To ISDA or not to ISDA? The Purpose of Long Form Confirmations

When negotiating ISDA Master Agreements (“ISDA”), it is impossible not to come across Long Form Confirmations (“LFCs”).    

LFCs are used if parties wish to engaged in a derivatives trade, but have not yet executed an ISDA and are unable to do so within the timeframe required. Instead, they typically agree to use their best endeavours to enter into an ISDA as soon as possible and until then the ISDA Form (which is essentially an ISDA without the negotiated Schedule) is deemed to be incorporated into the LFC.

LFC can therefore provide a speedy solution to document a transaction, but one which provides a minimal protection, as it is stripped of all the choices and additional provisions and enhancements we would normally want to see when entering into an ISDA (albeit you can negotiate the inclusion of certain ISDA elections into the LFC, time permitting). While LFCs do the job, they are not an ideal solution and generally not advisable unless absolutely necessary (e.g., trading is imminent or the trade has been already placed) as they simply do not provide adequate protections when compared to ISDAs.

Typical LFCs confirm the governing law and jurisdiction and the termination currency in addition to setting out the economic terms of the transaction that is being entered into. You will therefore be making only two or three basic elections out of multiple that ISDA Schedule allows. There are certain risks associated with this, as you will be effectively waiving such protections like additional termination events, events of default, financial deliverables, calculation agent dispute rights, tax representations, payment measures and methods, just to name a few.

Also, one must not forget that if no choices are made at all in respect of the ISDA Schedule, certain fallbacks automatically kick in and these usually are not favourable for the buy-side as the pre-printed form of the ISDA was designed to protect the dealers. The key provision to mention in this context is cross default, which would not apply unless selected in the ISDA Schedule. This means, for example, that if your counterparty defaults on its debt obligations under any loan agreements with other banks, those banks with signed ISDAs could terminate their transactions with your broker while you could not. Not to have cross default applying is a counterparty credit risk you need to consider. Further, if for whatever reason the trade collapses before the ISDA is signed, you will be at the mercy of your counterparty when it comes to final calculations, benchmarks they will use, close-out amount due, settlement timings and any other commercials that they will decide at their sole discretion, moreover you will have no ability to dispute any of their determinations or calculations.

In my view, there are at least four good reasons to argue for an ISDAs over a LFC: (i) it is easy to do further transactions (credit lines permitting) if it’s already in place (LFC covers a one-off trade), (ii) it covers a variety of different products (again, LFC is one specific trade); (iii) the close-out mechanism under the ISDA is proved and works in a court; (iv) the single agreement concept prevents liquidators from cherry picking.

Also, there is some interesting case law on LFCs  (see LSREF III Wight Limited v Millvalley Limited or Macquarie Bank Ltd v Graceland Industry Pte Ltd), which illustrate the potential issues you need to consider, including human errors conducted by banks when restructuring LFC trades, incorrectly prepared LFC documentation and technically simple trade collapsing before the ISDA was entered into, thus causing issues with close-out amounts. It is also worth noting that the Risk Mitigation Standards published in 2014 by ISOCO (International Organisation of Securities Commissions) confirm that LFCs should only be used in exceptional circumstances and as one-off transactions. According to the IOSCO guidelines, agreeing a master agreement whenever possible before entering into transitions should always be the preferred option.

Having said that, it’s important to consider each LFC individually, in a context of a specific trade, and approach the risk associated with it from a realistic, commercial perspective. If the relevant approvers are happy to accept the risks involved and the ISDA is already in negotiation, then it is a commercial decision for the relevant stakeholders to make (more than a legal matter).

One last final point, if the transaction you’re contemplating an LFC for has already been entered into, then the signing the LFC may be your best option – in this case, any documentation is better than none!

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Best regards,

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