioned above, the 1992 ISDA has the benefit of opinion letters commissioned by ISDA from law firms in different jurisdictions. They principally cover the validity of:

• closeout netting;
• the ability to terminate Transactions on insolvency;
• enforceability of the automatic termination provision;
• the impact of entering into Transactions through branches in different jurisdictions; and
• collateral.

Definitions. Section 14 of the 1992 ISDA contains definitions of the terms that are used in the ISDA. Separately, ISDA has prepared a number of definitional booklets, which are relevant to particular types of products, which the parties to the ISDA propose entering into. There are:

The “2000 ISDA Definitions and Annex”, which are commonly incorporated into the ISDA between the parties by electing to do so in the Schedule or in the relevant Confirmation, if the proposed Transactions are basis swaps, currency or cross-currency swaps or forward rate transactions or interest rate caps, collars or floors or other similar transactions.

The “2006 Definitions” update the “2000 Definitions” and apply to same categories of Transactions. Some counterparties may found handy to incorporate the 2006 Definitions into Confirmations relating to some types of transactions covered by some more specialised definitions such as the 2002 Equity Derivatives Definitions or the 2005 Commodity Derivatives Definitions, in order to better frame the modalities of variable or fixed payments.

The “1998 FX and currency option Definitions” are usually incorporated for foreign exchange transactions or currency option Transactions. Forms of confirmations for the Transactions are included in these booklets, together with specific definitions and provisions regarding the manner in which the relevant Transactions operate, the making of payments and calculations thereunder, the exercise, termination and settlement of the Transactions.

It should be noted that the definitions contained in Section 14 have been revised in the 2002 ISDA Master Agreement to take account of some of the more substantive changes to the events of default and valuation mechanisms.

Some further posts will be specifically dedicated to the study of the Equity Derivatives Definitions and Funds Definitions.

ISDA: A User’s Manual (1) – Introduction

ISDA or the International Swaps and Derivatives Association is an industry body comprising full and associate members from the finance community and associated service providers such as law firms. ISDA has designed a suite of high-quality documents aimed at documenting the over-the-counter derivatives (“OTCs”), i.e. the financial derivatives that are not traded on a regulated market such as an exchange.

The ISDA’s objective is to facilitate and provide some legal comfort to these transactions: the ISDA’s website displays a number of legal opinions dealing with the key issues involved by the ISDA. These legal opinions are drafted by prominent law firms and cover a wide range of jurisdictions.

Before considering the structure and content of the ISDA documentation, it is useful to step back and take an overview. The daily volumes of transactions between participants in the capital markets are massive: transactions totalling billions of dollars are transacted every day. This means that the participants in these markets potentially have large exposures to each other. Regulators and the participant financial institutions themselves are concerned about the consequence of the failure of a participant in the market, as this can have a domino effect on other participants. The failure of one participant can trigger other participants being unable to meet obligations they have entered into with other parties. This risk of “domino effect” is known as systemic risk. Netting, which is considered below in more detail in the context of ISDA documentation, is considered as a method of reducing systemic risk.

This is best demonstrated through an example below:

Bank A owes Bank B 50 million. Bank B owes Bank A 30 million. Instead of Bank A being exposed to a 30 million exposure on Bank B and Bank B being exposed to a 50 million exposure on Bank A, if netting is used, the 50 million exposure of Bank A is reduced by the 30 million exposure owed to it by Bank B. This results in the exposures being replaced by one single net payment of 20 million due by Bank A to Bank B.

Within the framework of regulated markets, it is the clearing house’s job to daily calculate the net exposure of  each participant to a given market. As the clearing house operates as a central counterparty, there is no counterparty risk – to the extent that the clearing house is sufficiently funded.

The situation is different for OTC markets because there is no clearing house: it is therefore of the utmost importance to find legal means to limitate counterparty risk and “chery picking” risk as much as possible.

“Cherry picking” risk may occur in case of insolvency: the liquidator or other insolvency official appointed to either bank might decide to honour trades that are “in the money”, i.e. trades under which the other party owes money to the party in liquidation, thereby recovering payments due to it but not honouring trades that are “out of the money”, i.e. where it owes money to the other party, and leaving the other party to rank as an unsecured creditor in the liquidation. In our example, if a liquidator is appointed to Bank A, the liquidator might seek to disclaim the contract under which 50 million is owed by it to Bank B but seek to enforce the payment by Bank B of 30 million to Bank A. This clearly increases financial risk in Bank B whereby it could effectively not recover the 50 million due to it but be forced in addition to pay out 30 million as opposed to receiving a net 20 million back.

The scope of this post is not intended to cover the capital treatment of OTC transactions for capital adequacy purposes. However, it is important to remember that effective netting arrangements can enable participants in financial markets to avail of reduced risk weighting for regulatory capital purposes and consequently reduce the amount of capital allocated for these purposes.

It is important to understand the distinction between exchange traded derivatives and OTCs in this context as the ISDA documentation is focused with documenting OTC products. OTC products are generally tailored products that are poorly stantardised – there is however a standardisation trend that grows together with the size of the OTC markets, especially in the fields of equity derivatives and credit default swaps. OTC derivatives are the only products documented under the ISDA, while standardised derivatives such as the futures are negotiated on regulated markets, and benefit from the safety offered by a clearing house.

