Publications: Negotiating Over-the-Counter Derivative Contracts

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Over-the-counter (OTC) derivatives contracts are much in the news because of the new financial reform act, “Dodd-Frank Wall Street Reform and Consumer Protection Act” (Dodd-Frank). This Act will change who regulates derivative contracts; who can and cannot trade these contracts; where these contracts can be traded and when they must be cleared; and how and when these contracts are to be margined or collateralized. Given all of these changes, it is important to keep in mind what Dodd-Frank will not change: how OTC derivatives contracts are documented and the importance of their careful negotiation. Indeed, it is now more important than ever that attorneys and corporate executives dealing with OTC derivatives not fall into the trap of viewing the documentation of these transactions as “standard,” “routine,” or “ordinary commercial contracting.” Far from it.

Dodd-Frank will force many derivatives transactions onto exchanges where their non-economic terms will be fixed by exchange rules, but many more derivative contracts will continue to be traded OTC. And no matter how complex or “plain vanilla” the economic terms of those contracts may be, their non-economic terms will remain in need of focused and serious negotiation. In the “Questions and Answers” that follow, we discuss why careful negotiation of OTC derivatives transactions is so important and identify the key issues that need particular attention. Our aim is to dispel many of the common misunderstandings surrounding the OTC derivatives contracting process and give all users of derivatives a surer sense of how to approach the legal and contractual—as opposed to economic—complexities of these products.

Question:

Once my trading desk or department enters into an OTC derivative transaction with a dealer, that dealer generally sends us a set of papers that I am told are “standard industry forms.” Are these forms “standard” and what should I do before authorizing their execution?

Answer:

Wholly apart from the economic terms of an OTC derivative contract—who pays whom what in the event of such and such—a large number of contingencies can affect the operation and outcome of such a contract. The derivatives dealer, as your counterparty, wants to be in the strongest possible legal position in the event of the occurrence of any of these contingencies. But, of course, if the derivatives dealer is in the strongest possible legal position then your company is in the weakest possible position. Thus, the forms the dealer sends are far from “standard” and before authorizing their execution they need to be carefully reviewed and negotiated by persons knowledgeable in derivatives contracting.

Question:

What exactly is included in the set of papers that a derivatives dealer sends in connection with my company’s first OTC derivatives trade with that dealer?

Answer:

The “standard industry forms” that you are given most likely include an ISDA Master Agreement and an ISDA Credit Support document, both customized to the derivatives dealer’s advantage (through the Schedule to the Master Agreement and the last Paragraph of the Credit Support document).