"E-Alert: Derivatives—Vol. 1 Issue 1"

• Andrews Kurth Announces New Derivatives and Hedge Fund Practice Group
• Derivatives & Derivative-Specific Risks
• Case Study: The Anatomy of a Collar
• Current Trends & Practice Tips

Hedging the Right Risk

Andrews Kurth LLP announces the formation of the Derivatives and Hedge Fund Practice Group. Pulling resources from its Dallas, Houston, London and New York offices, this group will serve clients in their investment and risk management needs. Experienced in all facets of derivatives and private investment fund work including formation, compliance, tax matters, trading (prime brokerage, Repurchase Agreements, ISDA Master Agreements, Trade Confirmations Master Netting Agreements, Overseas Securities Lenders Agreements and other similar agreements), direct investments (including PIPE transactions and venture capital), financing, distressed debt investments and credit derivatives.

Members of the group include:

Dallas--David Barbour: David's practice includes experience in various commercial transactions on a national and international basis, including: structured debt issuances of asset-backed securities; the negotiation and structuring of various corporate financings, swaps and other derivatives; the negotiation and structuring of asset and stock acquisitions; and general corporate and securities transactions.

Houston--Roy Bertolatus: Roy's practice includes securities offerings; mergers and acquisitions; venture capital and corporate finance. Roy has represented clients in connection with fund formations, investments in portfolio companies, securities offerings and private placements.

David Buck: David's practice includes public and private equity and debt offerings; mergers and acquisitions; and representation of purchasers in negotiating and structuring equity derivative transactions.

Jeff Dodd: Jeff's experience includes representing venture capital and other investment groups or funds in financing transactions as well as in merger and acquisition and change of control transactions. Jeff advises regulated companies (including broker/dealers and investment advisors) as to regulatory compliance matters.

Barney Loeffler: Barney has experience in derivative transactions involving crude oil, natural gas, refined products and interest rates and in negotiating ISDA Master Agreements and ISDA Credit Support Annexes.

Jason Peters: Jason's experience involves a broad spectrum of project finance and real estate matters. Jason also has significant experience in negotiating ISDA Master Agreements.

Eddy Rogers: Eddy's practice includes the formation of private leveraged and unleveraged junk bond fund partnerships and venture capital fund partnerships; and representation of issuers and investor groups in numerous venture capital financings.

London--Danny Sullivan: Danny is admitted to practice law in England and in New York and has experience in a wide range of derivative instruments, including credit derivatives.

New York--David Concannon: David's practice includes general corporate and securities work with an emphasis on mergers and acquisitions, capital markets and venture capital transactions for technology companies.

Marguerite Felsenfeld: Marguerite's practice includes the purchase and sale of claims and securities of distressed and bankrupt companies. In addition, Marguerite has experience in international banking, portfolio management for CDO's and municipal bond reinvestment programs.

Kenneth Rothenberg: Ken represents Wall Street financial institutions and small to large investment funds. Ken has experience with credit default swaps, total return swaps and is experienced in negotiating ISDA Master Agreements and ISDA Credit Support Annexes.

Derivatives & Derivative-Specific Risks

In light of the recent stock market turmoil and the situation at energy trading companies, talk of "Derivatives" and "Derivative Contracts" is starting to become common. However, many people have been left asking the question, "What is a derivative?"

A derivative is a contractual relationship between two or more parties where payments are derived from some agreed-upon benchmark. Common examples of derivatives are forward contracts, futures, options and swaps. A derivative could be based upon virtually any benchmark, from an individual stock or basket of stocks to the temperature in Norway, and can be tailored to hedge existing positions, provide funding (similar to a loan), mirror equity or debt investments, provide additional leverage, or almost any other scenario imaginable. Almost all derivatives transactions utilize leveraging of one type or another, and as a result, can involve significant risks and potential returns.