The ISDA is a good example of a consensual regulation devellopped by the participants to a market: it is a legal standard stemming from a ongoing negotiation and enhancement process.  It illustrates how the wise use of contractual freedom can contribute to the consistency of the economy and financial law. The ISDA documentation is however a sophisticated one, which I will try to clarify and explain in this series of posts.

The ISDA Documentation

These posts will focus on the 1992 ISDA Master Agreement (Multi-Currency/Cross- Border) (the “1992 ISDA”) which is aimed at documenting cross-border transactions involving a number of currencies.

While the 1992 ISDA has been updated with the publication of the 2002 ISDA Master Agreement (“2002 ISDA”), the 1992 ISDA is still currently used by many counterparties. I will therefore focus on the content of the 1992 ISDA but also highlight the key changes that are incorporated in the 2002 ISDA. The 2002 ISDA does not amend the 1992 ISDA: it is just the most recent form of Master Agreement available.

The market participants that keep using the 1992 ISDA often amend the existing 1992 ISDAs to incorporate some of the more important changes incorporated in the 2002 ISDA.

In addition, I will consider (i) the 1995 UK Credit Support Annex (English Law) which creates a title transfer financial collateral arrangement, under which cash collateral is deposited with and readily marketable securities are transferred to the collateral taker, (ii) the 2001 ISDA Margin Provisions dealing with the margin calls, i.e. the right for the collateral taker to adjust the amount of the collateral deposited with him depending on the variations of the value of the derivatives covered by the ISDA and, briefly, (iii) the provision of security in more traditional form in the form of guarantees, mortgages and debentures.

Réglementation des produits dérivés: la quadrature du cercle

C’est désormais une quasi-certitude au vu des discussions avancées en cours aux Etat-Unis et en Europe: une réglementation accrue des produits dérivés est imminente. Voici quelques réflexions sur les discussions en cours:

(a) L’utilisation de dérivés devrait être limitée à la confection de stratégies de couverture. C’est notamment ce que recommande Georges Soros en matière de CDSs: un participant au marché ne peut acquérir un CDS le protégeant contre la faillite d’une entité que s’il a acquis des titres de dette émis par cette entité. En évitant une activité spéculative décrite comme vicieuse, puisqu’en cas de faillite imminente de l’entité de référence les détenteurs de CDS spéculatifs sont incités à faire échouer toute tentative de sauvetage, cette limitation à des CDS purement de couverture permettrait de profiter des progrès apportés par les produits dérivés (couverture de risque sophistiquée) sans en connaître les inconvénients (spéculation destructrice + marchés opaques = important risque systémique). Outre le fait qu’une telle position heurte la notion de liberté contractuelle, il en ressort également que le marché des dérivés serait certainement considérablement réduit, et probablement rendu inexistant. En effet, si seuls les dérivés de couverture sont autorisés, alors un participant cherchant à se couvrir aura bien des difficultés à trouver une contrepartie cherchant à se couvrir d’un risque exactement opposé ! Les spéculateurs tels que les hedge funds sont des pourvoyeurs de liquidité indispensables qui rendent les marchés plus efficaces. Il existe de nombreux marchés stables et parfaitement en ordre où les spécsulateurs pullulent: les marchés des obligations étatiques par exemple, ou encore les marchés de futures (dérivés cotés).

Notons qu’une solution intermédiaire est envisageable: l’exigence que l’une au moins des contreparties à un dérivé procède à une couverture par CDS, les CDS où les deux contreparties spéculent (cad elles ne couvrent aucune position: elles se contentent d’en prendre) étant alors prohibés.

(b) Les dérivés devraient être négociés sur des marchés réglementés. L’un des inconvénients associé aux marchés de produits dérivés OTC est leur opacité (les volumes échangés sont difficilement quantifiables, le processus de formation des prix n’est pas automatique et centralisé). Par contraste, les marchés réglementés ne les sont pas. Donc rendre obligatoire la négociation de produits dérivés sur les marchés réglementés permettrait de rendre ces marchés transparents. Logique mais … peu pratique. La popularité des dérivés OTC est au moins en partie due à la possibilité de les structurer sur mesure, c’est à dire pour refléter un risque précis. Les instruments sur mesure ne se prêtent pas à la négociation sur les marchés réglementés: le nombre de participants intéressés par l’échange d’un même produit sera par définition réduit, et ne justifiera en aucun cas une cotation. Les dérivés sur mesure devraient donc être exclus du champ d’une telle réglementation, ce qui emporte quelques difficultés (voir plus bas).

(c) Les dérivés devraient bénéficier d’un système central de compensation. Ceci semble souhaitable. Une chambre de compensation augmente à la fois la transparence d’un marché et réduit sensiblement le risque de contrepartie, dans la mesure bien sûr ou elle est suffisamment bien capitalisée pour réellement permettre de garantir les opérations qu’elle centralise. L’effet amortisseur de risque procuré par une compensation centrale est a priori augmenté si plusieurs agents centralisateurs interviennent sur un marché.

