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, Required Consents, Voting and Control, Reporting, and Regulatory Issues THURSDAY, JANUARY 26, 2017 1pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Alexander P. Fraser, Partner, Michael Best & Friedrich, Milwaukee Harris I. Antoniades, CFA, FRM, Managing Director, Stout Risius Ross, Los Angeles Felix Shipkevich, Principal, Shipkevich, New York The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.
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Swap Documentation in Loan Transactions: Coordinating Loan Document Terms with the ISDA Master Agreement Alexander P. Fraser, Esq., Michael Best & Friedrich LLP Felix Shipkevich, Esq., Shipkevich PLLC Harris I. Antoniades, CFA, FRM, Stout Risius Ross January 26, 2017
Agenda 1. Financial Overview Use of Derivatives to Obtain Fixed Rate Loan 2. ISDA Document and Regulatory Overview 3. Coordinating Loan Documents with the ISDA Master Agreement 6
Use of Interest Rate Swaps (IRS) to Hedge Interest Rate Risk Interest Rate Swaps are derivatives 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, companies enter into credit agreements with banks based on a benchmark interest rate such as LIBOR or prime, plus a spread for a total interest rate Companies usually get loans with floating interest payments and then enter into swap agreements as the Fixed Payer in order to transform the loan to a fixed rate loan by hedging the interest rate risk (cash flow hedge) Eliminates or reduces the exposure that arises from changes in interest rate payments due to changes in the benchmark interest rate on a floating rate debt instrument 7
Example: On July 1, 2016, the Company entered into $200 million Loan (hedged item) with interest rate payments of 3M USD-LIBOR (with 1% floor) plus 3.50% spread The loan matures in 5 years when all principal will be repaid, and provides for quarterly interest payments due on March 31, June 30, September 30 and December 31 until maturity On the same day, July 1, 2016, the Company entered into an interest rate swap (hedging instrument), which matures in 5 years as well Fixed rate: Company Pays 3M USD-LIBOR - Floating rate: Company receives 1.001% At inception, the terms of the swap agreement (outlined in a term sheet) are typically established such that the net present value of the anticipated payments from the Floating Payer and the Fixed Payer is equal to zero I.e., the swap is entered into at-market (i.e., at a fair value of zero) and as a result there is no exchange of a premium at the inception date However, changes in interest rates and counterparty credit risk can result in an advantageous or disadvantageous financial position for counterparties in subsequent reporting periods 8
Terms of the Interest Rate Swap Fixed Payer: Company A Floating payer: Bank B Notional Amount: $100 million Fixed Interest Rate: 1.001% Floating Interest Rate: 3M USD-LIBOR Day-Count Convention Actual/360 Original Settlement Date: 07/01/2016 First Exchange: 09/30/2016 Maturity Date: 06/30/2021 9
Determination of Cash-Flows To determine the net pay position of the counterparties, it is first necessary to determine the future payments for the Fixed Payer as well as for the Floating Payer. Fixed Payments: The projected fixed payments are based on the fixed interest rate established upon consummation of the initial swap contract. This interest rate is typically set such that the net present value of the anticipated payments from the Floating Payer and Fixed Payer is zero at the contract s initiation. Floating Payments: The projected variable payments are based on the estimated LIBOR forward (i.e., future) yield curve as of the measurement date, which is derived by bootstrapping the LIBOR spot yield curve. 10
Determination of Present Value Cash Flow Analysis Date LIBOR Reset Rate Floating Interest Rate Tenor Fixed Payment Floating Payment Net Cash Flows Discount Factor PV Cash Flows 1 9/30/2016 0.4724% 1.0000% 0.2556 $ -255,226 $ 252,778 $ -2,449 0.9934 $ -2,432 2 12/31/2016 0.5023% 1.0000% 0.5111-258,031 255,556-2,475 0.9908-2,453 3 3/31/2017 0.5239% 1.0000% 0.7611-252,422 250,000-2,422 0.9892-2,395 4 6/30/2017 0.5576% 1.0000% 1.0139-255,226 252,778-2,449 0.9877-2,419 5 9/30/2017 0.5993% 1.0000% 1.2694-258,031 255,556-2,475 0.9857-2,440 6 12/31/2017 0.6329% 1.0000% 1.5250-258,031 255,556-2,475 0.9844-2,437 7 3/31/2018 0.6531% 1.0000% 1.7750-252,422 250,000-2,422 0.9847-2,385 8 6/30/2018 0.6495% 1.0000% 2.0278-255,226 252,778-2,449 0.9852-2,412 9 9/30/2018 0.6794% 1.0000% 2.2833-258,031 255,556-2,475 0.9842-2,436 10 12/31/2018 0.7010% 1.0000% 2.5389-258,031 255,556-2,475 