Derivatives have been utilized in the financial sector for many years to manage risks with increased precision, to decrease funding costs, and to limit risk on other investments. In fact, since the International Swaps and Derivatives Association began surveying derivatives activity, estimates of the notional amount of outstanding derivatives have grown from under $700 billion in 1987 to over $69 trillion at the end of 2001.1 Federal Reserve Chairman Alan Greenspan has acknowledged that the use of derivatives has increased economic efficiency allowing "financial market risks to be adjusted more precisely and at a lower cost than is possible with other financial instruments."2

Derivative-Specific Risks

Clients must be aware of the risks involved in entering into derivatives. In addition to the normal investment risk that the underlying benchmark may move in the wrong direction, derivatives also involve a variety of more specific risks:

Counterparty Risk

The identity of the counterparty is not generally an issue when purchasing publicly traded derivatives, but counterparty risk is an important factor in individually negotiated derivative contracts (also known as Over-the-Counter or OTC derivatives). If the counterparty to an OTC derivative is unable or unwilling to pay its obligations, the value of the derivative may be nullified. Stringent collateral terms requiring the counterparty to post collateral to assure its performance can be used to help reduce the credit risk inherent in an OTC derivative.

Because derivatives are not necessarily traded in the open market, the pricing of the derivative (and any payments to be made) may be difficult to determine. This risk should be addressed through agreed pricing mechanisms and an established dispute resolution procedure.

As in any investment involving the use of leverage, the risk of a change in the value of the underlying benchmark may be significantly magnified by the derivative. In addition, changes in a party's financial situation may impact its ability to continue a derivatives transaction (i.e., a counterparty may terminate a derivative under certain circumstances, frequently including changes in the other party's credit-worthiness).

Because the derivative may not have a ready-made market, a premature exit may be more difficult than with other investments. For most types of derivatives, counterparties will unwind promptly and at a fair value; however, in some cases this unwind procedure can take days. Early unwind rights should be negotiated for certain types of derivatives.

Event-Driven Risks

Events effecting the underlying benchmark can significantly alter the derivative. Common events that should be addressed include mergers, insolvency, market disruption events, illegality and impossibility.

Andrews Kurth's Derivatives and Hedge Fund Practice Group has experience dealing with these risks and the many other considerations involved in derivatives transactions. Please contact one of us to assist you in negotiating these transactions or to further explain the risks involved.

Case Study: The Anatomy of a Collar

For years now, stockholders have “collared” shares to lock-in gains, especially when the stock represents a significant percentage of a person’s net worth or overall portfolio. The bursting of the dotcom bubble has brought prominence to some of these collars, including Mark Cuban's collar of his Yahoo stock. The following article gives an example of the anatomy of a collar using the publicly available information about Cuban's Yahoo collar. A collar is essentially a risk shifting agreement between parties allowing the current stockholder to lock-in gains at a certain level (frequently with an accompanying loan). Under a collar, the parties (the "Stockholder" and the "Bank") agree to place both a floor and a cap (or ceiling) on the price of stock for a defined period of time, effectively creating a "collar" around the stock. If the price of the stock is below the floor at the end of the collar, the Bank pays the Stockholder the difference between the current market price and the floor. If the stock price is above the cap, the Stockholder pays the Bank the difference between the stock price and the cap. If the Bank held the shares as collateral for the collar (and a loan), the Bank will return the shares to the Stockholder once all payments are made and any loan is repaid. The Stockholder may elect to sell some of the shares to pay any losses on the collar (in this case, any gain recognized on the sale of the stock may be offset by the loss on the collar).

Both the floor and the cap can be set at almost any point, but are generally priced so that the transaction is costless for the Stockholder through the setting of the floor with a corresponding cap. The cap is generally set at a price that would equal the cost of the floor. Accordingly, a higher floor price will result in a lower cap price, and vice-versa.

The actual pricing is based on the term of the collar and the volatility of the stock. The Stockholder could actually pay for a higher floor with additional funds, but most choose to have the floor at a level of approximately 80 - 90% of the current market price, and the ceiling set at a price of equal value. A collar is frequently married to a loan. This allows the Stockholder to borrow money against the stock on better terms than he could without the collar (the Stockholder can usually borrow up to 90% of the floor price at desirable interest rates). In addition, as the Bank will require that it hold the shares as collateral, it is fully secured during the term of the collar. As a result, the Stockholder does not need to worry about margin calls during the term of the collar. In this manner, the stockholder may hold on to his stock (differing from a taxable sale), lock-in a certain minimum value, and obtain cash on reasonable terms.

