Presenting a live 90-minute webinar with interactive Q&A. Today s faculty features:

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1 Presenting a live 90-minute webinar with interactive Q&A Swaps in Loan Transactions: Coordinating Loan Document Terms With the ISDA Master Agreement Documenting Covenants, Security, Voting and Control, Reporting, and Regulatory Issues WEDNESDAY, JANUARY 24, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Cheryl I. Aaron, Senior Counsel, Michael Best & Friedrich, Washington, D.C. Alexander P. Fraser, Partner, Michael Best & Friedrich, Milwaukee The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 1.

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5 Swap Documentation in Loan Transactions: Coordinating Loan Document Terms with the ISDA Master Agreement Alexander P. Fraser Cheryl I. Aaron January 24, 2018

6 Agenda 1. Overview Using Derivatives to Obtain a Fixed Rate Loan 2. ISDA Document and Regulatory Overview 3. Coordinating Loan Documents with the ISDA Master Agreement 4. LIBOR Phaseout - Update michaelbest.com 6

7 Using Swaps to Hedge Against Interest Rate Risk Swaps are a type of derivative instrument that can be used to hedge against exposure to fluctuations in interest rates An agreement between two parties (the counterparties) where future interest payments are exchanged based on a specific principal (notional) amount Typically, a company will borrow money from a bank and the interest rate on the loan is based on a benchmark such as LIBOR, plus a spread Because these types of loans have a floating interest rate, the borrower will also enter into a swap agreement in order to transform the loan to a fixed rate loan by hedging the interest rate risk By entering into an interest rate swap, the borrower can eliminate or reduce its exposure to fluctuations in the interest rate michaelbest.com 7

8 Example: On January 1, 2018, the Company borrows $200 million from the Bank with interest rate payments of One Month USD-LIBOR plus 3.50% spread The loan will mature in 5 years when all principal is repaid, and interest payments are due monthly until maturity On the same day that it executes the loan agreement, the Company enters into an interest rate swap, which also matures in 5 years Fixed rate: the Company Pays 1.001% to the Bank (effective fixed rate is plus 3.50 spread) Floating rate: the Company receives One Month USD-LIBOR from the Bank At inception, the net present value of the anticipated payments from the Floating Payer and the Fixed Payer is equal to zero However, changes in variable interest rates and counterparty credit risk can result in an increase or decrease in the value of the swap over time. 8

9 Terms of the Interest Rate Swap Fixed Payer: Customer Floating payer: Bank Notional Amount: $100 million Fixed Interest Rate: 1.001% Floating Interest Rate: 1M USD-LIBOR Day-Count Convention Actual/360 Original Settlement Date: 01/01/2018 First Exchange: 03/31/2018 Maturity Date: 12/31/2023 9

10 Counterparty Risk The fair value of the swap should also reflect the counterparty credit risk, which is the exposure to loss as a result of a counterparty default Prior to the 2008 financial crisis, swaps were valued without incorporating this type of risk under the assumption that large counterparties would never default Derivatives can have one-way counterparty credit risk (e.g., options, caps) or bilateral counterparty credit risk (e.g., swaps, forwards) Bilateral derivatives are inherently more complex because both counterparties have exposure to the other Contract terms that allow for netting and offsetting positions in case of default may mitigate some counterparty credit risk Derivatives counterparties can also use an ISDA Credit Support Annex (CSA), which allows one or both parties to post collateral to cover all or a portion of the net market value of the positions to limit the other party s exposure And tying collateral under the loan documents to the swap also can mitigate this exposure. 10

11 ISDA Document Architecture ISDA Master Agreement Derivatives are governed by the ISDA Master Agreement (a separate legal document from the related loan documents) Contains the basic legal terms applicable to all derivatives between bank and customer Universally adopted, never changed or negotiated Intended to be even-handed; representations, covenants, termination events, and defaults apply to both parties equally Schedule to Master Agreement Allows bank to customize swap to its credit, collateral, and legal requirements Adds additional events of default (termination events) Adds cross-defaults to different loan agreements and to subsidiaries and affiliates Adds cross-collateralization, guarantors, etc.; note that for real property, addressing security in the schedule is not sufficient to protect the bank Unlike the Master Agreement, the schedule is often negotiated Confirmation Contains the economic terms of transaction: Fixed Rate and Floating Rate Payors, payment dates, notional amount, etc. Note that confirmation is required for initial trade, as well as any amendments or voluntary termination prior to maturity In the event of a conflict between the terms of the confirmation, schedule, and ISDA Master, conflicts are resolved in the reverse priority listed on this page 11

