Table of Contents
Master agreements are of critical importance for the financial commercial transactions. Internationally, the ISDA Master Agreement is by far the most widely used one (Zepeda 2013). Noticeably, the Master Agreement is a section of a group of documents that facilitate on-the-counter (OTC) derivatives to be documented flexibly and fully (Zepeda 2013). The Master Agreement is also viewed as a certificate of agreement between the two parties setting the standards related to transactions that the two parties are entering in international trading arrangements. It should be noted that the agreement does not have to be renegotiated every time the parties carry out a new transaction. Instead, the terms set in the Master Agreement apply automatically. Largely viewed as an instrument or tool employed by banks, master agreements are also predominantly used by a great number of counterparties. To put it simple, such agreements contain non-commercial terms such as regular/ standard provisions that the two parties wish to apply regularly. The paper explores the application of the Master Agreement with specific reference to the aspects that the parties need to understand.
In many commercial activities, it is acknowledged that the risk is inherent. In particular, trading in financial derivatives is associated with a number of risks (Rossman & Moskin 2011). For example, credit risk is a concern given that counterparties might not pay on the specified due dates. Alternatively, they might fail to execute their financial obligations as stipulated. In worst case scenarios, instances of insolvency might arise, which will threaten the completion of a transaction (Rossman & Moskin 2011). Given that a big percentage of monetary derivative transactions allow for routine payments to be made on specified dates, certain concessions are necessary. Documentations such as the ISDA Master Agreement that governs such financial transactions are critical because they provide parties with net amounts that are due in multiple transactions (Haentjens & de Gioia-Carabellese 2015). The implication is that total amounts owed by each party are assessed to establish the net amount owed to or provided by the party in question. In addition, collateral requirements can be evaluated based on a net basis. It should be noted that in derivative transactions, collateral that is necessary to secure a liability is specialized to guarantee security (Rossman & Moskin 2011). Based on the above discussion, the role of master agreements is to enhance security in the international commercial financial transactions.
Important Provisions of Master Agreements
Master agreements demonstrate a certain degree of similarity based on their guiding provisions. For instance, both 1992 and 2002 agreements alongside other scheduled procedures have related guidelines. In particular, reciprocity is a key provision in Master Agreements (Harding 2010). Terms of the agreements encourage reciprocity given that they apply to both of the transacting parties equally. Secondly, the term single agreement is commonly adopted. In this regard, reference is made to the idea that financial or derivative transactions entered by parties are outlined in one document as one agreement (Harding 2010). This aspect is significant in cases of insolvency and when multiple trades are involved. The role of the singularity is to prevent the liquidator from assuming charge of the most favorable trades while at the same time disclaiming those trades deemed unfavorable (Harding 2010). In this regard, the agreement protects the interests of parties in a deal.
Payment netting and conditionality of obligations also apply significantly to the execution of master agreements. Whereas payment netting applies to the payments that are due on a given date, in the same currency, and in terms of one transaction, obligation conditionality applies to the conditions surrounding payment based on precedents (Dalhuisen 2014). An example of conditionality is that no default has taken place regarding to the counterparty. In this case, the conditions are unmet, while the right to get a due payment becomes suspended (Dalhuisen 2014). The above provisions also work towards ensuring fairness in international financial transactions.
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Other critical aspects related to master agreements are representations and undertakings. Regarding representations, reference is made to the idea that aspects included in the agreement remain largely similar to those found in usual representations under facility pacts (Eun & Resnick 2011). On the other hand, undertaking of master agreements must be basic in comparison to usual transactions that are captured in facility agreements (Gregory 2010). The implication is that a derivative transaction differs from a credit deal. It is noted at this stage that many of the activities listed in facility transactions (such as disposals, financial ratios and restrictions) are not a part of the derivative agreements (Gregory 2010). As in the previous cases, the provision focuses on reducing the risk associated with a financial transaction.
Default possibilities are also explored under the master agreements in commercial financial transactions. The coverage of default under derivative transactions is largely similar to that in the facility agreement (Grundmann, Möslein & Riesenhuber 2015). However, certain differences can be discerned. For example, in derivative transactions, default events are reciprocal, and in the unlikely event of defaulting, all transactions can be terminated, and the netting provisions can be trashed (Grundmann, Möslein & Riesenhuber 2015). Regarding termination, the Master Agreement shows details or events that are classified as termination issues (Grundmann, Möslein & Riesenhuber 2015). Such include tax or illegal occurrences. The events take place not because of any counterparty’s fault although they pose a danger of ending the deal.
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Close-out netting is also an important notion that must be understood in relation to master agreements. Differently known as termination netting, close-out netting is a process that involves the ending of a derivative transaction that was entered as one deal/agreement (Gregory 2010). In addition, the concept entails the valuation and calculation of reciprocal amounts owed to each counterparty resulting from the termination, and the combination of the amounts to a single net figure payable by one of the parties to the other (Gregory 2010). The role of the provision is to ensure smooth termination of an agreement whenever circumstances do not support the furtherance of a deal.