0.9818-2,430 11 3/31/2019 0.7347% 1.0000% 2.7889-252,422 250,000-2,422 0.9785-2,370 12 6/30/2019 0.7764% 1.0000% 3.0417-255,226 252,778-2,449 0.9749-2,387 13 9/30/2019 0.8100% 1.0000% 3.2972-258,031 255,556-2,475 0.9718-2,406 14 12/31/2019 0.8089% 1.0000% 3.5528-258,031 255,556-2,475 0.9689-2,399 15 3/31/2020 0.8931% 1.0000% 3.8056-255,226 252,778-2,449 0.9664-2,366 16 6/30/2020 0.9294% 1.0000% 4.0583-255,226 252,778-2,449 0.9637-2,360 17 9/30/2020 0.9650% 1.0000% 4.3139-258,031 255,556-2,475 0.9608-2,378 18 12/31/2020 1.0048% 1.0048% 4.5694-258,031 256,777-1,254 0.9574-1,201 19 3/31/2021 1.0769% 1.0769% 4.8194-252,422 269,235 16,813 0.9539 16,038 20 6/30/2021 1.1182% 1.1182% 5.0722-255,226 282,659 27,432 0.9502 26,067 21 Risk-Free Swap Value $ 0 Source: Bloomberg, L.P. 11
Counterparty Risk The fair value of the swap should also reflect the Counterparty Credit Risk (CCR), which is the exposure to loss as a result of a counterparty failing to meets its contractual obligations due to default Prior to the financial crisis OTC derivatives were valued without incorporating CCR due to the assumption that large derivative counterparties will never default Derivatives can be classified as unilateral, which have only one sided CCR (options) and bilateral derivatives (swaps, forwards, etc.) Bilateral derivatives are more complex, with two way counterparty risk, since both the company and the counterparty are exposed to each other CCR may be mitigated through netting and offsetting positions in case of default through ISDA master agreements There may also be an ISDA Credit Support Annex (CSA) that provides for posting of collateral to cover all or a portion of the net market value of the positions to limit the exposure 12
Counterparty Risk: Credit Value Adjustment (CVA) Valuation Methodologies They are not standardized and vary amongst market participants, ranging from very simple to very complex methodologies, driven by the sophistication and resources of the company and also by the purpose of the analysis The simplest approach is to calculate the risk free value of the derivative and then repeat the calculation by adjusting the discount rates by the credit spread of the counterparty that is in the liability position. There is a few variations of this, either looking at each cash flow leg or looking at the present value of the remaining cumulative position at the time of each payment More sophisticated approaches involve modeling and simulating interest rate volatilities and revalue the derivative under thousands of simulations. The resulting simulations are then aggregated to generate an expected exposure profile for each counterparty Collaterized positions based on the ISDA CSA are also incorporating in the analysis if applicable Using hedge accounting a company is hedging for a particular risk, i.e., interest rate risk, so one could perform the hedge effectiveness testing ignoring CVA, but will need to incorporate it when fair value the derivatives for mark-to-market purposes In most cases, CVA reduces the value of the asset or liability, but not always 13
Fair Value of Swap Including Counterparty Risk Cash Flow Analysis Value Date Tenor Risk-Free Net Cash Flows [a] Discount Factor Risk-Free PV Cash Flows Aggregate Future Cash Flows [b] Asset or Liability [c] Risk- Adjusted Rate [d] Risk- Adjusted Discount Factor Fair Value Adjusted for Counterparty Risk 7 3/31/2017 0.2500 $ -2,366 0.9892 $ -2,340 $ 2,963,210 Asset 2.0840% 0.9949-2,354 8 6/30/2017 0.5028 2,100 0.9877 $ 2,074 $ 2,965,551 Asset 2.2236% 0.9890 2,077 9 9/30/2017 0.7583 15,989 0.9857 15,761 2,963,477 Asset 2.1008% 0.9844 15,739 10 12/31/2017 1.0139 46,058 0.9844 45,339 2,947,716 Asset 1.9781% 0.9803 45,152 11 3/31/2018 1.2639 71,019 0.9847 69,935 2,902,377 Asset 1.8581% 0.9770 69,386 12 6/30/2018 1.5167 102,592 0.9852 101,072 2,832,443 Asset 1.7522% 0.9740 99,924 13 9/30/2018 1.7722 126,382 0.9842 124,389 2,731,371 Asset 1.7727% 0.9693 122,507 14 12/31/2018 2.0278 151,004 0.9818 148,262 2,606,981 Asset 1.7931% 0.9646 145,659 15 3/31/2019 2.2778 173,152 0.9785 169,428 2,458,719 Asset 1.8131% 0.9599 166,208 16 6/30/2019 2.5306 200,571 0.9749 195,542 2,289,291 Asset 1.8333% 0.9551 191,559 17 9/30/2019 2.7861 227,229 0.9718 220,810 2,093,750 Asset 1.8538% 0.9501 215,893 18 12/31/2019 3.0417 251,596 0.9689 243,784 1,872,940 Asset 1.8742% 0.9451 237,780 19 3/31/2020 3.2944 261,172 0.9664 252,383 1,629,156 Asset 1.8944% 0.9400 245,513 20 6/30/2020 3.5472 269,824 0.9637 260,030 1,376,773 Asset 1.9153% 0.9349 252,264 21 9/30/2020 3.8028 281,537 0.9608 270,491 1,116,743 Asset 1.9383% 0.9296 261,716 22 12/31/2020 4.0583 