12 Regulatory Overview Dodd-Frank imposes new regulations on Swaps, a previously unregulated area Registered Swap Dealers are subject to business conduct rules, most of which do not apply to non-swap Dealers Counterparty Verification (ECP and non-special Entity status) Risk Disclosures (of the material risks and characteristics of swaps) Notification of right to clear, daily mark, etc. Special requirements for dealing with Special Entities Some rules apply to everyone Only Eligible Contract Participants can enter into swaps Recordkeeping and reporting requirements typically dealer complies Clearing; however small banks and commercial end-users (i.e. bank customers) usually qualify for an exception. 12

13 Regulatory Overview Eligible Contract Participants Only Eligible Contract Participants (ECPs) may enter into swaps. ECP s include: Entities with $10 million in total assets, or Entities with a net worth of at least $1 million which are hedging Individuals with amounts invested on a discretionary basis that exceed $10 million, or $5 Million if hedging If counterparty does not satisfy the requirements above, it may qualify: Under another section of the ECP definition With a guaranty from an entity with more than $10 million in total assets If 100% of the owners of an entity are ECP Under CFTC No Action Letter as an indirect proprietorship or an anticipatory ECP 13

14 Regulatory Overview End-User Exception A counterparty may elect the End-User Exception if it (i) is not a financial entity (including banks under $10B in total assets) (ii) is hedging commercial risk, and (iii) notifies the CFTC how it will meet its financial obligations Generally, publicly traded companies must obtain board approval to elect end-user exception Dealer typically notifies CFTC on behalf of customer A dealer will confirm ECP status, the End-User Exception and other Regulatory requirements either through a bilateral agreement or through the Dodd-Frank Protocols promulgated by ISDA 14

15 Overview of Customer Documentation Non-Cleared Swaps Customer Documentation now includes both Dodd-Frank Compliance Documents and Trading Documents Compliance Documents one or more agreements/documents which address: Transaction Documents include: LEI/GMEI ISDA Master Agreement and Schedule End-User Exception Confirmation ECP Status Credit Support Annex (if applicable) Confidentiality, Risk Disclosures, etc. Review of Loan / Collateral Documents 15

16 Coordinating Loan Documents with the ISDA Master Agreement Key Loan Documents to Coordinate: Promissory Note Loan Agreement Security/Pledge Agreements Mortgage/Deed of Trust Guaranties Collateral Assignment of Swap Authorizing Resolutions 16

17 Loan Documents Coordinating Financial Terms Confirm Floating Rate on loan and swap is based on the same index (i.e., one month LIBOR which resets two business days before the 1 st day of each calendar month) Confirm swap payment dates and interest payment dates are the same Confirm treatment of negative interest rates/zero rate floor is the same in loan and swap documents Confirm notional and principal amounts match, and amortization is the same Obligation to make loan and swap payments should be independent of each other Confirm prepayment language does not preclude or conflict with early termination payments on swap Generally, swap should mature before or contemporaneously with loan maturity to avoid credit and documentation risk of extending beyond loan maturity 17

18 Loan Agreement Terms Covenants Negative Covenants permit or prohibit swaps as appropriate in the following covenants: Indebtedness Liens Loans Investments Hedging this may restrict hedging generally or limit changes to existing swaps Affirmative Covenants A specific hedging requirement is permitted, but tying to a specific lender may violate antitying rules 18

19 Loan Agreement Terms Default, Payoff and Termination Events of Default Bankruptcy Cross-default to ISDA Documents Failure to maintain hedge Other typical loan defaults Acceleration make sure acceleration language does not include swap, including in the event of automatic loan acceleration resulting from bankruptcy Payoff and Default Letters: Consider swaps when drafting, and avoid all obligations language which might inadvertently include the swap Termination/Prepayment Mechanics: In the event of a default, the ISDA termination mechanics are very specific and easy to get wrong; experienced swap counsel in this instance is an absolute must 19

20 Loan Agreement Terms Miscellaneous Definitions: Hedging/swap/rate management definitions Obligations and Loan Documents Consider whether hedging should be included and impact on cross-default, acceleration, and payoff Conditions Precedent Ok to require swap and general swap terms, but do not tie to lender (i.e., counterparty reasonably acceptable to Lender ) Waterfall/application of proceeds if there is a waterfall for application of proceeds upon a default, consider where swap obligations (i.e., early termination payments) should fall. Usually pari passu with loan principal Notice Requirements On agented facilities, a notice requirement to agent is common. The specific notice requirements vary, so it is important to closely review and tailor the notice as required by the loan agreement Voting Rights Consider whether a swap provider who is not a lender has voting rights and how, if at all, swap impact voting percentages. Interests of swap providers and lenders may not always be aligned 20