Proper understanding of the master agreements demands reference to jurisdiction and governing laws. When drafting this type of agreements, it is necessary to identify the laws that will guide the deal (Gregory 2010). For instance, English law applies to the ISDA documentation. However, it should be noted that the decision is open, and the parties are free to select the law or jurisdiction to adopt. The flexibility is a desirable feature that eases reaching an agreement as it allows parties to select the most suitable laws to use.
1992 v. s the 2002 Master Agreements
A close relationship exists between the provisions of 1992 and those of 2002. As Harding (2010) indicated, the 2002 Master Agreement is an update of the 1992 provisions. The newer version was released to take care of shifts in the business environment. However, both of the two versions of the agreements continue being used. Harding (2010) noted that a large percentage of counterparties still apply the 1992 version. Hence, it is inferred that the two differ in not many aspects. However, certain variations are discerned.
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The first difference is related to representations. As already indicated, the new Master Agreement has a representation requiring that each party acts as a principal instead of acting as an agent (Ziman 2006). The inclusion of the representation is to assist in the establishment of mutuality, an aspect that is necessary for identifying the right of set-off based on jurisdictions and/or circumstances (Ziman 2006). Mutuality is also necessary in establishing close-out netting in the selected areas/jurisdictions (Ziman 2006). Default events also serve as a point of departure. For instance, the 2002 Master Agreement introduces stricter terms compared to the 1992 provisions (Harding 2010). Differences are also observed in the termination events. Under the 2002 terms, a new event: force majeure is introduced (Harding 2010). It is also noted that the approach of calculating termination payments varies between the two agreement versions. Whereas the 1992 agreement has two alternatives (the loss or market quotation methods), the 2002 arrangement only relies on the close-out amount in the determination of termination payments (Harding 2010). In addition, differences are seen in the methods used to make payments upon termination. Similarly to the previous attribute, the 1992 provisions provide two options (first and second methods) (Ziman 2006). For the 2002 agreement, only one approach is available; the second method is similar to that of the 1992 provisions (Ziman 2006). Finally, the set-off clause is also a factor of departure. Commonly, a set-off provision must be set in master agreements. For the 1992 agreement, a set-off clause is included in the schedule in the 2002 framework; the clause is based on the agreement itself (Harding 2010). The above discussion shows that the two frameworks have differences along with a number of similarities.
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Cross Border Transactions
It should be noted that a great number of transactions are over-the-counter (OTC) financial deals. A large percentage of OTC transactions involve counterparties coming from dissimilar jurisdictions (Madura 2007). This creates a scenario that requires an agreement before proceeding. Practitioners also need to comprehend the risks involved in cross-border transactions with counterparties. When entering cross-border dealings, certain aspects come into play. Such aspects largely rely on enforceability or legality (Madura 2007). Regarding enforceability, it is advisable to consider whether the local laws of counterparty in a derivative pact supports the upholding of terms entered in the agreement. In addition, it might be necessary to establish whether individual transactions can be enforced. Besides, it is prudent to find out whether the foreign counterparty is authorized or has the power to enter a financial derivative agreement.
Based on the above factor (enforceability), it appears that derivative trading is highly risky. Thus, the parties of an agreement must carry out due diligence before concluding a deal. In particular, understanding various country laws might be helpful. Given the difficulties associated with such exercise, it is advisable that parties enlist the services of qualified attorneys or legal practitioners to do the research on their behalf. Failure to do so is likely to expose an individual to a high level of risk. It is also true that the absence of uniformity in country laws is a hindrance to the use of master agreements.
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Exposure to risk in international commercial transactions highlights the need to have legal knowledge on the trade. Parties to a Master Agreement are allowed to assess their financial exposure when carrying out OTC transactions by calculating the balance between what is owed to a counterparty and what the counterparty owes the other (Feenstra & Taylor 2008). The calculation is based on market-to-market conditions to reflect the current position for every transaction (Feenstra & Taylor 2008). The Master Agreement allows the netting of payment under the same deal to ensure that only one amount of exchanges is paid rather than carrying out numerous payments involving similar transactions (Feenstra & Taylor 2008. In practice, many counterparties accept netting all sums due in a day irrespective of the amounts being due to multiple or a single transaction.
Another important aspect under legal issues is the set-off. The term is used as the final accounts settlement to end the mutual debts between parties in favor of a net figure (Zepeda 2013). Parties of a deal are incentivized to observe time of making payments based on interest imposition on sums paid before the expiry of the set date (Zepeda 2013). To support the practice, these terms apply even when a party is facing bankruptcy claims.
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Capacity and authority are also central to the legal aspects of master agreements. In practice, the tenets of resolving concerns regarding the authority of an individual to tie a company are not distinct for derivatives but obtained from mainstream agency law (Zepeda 2013). Thus, it is advisable to assess the relevant conditions regarding the capacity or authority of an individual to bind a company to a given transaction. Commonly, parties exchange authorized lists of signatories who can commit an entity. However, it is possible that an individual who is not included into such lists has the power to authoritatively act on behalf of the company (Vardi 2014). The issue is addressed according to the knowledge that such matters are internal, and companies can authorize any individual to sign on their behalf.
