It’s amazing what you miss when you ignore social media for a few days. For example, take this declaration published in a recent article in the Minnesota Star Tribune: “The days when a convicted bank robber could get a job selling gold coins in Minnesota are coming to an end.” What? Over already? I only just learned that this is a thing! But alas, it’s true. It seems that unscrupulous numismatists are about as common as lakes up there in Minnesota, so much so that the state recently passed a law aiming to get the crooks out of the coin business.
The new law shakes down around two central thrusts: regulate retail coin dealers, and formalize the transaction relationship. No longer can convicted felons pitch complete sets of American Silver Eagles as a retirement nest egg for Grandma. All dealers will be subject to criminal background checks, be required to post a surety bond that consumers can access in event of misdealing, and suffer fines as high a $10,000 for each infraction. As for bringing more formality to the transaction, the requirements are a little less succinct.
If you are classified as a Bullion Coin Dealer (retail buyer and seller of coins), then you are required to provide a written invoice to customers containing price and precious metal content of all purchases, and including the ID number issued to you by the Department of Commerce. The new law requires you to detail to the customer the date that you will deliver any coins you’ve sold, to pay the customer by the agreed upon time for any coins you purchase, and respond within three days to customers asking about delivery status. Finally, you can’t renegotiate the terms of the sale after receiving funds, misrepresent the terms of the sale, or violate any federal, state or local law relating to the transaction. While all of these steps are important to protecting coin buyers, there is yet to emerge anything resembling formalized documentation complying with these requirements.
The swap world is ever so slightly more regulated than the coin dealing world (but only by several thousand pages of regulation and legislation). Various licenses and registrations are required, depending on where you slot in the process, and since the introduction of Dodd-Frank, documentation governing the terms of all trading relationships is mandatory before parties can trade. The good news is that, unlike the numismatic sphere, the swaps world has a tried and true document for formalizing trading relationships: the ISDA Master Agreement.
If you’re reading this newsletter, there’s a good chance that you’ve either come in contact with, or at least had to think about an ISDA Master Agreement, or an ISDA for short. But what exactly is it, and what is it good for?
The derivatives world has been trading under documentation published by the International Swaps and Derivatives Association as far back as 1987. These documents are not officially sanctioned by any US regulatory body, but have been widely accepted as the market standard in derivatives documentation for more than 20 years. The two most commonly used documents are the 1992 ISDA Master Agreement and the 2002 ISDA Master Agreement. It is apparent from their names that both of these documents pre-date the recent ramping up of regulation since Dodd-Frank, but even through this period of drastic transformation they have retained their relevance.
The ISDA does many things and affects nearly all aspects of the swap trading relationship, but its primary importance breaks down along three main lines (the Three Pillars of ISDA):
- 1. Single Agreement: While some derivatives end-users will only ever have one derivative executed with a given bank, the ISDA is designed to allow counterparties that have more than one trade (which indeed accounts for the vast majority of derivatives users) to bundle all of their OTC derivative transactions into one single agreement. This has the excellent advantage of standardizing the terms of all swaps (used here to mean relationship and legal terms; economic terms are, of course, individually tailored) between two parties. But beyond that, this is also invaluable in a bankruptcy scenario. If your counterparty goes into receivership and all swaps you have with that counterparty constitute a single agreement, then the bankruptcy court is prevented from “cherry picking”, or upholding the swaps where you owe money to the bankrupt entity, and annulling swaps where you are owed.
- 2. Condition Precedent: The obligation for one party to make payments to its counterparty is solidified in the ISDA, but it is also conditional upon a certain precedent. The “condition precedent” to making these payments is that no Event of Default or Termination Event (as defined under the ISDA) has occurred. This doesn’t mean that the obligation to make the payment goes away just because your counterparty falls afoul of certain provisions in the agreement, it merely suspends the requirement to do so. If the trade is terminated, the unpaid amounts will still come due in the final settling of the termination. The real advantage to Condition Precedent comes into focus when considered alongside Set-Off. In brief, Set-Off means that you can set-off, or not pay, an amount that your counterparty owes you over here against an amount that they owe you over there. For example, I owe you $100 under swap A, you owe me $150 under swap B, but when the swap is terminated, we’ll just say you owe me $50 and I owe you nothing. That’s set-off. Because Condition Precedent lets you stop making payments as soon as your counterparty triggers an Event of Default or Termination Event, this allows you to avoid paying into an entity that could potentially be financially distressed. In the event that this entity goes into insolvency, rather than making payments you owe at face value and receiving payments owed to you at pennies on the dollar, you set-off the payments you owe against the face value of payment owed to you.
- 3. Close-out Netting: Like Single Agreement, Close-out Netting is designed with multiple swaps in mind. If and when the time comes to terminate, or close-out, some or all existing transactions under an ISDA, do you have to calculate individual settlement amounts for each trade, or can you net them all down into one easy number payable in whichever direction is due? The Close-out Netting provision in the ISDA gives you the right to do exactly that, and your accountants will love you for it.
In addition to the three Pillars of ISDA, the ISDA Master Agreement plays many other important roles, among them defining Events of Default and Termination Events, making critical tax and other representations, providing contact information and so on. It is also flexible enough to comprehend the ever changing regulatory environment that derivatives inhabit. It is, in short, a wonderful thing.
But like a coin collection, it’s only wonderful if you know exactly what you are getting. Negotiating ISDA terms with your counterparty can be complex and overwhelming, and the advantage goes to the party with the most experience. At Chatham, we help our clients negotiate over 2,000 ISDA documents each year. While we always advocate for our clients, we also have ongoing dialogue with the dealer banks that our clients face. This helps us keep our finger on the pulse of where the market stands at any given moment on particular trends and issues and make sure that our clients get the best possible terms.
With a little bit of legal finesse and just the right creative touch, I wonder if the ISDA Master Agreement might not just work for numismatic transactions? It could be called the NumISDAmatic Master Agreement, and who knows but that it might just be the balm that the Minnesota coin dealing industry’s reputation needs. If you want to talk more about ISDA in general or about any ISDAs you have outstanding, give us a call. In the meantime, keep saving those Drummer Boy Quarters; you never know when you’ll be in Minnesota next. Please give us a call at 610.925.3120 or email us.