290,285 0.9574 277,932 846,252 Asset 1.9613% 0.9242 268,282 23 3/31/2021 4.3083 292,532 0.9539 279,035 568,319 Asset 1.9838% 0.9189 268,793 24 6/30/2021 4.5611 304,435 0.9502 289,284 289,284 Asset 2.0058% 0.9134 278,071 26 Risk-Free Swap Value $ 2,963,210 $ 2,884,169 29 Counterparty Risk Adjustment [e] $ (79,042) [a] The expected net payment for both the interest rate and cross currency swap with Counterparty. [b] The net present value of all future payments as of that payment date. [c] The position of Tower International vs. the counterparty as of that payment date for both instruments. [d] The risk adjusted rate is based on the credit spread of the party who is in the liability position. [e] The counterparty risk adjustment is the difference of the Fair Value of the position minus the risk free value of the position vs. a counterparty. 14
Derivatives Accounting Treatment Mismatch When a company is using derivatives to hedge against market risk exposures, that are not measured at fair value through the P&L, an accounting treatment mismatch can occur This lead to volatility in the income statement, due to the different basis of accounting treatment between the hedged item and the hedging instrument (a derivative) Hedge accounting in dealing with this accounting mismatch. A company can reduce this income statement volatility by adjusting the basis of accounting for the hedging item (in a Cash flow hedge) or hedged item (in a Fair Value hedge) A company can apply hedge accounting if they show that the hedge relationship has been and will be highly effective through the term of the relationship Highly effective does not mean 100% match, it means the changes in fair value or cash flow of the hedged item and the derivative offset each other for the most part. Certain amount of ineffectiveness is permissible 15
Hedge Documentation Example The Company designates the swap as the hedging instrument to hedge of the variability of the interest rate payments of the floating-rate loan due to changes in the designated LIBOR benchmark interest rate. The Company designates the changes in the 3-month USD LIBOR swap rate in arrears as the benchmark interest rate in hedging interest rate risk Hedge Relationship: The hedging relationship is designated on July 1, 2016. The hedge of the interest rate exposure in a recognized fixed-rate liability is considered a cash flow hedge per ASC 815-20-25 Risk Management Objective: Offset the variability of the interest rate payments of the Company s float-rate loan attributable to changes in the designated benchmark LIBOR interest rate. In essence, the objective is to economically convert the Company s float-rate loan to fixed-rate loan Designated Risk Being Hedged: Variability of the quarterly interest rate payments of the Company s float-rate loan, due to changes in the 3-month LIBOR swap rate ( hedged risk ) Hedging Instrument: The interest rate swaps is designated as the hedging instrument Hedged Item: The Company is hedging 50% of the $200 million floating-rate notes ($100 million in total). The quarterly payments dates are March 31, June 30, September 30 and December 31 until maturity 16
Qualify for Hedge Accounting In order for a company to be eligible to apply for hedge accounting, three basic requirements must be satisfied: At the time of designation, a formal hedge documentation of the hedge relationship must exist that details the following: Risk management objective and strategy of the hedge The nature of the risk being hedged Identification of the hedge item and the hedge derivative Description of the methods that the effectiveness of the hedge relationship will be assessed on both prospective and retrospective basis How ineffectiveness will be measured, if any At inception and at each reporting period after that the company must demonstrate that the hedge relationship is expected to be highly effective on a forward looking basis (prospectively) and has actually been effective since the designation date (retrospectively) Each reporting period any ineffectiveness must be recognized in the Income Statement as profit or loss 17
Hedge Effectiveness Hedge effectiveness is the extent to which changes in the fair value or cash flows of the derivative offset the changes in the fair value or cash flows of the hedged item Hedge effectiveness is tested at the inception of the hedge relationship (hedge designation date) by using a prospective hedge effectiveness test After inception, hedge effectiveness is tested at each reporting period by using a retrospective test (to demonstrate that the relationship has been effective) and a prospective test (to demonstrate that the relationship is still expected to be effective in the future) Methods of hedge effectiveness testing: Qualitative Critical Terms Match method Short-Cut method Quantitative The Dollar Offset Method Regression Analysis 18