(d) Les dérivés devraient être standardisés. La standardisation facilite la négociation sur les marchés réglementés, mais dans la mesure ou cette dernière n’est pas nécessaire pour garantir plus de transparence (voir c), et puisqu’un tel objectif est inenvisageable pour l’ensemble des dérivés (voir b), la standardisation semble avoir peu d’importance. Cependant, la standardisation permet l’intervention d’une chambre de compensation, ce qui est souhaitable. A ce propos, s’il est envisageable de faire passer par une chambre de compensation un produit non-standard, il n’en demeure pas moins impossible de procéder ainsi si l’ensemble des produits sont non standards ! Trop peu de standardisation aurait pour conséquence de rendre la tâche des agents compensateurs très diffcile, et donc très couteuse.

(e) Dans la mesure où la standardisation est souhaitable, comment la mettre en oeuvre ? Je considère que l’ISDA a déjà réalisé un incroyable travail de systématisation, si ce n’est de standardisation, des dérivés OTC. Le marché des CDS et des dérivés actions est également, dans une large mesure, standardisé en raison du volume pris par certains secteurs du marché. Ainsi, les CDS ayant une même entité de référence ont souvent la même maturité. Comment imaginer l’étape supérieure de la standardisation ? Des bataillons d’avocats devraient définir dans le détail les caractéristiques de tous les dérivés standards imaginables ? Et dans l’hypothèse ou cette tache herculéenne – et espérons-le décemment facturée – serait menée à bien, combien de jours cela prendrait-il pour l’ingénierie financière – évidemment conseillée par les mêmes avocats que précédemment – de restructurer ces nouveaux standards et de créer de nouveaux produits non-standards ? Se pose ici une question cruciale: mais pourquoi diable certains intervenants favoriseraient-ils les produits non-standards ?

(f) Show me the money. Les marchés opaques sont plus juteux que les marchés transparents, donc les dealers préfèreront toujours les premiers. De nombreuses évolutions récentes affectant les produits de la dette (fixed income) sont en partie explicable par une tentative de création d’un nouveau marché opaque et très profitable. Les marchés dérivés OTC sont une manifestation récente d’une telle motivation. Ainsi que remarqué plus haut, il existe des dérivés OTC dont les volumes échangés justifieraient une cotation en bourse, mais les dealers s’y sont opposés. Au vu du fait que les intérêts d’une cotation sont peu nombreux, mais que les intérêts de l’interposition d’une chambre de compensation sont importants, et que cette dernière bénéficierait d’un processus de standardisation des dérivés, la question suivante demeure: comment promouvoir un système de compensation central ?

(g) Mesures incitatives. Des exigences en matière de ratios règlementaires pourraient encourager les participants à favoriser une compensation centrale de leurs dérivés. Si les dérivés dont la compensation n’est pas centralisée sont pénalisés par une réduction du taux d’efficacité des fonds propres des entités impliquées, les dealers seront alors encouragés à conformer leurs opérations aux standards supportés par les agents compensateurs. Le dealer devra procéder à un calcul coût/avantage lui permettant d’arbitrer entre une compensation centrale et une compensation directe. Ainsi, les dérivés très structurés dont la compensation centrale sera rendue difficile pourront continuer à évoluer au large des chambres de compensation.

Islamic Finance in France – Overview of the Legal Framework

Hereunder is an article co-authored with Mr. Ibrahim Cekici who co-heads the Islamic Finance department at the University of Strasbourg. It was published in August 2009 in Islamic Finance News Volume 6 Issue 34. Islamic Finance News organised a roadshow aimed at informing on the latest development in the field of Islamic Finance. I was a moderator at the Hong Kong event.

ISLAMIC FINANCE IN FRANCE:

AN OVERVIEW OF THE LEGAL FRAMEWORK

Gerald Pasquier – Member of the Paris Bar – Registered with the Hong Kong Law Society – Part-time lecturer at the University of Strasbourg

Ibrahim-Zeyyad Cekici – Lecturer-Researcher – Co-head of University Diploma in Islamic Finance (Executive Master’s Degree) – Business School EM Strasbourg – University of Strasbourg

In the European landscape, Paris is, along with Frankfurt, Zurich and Luxembourg, one of the financial centres willing to challenge London’s leadership in the field of Islamic Finance.

The French civil law system takes its historical roots in both Roman law and Canon law. As such, French law rests on principles that are similar to those of the Islamic law: some prohibitions are common to both legal systems even though their scope vary.

For instance, the Shari’ah’s prohibition of paying, charging and facilitating interests may be compared with French laws prohibiting usury (even though Islam clearly prohibits interests)under which interests rates applicable to some loans granted to non-professionals shall not exceed of more than 33% the average rate used by banks for the same category of loans. Accordingly, when the Shari’ah contract law prohibits uncertainty in object, price and delivery, the French Civil Code provides that contracts’ objects shall be determined or capable of determination. Also, the Shari’ah’s prohibition of involvement in haram items echoes French statute laws aimed at ensuring public protection and moral, which may not be waived or derogated from by private agreements.

Over the past few years France has seen noticeable developments of its legal framework that are aimed at better accommodating Islamic finance products and activities: a number of French public authorities, organisations, scholars and legal professionals have discussed and will continue discussing what amendments shall be made to French laws and regulations if Paris wants to achieve its ambitions to become a prominent Islamic finance centre.

The most salient measures facilitating Islamic finance in France have been taken by the financial regulator, i.e. l’Autorité des Marchés Financiers (“AMF”) on the one hand, and the tax authorities on the other hand.

