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Trading profit and loss account questions and answers doc
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. The basic contractual terms agreed between the broker and the client governing the brokerage account will be set out in an agreement between them.
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.
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.
The lender will want to take security over the trades and other property held in the brokerage 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.
This will be addressed through express provisions in the Tripartite Agreement. One concern for the lender is that the broker and the client may engage in other unconnected futures trading.
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. Where the lender advances the margin, the broker and the lender will usually prefer that the lender pays the margin directly to the broker. Lenders should take account of these requirements in structuring facilities and analysing their exposures to the client.
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.
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. 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.
Under English insolvency law, floating security has several disadvantages including that the holders of such security rank behind: 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.
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. 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.
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 Regulations are complex, and it is unlikely that most Tripartite Agreements will meet the conditions for exemption from the registration requirements. 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.
Again, a lender should think about what rights the facility agreement should grant it if this happens. 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. Introduction Lenders in commodity finance will often require borrowers to hedge exposure to commodity price movements. What does the Tripartite Agreement cover?
Competing creditors The hedging arrangements protect the cash flow available to the client to repay the facility. Ranking of security The lender will want to take security over the trades and other property held in the brokerage account. Margin 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.
Control over the hedging account Invariably, the client will make the initial decision about what trades should be entered into for the account. Tricky issues Tripartite Agreements can give rise to difficult legal issues.
Broker or lender failure As the MF Global insolvency has shown, it is not just clients that can get into financial difficulties. Conclusion Tripartite Agreements are a common feature of commodity financings and their use may rise as regulation pushes greater clearing of derivatives.