Master Confirmation Agreement 101
Master Confirmation Agreements are used in derivative transactions, repurchase agreements and securities lending relationships. A Master Confirmation Agreement is a stand-alone agreement that (i) contain a master confirmation of, and (ii) set forth the standard terms and conditions for, each future transaction, and in turn sets forth the standard terms and conditions for the underlying master agreement; or may be organized for only one particular agreement. In addition, incorporating the provisions into the broader agreement does not meet the standards of a Master Confirmation Agreement, however a properly executed Master Confirmation Agreement is immediately effective and enforceable.
Master Confirmation Agreements for derivative transactions , commonly referred to as ISDA, allow parties to operate under a consistent set of legal documentation for each transaction and the overall relationship. This consistency is extremely important in the financial industry and for specific instruments and derivatives. Most financial institutions have a standard form of ISDA or Master Confirmation Agreement which allows the specific terms and conditions for the transaction to be attached or incorporated into the ISDA, allowing the parties to utilize their own Master Agreement for the principal contractual terms. This allows each party to utilize their standardized Master Agreement allowing for consist effectiveness of the contractual agreement.
Key Elements of Master Confirmation Agreement
A Master Confirmation Agreement, commonly referred to as an MCA, is a binding contract between two parties that sets forth the material terms of a transaction involving a financial instrument. Most MCAs include certain common components that are specific to the asset class that they apply to. For instance, an MCA for a swap will contain terms and conditions unique to that type of derivative instrument. However, in addition to those unique terms and conditions, there are certain provisions and clauses commonly found in almost all MCAs. First, terms that would typically be spelled out in a trading confirmation will appear in the MCA, but the contents of those confirmations will not be individually negotiated. In this regard, the MCA often serves as a de facto confirmation between the parties. Second, certain terms of art are included in each MCA, and the meaning of those terms is often consistent throughout all MCAs. Finally, primary provisions common to all MCAs set forth the respective roles of the parties at issue. There are, however, other terms that depend on how the parties wish to structure their relationship with respect to the underlying asset involved in the transaction. As a preliminary statement, the parties should agree on the scope of the MCA, its applicability, and its role in setting forth the obligations of the parties involved in the underlying transaction.
How Master Confirmation Agreements Operate
When a deal is reached between the parties, it is often put down on a Master Confirmation Agreement (MCA) or similar document. The MCA will frequently reference an underlying ISDA Master Agreement and the MCA itself will incorporate by reference the relevant provisions of that ISDA. The MCA will still be a binding contract, subject to the ISDA terms, and — to the extent there are provisions in the MCA that are different from the ISDA — that will be the MCA.
Despite this, many counterparties fail to realize that any amendments to ISDA provisions must be done in writing and sent to both counterparties.
The process is as follows: One party sends, usually by email, the signed MCA to the other counterparty. The counterparty will sign the MCA and then send a copy to the initial party. If the MCA states that the ISDA will continue in effect, then the MCA should state in writing that the new agreement amends the prior ISDA and will have effect only to the extent inconsistent with the ISDA’s terms.
Whether the MCA amends the entire ISDA, or just certain parts, or whether it is simply a "swap" for the ICM, must be addressed in the MCA itself if it is to be effective. Failure to conform with this may mean that the transaction is not legally enforceable or is otherwise incorrect.
For example, the market standard for settlement in ISDA is T+2, yet many seat agreements specify T+1. A dispute could arise over the date of settlement. Does a T+1 settlement supersede the ISDA provision of T+2? Would a court interpret the MCA as overriding the ISDA, or merely as an unsigned, binding contract?
The answer to this question is much easier if an enforceable writing exists that overrides the ISDA. But this requires both counterparties to do an adequate job of redlining the ISDA, and even then it is often mishandled and the amended ISDA is not executed. In such cases, ISDA’s risk department will still view the original ISDA as remaining in force, meaning that the transaction is not legally complete and settlement would be a breach of the ISDA.
It is important for professionals to know how to properly execute these agreements in writing, and make clear the parties’ agreement of understanding so that they can avoid future disputes.