AMF’S POLICY STATEMENTS

The AMF has issued two statements relating to Islamic finance, which are available in English on its website.

Setting-up Shari’ah compliant investment funds

The first statement is dated July 17th 2007 and relates to the asset management industry. It should be noted at the outset that the structures of investment funds available under French law are compatible with the Mudaraba, i.e. the Islamic law structure typically used to set-up Shari’ah compliant investment funds. Under the Mudaraba model, the party funding the scheme is to be distinguished from the party bringing-in the know-how, which corresponds to the classic division between the investors and the managers of a French collective investment scheme. However, some special features of the management techniques used by Shari’ah compliant investment funds had to be addressed by the AMF.

First, in order to be compliant with the Shari’ah, a fund manager shall operate a financial screening of the assets invested by the fund, typically in order to avoid investments in companies having a gearing ratio higher than 33% and a too high liquidity ratio. A moral screening shall be conducted as well, in order to avoid investments in haram assets. In its statement, the AMF treats Shari’ah funds in the same manner as it treats other investment funds using extra-financial criteria to build their portfolios, such as socially responsible funds. The regulator insists on the fact that such screening process shall not impair the independence of the management company: an external investment advisor may duly provide the manager with its opinion with respect to the selection of investments, but the ultimate decision shall rest in the fund manager. As a Shari’ah board usually elaborates extra-financial investment guidelines to be observed by the manager, such independence condition can easily be fulfilled provided that (1) the said guidelines comply with French public policy principles and (2) the manager is able to understand and assess those guidelines. If a fund invests in a Shari’ah compliant index such as the Dow Jones Islamic Index, the practices of the entity compiling the said index will be scrutinised by the AMF when assessing the independence of the manager.

Second, Shari’ah compliant funds commonly use purification techniques aimed at morally neutralising an investment that appeared to be non-Shari’ah compliant, typically after an audit has been conducted on the morality of the assets. Such purification is effected by distributing part of the fund’s income to charities or selected non-for-profit organisations. This may harm the interests of the investors in the fund, as it will negatively impact the return on their investment. Therefore, the AMF authorises such management techniques under the condition that both the use of purification and the details of each charitable organisation be stated in the fund’s prospectus. The regulator also recalls that the investors shall be offered the possibility to trace the purification monies.

It is not surprising that the very first piece of French legislation dealing with Islamic Finance focuses on the asset management industry: with a volume of assets under management ranking third after the United States and Luxembourg, France is a strong player. On a global scale, Islamic asset management is however developing at a slower pace than other branches of Islamic finance, certainly because of the difficulties to screen non-equity assets. New screening processes for such non-equity assets would be worth developing further. Sukuks are currently difficult to price because they are commonly held until maturity: their secondary market is therefore not a relevant benchmark for pricing since it is poorly liquid. If funds managers were to increase their exposure to Sukuks, such liquidity gap may be plugged.

Issuing Sukuks

The second statement dated July 2nd 2008 explicitly states that Sukuks are admitted to the French regulated market, although they can only target qualified investors.

The AMF identifies two broad categories of Sukuks: (1) the asset backed Sukuks, where cash outflows are solely linked to the performance of underlying assets, and (2) the asset-based Sukuks, namely guaranteed Sukuks. The AMF has warned that it shall not be expected to verify the compliance of a Sukuk with the Islamic law. However, as a Sukuk’s prospectus should inform the investors of such Shari’ah compliance issues, the statement sets out a summary of the European laws governing the drafting of prospectuses, and indicates for each two categories of Sukuks how to construe the EU laws when preparing a prospectus.

In its statement, the AMF seems to consider that a Sukuk is a debt instrument, which substantially differs from the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions’ definition, according to which Sukuks are “certificates representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) the assets of particular projects”. This should be of particular concern since some influential scholars consider that a large majority of existing Sukuks structures are not Islamic. French law is however sophisticated enough to allow the issue of a wide range of fixed-income securities, including intensively equity-tainted hybrid instruments called “titres participatifs”, that could possibly permit the structuring of Sukuks affected by little Sharia’ah risk. As seen hereunder, such type of Sukuk may however not benefit from a favourable tax treatment.

TAX AUTHORITIES’ POLICIES

On February 25th 2009, the French tax department issued a statement (“instruction”) clarifying the tax treatment of Sukuk and Murabaha. The said statement is binding upon the tax authorities and will be referred to in tax rulings, thus providing consequent legal comfort.

Taxation of Sukuks

The main operative provisions pertaining to Sukuks state that the remuneration received by an investor in a Sukuk may be deducted from the issuer/borrower’s income tax basis, and that no withholding tax shall apply at source when such investor is not a French resident.

Such deductibility is available only when the Sukuk is structured as a debt instrument. In order to be considered a debt instrument, a Sukuk shall meet two series of conditions:

First, the Sukuk shall not have the characteristics of an equity instrument: the investors shall rank above the issuer/borrower in the event that the latter defaults, and the investors shall not be granted economic or political rights usually conferred to equity investors.

Second, the cash flow received by the investor shall be structured in accordance with specific rules. The remuneration of the Sukuk (which would correspond to the payment of interests in a conventional debt instrument) can effectively be correlated to the performance of the underlying assets, but it shall not exceed a recognised market rate increased by a margin (e.g. LIBOR + 2%). As for the reimbursement of the capital, its nominal value may not entirely be repaid if the value of the underlying assets is insufficient, but it may not exceed the nominal value if the underlying assets’ value is relatively higher.

