Lenders in commodity finance will often require borrowers to hedge exposure to commodity price movements. Hedging can shield the borrower from the downside of a change in the price of a commodity and help ensure the borrower can repay the loan. It is common for the borrower to hedge its exposure using exchange-traded derivatives entered into with a clearing broker. Hedges cleared with UK or European-based brokers will usually be principal-to-principal trades between the broker and its client the borrower. The trades will be held in a futures brokerage account maintained with the broker.
The lender will often look to obtain security over this account. Where this is agreed, the security will be contained in a three-way agreement between them, commonly known as a "Tripartite Agreement" or "TPA". This Alert will highlight the key concerns and common negotiation 'flashpoints' from the perspective of the three parties.
What does the Tripartite Agreement cover?
The basic contractual terms agreed between the broker and the client governing the brokerage account will be set out in an agreement between them. This will usually be based on the broker's standard terms of business. The lending terms will be set out in a facility agreement between the lender and the borrower. The Tripartite Agreement bridges the gap between the bilateral brokerage account and lending terms, and deals with matters relevant to all three parties. These will include:
- the client's grant of security in favour of the lender
- the lender's guarantee of, or responsibility for funding, the broker's margin calls
- how it is determined what trades will be held on the secured account
- the rights of the broker and the lender in relation to closing-out the hedging account
Are Tripartite Agreements normally standard form documents? Are they heavily negotiated?
Tripartite Agreements will typically begin life on the standard form of the broker or, sometimes, the lender. They will then be negotiated to a greater or lesser degree. The key negotiating points will usually be between the broker and the lender as potentially competing creditors of the client.
The hedging arrangements protect the cash flow available to the client to repay the facility. In an effective hedging programme, if prices move against the client, this will result in gains to the client on the hedges. If the client defaults, the lender will want the ability to mitigate any losses by enforcing its security and applying the gains against the sums it is owed.
The broker wants to ensure that it does not suffer losses on its trades with the client and protects itself by requiring the client pay initial and variation margin with respect to its futures positions. If the client gets into difficulties, the broker can close out the futures account and use the margin to cover any losses on its trades with the client.
Ranking of security
The lender will want to take security over the trades and other property held in the brokerage account. It will also want to take security over the client's rights against the broker in respect of the account (e.g., rights to receive payment under the trades carried in the account).
The broker will not want the security interests granted to the lender to threaten its ultimate ability to close out the futures account and use the margin held on the account to cover any losses. And so the broker will want its close-out netting rights and any security rights relating to margin to rank ahead of the lender's security rights. This will be addressed through express provisions in the Tripartite Agreement.
Provided it is comfortable with the broker, a lender can probably live with the priority of the broker's close-out netting and security rights as they apply to the specific hedging trades. The lender is interested in securing the client's net gains on those hedges, as opposed to the client's losses due to the broker. One concern for the lender is that the broker and the client may engage in other unconnected futures trading. The brokerage agreement will usually provide that the broker's netting and margining rights will apply across all accounts, thus allowing the broker to use a surplus on one account to offset a shortfall on another. To avoid hedging gains being used to meet other losses, the lender is likely to require that (1) the trades hedging that lender's financing be held in a separate account and (2) the broker's rights relating to close-out and margining apply separately to that account from any other accounts the client has with the broker.
While the lender will want the broker to agree that the secured account is treated separately for netting and margining purposes, the broker will expect the lender in return to accept some level of responsibility for the margin the broker requires to cover the secured account. In some financings the lender will agree to fund the client's initial and/or variation margin payments to the broker. In those transactions, the lender will usually agree in the Tripartite Agreement that it will fund the client's margin payments and that any margin payments it makes to the broker will constitute an advance under the relevant facility. Where the lender advances the margin, the broker and the lender will usually prefer that the lender pays the margin directly to the broker.
Where the lender is not financing the margin calls, the broker will usually expect the lender to guarantee the broker's margin payments or provide some other form of support such as a standby letter of credit. Lenders should take account of these requirements in structuring facilities and analysing their exposures to the client.
Control over the hedging account
Invariably, the client will make the initial decision about what trades should be entered into for the account. In some arrangements, the lender has to pre-approve a trade before it is accepted for the account; in others, the lender has an opportunity to veto that a trade is carried in the secured account.
It will normally be agreed in the Tripartite Agreement that the broker will provide the lender with copies of all statements and confirmations relating to the secured account.