Sustainability and reliability are also critical for understanding legal issues surrounding master agreements. Parties to an OTC deal are not immune for an attack by one of the counterparties. Problems emerge if some form of fiduciary role is involved yet a party misleads the other (Dechert LLP 2013). Under such circumstances, principles of contracting, equity and trading law practices must be invoked (Dechert LLP 2013). In order to curtail the responsibility, parties opt to include “non-reliance” representations in their deals (Ziman 2006). Such inclusion specifies that each person is not dependent on the other, but independent in reaching their decisions. Although the representations are helpful, they do not stop taking actions under the purview of trade practices in cases where the behavior of a party is conflicting with his/her representation.
Without a doubt, termination is also a critical term as it pertains to legal matters of master agreements. Whereas set-off clauses offer creditors a form of relief in instances of counterparty insolvency through the allowance of set-off obligations, they fail to cushion them from future positions that are not due (Zepeda 2013). Due to this problem, Master Agreements comprise of provisions that permit creditors to end and liquidate transactions whenever the counterparty becomes bankrupt or defaults on obligations. The Master Agreement outlines two ways of termination of transactions. Firstly, the occurrence of a default event can necessitate the termination of the agreement (Zepeda 2013). On the contrary, actions of third parties might facilitate the termination of the agreement as well. In the latter case, a grace period is allowed to ease the termination of the agreement. It is evident that knowledge on legal matters pertaining to transacting internationally is central to the business.
From the previous sections it can be discerned that disputes are likely to emerge in the entering and execution of master financial agreements. Thus, establishing systems or procedures for conflicting resolution is desirable. It is also evident that counterparties are obliged to choose the set of rules to apply in resolving their conflicts. Dechert LLP (2013) proposes the use of arbitration to tackle problems that emerge in this type of agreements. According to Dechert LLP (2013), contractual rights form the basis of international finance and commerce. Additionally, the body that wields the authority regarding the constituents of such rights plays a significant role in the agreements. Within an international context, possibilities abound that disputes can emerge based on interpretation alongside related concerns. Arbitral tribunals and domestic courts operating in different areas might interpret a contract differently. Besides, arbitrarily or incompetent decisions might lead to the rewriting of a contract leading to far-reaching consequences.
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In order to avoid negative outcomes such as the ones mentioned above, arbitration is recommended. For arbitration to yield positive results, certain principles need to be observed. The tenets support impartiality, centrality, party autonomy, neutrality and procedural flexibility (Dechert LLP 2013). As one of the principles, neutrality demands that arbitrators should adopt non-biased procedures/rules to arrive at a just solution to a dispute (Dechert LLP 2013). As for the aspect of centrality, counterparties need to agree on exclusive arbitration if a contractual matter is disputed (Dechert LLP 2013). Having a single arbitration forum negates the possibility of one dispute being determined in different forums. It is also necessary that arbitral awards are not only binding, but also final. However, for the awards to be effective, grounds for appeal must be limited. Finally, it is noted that arbitrators enjoy broad autonomy in terms of agreeing on rules, procedures and time frames. Such provisions enhance autonomy and flexibility in the process.
The question of whether the arbitration system is helpful has been deliberated by Dechert LLP (2013). This author concedes that historically, parties involved in international financial transactions refer to the jurisdiction of New York or English courts. Without any doubt, the dependence on the jurisdiction was logical given the dominance of New York or English cities in international business. It is also highlighted that financiers from the cities had significant power in making reference to foreign parties. Hence, they were in a commanding position to influence the choice of procedures/laws. Unlike in the past, the financial landscape has dramatically changed. Thus, the demands of international users are no longer the same as they were two decades ago. In particular, at the moment, big business transactions are being carried out in different frontiers. Hence, players from the English and American centers can no longer claim monopolistic power over the markets.
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From the above discussion, the reliance on international arbitration as a dispute resolution approach in international financial engagements has increased. The main reason is the flexibility and ease that arbitration brings compared to litigation. Hence, arbitration is a compromising method to counterparts in financial transactions. Secondly, enforcement is a major consideration. Common knowledge indicates that a debt has value based on the ability to recover it. Referring to the New York Convention, it shows that arbitral awards are to be enforced as if they were judgments in domestic courts. The provisions make arbitration a viable option to litigation.
Although Master Agreement is a useful document in the financial commercial markets, it is long-term due to the burdensome negotiation process involved. Despite these concerns and some others, it should be highlighted that once signed, the agreement covers future transactions between the parties. Thus, in upcoming engagements, the parties will not have to go back to negotiations. Rather, they will refer to the initial deal, or make minor alterations as dictated by circumstances. Thus, in the long run, the agreement is both cost and time effective as it saves both of them.