Moreover, in compliance with the general French tax rules, the issuer/borrower may deduct the remuneration only if the investor in the Sukuk is a minority shareholder of the issuer/borrower or a company connected to the issuer/borrower – two companies being connected when one company directly or indirectly owns a majority stake in the other company. Finally, the deductibility is also limited by the average rates set out by the French banks in loans extended to companies which incorporate a maturity exceeding two years and a floating rate. Some exceptions apply to this last rule.

Considering the AMF’s statement hereupon, Shari’ah risk may be carefully weighted against tax efficiency when structuring a Sukuk under French law: if a Sukuk is structured as an equity-tainted hybrid, the issuer may not be allowed to deduct the remuneration it pays to the investor from its income tax basis. To date, no Sukuk is listed on the Paris stock exchange.

Taxation of Murabaha

Murabaha is duly described in the statement as a technique used to finance an asset acquisition: a bank or its SPV acting as a financier, purchases an asset from a seller and subsequently transfers the asset to a buyer in consideration of the payment of a profit margin, which will be settled by the buyer in instalments.

The two main features of a Murabaha transaction are therefore a double property transfer on the one hand, and the intermediation of a financier on the other hand, both of which triggered disadvantageous consequences under French tax law that are neutralised by the statement.

The statement indicates that the profit margin paid to the financier by the buyer shall be treated as an interest under French tax law, which implies that it can be deducted from the financier’s income tax basis. A series of conditions shall be met to allow such deductibility:

First, the agreement shall state that the asset purchased by the financier shall be transferred to the buyer within a six months period.

Second, the agreement shall stipulate the acquisition price by the buyer and by the financier. Most importantly, the agreement shall clearly distinguish which part of the profit margin results from commission fees and which part results from the facilitation of a deferred payment. Only the latter part of the profit margin may be deducted – on a linear basis until maturity – which certainly involves that the commission fees have to be computed on a lump-sum basis.

Besides income tax issues, the statement comprehensively addresses other tax regimes, this paper covering only some of the most relevant aspects.

The statement notably deals with the taxation of real estate transactions. Under French tax law, a tax is levied on capital gains realised on such transactions. Murabaha operating a double transfer of property, double taxations would have been detrimental to the development of Islamic finance in France, especially since Murabaha is commonly used to structure the acquisitions of real estate properties by retail clients, which is a promising market niche for Islamic banks willing to set-up in France.

The statement provides that the profit margin paid by the buyer to the financier shall not be treated as capital gains. It further provides that if the buyer sells the property, capital gains shall be derived from the price paid by the seller to the financier, and not on the price paid by the buyer to the financier, this regime being aimed at discouraging speculation.

The statement also envisages the taxation of commodities Murabaha, which are crucial to the sound functioning of Islamic banks that are obliged to back their financing operations with real assets in order to be compliant with the Shari’ah. According to French tax law; only the physical delivery in France of personal chattels is subject to VAT, therefore commodities Murabaha transactions conducted on a foreign exchange such as the London Metal Exchange are VAT exempt provided that the commodities are not located in France.

***

In conclusion, some significant adaptations of the French legal framework to the specifics of Islamic finance have been achieved although additional measures certainly need to be implemented. For example, French statute law provides that a seller shall warrant a buyer against the hidden defects affecting the goods it sells. Within the framework of a Murabaha transaction, the financier should be allowed to waive this currently compulsory warranty, as it essentially acts as a financial intermediary.

Published on 10 August 2009

ISDA Mode d’Emploi (3): Etude des Clauses – Concepts-Clés & Stipulations Opérationnelles

L’ISDA 1992 peut être découpé en trois parties. Les articles (ou “Sections“) 1 à 4 contiennent les concepts-clés tels que le principe de negotium unique (“Single Agreement“) et les stipulations opérationnelles se rapportant au cours normal du trading entre les parties (ce post est consacré à ces clauses). Les articles 5 et 6 sont afférents aux situations autorisant les parties à se prévaloir d’une résiliation, et aux conséquences d’une telle résiliation. Les articles 7 à 14 contiennent les clauses contractuelles techniques dites “boilerplates” en droit transactionnel.

Les types d’opérations (ou “Transactions“) pouvant potentiellement entrer dans le champ d’un Master ISDA sont nombreux et variés. Dans le premier paragraphe du pré-imprimé ISDA 1992, le terme “Transaction” est défini comme étant chacune et toutes Transactions qui sont ou seront soumises à l’ISDA 1992. En pratique, les types de trades en question sont des produits de gré à gré (“Over-the-Counter“, “OTC”). Afin de renforcer le principe de negotium unique, la première référence faite dans l’ISDA 1992 à la notion de “Master Agreement“, c’est à dire de contrat-maître ou cadre, inclut explicitement la Schedule et les Confirmations, qui sont en l’occurrence les documents enregistrant chaque Transaction individuelle.

