CHAPTER 13 PRICE RISK MANAGEMENT: THE ISDA® AGREEMENT
| Jurisdiction | United States |
(Feb 2011)
PRICE RISK MANAGEMENT: THE ISDA® AGREEMENT
William C. Holland
Holme Roberts & Owen LLP
Denver, Colorado 1
JAMES F. CRESS is a partner in the Denver office of Holme Roberts & Owen LLP practicing mining and natural resources law. His practice includes extensive experience in the negotiation and documentation of a broad range of derivatives transactions and U.S. regulation of over-the-counter derivatives. He has represented oil and gas companies and utilities in the design and documentation of gas hedging programs, mining companies in the construction of metal and cost-side hedging programs, corporate and finance clients in hedging currency and interest rate exposure, and high net worth individuals in minimizing exposure to large securities holdings with costless collars and other equity derivative products. He has extensive experience in the negotiation of International Swaps and Derivatives Association (ISDA) master agreements and related margin and collateral agreements, with particular emphasis on issues of concern to corporate and individual counterparties, including integration with other financing documents and inter-creditor issues. He has experience in workouts and bankruptcies involving substantial derivatives exposures. In the natural resources area, he has negotiated and documented complex acquisitions, asset dispositions and financings for coal, uranium, molybdenum, gold, copper, oil and gas and other mineral-producing clients. 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 mining practice also has experience in private and U.S. federal mineral royalty matters and has testified as a royalty expert before House and Senate committees considering mining royalty legislation. His international mining experience includes negotiation of substantial investments in developing countries, including negotiations with host governments, and includes work in the Philippines, Kazakhstan, Mexico, Argentina, Peru, Ethiopia, Brazil, Suriname and Burma. He has been an adjunct professor and lecturer in the University of Denver's Graduate Studies Program in Natural Resources and Environmental Law. He is listed in "Who's Who of International Mining Lawyers" and in "Best Lawyers in America".
Over the last 20 years, the market for oil and gas derivatives has expanded rapidly, despite the twin shocks of the Enron and Mirant bankruptcies and foundering of other energy merchants in 2001-02, and the current financial crisis marked by 2008 collapse and bankruptcies of Lehman Brothers and SemGroup, L.P. The total "notional value" of oil & gas and other commodity-based derivatives held by U.S. banks now exceeds a trillion dollars.
Types of financial derivatives contracts include over-the-counter or "OTC" derivatives contracts, customized, bilateral agreements between a producer and a financial institution, and exchange-traded derivatives, such as NYMEX futures contracts, the terms of which are standardized and which are traded and cleared on regulated commodity exchanges with collateral or "margin" requirements for the parties. A third, hybrid category, bilaterally-negotiated (OTC) derivative transactions that are booked and cleared with a clearinghouse and subject to margin requirements, will become more prominent as a result of the enactment of derivatives regulatory reforms in Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Title VII" or the "Dodd-Frank Act").2 This article focuses primarily on the negotiation and documentation of bilateral, OTC financial derivatives contracts.
Financial derivatives are used by oil and gas producers to hedge or mitigate different business risks. Producers may use commodity derivatives to hedge against short and long term exposure to falling oil and gas prices, or to lock in a portion of the value of an acquisition in order to obtain financing. Producers may use interest rate derivatives to fix or float interest rates on loans or debt securities. Producers with foreign operations that pay expenses in local currency may use foreign exchange derivatives to fix their exposure to fluctuations between the values of the local currency and the U.S. dollar, which is usually the currency of the company's oil and gas revenue. Most of these hedging tools are financial contracts, under which cash payments are exchanged by the parties based on different "underlyings" (notional quantities of oil or gas for energy transactions, for example), rather than contracts for physical delivery such as forward purchase and sale agreements for oil or gas.
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When used to hedge risks in this fashion, derivatives can contribute substantially to a producer's bottom line by transferring to the producer's derivatives counterparties risks that the producer does not want to assume (downside oil and gas price risk, on a company-wide or acquisition-specific basis) or that are not part of the producer's core business expertise (predicting fluctuations in currency exchange rates and interest rates). Derivatives can be a two-edged sword, however. They have been contemporaneously 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 The contribution of derivatives to the recent financial collapse has led to a complete overhaul of derivatives regulation that is ongoing.
Most derivatives used by oil and gas producers 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 11th 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 collateral) 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." Significant terms, the importance of which may not be obvious to the producer, may be left out of the schedule with a simple "not applicable," such as the payee tax representations in Part 2(b) of the schedule.
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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 an oil and gas producer as a result of a series of acquisitions, and may have been negotiated years before by the producer or a predecessor under circumstances that no longer reflect the situation of the company. Unlike other financing agreements, ISDA agreements have no expiration date or term, and no provision for periodic re-negotiation or renewal.
This paper is intended primarily to provide examples of issues that arise in negotiating OTC derivatives agreements based on the ISDA documentation, as viewed from the perspective of the end user, here 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 necessarily 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 authors have reviewed, drafted or resisted. Several important preliminary issues to setting up a derivatives trading program, certain recent regulatory developments affecting OTC derivatives agreements, and certain tax aspects of ISDA agreements will also be discussed. Finally, the impact of Title VII of the Dodd-Frank Act on OTC derivatives end-users will be outlined, although the precise parameters of those impacts are still being defined in detailed regulations.
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's guides to
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help navigate the sometimes murky waters of the documentation.7 No attempt is made to cover comprehensively...
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