Advantages of Employing a Master Confirmation Agreement
Master Confirmation Agreements streamline the often convoluted process of buy-sell transactions. Often times a seller and buyer must agree on terms for the transaction before the actual transaction can occur. A master confirmation agreement can accomplish this goal. A master confirmation provides a fast avenue through which both parties can essentially agree to the ground rules governing their future dealings. It also serves as a safeguard against later attempts to alter or change the agreed upon parameters of the deal so that both parties will have some protection against unexpected loss if a future deal is not executed by either party.
Standardization and Efficiency. Master confirmation agreements encourage efficiency and uniformity. Most commercial transactions are premised upon oral or informal agreements. If two parties reach an agreement on the phone or through email, it can take a great deal of time and arguments over differing interpretations of what has been agreed upon before the agreed upon terms are implemented. The master confirmation eliminates this problem by providing the parties with a standard form of language upon which the buyer-seller transaction is realized. The master confirmation agreement will have all of the necessary details for the transaction embedded in its language so that the seller and buyer only need to fill in the blanks.
Cost Efficiency. Taking advantage of a master confirmation can also save businesses a great deal of money. Many financial professionals are hired at great expense to make a single buy-sell transaction. However, the cost of these transactions can be drastically cut down if a master confirmation is used. If the master confirmation contains all of the relevant details for the particular deal, the financial professional will only need to re-use the existing terms and even put in boilerplate language regarding the specifics of the deal, thereby saving the buyer a great deal of money.
Displeasure Avoidance. The master confirmation agreement provides more than just monetary benefits for the parties involved. It also provides each party with the investment certainty they crave. Those who engage in securities transactions generally do so because of their interest in making a profit. However, if dealers are unable to actually make a profit because a deal closes below market value, then the profit center becomes the loss center. Thus, it is imperative for both parties to ensure that the transaction is priced accordingly and will generate profit. The master confirmation provides the buyer and seller the ability to ensure that profits can be generated from the transaction.
Pitfalls and Hazards Associated with Master Confirmation Agreements
There are several open legal issues to be considered, not only in structuring many types of derivative transactions, but also in determining the enforceability of such agreements. Some of these areas of concern include whether the agreement:
• contains a sufficient indicia of formality;
• constitutes a writing sufficient to satisfy the Statute of Frauds;
• is supported by adequate consideration;
• is unconscionable or illusory;
• was procured by fraud;
• contemplates an illegal act or transaction;
• is entered into with a party who lacks capacity;
• is undertaken by a corporation or other entity that lacked authority to do so;
• is a non-negotiable contract whose terms were unilaterally imposed by one of the parties;
• is unenforceable for lack of mutuality;
• is an agreement to agree type of arrangement; or
• is a binding unwritten or oral agreement .
Concerns with respect to the existence and enforceability of the Master Confirmation Agreement revolve around (i) the heightened emphasis placed on such an agreement by the SEC and CFTC in light of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd Frank Act") imposed public regulatory authority over swaps and (ii) whether the broadened regulatory framework significantly increases the risk of claims for rescission, avoidance or rejection from the estate of a variety of entities subject to a Master Confirmation Agreement (e.g., swap dealers, major swap participants, swap dealers and other market participants engaged in various hedging strategies… ).
Despite these concerns, the overall utility of the Master Confirmation Agreement remains unchanged and, for the reasons identified, there is no indication that this industry-wide practice will cease or materially change in the near future.
Legal Landscape for Master Confirmation Agreements
While much of the regulatory framework governing the Over-the-Counter derivatives market is ill-suited for applying to privately negotiated Master Confirmation Agreements, such as the FXC DEA, there are some circumstances where CFTC regulation does come into play. For example, the CFTC’s definition of swap includes a foreign exchange forward, which is cross-border in nature. In addition, since some Master Confirmation Agreements are entered into by swap dealers, there are implicit trading restrictions upon those market participants that enter into such privately negotiated agreements. For instance, the FEMA rules contain restrictions on dealing with counterparties and requires swaps dealers to designate certain counterparties as Small Bank Holding Companies or Foreign Holding Companies prior to entering into a swap. Similar registrations are also required under the SEF trading rules. Furthermore, there will be restrictions relating to the designated contract markets, including contract specifications and trading hours. In addition, with respect to the clearing of swaps, one cannot capture exempted principal transactions (EPTs) in the context of a Master Confirmation Agreement. Nevertheless, exemptions apply to the execution of swaps between affiliated entities, the cross-border question of whether an entity is "carrying" trades for another entity, and how the clearing restrictions apply to such trading.