Hedging gains form part of the lender's security and so the lender will not want those gains dissipated. Therefore, the lender may require that the Tripartite Agreement prohibits the client from withdrawing any credit balance from the account without the lender's prior agreement.
The lender will want the right to collapse the tripartite arrangement by requiring that the broker close-out the client's open positions in the account. Generally, in Tripartite Agreements these rights are written very broadly and do not, for example, require that there has been a default under the facility agreement. This reflects convenience for the lender and a broker using its standard-form. But it can be of concern to a client that has negotiated that only the occurrence of specific events of default (perhaps including termination of the hedging arrangements) enable the lender to accelerate its facility.
Brokers will generally look to preserve their (usually wide) rights to close-out the account under their brokerage agreement with the client. Clients and lenders will generally agree to this. But clients can have concerns about precipitant broker action triggering cross-acceleration provisions in the facility. In some cases, a lender may want the right to receive prior notice of, and potentially veto, any close-out so as to prevent a close-out in circumstances that reduce the lender's recovery. This approach can cause difficulties for a broker as the brokerage account is likely to be their sole source of recovery and any delay in close-out may expose the broker to significant risk. Hence, brokers will usually resist this approach.
Tripartite Agreements can give rise to difficult legal issues. These include whether the lender's security over the hedging account should be and/or can be fixed rather than floating and whether it needs to be registered or is exempt pursuant to the Financial Collateral Regulations.*
(a) type of security
Under English insolvency law, floating security has several disadvantages including that the holders of such security rank behind: (1) holders of fixed security; (2) the expenses of the insolvent estate; and (3) certain 'preferential' creditors. In addition, pay-out will be subject to the prior carve-out of the fund available for distribution to unsecured creditors and later fixed security will take priority over earlier floating security.
While fixed security has clear advantages over floating security, it requires the lender to have control over the charged asset i.e., the hedging account and the proceeds in that account. This standard is very difficult to meet in the context of security over brokerage accounts maintained by a third-party broker and would in any case make the operation of the hedging account burdensome.
(b) registration of security
Where the client is an English company or is an overseas company that has registered one or more places of business in England and Wales, the English law rules about registering company charges will be relevant. In practice, where the rules are relevant, the lender's security may well be registrable either because it is a floating charge or because it is regarded as a charge over "book debts" of the client.
Registrable charges must be registered at Companies House within 21 days of creation otherwise the debt secured by the charge becomes immediately repayable and the charge is rendered void against a liquidator, administrator or creditor of the company. In practice, the lender will have control over ensuring charges are registered, but it is the client (as the company creating the charge) who is legally responsible for doing this.
The Financial Collateral Regulations provide that certain specified types of 'security financial collateral arrangements' are exempt from the registration requirements that would otherwise apply. The Regulations are complex, and it is unlikely that most Tripartite Agreements will meet the conditions for exemption from the registration requirements.
Broker or lender failure
As the MF Global insolvency has shown, it is not just clients that can get into financial difficulties. It is prudent for a lender in a tripartite arrangement to make sure it has the right protections if the broker fails.
If a broker loses creditworthiness or, where the relevant legal and regulatory regime allows, defaults or becomes subject to an insolvency procedure, the client may be able to transfer its positions to another broker. In that case, the lender would presumably seek to put in place tripartite arrangements with the new broker and should think about what rights it has under the facility agreement if it fails to agree satisfactory terms with the new broker. Under most current clearing models in the UK and Europe, client margin will not be transferred with the positions. Thus, the client (or lender) will need to fund margin covering the positions with the new broker.
Transfers of positions are not always possible and the exchange may close-out the client's positions resulting in the loss of the hedges and the client either having a claim in the insolvency or owing a settlement amount to the defaulting broker. Again, a lender should think about what rights the facility agreement should grant it if this happens.
If a lender gets into financial difficulties, a broker will typically want the ability to terminate the separate account and so should think about whether its brokerage agreement close-out rights would allow it to do this.
Tripartite Agreements are a common feature of commodity
financings and their use may rise as regulation pushes greater
clearing of derivatives. It is important that in negotiating these
agreements parties are sensitive to the legal issues that can arise
as well as the commercial concerns of the other parties.
*The Financial Collateral Arrangements (No. 2) Regulations 2003 (2003 No. 3226) (as amended)
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.