18Legal Documentation

When Lehman Brothers filed for bankruptcy in September 2008, Metavante Corporation had an interest rate swap on $600 million of notional with one of its subsidiaries, and the swap had moved in the subsidiary’s favour. Metavante neither terminated nor paid: it relied on a clause of the standard master agreement that makes each payment conditional on no event of default having occurred with respect to the other party. A year later, in September 2009, the bankruptcy court in New York ruled from the bench that “riding the market for the period of one year, while taking no action whatsoever” was contrary to the spirit of the Bankruptcy Code, that Metavante had waived its right to terminate by not exercising it promptly, and that it had to pay. In April 2012 the Court of Appeal in London read the same clause in the Lehman European administration and held that, under English law, a non-defaulting party’s payment obligation stays suspended for as long as the default continues. A few lines of a standard document decided who owed what to whom, and two courts read them differently.

18.1 The master agreement and why it exists

A firm trading over the counter signs one master agreement with each counterparty, and every trade between them becomes a confirmation under it. Book 2 introduced the ISDA master agreement and the repo market’s GMRA; Book 6 the close-out netting they make possible. The design point is that all the trades under one master form a single agreement, so that on a default they are terminated together and netted to one amount, rather than cherry-picked by an administrator who performs the profitable ones and disclaims the rest.

The agreement’s printed form is standard; the negotiation is in its schedule, which elects and amends the printed terms, and in the collateral annex. What a trading firm’s legal and treasury staff negotiate is a short list: which events let each side terminate, how much collateral moves and when, what collateral is eligible, and what happens on the first day something goes wrong (Figure 18.1).

18.2 Events of default, termination events and close-out

The master agreement’s section 2(a)(iii), as the Court of Appeal quoted it, makes each payment obligation subject to “the condition precedent that no Event of Default or Potential Event of Default with respect to the other party has occurred and is continuing”. The clause lets the non-defaulting party stop paying while it decides whether to terminate. How long it may wait is where the two courts of the hook diverged.

The English court held that the underlying debt is undisturbed and only the payment obligation is suspended, that the suspension has no end date and continues until the default is cured, and that the clause does not offend the principle against depriving an insolvent estate of its assets. The US bankruptcy court, reading the Bankruptcy Code’s safe harbours as protecting the right to terminate and net rather than the right to wait, held that waiting a year had waived the right. A firm facing a defaulting counterparty in the money to the defaulter therefore has a decision to make, promptly, whose answer depends on the governing law and the forum.

18.3 Collateral annexes

The collateral annex turns the master agreement’s credit exposure into daily transfers. Book 6 defined its terms: the threshold below which no collateral is due, the minimum transfer amount below which no transfer is made, and the independent amount posted regardless of exposure. The annex adds a rounding convention, a list of eligible collateral and the haircut on each.

@dataclass(frozen=True)
class Annex:
    threshold: float = 0.0
    mta: float = 0.0
    rounding: float = 0.0
    independent_amount: float = 0.0
    haircuts: dict = field(default_factory=lambda: {"cash": 0.0})


def held_value(annex, collateral):
    """collateral: {asset: market value} held by the secured party."""
    return sum(v * (1 - annex.haircuts.get(a, 1.0)) for a, v in collateral.items())


def call(annex, exposure, collateral):
    """Positive: the secured party calls a delivery; negative: it must return collateral; 0 below the MTA."""
    need = max(exposure + annex.independent_amount - annex.threshold, 0.0) - held_value(annex, collateral)
    if abs(need) < annex.mta or need == 0:
        return 0.0
    if annex.rounding:
        r = annex.rounding
        need = math.ceil(need / r) * r if need > 0 else -math.floor(-need / r) * r
    return need

18.4 Prime-brokerage and clearing agreements

Prime-brokerage agreements are where NAV triggers matter most, because they sit beside the broker’s discretion over margin: a fund in a drawdown may trip a trigger at the moment its brokers raise margin, and a trip at one counterparty can become a default at others through cross-default. Clearing agreements with a futures commission merchant (Book 1) and give-up agreements between executing and clearing brokers complete the set; their terms are shorter because the clearing house’s rulebook carries most of the weight.

18.5 Tutorial: the trigger

The fund peaks at $447.7 million on day 45 and falls to $247.7 million on day 204, 44.7% below the peak. The triggers trip in the order of their tightness, not of the fund’s troubles: dealer B’s 12% in a month trips on day 137 when the fund is still at $369.3 million, 12.4% below its level a month earlier; the prime brokers follow within six weeks; dealer A’s floor trips last, on day 180 at $275.2 million. Four counterparties can terminate within 43 business days, which is the risk the treasurer of chapter 14 must plan for: the terms of the documents decide when the funding stops.

Over the year the annexes move collateral on 87 days for dealer A (44 calls, 43 returns) and 39 for dealer B, and never for dealer C, whose $10 million threshold is above its largest exposure. Dealer B terminates on day 137.

With a set-off clause across the dealer’s agreements, the fund’s debt on the swaps and the dealer’s debt on the repo net to $1.36 million owed to the fund. Without one, the fund must pay $4.64 million under the swaps and pursue $6 million under the repo separately, which is the same money only if the dealer pays; the exposure to the dealer’s credit is the gross $6 million, not the net.

18.6 Exchange memberships and give-ups

Exchange membership (Book 1) is itself a contract: the rulebook binds the member, its traders and its systems, and the clearing agreement with a clearing member guarantees the member’s trades to the clearing house. A firm that executes through several brokers and clears through one signs give-up agreements (Book 2’s give-up lines) that let the executing brokers pass its trades to its clearer, within limits the clearer sets. The documents are shorter than a master agreement and change less, but the limits in them are operational: a give-up line that is full stops trading.

18.7 Build: agreement terms as data

18.8 Exercises

18.9 Problem: The Trigger

18.10 Interview questions