Borrowers for variable rate commercial loans generally enter into interest rate hedging arrangements to eliminate or reduce their exposure to interest rate risk from their variable debt service obligations. While much recent comment has been devoted to changes, waivers, and defaults on commercial mortgages and other commercial loans, careful consideration should also be given to how any action contemplated under of the loan affects the hedging arrangement and whether any corollary action should occur with respect to the hedge. Here are some issues to keep in mind when it comes to interest rate hedges in today’s market environment, particularly if the borrower and lender are considering a loan waiver or modification, or if a loan default can be triggered.
Types of hedging agreements
There are generally two categories of hedging agreements that borrowers use in this context. The first is an interest rate cap, which is technically a series of interest rate options that match the loan payment dates. The borrower pays a premium in advance and receives payment if the interest rates are higher than the strike rate or the ceiling rate at the time of determination, such payment offsetting the debt service payment of the borrower. borrower exceeding the ceiling. The second is a fixed-to-float interest rate swap, where the borrower pays a periodic fixed rate in exchange for receiving a variable rate payment aligned with their variable rate under the loan. Since interest rate caps are fully prepaid, they generally do not imply that the hedging provider has credit exposure to the buyer, whereas interest rate swaps involve a bilateral credit risk. This distinction becomes important in contexts of default or waiver or modification that may require modification of coverage. Since interest rate swaps involve exposure to credit, the hedging provider (who is usually also the lender or one of the lenders) usually takes pro-rata security against the loan collateral and may require that any loan collateral is extended to the interest rate. to exchange.
Separate legal agreements
Borrowers can view their variable rate loan plus a hedging contract as a built-in capped interest rate obligation (in the case of a hedge that is an interest rate cap) or as a synthetic interest rate bond. ‘fixed interest (in the case of a hedge that is an interest rate swap). However, the documents governing these transactions are usually explicit that the loan and the hedge are separate and distinct legal agreements. While the borrower can in practice make a one-time payment reflecting their net debt service and hedging obligation, the borrower has two sets of legal contracts with two sets of rules that govern how the instruments can operate under conditions. extraordinary circumstances.
Questions to consider when considering waivers or related loan modifications
Since the hedging agreement and the loan are separate legal contracts, any waivers or modifications to the loan will not automatically transfer to the hedging agreement and the borrower and lender will naturally be more focused on the loan and the loan. loan documentation. The parties should consider the coverage agreement in the context of any such waiver or modification and make specific reference to the intended effect on coverage in the written agreement relating to such waiver or modification.
If the modification changes the economics of the loan, consider whether the economics of the hedge will also need to be changed. Interest rate caps and fixed-to-floating interest rate swaps are usually tailored to match the loan being covered, and hedging providers should be able to restructure the hedge to match any proposed loan changes. In fact, in loan agreements that require the existence of a hedging agreement and impose certain criteria that the hedging must meet, a modification of the hedging agreement may be necessary to remain in compliance with the loan requirements. However, any restructuring of the hedging arrangement may require direct payment from the borrower even though there is no corresponding cost to restructure the loan.
For loans that are intended to be forborne for a period of time, the parties may wish to restructure coverage for similar toll payment requirements for the forborne period. This may not be relevant for interest rate caps as they are unlikely to be paid during this time due to recent cuts in market interest rates. However, for interest rate swaps this may mean restructuring the swap to reduce or eliminate the borrower’s current fixed payments and correspondingly increase the payments the borrower would make in subsequent periods of the swap. Note that such a change would increase the credit risk that the hedging provider takes on the borrower and that in addition to a cost associated with the restructuring, the hedging provider may require additional collateral, collateral or other credit protection.
As always, with any modification to the hedging agreement, it is wise to consult with tax and accounting advisers to consider any tax or accounting implications such a modification could have on the borrower.
Issues to consider in potential defaults
Many agreements governing interest rate swaps in this context provide that an event of default under the loan or related documents becomes a termination event under the hedging agreement, even if the lender waives or ‘exercise no recourse with regard to this event of default. Although we would not expect a hedging provider (usually in this case the lender or one of the lenders) to exercise their right to terminate the hedging contract while waiving or not exercising rights similar under the loan agreement, borrowers should be aware of this. potential and seek, to the extent possible, to have the effect of a contemplated loan default and / or waiver on the hedging agreement, in writing to limit the possibility of subsequent litigation.
Like the previous bullet point, many of these interest rate swap agreements provide that a sale of the loan by the lender becomes a termination event under the hedging agreement. While the distressed nature of the loan increases the likelihood that the loan will be sold to another lender, borrowers should be aware of the possibility that their hedging contract could be terminated as part of such a sale.
In each of the above contexts, note that terminating an interest rate swap typically involves a termination fee that is a function of current market rates relative to the fixed rate of the agreement, as well as the remaining term and other conditions. For borrowers who entered into interest rate swaps before the recent period of declining market interest rates, their interest rate swap likely has a large negative value that they would be required to pay as part of the early termination.
Provisions of hedging agreements applicable to extraordinary circumstances
Interest rate hedging agreements are typically documented as part of an International Swaps and Derivatives Association (ISDA) framework agreement, including a termination event for “illegality” and, for the 2002 version of the ISDA framework agreement, a termination event for “force majeure”. In interest rate hedging agreements, the primary performance obligation is the exchange of payments rather than the fulfillment of any physical obligation that is more likely to be hampered by the current pandemic or government stay orders. associated home. Although we do not believe that the current situation in the United States would be considered to reach the level of these provisions for interest rate hedging agreements, it would be possible in more severe disruption scenarios than the communication mechanisms or payments are interrupted in a manner that could potentially give rise to these events under the Master Agreement. In this case, one or both parties may be authorized to terminate the cover contract.
© Polsinelli PC, Polsinelli LLP in CaliforniaRevue nationale de droit, volume X, number 101