21 Loan Agreement Terms Security Most lenders expect that the loan collateral will also secure the swap. This requires a thoughtful analysis of collateral documents. A failure to do this can result in incomplete rights in a default/termination scenario. For personal property, source of security interest may be in a loan and security agreement, stand-alone security agreement, pledge agreement, collateral assignment or similar document, or in a granting clause contained in the ISDA Schedule itself. Generally, a security interest in personal property is perfected by filing a UCC financing statement, but in certain cases (i.e., securities) it may be perfected by possession or control. This is important to understand and coordinate with loan counsel For real estate collateral, swap obligations must be specifically described in the recorded mortgage or deed of trust: Drafting trap Use all obligations and liabilities in connection with swap rather than amounts due and payable, since the latter does not recognize the indeterminate and contingent nature of early termination payments. Swap endorsements to loan policy Consider coverage and cost. Special care must be taken if the lienholder and swap provider are not the same (i.e., bank provides the loan but a bank affiliate provides the swap) State law must be reviewed where the real estate is located, as many states have special requirements, such as (i) mortgage registration tax, or (ii) requirement that mortgage/dot state maximum secured amount. 21

22 Swap Guaranties Post-Dodd-Frank, swap guaranties have become more complicated A guaranty of a swap is a Swap under Dodd-Frank, so only an Eligible Contract Participant may guaranty a swap; this applies to any new and amended swaps Bank must confirm ECP status; if a loan guarantor does not qualify, often the swap must be re-reviewed from a credit standpoint Swap guaranties must exclude swaps which are entered into at a time when the guarantor is not an ECP ISDA published exclusionary terms which can be incorporated into loan documents and guaranties to exclude swaps for non-eligible guarantors When entering into a new or amended swap, banks must consider old loan guaranties: formerly well-drafted guaranties covering all obligations are now a potential trap 22

23 The End of LIBOR July 2017: FCA CEO announces that as of the end of 2021, panel banks will no longer be compelled to provide LIBOR quotations Markets underlying LIBOR are no longer sufficiently active with little prospect of becoming more active any time soon E.g., one currency-tenor combination, published daily, relies on pricing input from 12 panel banks that only executed 15 qualifying transactions in all of 2016 In recent years, the FCA has had to coax panel banks to continue LIBOR submissions Panel banks are uncomfortable providing pricing submissions based solely on judgment, where there is little actual borrowing activity However, these banks have agreed to continue providing quotations through the end of 2021 If an active market does not exist, how can even the best run benchmark measure it? michaelbest.com 23

24 LIBOR in Derivatives and Credit Facilities LIBOR is used as a reference rate in $160 trillion (notional) of derivatives contracts, including the vast majority of interest rate and cross-currency swaps As written, the LIBOR replacement language in the ISDA Master Agreement is insufficient The 2006 ISDA Definitions create a fallback where LIBOR is unavailable, in which case the Calculation Agent can collect alternate rates from other major banks and use the arithmetic mean to determine the replacement Corporate and consumer loans, mortgages, floating rate notes and securitizations all have material exposure to LIBOR as well and, as with derivatives, the LIBOR fallback language in these contracts is almost always insufficient 24

25 LIBOR in Derivatives what to do now? First Step: portfolio review Examine your company s derivatives portfolio (ideally as part of a review of all financial contracts), and determine which contracts reference LIBOR Second Step: divide derivatives into 3 categories 1. Already-executed transactions that expire by the end of 2021 No need to act counterparties can rely on LIBOR 2. Already-executed transactions that expire after 2021 Amend, incorporate appropriate fallback terms, allocate associated risks/losses, and align with related loan fallback terms (as applicable) 3. Transactions that have not yet been executed Incorporate appropriate fallback terms, align with related loan fallback terms (as applicable); potentially choose alternative reference rate michaelbest.com 25

26 LIBOR Replacement Terms LIBOR fallback language in derivatives contracts, credit facilities and other financial contracts should: Select a specific replacement rate OR (i) clearly delineate which party or parties will choose the replacement rate, and (ii) set any other parameters for the rate Account for all scenarios in which LIBOR may go away (e.g., become unavailable, no longer be published, be unlawful to rely upon see ISDA triggers) Set a date on which the replacement rate will go into effect under the contract Allocate any costs / risks associated with relying on the replacement rate in lieu of LIBOR Create termination rights and payment obligations (if no replacement rate) michaelbest.com 26

27 The ISDA Solution ISDA is in the process of creating a universal LIBOR transition solution for derivatives and other financial contracts At present, ISDA is: 1. Developing a roadmap for the transition (was expected December 2017) 2. Drafting a report that will include the results of a market survey on the use of LIBOR, will identify potential transition issues for existing and new contracts, and will make recommendations for possible solutions (expected March 2018) Going forward, ISDA expects to: 1. Develop strategies related to term structures for the LIBOR replacement rate and the credit spread that will arise 2. Amend the 2006 ISDA Definitions to incorporate the fallback terms 3. Create a Protocol to incorporate the fallbacks into already-executed transactions michaelbest.com 27

28 Conclusion 1. Conclusion 2. Questions 3. Thank You! 28

29 Who We Are Alexander P. Fraser Partner Cheryl I. Aaron Senior Counsel T T