Date. La date de l’ISDA ne correspond pas forcément à la date de signature des documents et peut à vrai dire être antérieure à la signature, afin d’inclure des Transactions préexistantes entre les parties. En conséquence, la date choisie correspond généralement à la date du premier trade passé que les parties souhaitent assujettir au Master 1992 en question. La définition du terme “Transaction” atteste que des trades ont déjà pu être passés ou le seront à l’avenir:

Premier alinea de l’ISDA 1992:

[the parties] have entered and/or anticipate entering into one or more transactions (each a “Transaction”) that are or will be governed by this Master Agreement, which includes the schedule (the “Schedule”), and the documents
and other confirming evidence (each a “Confirmation”) exchanged between the parties confirming those Transactions.

Parties. Les parties figurant dans un ISDA 1992 sont avant tout les réelles parties à l’accord. Elles sont désignées comme contreparties (“counterparties“), et il est important de noter que dans certaines juridictions les dispositions législatives spéciales permettant la compensation intégrée au mécanisme ISDA ne sont applicables que si l’ISDA ne comprend pas plus de deux contreparties. Mises à part les contreparties, les autres parties à un ISDA sont les “Specified Entities” et les “Credit Support Providers“.

Specified Entities. Les Specified Entities présentent une certaine importance dans le cadre de certains cas de défaut (“events of default“), en l’occurence:

(1) Specified Transactions. les défauts attachés à certaines types spécifiques de Transactions sur produits dérivés (désignées par le terme “Specified Transactions” définies à l’article (14) de l’ISDA 1992 sous la forme d’une liste non-exhaustive d’opérations OTC), l’article (5)(a)(v) de l’ISDA 1992 abritant les cas de défaut correspondants ;

(2) Cross Default (article (5)(a)(vi)) détaillé plus bas;

(3) Bankruptcy (article (5)(a)(vii)); et

(4) l’évènement résolutoire nommé “Credit Event Upon Merger“, situation se présentant lorsqu’une contrepartie fusionne avec une autre entité et que l’entité résultant de la fusion est substantiellement plus faible que l’entité originale (article (5)(b)(iv)).

Activer dans l’ISDA 1992 les Specified Entities, qui sont habituellement membres du même groupe de sociétés qu’une contrepartie, signifie que les cas de défaut ci-dessus listés sont non seulement testés en référence à la contrepartie, mais également en référence à ces entités spécifiées: le périmètre des cas de défaut est donc élargi.

Credit Support Providers. Les Credit Support Providers sont des tiers procurant des garanties aux obligations des contreparties. Les Credit Support Providers figurent dans de nombreuses clauses de l’ISDA 1992 et sont également détaillés dans les parties (4)(f) et (g) de la Schedule. Les cas de défaut cités ci-dessus s’agissant des Specified Entities sont également testés en référence aux Credit Support Providers. Des cas de défauts additionnels sont de plus testés en référence aux Credit Support Providers. Les cas de défaut et évènements résolutoires sont étudiés plus bas.

Inconsistency. La hiérarchie de la documentation ISDA est formalisée à l’article (1)(b), stipulant que les éléments figurant dans la Schedule prévalent sur les éléments du pré-imprimé, que les éléments d’une Confirmation prévalent sur le pré-imprimé et la Schedule s’agissant de la Transaction documentée par la Confirmation en question. Est ici fait application du principe contractuel selon lequel les stipulations spéciales dérogent aux stipulations générales. Il est remarquable que lorsque les parties élisent des Definitions, elles prennent le soin de régler le sort des contradictions éventuelles entre lesdites Definitions et la Schedule.

Article 2: Relations Quotidiennes

L’article 2 est consacré au relations quotidiennes entre les contreparties.

General Conditions. Il est prévu au (2)(a) que les parties doivent effectuer les paiements ou livraisons ainsi que spécifié dans chaque confirmation, cette obligation étant sujette aux conditions suspensives suivantes:

(1) aucun Event of Default ou Potential Event of Default n’est survenu et ne se poursuit relativement à l’autre partie ;

(2) aucune Early Termination Date relativement à la Transaction n’est survenue ou n’a effectivement été désignée ; et

(3) les autres conditions suspensives contenues dans l’ISDA 1992 ont été satisfaites.

Netting. L’article (2)(c) est dédié à la compensation des paiements et règlements relativement aux montants échus le même jour pour une même Transaction. Cette modalité de paiement ou règlement par compensation doit être distinguée du “Close-Out-Netting” visé à l’article (6)(e), qui intervient en cas d’évènement résolutoire, et a une portée plus étendue. Il est remarquable que les parties peuvent choisir de compenser entre plusieurs Transactions: le montant net compensé sera alors déterminé sur la base de l’ensemble des montants payables le même jour dans la même devise au titre de l’ensemble des Transactions passées entre elles. Ce “cross Transaction netting” doit être activé en mentionnant dans la partie 4 de la Schedule que la Section (2)(c)(ii) est inapplicable.

Deduction or Withholding for Tax

L’article (2)(d) se rapporte au traitement fiscal des paiements effectués au titre des opérations sur dérivés. Il est d’une importance centrale: si des prélèvements fiscaux non anticipés doivent être déduits des paiements versés ou reçus, l’équilibre financier fondant la Transaction que les parties ont conclu est compromis. Il est donc important de déterminer qui devra supporter des coûts additionnels.  L’article (2)(d) de l’ISDA 1992 contient une clause s’attachant à l’imputation de ces coûts. De plus, la Partie 2 de la Schedule contient des “tax representations” données par les parties en leur qualité de payeur et de payé, qui peuvent être activées. Voici une description succincte du contenu de l’article (2)(d):

(1) Les paiements sont effectués sans être affectés de déductions ou retenues fiscales, à moins qu’une législation ne l’impose. Si l’impôt prélevé correspond à la définition de “Indemnifiable Tax” (“IT”), le payeur doit majorer son paiement afin que le payé ne soit pas affecté par l’impôt. Il existe quelques exceptions à ce principe.