How to Properly Draft Master Confirmation Agreement
Master Confirmation Agreements can vary widely in form and substance depending on the parties’ particular deal, risk exposure, and credit policies. However, smart practitioners follow a number of best practices. First, take the time to prepare a customized agreement rather than cut-and-pasting a form that may lack important provisions or incorporate inappropriate terms. Second, consider that the form should reflect the particular negotiation history and relationship of the parties. Third, use plain language to allow even non-lawyers to understand the key terms.
Another important practice is to determine beforehand which party’s form agreement should prevail and to know how an agreement may be modified. For instance, many form agreements specify that the recipient of the instrument writing the confirmation reviews it and returns a copy to the sender, but the agreement goes into effect if no modifications are made within a certain period. Also, many Master Confirmation Agreements state that the sender’s confirmation takes priority in case of inconsistent or differing terms such as a purchase price.
It is also essential to evaluate whether a Master Confirmation Agreement covers all the terms and conditions necessary to adequately govern the transaction. A few examples include confidentiality, representations, warranties, acknowledgements, indemnities, default provisions, delivery details, dispute resolutions, governing law, exclusions, limitations, reliance, consent process, and termination provisions. Best practices dictate that (1) such provisions should include specific coordinates and other information about the financial instruments or product and that (2) each party’s rights and obligations under the Master Confirmation Agreement must be clearly laid out. It is also beneficial to include the applicable law that will govern the interpretation of the terms of the agreement and any dispute that may arise out of it. Finally, it is useful to identify a forum for dispute resolution, such as an exchange, arbitration, or other authority.
Finally, a Master Confirmation Agreement should appoint an managing officer to which the parties are required to direct all notification and correspondence, who will serve as the primary point of contact for the parties, including their counsel.
Practical Situations for Master Confirmation Agreements
When applying these agreements, the position may not be that simple. Let us look at an example scenario involving A and B, trading cryptocurrencies, and both of their positions are good. Assuming the legitimacy of both parties, neither of them is likely to default on the loaned cryptocurrency. However, in the crypto industry, volatile volatility is the name of the game. Both of their positions quickly go bad and they cannot repay the borrowed cryptocurrency. A and B have lost money, but for different reasons. A is a well-advised sophisticated cryptocurrency investor, while B is a retail client. The former, being empowered by legal counsel, understands how to create a risk profile which enables him to hedge against volatility in the market. This hedging strategy means that the cryptocurrency A ultimately ends up selling loses value to a much lesser degree than B’s short position. The long position A has taken achieves capital gains and the repayment of the cryptocurrency lends great creditworthiness to A and allows him to progress in the industry. From a purely paper document position, A has clearly fulfilled its obligation and should be entitled to keep the collateral. On the other hand, although B fundamentally understands the volatile nature of cryptocurrencies, they may not have been capable of navigating an investment strategy and relied on a final, poorly drafted piece of legal advice from time past . If B had paid slightly more and instructed a lawyer to draft the master confirmation agreement it entered into with A, perhaps it would have worked out. While A does redeem the cryptocurrency as described in the master confirmation, B’s position is so bad that it cannot salvage itself. B may bear the capital loss of not paying A back, and subsequently events become irrevocable. In this case, assuming B gives A notice of force majeure, A may agree with B to increase the margin call and B may then be in a good position to pay A back. A "Force Majeure" clause in a repurchase agreement will protect sophisticated traders out of the blue sky. In addition, if each party has a legal right to set off amounts, in case one party owns something to another. It may keep the deal overall but may result in an irredeemable imbalance. The above example shows that a master confirmation agreement, when done correctly, can help both parties understand their responsibilities to each other and the results of default. Positively drafted documents take the sides away from each party and allow for negotiations to form. When the opposite is true, rely on lawyers. The specific application of the Master Confirmation Agreements will, of course, depend on the jurisdiction and the specifics of the transactions. For any business using a Master Confirmation Agreement, it is highly recommendable to seek professional legal advice to ensure that the terms best reflect the objectives of your transaction.