In the Cuban example, Cuban held approximately 14.6 million shares of Yahoo, which were trading at $95 per share, for a total market value of almost $1.4 billion. Cuban had the option to: (i) sell his shares and recognize his gains, (ii) hold the shares in hopes of future gains but at the risk of a future loss, or (iii) engage in a collar or other hedging transaction to lock-in certain gains. Cuban chose to enter into a three-year "costless collar" for his Yahoo stock. In this case, it has been estimated that Cuban received a floor of $85 a share and a cap of $205 per share. Initially, when Yahoo soared to $237 per share in January of 2000, Cuban's collar did not appear to be a wise move, but in light of Yahoo's current price of roughly $13 a share, the collar may have saved Cuban over one billion dollars.

In more recent times, forward sales and other derivatives transactions have been used to replace some collar and loan arrangements resulting in improved tax and lending terms. Please contact a member of the Derivatives and Hedge Fund Practice Group for further information and assistance regarding collars and similar transactions.

Current Trends & Practice Tips

The stock market's increased volatility over the last few years has led to significant changes in the standards used for ISDA Master Agreements ("Master Agreements"), the base document that governs most OTC derivatives transactions. Many dealers have tightened their credit terms and otherwise amended the standard form agreement in ways that have created significant concerns for many of our clients. By way of introduction, all of our clients should be aware that Master Agreements, Master Trade Confirmations, and other similar documents are not set in stone or truly "standard" in form. These agreements are negotiated regularly by many of our clients. In addition, some clients actively seek to amend their older agreements to more appropriately recognize the current size and market power of the client (and to facilitate uniform agreements). This article is designed to make our clients aware of some of the many issues that they should consider and be watchful of in entering into Master Agreements and similar arrangements.

Monthly, Quarterly and Annual NAV Measures. Many dealers have shifted from using simple Net Asset Value ("NAV") floors to floating NAV termination events. Typically, these termination events apply if the client's NAV has declined by 10-20% in any month, 15-35% in any quarter and 20-45% in a floating 12-month period. These NAV events are typically triggered by both redemptions and trading losses, as a result, funds need to be particularly cautious in negotiating these provisions. In some cases, it may be appropriate to separate redemptions from trading losses.

Beware of Cross-Defaults

Clients should be very concerned about obligations that are no longer being given the protection of the "Cross-Default Threshold." Many Master Agreements may now be cross-defaulted over very small dollar amounts.

Additional cross-default and/or netting language added to a Master Agreement must not contradict the terms of the agreement subject to the cross-default provision. Watch for aggressive cross-default language that might permits the Counterparty to cross-default the Master Agreement upon a technical default of another agreement. In theory, a cross-default provision of this type would allow the Counterparty to default the Master Agreement (and take close-out steps) even though the "defaulted agreement" still has an applicable grace and/or cure period. Optional Early Termination

Many dealers are now seeking to place optional early termination provisions in the Master Agreement. Traditionally, these provisions, which allow the dealer to terminate a trade after a specified period of time (frequently two years), have been restricted to trade confirmations. Although a trade confirmation generally governs in the case of an inconsistency between it and the Master Agreement, it must be noted that an optional early termination provision would not be considered inconsistent with most confirmations. For the confirmation to override the optional early termination provision, it should state specifically that the dealer's optional termination right does not apply to this transaction. Short of a specific contradiction, any trade should be viewed as lasting for the period set forth in the confirmation, unless earlier terminated at the dealer's option.

Optional early termination raises a second concern for client's administrative managers. Many traders who only see the trade ticket and/or confirmation, may not realize that the optional early termination provision applies. As a result, a multi-year hedge may not be as "hedged" a position as desired. Though we have found great resistance to eliminating optional termination provisions from recent Master Agreements, we have had success extending the notice periods (usually offered as five calendar days) to allow our clients time to place their position with another dealer.