(2) Le principe sous-tendant la définition d’Indemnifiable Tax est qu’un tel impôt est autre qu’un impôt dû en raison d’un rapport entre (a) la juridiction de l’autorité levant l’impôt et (b) le payé, mais excluant un rapport consistant seulement en une signature ou une exécution.

En résumé, lorsque le fait générateur de l’impôt n’est pas attribuable au payé (“IT“), le payeur ne devra pas diminuer le montant qu’il verse au payé du montant qu’il pourrait être amené à payer au titre de l’IT.

Default Interest; Other Amounts

Si une partie est défaillante quant à l’exécution d’une obligation de paiement avant la résiliation de l’ensemble des trades désignés par l’ISDA 1992 en vertu de la survenance d’un Event of Default ou d’un Termination Event, la partie défaillante doit payer des intérêts sur l’impayé à un taux correspondant au coût de financement de cet impayé, majoré de 1%, et calculé sur une base composée (cf. définition de “Default Rate” à l’Article (14) de l’ISDA 1992).

L’ISDA 2002 a supprimé la clause (2)(e), et adapté les stipulations en question, qui deviennent plus sophistiquées. L’ISDA 2002 en sa Section (9)(h) contient des stipulations se rapportant au calcul des intérêts applicables en cas de défaut de paiement, défaut de livraison et de paiement ou livraison retardé(e). Chacune de ces situations est traitée séparément et les stipulations sont telles qu’un seul régime d’intérêts s’applique à une situation donnée.

Article 3: Representations

L’article (3) de l’ISDA 1992 contient des garanties conférées réciproquement par les parties. En terminologie contractuelles anglo-saxonne, ces garanties sont des Representations, c’est à dire des constatations et allégations ayant pour objectif d’inciter une personne à agir, et plus particulièrement à contracter (théoriquement, les representations, ne portent que sur le passé et le présent, et doivent en cela être distinguées des warranties, qui portent sur le présent et l’avenir).  Si les Representations s’avèrent substantiellement incorrectes ou trompeuses lorsqu’elles sont données, réitérées ou sont réputées avoir été réitérées au titre de l’ISDA 1992, il y a alors lieu de constater un Event of Default.

L’article (3)(a) expose les Representations de base relatives à l’organisation, à la capacité et à la personnalité juridique des parties, au fait qu’elles ne contreviennent à aucune loi les régissant, et confirmant que les consentements nécessaires ont été obtenus, ceci afin de s’assurer que les obligations contractées ont force obligatoire. Ces Representations sont importantes puisque dans certaines circonstances, en particulier sur le marché interbancaire, lorsque les institutions financières concluent des dérivés entre elles, elles ne vérifient pas systématiquement les statuts de leurs contreparties et ne cherchent pas toujours à obtenir les résolutions du conseil d’administration approuvant le Master ISDA. Par conséquent les parties se reposeront d’autant plus sur ces Representations de base et sur la possibilité de résilier l’ensemble des Transactions en cours si celles-là s’avèrent fallacieuses – ce qui peut d’ailleurs s’avérer d’un intérêt pratique limitée.

L’article (3)(d) mérite une attention toute particulière, puisqu’il est lié à la Partie 3 de la Schedule. Si une information est désignée en Partie 3 de la Schedule comme étant sujette à l’article (3)(d), cette information est réputée être substantiellement vraie, exacte et complète, ces caractères étant appréciés à la date de ladite information. Il est recommandable de soumettre au régime des garanties prévu en (3)(d) les documents constitutifs et les documents sociaux autorisant la signature de l’ISDA, ainsi que les états financiers. En revanche, il est inapproprié d’y inclure une consultation juridique, qui sera listée à l’article (4), avec l’ensemble des autres documents devant être remis par les parties au cours de la vie de l’ISDA. L’article (4), dénommé “Agreements” c’est à dire “accords” vaut donc pour l’avenir.

Hereunder is an excerpt of the article I wrote with Daniel Boone and David Maria of the Luxembourg law firm Wildgen Partners. Here is a link to the entire article published in Hong Kong Lawyer, a LexisNexis publication. We organised a conference in Hong Kong (in May 2009, with Mr. Michel Bots of Equity Trust) and Luxembourg (in July 2009, with Mr. Siegfried Verstappen of Invest Hong Kong) to advertise the opportunities offered by the Treaty.

Luxembourg-Hong Kong Double Tax Treaty: The Best of Both Worlds

Gerald Pasquier, Daniel Boone and David Maria examine the potential benefits for business connections between Asia and Europe (May 2009).

On 20 January 2009, the bilateral treaty for the avoidance of double taxation between the Hong Kong SAR and the Grand-Duchy of Luxembourg (the Treaty) entered into force in both jurisdictions. The Treaty has retroactive effect, and is applicable as from 1 January 2008 with respect to Luxembourg and as from 1 April 2008 with respect to Hong Kong.

