CHAPTER 11 PRICE RISK MANAGEMENT: THE ISDA® AGREEMENT
| Jurisdiction | United States |
(May 2005)
PRICE RISK MANAGEMENT: THE ISDA® AGREEMENT
Holme Roberts & Owen LLP
Denver, Colorado
James F. Cress is a partner in the Denver office practicing in the commercial law and securities and natural resources groups. His general corporate practice includes acquisitions and derivatives. His natural resources practice emphasizes international and U.S. mining and oil and gas law transactions, including financing. He has been with the firm since 1988.
Mr. Cress' practice is primarily transactional. Mr. Cress' general corporate practice includes development, implementation and documentation of derivatives trading programs for corporate end-users of derivative products, including oil & gas, precious metals, interest rate and currency hedging programs, as well as synthetic debt instruments with derivates components. He also has extensive experience with derivatives. In the natural resources are, he has negotiated and documented complex acquisitions, asset dispositions and financings for coal, uranium, gold, copper, oil and gas and other mineral-producing clients. He has experience in private and U.S. federal mineral royalty matters. He has advised clients on the development, implementation and interpretation of mining law and regulation in the U.S., Asia, the former Soviet Union and Latin America. His international experience includes negotiation of substantial investments in developing countries, including negotiations with host governments, and includes recent work in the Philippines, Kazakhstan, Mexico, Argentina, Peru, Ethiopia, Brazil and Burma. He also teaches at the University of Denver's Graduate Studies Program in Natural Resources and Environmental Law.
Education: J.D., University of Denver, summa cum laude (1988), Order of St. Ives Honorary Society; Associate Editor and Technical Editor, Transportation Law Journal; University of Denver Scholarship; Coulter Scholarship; Janet W. Starkey Scholarship; Denver Transportation Club Scholarship; B.S.J., Northwestern University, with honors (1983), Kappa Tau Alpha Honorary Society; National Merit Scholarship; McCormick Journalism Scholarship.
Memberships: American Bar Association, Section of Energy, Environmental and Resources Law (former Vice Chair, Public Lands Committee and contributor to Year In Review); Colorado Bar Association, Mineral Law Section (Chair 2001-02; Vice Chair 2000-01; Secretary/Treasurer 1999-00); Council Member since 1997 Colorado Bar Association, International Law Committee; Rocky Mountain Mineral Law Foundation, revision author American Law of Mining (2d Ed.), Mining Chair 1998 Annual Institute, Editorial Board Form 5A Joint Venture Agreement, Form 7 Confidentiality and Non-Disclosure Agreement, Publications Committee; International Mining Professionals Society; Colorado Mining Association (Co-Chair, Mining Law Review Committee, 1998-99); listed in International Who's Who of Mining Lawyers 1999-present; International Trademark Association; University of Colorado Natural Resources Law Center board member 2000-02; Annual Survey of Colorado Law (Author 1989-96, Editor 1996-98, Mining and Public Lands Law.
Over the last 10 years, the market for oil and gas derivatives has exploded, despite the shocks of the Enron collapse and the foundering of other energy merchants in the wake of Enron and the California power crisis. 2 Derivatives are used by oil and gas companies to hedge against short and long term exposure to gas prices, to lock in the value of an acquisition, to fix or float interest rates on debt, and to manage exposure to currencies in foreign operations. Derivatives can be a two-edged sword, however, and have been described by proponents as "a major contributor to the flexibility and resiliency of our financial system," 3 and by detractors as "financial weapons of mass destruction." 4
Most energy derivatives are now documented using the forms and definitions published by the International Swaps and Derivatives Association, Inc. (ISDA). 5 The ISDA forms have been adopted by all major participants in the derivatives markets, in the United States and in many other countries, and have resulted in an unprecedented standardization of derivatives documentation, with greater efficiencies in negotiating and entering into derivatives contracts for financial institutions and corporate end users of derivatives alike.
