THE FIRST SIX PARAGRAPHS USE “STORYTELLING” AS A WAY TO EDUCATE – IF YOU DO NOT ENJOY STORYTELLING, THEN SKIP DOWN TO “WOULD YOU PLEASE STOP THIS STORYTELLING NON-SENSE TSR?!?!” AND READ FROM THERE TO THE END

A long time ago in a galaxy far, far away, certain derivative trade counterparties called mutual funds (registered investment companies to enlightened 1940 Act bar) could not post collateral directly with a swap dealer due to regulatory restrictions – in particular, the collateral is an asset of the fund that had to be kept in the custody of the bank that the fund’s board had tasked with the safekeeping of the fund’s assets (see Section 17 of the Investment Company Act of 1940).

So, to address these regulatory restrictions these so-called “mutual funds” entered into an agreement – that was ancillary to their ISDA Master Agreement – with the derivative trade counterparty and the fund custodian that:

1) Required the fund custodian (the “Intermediary”) to hold collateral posted by the fund (as the “Pledgor”) for the benefit of the trade counterparty (as the “Secured Party”) in a separate account ; and

2) Allowed the Secured Party to exercise exclusive control over the collateral if the Pledgor defaulted under the terms of the related ISDA Master Agreement.

Because there were three parties (Pledgor, Secured Party, Intermediary) to the agreement and the subject matter was who had control over collateral, the agreements came to be known as “Tri-Party Account Control Agreements” (how unoriginally descriptive in a legal kind of way!).

Initially, many Secured Parties resisted this idea, but slowly after the turn of the last millennium (assuming that we all agree for purposes of this tale that was 2000), it became accepted that the 1940 Act bar was not fabricating the Section 17 issue. Also,  in the meantime, a number of pension plans grew fond of the concept and starting telling their fiduciaries – don’t post collateral directly with a swap dealer, rather keep them with our custodian. It can not be verified, but it is rumored that counsel to some of these fiduciaries really enjoyed saying, “Their clients made them do it.”

Then, becoming more facile with these agreements, several (but certainly not all) Pledgors began to demand that they be allowed to exercise exclusive control over the collateral prior to any default occurring. But the Secured Parties countered that the starting point for control should be the ISDA collateral document (which does not give the Pledgor exclusive control at any point in time),  so many (but not all Pledgors) settled on joint control prior to the occurrence of an event of default.

Then, in the year 2008, a certain investment bank named Lehman went bankrupt, causing a lot of market participants to sit up an ask “WHAT DO ALL OF THOSE DERIVATIVE TRADING AGREEMENTS MEAN AGAIN?” And, after that experience, some (but certainly not all) Pledgors started to demand that they have exclusive control over collateral to which the Secured Party was not otherwise entitled if a) the Secured Party was in default and b) was not responsive to the very reasonable demands of the Pledgor.

Subsequently, in the year 2010, an act was passed by the U.S. Congress called “The Dodd-Frank Act” or some such thing and, somewhere in the center of that gigantic mass, a provision was inserted into Title VII that said, “A swap dealer’s customer can demand that collateral in respect of a non-cleared swap be maintained at an independent-third party custodian” (see Section 724(c), Segregation Requirements for Uncleared Swaps).

And investment management and derivatives lawyers sat up and said, “Here we go again.”

WOULD YOU PLEASE STOP THIS STORYTELLING NON-SENSE TSR?!?!

Sure, for the time being. But, as with all storytelling, there is a point larger than the story and here it is.

1) Section 724(c) of Title VII, Dodd-Frank Act allows customers of a swap dealer to demand that their collateral in respect of a non-cleared swap be held by an independent third party custodian.

2) To allow the customer to exercise this right, it may be the case that parties will need to enter into a tri-party agreement among the custodian, the customer (as pledgor) and the swap dealer (as secured party). Essentially, this agreement allows the customer (pledgor) to post collateral through an account at its custodian. The custodian acts as an intermediary between the pledgor and the secured party, holding the collateral for the benefit of the secured party.  Among other things, the tri-party agreement specifies the circumstances under which the secured party and pledgor can exercise exclusive and/or joint control over the collateral. For this reason, the agreement is often called a tri-party control agreement or a tri-party account control agreement.  It should be noted that it may also be the case that no such “customer level agreement may be required” – the area is one that is subject to possible CFTC rulemaking.  But, the occasion and introduction of section 724(c) does present a good opportunity to focus on the tri-party agreements.

3) Mutual funds and retirement plans have been using these tri-party agreements for quite some time in connection with their OTC derivatives trading activity. In the case of a mutual fund, the use of a tri-party arrangement is a statutory requirement, since Section 17 of the Investment Company Act of 1940 requires, in pertinent part, that the fund’s assets be maintained at a bank or, in certain circumstances, a national securities exchange – an exception is made for initial margin on futures contracts under a rule promulgated by the SEC (Rule 17f-6). As an aside, the American Benefits Council submitted a comment letter to the SEC that makes a compelling case for continuing this practice for retirement plans even vis a vis cleared swaps (see page 13 of 16 in the ABC’s letter).

4) The friction points in the negotiation of a tri-party control agreement are always the same:

a) Circumstances under which pledgor will have a right to exercise exclusive control over collateral prior to its default; alternately, whether joint control will be required at all times prior to pledgor’s default.

b) Circumstances under which pledgor should be able to exercise exclusive control over collateral subsequent to a secured party’s default, especially as it relates to collateral that is in excess of what the secured party is otherwise entitled to by agreement of the parties (frequently referred to as excess collateral).

c) Subordination of secured party’s lien to the custodian’s lien and vice versa.

5) The SEC would do mutual fund shareholders well to take this opportunity to clarify the manner in which Section 17 of the 1940 Act applies to cleared and non-cleared swaps. In providing this clarification, the SEC should articulate uniform standards that should apply to tri-party control arrangements that involve a registered investment company. (HINT: The SEC used to do this in the context of margin on futures contracts – see the series of mid-1980’s No-Action Letters on the topic.)

Go ahead, you can tell us that we are about as “subtle as artillery” (source that phrase to “Who are We Trying to Fool?” – right, Jimmy Buffett, 1998 Don’t Stop the Carnival).