Hedge Effectiveness: Critical Terms Match method The critical terms approach can be applied if the key terms of the hedging instrument and that of the hedged item are the same. In other words, the changes in the fair value and cash flow of the derivative are likely to offset those of the hedged item, both retrospectively and prospectively. To ensure compliance with the critical terms method the following criteria must be met: The notional amount of the derivative is equal to the notional amount of the hedged item The maturity of the derivative equals the maturity of the hedged position The underlying of the derivative matches the underlying hedged risk The fair value of the derivative is zero at inception No change in counterparty credit risk Critical terms must be checked at each effectiveness testing date 19
Hedge Effectiveness: Shortcut Method The shortcut method is similar to the critical-terms method but is only allowed in limited cases involving interest rate swaps. Effectiveness is automatically assumed to be 100% between the hedged risk and the derivative (no ineffectiveness) and there is no need to perform effectiveness testing retrospectively or prospectively. This saves a significant amount of time and effort. The following items must be met before this method can be used: Notional amount must match between the swap and hedged item Fair value of the swap is zero at inception Fixed rate on the swap, the index used for determining the floating rate and any spread adjustment (if any) must remain the same over the life of the swap No embedded options (ex. Pre-pay option) 20
Overnight Index Swap (OIS) Rate The valuation of interest rate swaps is based on a discount cash flow model, where a stream of future cash flows is discounted using an appropriate discount rate Prior to the financial crisis, it was common industry practice to use the LIBOR swap curve to construct the forward yield curve that used to project the floating rate cash flows and to also use it to discount the cash flows of the swap During and after the crisis, market participants start using the OIS curve for discounting those cash flows for collateralized instruments The use of the OIS curve reflects the funding basis of these collateralized instruments and is a more appropriate valuation approach. It has become the market standard for pricing collateralized deals in a number of currencies The move to the use of OIS discounting for purposes of valuing derivatives reflects move to a better valuation methodology that better considers the economics of the instruments and the relationship of the counterparties 21
Practical Issues with OIS Rate Need for better integration of valuation and credit/ collateral management Need for using a separate curve for discounting and a separate curve for estimating the expected floating cash flow The market reference swap is now using the LIBOR curve as the cash flow forecast curves, but the OIS as the discounting curve. For the same swap instrument, the par coupon would now be different based on the different discounting curves Additional source of ineffectiveness, i.e., the use of different discount curve between the hedged item (LIBOR) vs. the derivative (OIS) Change in valuation methodology may trigger de-designation and re-designation of the hedging relationship 22
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 23
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. 24
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 12-17 as an indirect proprietorship or an anticipatory ECP 25
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 26
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 27
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 28
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 29
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 30
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 31
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 32
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. 33
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 34
Conclusion 1. Conclusion 2. Questions 3. Thank You! 35
Who We Are Alexander P. Fraser Partner Michael Best apfraser@michaelbest.com T. 414.347.4757 Felix Shipkevich Principal Shipkevich PLLC fs@shipkevich.com T. 212.252.3003 Harris I. Antoniades Managing Director, CFA, FRM Stour Risius Ross, Inc. hantoniades@srr.com T. 310.601.2565 36