Unfortunately, this greater efficiency is sometimes achieved at the expense of the oil and gas producer looking to hedge its next deal. The ISDA master agreements are bilateral contracts that theoretically treat both counterparties alike, but are often negotiated on an uneven playing field. The financial institution and energy merchant counterparties that offer energy and other derivative products to oil and gas companies (hereafter, "financial institutions") have extensive experience in negotiating these contracts. Oil and gas producers are "end users" of derivatives who typically hedge as an incident to their business, with little knowledge of the business of hedging or the details of the ISDA documentation. To make matters worse, the draft agreement often arrives at the 11%gth%g hour, just prior to closing a loan or acquisition, in the form of an innocuous-looking, ten-page schedule to a master agreement (and perhaps a six-page "paragraph 13" to the Credit Support Annex, if the transaction is to be secured with margin) that the financial institution may describes as its "standard" form. The schedule is written in a shorthand familiar only to long-time users of the document," with unfamiliar and non-intuitive defined terms like "Specified Transaction," "Specified Entity" and "Multibranch Party."
Moreover, ISDA agreements tend to have a long shelf life. Once signed, they stay in effect indefinitely, governing any future derivative transaction between the parties. ISDA agreements may be inherited by virtue of a series of oil and gas acquisitions, and may have been negotiated years before by the company or a predecessor under circumstances that no longer reflect the situation of the company. Unlike other financing agreements, ISDA agreements have no provision for periodic renewal.
This paper is intended primarily to provide examples of issues that arise in negotiating derivatives agreements based on the ISDA documentation, as viewed from the perspective of the oil and gas producer. Attached is a sample schedule to an ISDA master agreement (the "Sample Schedule") which will be used to illustrate some of these issues. The Sample Schedule is not a recommended form, and in fact is provided to emphasize the subtle (and sometimes not so subtle) ways in which the "standard form" ISDA schedule proffered by a financial institution is not "standard," nor in the best interest of the producer. The provisions of the Sample Schedule discussed (which are highlighted in gray in the attachment) and other examples in the text are taken from various ISDA agreements that the author has reviewed, drafted or resisted. Several important preliminary issues to setting up a derivatives trading program and certain tax aspects of ISDA agreements will also be discussed.
The ISDA agreements and related derivatives legal and documentation issues are addressed in several treatises and in special and annual institutes of the Rocky Mountain Mineral Law Foundation and the Practicing Law Institute. 6 ISDA also publishes several user-friendly guides to help navigate the sometimes murky waters of the documentation. 7 No attempt is made to cover comprehensively the many legal and documentation issues raised by derivatives, which are covered in greater detail in some of these sources. The objective is to provide some practical assistance to avoid "slitting your throat" on the ISDA documentation. 8
I. The ISDA Documentation
A. The ISDA Architecture -- A Brief Overview
The first problem in negotiating an ISDA agreement is getting a complete copy of the contract. To make sense of the schedule provided by the financial institution, the producer may need to acquire a small library from ISDA. Figure 1 illustrates the relationship of the various (and voluminous) master agreements, definition books, collateral documents, and confirmation forms that together comprise the ISDA agreement.
The ISDA architecture is based on the 1992 or the 2002 Master Agreement forms, 9 which contain the principal contractual terms, including representations, covenants, events of default, and the mechanics of closing out the transactions in the event of a default or other termination event. The closeout provisions are a primary purposes for the master agreement format, as they are designed to reduce the risk of multiple transactions by netting the exposures into one amount owing from one party to the other. The bankruptcy laws of the U.S. and many other countries have been amended to permit the closeout of derivatives agreements and the netting of transaction exposures even after bankruptcy commences, without the transactions being subject to the automatic stay or "cherry-picking" of in-the-money transactions by the bankruptcy trustee or administrator. 10
The schedule to the master agreement is used to make amendments or additions to the Master Agreement and to make certain elections. The schedule is the primary focus of ISDA negotiations.
Individual transactions under the master agreement are documented by ""Confirmations," which specify the economic terms of each transaction and may include other specific provisions for individual transactions (for example, a collateral requirement or covenants required for credit approval). In the event of a conflict between a confirmation of a particular transaction and the master agreement or schedule, the confirmation controls for purposes of the transaction. 11
Figure 1
The ISDA® Architecture
| 1992 or 2002 |
To continue reading
Request your trial