The master agreements and supporting documents produced by the International Swaps and Derivatives Association have a common trait - they are superb.

They do what they were intended to do. But, documents - particularly standard forms - no matter how good, cannot control many of the most significant risks.

In fact, the swap legal catastrophes to date -- Hammersmith & Fulham and Mutual Benefit Life -- occurred despite use of state-of-the-art documentation.

Indeed, the association recently issued a bold-print disclaimer: "ISDA assumes no responsibility for any use to which any of its documentation ... may be put."

Short cuts are, however, naturally appealing, and some would like to deal with their legal risk by simply signing a standard form prepared by the association -- though they may not adequately understand the risk or what the association's documentation says and does not say.

The responsible professional will immediately recognize many flaws and dangers with this convenient approach. These include:

Capacity to Contract

In the ISDA agreements, your counterparty represents to you that it has the legal capacity to enter into the agreement - but, if in fact if does not, this representation is meaningless.

You have no rights under the ISDA agreement, because there is simply no contract.

Contract Formation Risks

Under the applicable law of contracts -- typically New York law -- your counterparty may be able to assert any of several defenses to enforceability of a trade, such as the New York Statute of Frauds requirement for a writing -- the federal D'Oench Duhme doctrine (if a U.S. bank) -- trade call language incompatible with contract formation -- a material conflict between the trade call and the confirmation -- recording of the trade call without provable consent.

The form ISDA agreements do not address these risks.

Structural Credit Risks

Even if the agreement is "enforceable," meaningful assets may not be reachable due to a defective credit structure, such as holding company subordination either of the counterparty or (more commonly) of a guarantor.

Regulatory Compliance

Although the form ISDA agreements contain a general representation of compliance (possibly meaningless if inaccurate), often much more -- such as specific representations and independent due diligence -- is required to avoid hidden regulatory pitfalls.

Credit Provisions

Your credit analysis may dictate that you obtain meaningful credit-protective provisions in your agreement.

The agreements were drafted by dealers for use primarily between dealers. The natural result of this parity of bargaining power coupled with a two-way instrument is that the form agreements provide only minimal credit protection.


Though generally superb documents, many readers (including seasoned "swappers") regard numerous provisions (including some of the most crucial) as bewilderingly complex -- making it difficult to understand what the documentation actually says.

These agreements are intended to provide protection against potentially huge credit exposure. Does the individual signing the document really know what it says -- and does not say?

Possible Unenforceability

Even if the reader really understands the trade group's language, what you see is not necessarily what you get.

While the agreements' numerous provisions are generally considered to be sound and enforceable, there are certain provisions -- some major -- where enforceability and certain circumstances is not certain.

Can an informed credit decision be made without knowing what might not work?

Decisions Required

The agreements themselves anticipate that the parties will negotiate and reach decisions on numerous key issues.

Can individuals adequately protect their institution if they negotiate (typically against an informed and skilled counter-party) without really understanding the scope and nature of the numerous risks -- the relevant language in the agreement -- the alternative solutions available -- and current market practices?

Issues that commonly need to be addressed in these negotiations include:

* To which of your counterparty's affiliates should certain protective provisions apply?

* What should you obtain as "closing documents" and as ongoing information?

* What should be your position on the several variables relating to cross-default? When is this provision of no practical value?

* What tax law representations should you insist upon?

* Which tax law representations can you properly give?

* What are the risks to you if your counterparty wants to contract as a multibranch party?

* Should you receive the head-office liability representation?

* How should close-out values be calculated -- by market value or indemnification?

* Should be defaulting party be required to forfeit damages (first method) or be permitted to recover (second method)?

* What should be the governing law?

* Which courts should have jurisdiction?

Proposed Changes

Many dealers often alter the standard agreement by proposing numerous "Additional Provisions." Obviously, these changes benefit the dealer.

What impact would these changes have on you?

Also and importantly, should you be requesting any amending changes to address your needs?

Insolvency Laws

Vital to the credit decision is an understanding of what would happen in an insolvency.

Even if the agreement is enforceable under the applicable laws of capacity, the laws of contract and the regulatory laws, real-world test of enforceability is whether you can recover in an insolvency proceeding.

If your counterparty cannot pay, it is likely insolvent -- if it is insolvenet, the insolvency laws apply -- and if the insolvency laws apply, these laws can override crucial and otherwise enforceable provisions of the agreements -- and make those provisions unenforceable at the precise time that you need enforceability.

Due in large part to the efforts of the association, legislation has been adopted in the United States bringing certainty with respect to most (though not all) counterparties and as to most (though not all) issues. Greater uncertainty exists with non-U.S. entities.

* What bankruptcy law applies?

* Can the solvent party terminate?

* Can the receiver of trustee "cherry pick" among the transactions?

* If the law has been amended as to derivatives, are there statutory gaps?

* If you or your counterparty is a New York branch of a foreign, what is the impact on you of the 1993 New York State foreign bank legislation?

* If you are secured, can you foreclose and liquidate the collateral?

* If you obtained collateral, can you be forced to return it as a voidable preference?

* If you delivered collateral to the now-insolvent debtor, have you inadvertently waived and lost your right to recover the property?

* If you are unsecured, are you subordinated to a significant class of preferred creditors?

* When is the impact of the new U.S. national depositor preference statute?

The ISDA agreements are subject to (and at the mercy of) applicable insolvency laws.

By signing an ISDA agreement, the parties cannot - and do not - either select or change the applicable insolvency laws.

We could, in fact, go on. In addition to these points, there are many other compelling reasons why it is necessary to develop an adequate understanding of the many significant legal issues.

Mark-to-market collateral

Most of the preceding points are also applicable - often with even greater strength - to the recently introduced ISDA Mark-to-Market Credit Support Annex.

In fact, an additional set of critical issues needs to be addressed -- particularly if you are being asked to deliver collateral.


If your counterparty is not a free-standing credit and you are relying upon a guarantee not drafted by you but, rather, provided to you and drafted by your counterparty, to what extent does the form of guarantee adequately protect you?

Even if the language is satisfactory on its face, are there legal defenses to your enforcement, such as lack of capacity, lack of consideration, or fraudulent transfer.

The point seems clear. Appealing as it may have seemed: "We cannot simply sign an ISDA agreement and not have to learn about and worry about all these risks."

Indeed, given the significant potential exposure -- coupled with the complexity of the issues and the documentation -- understanding the risks and how to control them is vital.

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