To date, only a limited number of jurisdictions have signed a comprehensive double taxation agreement with Hong Kong: namely Belgium, Thailand, the PRC, Vietnam (not yet ratified) and now Luxembourg. The Luxembourg-PRC treaty of 1994 does not apply to Hong Kong.

As discussions at the recent G20 summit reminded the business community, Hong Kong lacks a competitive tax treaty network as compared to, for example, Singapore. The Treaty will strongly contribute to improving Hong Kong’s international tax strategy. As well as linking two major financial hubs and business-friendly jurisdictions at the crossroads of the Western and Eastern worlds, it will also give Hong Kong investors unique access to Luxembourg’s extensive tax treaty network: 54 jurisdictions have entered into comprehensive double tax treaties with Luxembourg.

This network is complemented by the Grand Duchy’s flexible corporate and tax environment, recently enhanced by the law dated 16 December 2008 (discussed below). It is worth mentioning in this respect that Luxembourg features one of the lowest VAT rates (15%) in Europe. As international tax rules tend to subject e-commerce transactions to the laws of the residence of the seller, a number of e-commerce companies such as Amazon and Skype have their head offices in Luxembourg.

The Treaty is attractive for several reasons: (i) because of its tailored provisions; (ii) because it allows freer cash flows between the two jurisdictions; and (iii) because it creates outstanding opportunities for investors willing to invest in and out of Asia through two complementary hubs.

The Treaty’s Tailored Provisions

Generally, there are three main aims pursued by countries entering into a comprehensive bilateral taxation agreement: (i) the avoidance of double taxation; (ii) the provision of advantageous taxation; and (iii) the promotion of fiscal cooperation between the treaty parties… (link to the entire article)

After almost one year of absence, I resume posting on this blog. Thank you all for your comments that encouraged me.

At first, I’m going to reference my “official” works and publications achieved since September 2008, which contributed greatly to my absence from the web. I will then complete my introduction to the ISDA, which should be done by late September (in French only for the moment, an English translation is scheduled !).

You will find below a summary of my thesis written under the accurate supervision of Michel Storck, Professor at the University of Strasbourg. If you want to get a full version (in French only !), please contact me by e-mail. This thesis has been blessed with a first class honours, and reached the final round in a contest organised by the Paris-based “Centre des Professions Financières“. I would like to thank all the friends and colleagues who have contributed to my inspiration.

I finished drafting this thesis a couple of days after the collapse of Lehman Brothers, and the conclusions that I drew tend to be confirmed by the recent trends in the asset management industry: investors favor investment schemes such as ETFs, that provide a better protection against liquidity risk.

Here we go:

LIQUIDITY AND HEDGE FUNDS – SUMMARY

Financial markets, specifically markets affected by crises, maintain close ties with the problems of liquidity. However, the concept of liquidity seems inadequately addressed by the techniques of valuation of financial instruments, it appears moreover insufficiently considered by financial law.

Liquidity crises involving hedge funds at significant levels, a clarification of the interactions between them and the concept of liquidity should focus on ties between the markets’ liquidity and hedge fund activities, and on the implications of the illiquidity of the hedge funds themselves, that is to say their “inherent illiquidity”.

(I) Hedge Funds include in their portfolios complex financial instruments that are characterized by a remarkable illiquidity.

The election of such assets is justified by the singular objectives Hedge Funds aim at, while concealing risks and uncertainties. Strategically, a Hedge Fund may choose to invest in illiquid assets to generate higher returns. The valuation of these assets, however,  explain the difficult issues facing hedge funds in case of the occurrence of extreme liquidity crisis. Hedge Funds can anticipate and overcome these problems, but they can also fail to do so, creating thereby a risk of systemic crisis, which apprehension by the law must be assessed, especially within the framework of the ISDA documentation.

In counterpoint, some hedge funds-specific economic activities and management techniques tend to alleviate or solve the problems posed by illiquidity.

The activities of hedge funds have indeed virtuous effects on the macroeconomic liquidity of markets. Moreover, their ability to innovate in the methods of capital management allowed them to develop original methods to compensate for the irrationality of  illiquid markets in times of crisis (e.g. Side Pockets).

(II) Hedge Funds are an asset class characterised by extreme illiquidity: the inherent illiquidity of Hedge Funds is primarily reflected by the reduced liquidity they provide to their investors.

The particular configurations of liquidity management techniques used by hedge funds, including those required by law, make them vulnerable to liquidity risk. The hedge funds managers have therefore developed ad hoc methods of liquidity management, techniques aiming at dealing with day-to-day liquidity issues being juxtaposed to methods responding to emergency situations. Such techniques have given rise to practices whose legitimacy is questionable.

The particular sensitivity to liquidity risk is more visible in funds of hedge funds: their portfolios tend to consist of investments in hedge funds whose intrinsic illiquidity is consistent. Funds of hedge funds are thus forced to implement highly efficient liquidity management policies, the inherent illiquidity of the underlying hedge funds impacting the structuring of derivatives used by the top fund and the use of underlying funds’ units to secure transactions undertaken by the top fund.

To conclude, liquidity is identified as a boundary of modern finance. It appears that a better taking into account by the law of liquidity issues would allow hedge funds to fully play their economic role.