Bilateral Credit Support

Traditionally, many hedge funds and wealthy individuals have not had bilateral credit support, i.e., they have been required to post collateral to the dealer, but they have not had collateral posted by the dealer to them. However, clients should be aware that many dealers do offer bilateral credit support to some of their clients. In addition to giving clients additional security in their position (i.e., a client in the money by $50,000,000 may be able to hold $49,000,000 of the dealer's treasury bills as collateral), the client can frequently post the collateral to other dealers to cover any exposure elsewhere. This may be permitted through what is termed a "6(c) election" allowing rehypothecation. Obviously, the ability to rehypothecate collateral from one dealer to another can lead to significant savings in cash management.

In addition, though some dealers do not allow rehypothecation, they may still allow a bilateral Credit Support Annex through the use of an appropriate custodian. Under this arrangement, the dealer would post collateral to the client by placing it in an account with a custodian meeting certain size and credit criteria. Though this arrangement is generally less beneficial than full bilateral credit support, it may be valuable as a starting point for future negotiations.

OTHER IMPORTANT ISSUES TO WATCH

Reasonable Assurance Provisions

Under these provisions, the dealer may, in its discretion, ignore the agreed collateral movement provisions of the Credit Support Annex, and ask for additional collateral at any time.

Minimum Transfer Amount

In many Master Agreements where the dealer offers a bilateral Credit Support Annex, the dealer's Minimum Transfer Amount is considerably greater than the client's Minimum Transfer Amount. This can result in a bizarre situation where the client may move $250,000 in collateral to the dealer when it's trades are down, but may not be entitled to the return of its collateral upon its trades heading into positive territory until the dealer's Minimum Transfer Amount is reached. This problem can be avoided by adding language such as the following: "For purposes of calculating the Return Amount, the Minimum Transfer Amount for Institution shall be $250,000 (match the client's Minimum Transfer Amount)."

Though the rounding of collateral movements always seems innocuous enough, in Master Agreements without bilateral credit support, rounding almost always works against the client. Generally, the Delivery Amount is rounded up, while the Return Amount is rounded down, resulting in the dealer always being on the side that receives the benefit of the rounding.

Hedging the Right Risk

Derivatives have become an important risk management tool for clients in many industries. Some of these industries have many factors that need to be thoroughly evaluated in order for the derivative to have the desired result. It is crucial when purchasing and negotiating a derivative to be used to hedge risk that the client ensures that the derivative matches the underlying risk to the required degree. The following tale illustrates this important concept:

A company producing natural gas in South Texas once decided to hedge its exposure to gas prices. The company purchased a derivative contract from a counterparty on the basis that if NYMEX gas fell below a specified price, the counterparty would pay the company; if NYMEX gas rose above the specified price, the company would pay the counterparty. Consequently, the company hoped to lock-in its return on the gas it produced and to eliminate exposure to price fluctuation. Unfortunately, the hedge did not have the desired result.

It was an extremely cold winter, and the NYMEX price, which is based on the Henry Hub prices (the price where seven pipelines converge around Erath, Louisiana), took off and remained well above the specified price for the entire winter. However, the Henry Hub was a "choke" point for gas going east and all the capacity was already taken on the pipelines running east, leaving no way for more gas to be run through the pipelines. As a result of the lack of capacity for additional gas, prices west of the Henry Hub (the market in which the company sold its gas) remained below the specified price for the entire winter.

As a result of the NYMEX price being above the specified price, the company had to pay the counterparty under the hedge, even though the prices actually obtained by the company for its gas were well below the specified price. The result was that the company made a loss on both the physical sales and on the derivative -- a result the company had not considered! This problem would not have arisen if the company had purchased a hedge based on the purchase point for its gas, instead of buying a swap based on an index which did not relate to the price risk it was attempting to hedge.

Footnotes

1 Source: International Swaps and Derivatives Association (www.isda.org/statistics/index.html).