1. The Core Concept

In a typical deal:

• Borrower has Term Loan + Interest Rate Swap to fix floating rate.
• Senior Lenders have security: mortgage, share pledge, account charge.
• Hedge Counterparty is often same bank or different bank.

Question: Does hedge counterparty get benefit of same security? If yes, in what order?

Under LMA (Loan Market Association) Standard Documents:

LMA Real Estate Finance Intercreditor: "liabilities under the Senior Facility and the Hedging Agreements (pari passu), and... first, the liabilities under the Senior Facility and the Hedging Agreements (pari passu)"

LMA Super Senior Intercreditor for Leveraged Deals: "A common security package would benefit both the bank lenders and the high-yield bondholders as well as any permitted hedging liabilities." The bank debt and bonds rank pari passu as regards payment and common security

Fieldfisher Analysis of LMA REF ICA: "amounts due by the senior borrower to the Hedge Counterparties rank first and pari passu with the senior facility liabilities as to both (a) payment and (b) transaction security; and third and pari passu with senior facility liabilities in post-enforcement waterfall"

If you FAIL to document this in Intercreditor Agreement (ICA) and Security Deed, you have:

1. No Collateral Sharing: Hedge is unsecured - ISDA close-out will not be paid from security proceeds
2. Wrong Ranking: Lenders think hedge is super senior, hedge thinks it's pari passu - dispute on enforcement
3. Regulatory Capital Failure: Bank cannot claim CRM benefit under Basel if collateral sharing not legally enforceable

2. Essential Documents Required (What Must Be Documented)

Failure is usually omission of one of these:

A. In Facility Agreement: Clause designating Hedge Counterparty as Secured Party / Finance Party

B. In Intercreditor Agreement:

• Definition: "Hedging Liabilities", "Hedge Counterparty"
• Ranking: "Super Senior Debt means all Liabilities due to: (b) a Hedge Counterparty under a Hedging Agreement" and "first, the Super Senior Debt (pari passu)"
• Subordination of intra-group hedges vs third-party hedges

C. In Security Documents: Security Trustee holds security for Senior Lenders AND Hedge Counterparties

D. In ISDA Schedule / CSA:

• Reference to ICA - "The Transaction Documents constituted the entire agreement and understanding of the parties with respect to their subject matter" - If ICA not referenced, ISDA may override
• Collateral type - One-way or two-way CSA

3. Case Laws - Consequences of Failure

CASE 1: BDC Finance L.L.C. v. Barclays Bank PLC - NY Court of Appeals 2015 - The CSA Collateral Call Crisis

Facts: BDC (hedge fund) and Barclays had ISDA + CSA. During 2008 crisis, collateral values collapsed. BDC sent Notice of Failure to Transfer Return Amount for $40M. Barclays disputed calculation.

Issue: Whether undisputed portion of disputed collateral call payment was timely under ISDA CSA.

Holding: NY Court of Appeals held questions of fact existed on whether payment was timely and complete under ISDA Master Agreement and CSA during onset of financial crisis.

Lesson for Collateral Sharing: Court noted this case "involves a derivatives transaction that—like more than 90% of derivative transactions—is governed by ISDA forms". If collateral sharing with senior lenders had been documented, Barclays could have set off against loan collateral. Because it wasn't, hedge collateral dispute became standalone unsecured claim.

CASE 2: The State of The Netherlands v Deutsche Bank AG - [2018] EWHC 1935 (Comm) & [2019] EWCA Civ 771 - Negative Interest on Hedge Collateral

Facts: State and Deutsche Bank had ISDA + 1995 CSA. CSA required Transferee to pay interest on cash collateral at EONIA -0.04%. When rates went negative, State claimed Deutsche should pay negative interest.

Holding: High Court and Court of Appeal: "Transferor of cash collateral under standard form 1995 ISDA Credit Support Annex was not obliged to pay, or otherwise account for, interest to the Transferee where contractually stipulated rate was negative" and "if the parties had envisaged that State might be entitled to receive negative interest, it would have been spelled out in the Agreement"

Relevance to Hedge Collateral Sharing: If you don't spell out in Paragraph 11 of CSA / ICA that hedge collateral sharing includes interest, negative interest, and reuse rights, English courts will NOT imply it. Must be express.

CASE 3: TRM v. BNP Paribas - Dovetailing Loan and Hedging - [Taylor Wessing Analysis]

Facts: TRM had Facility Agreement with lenders, and hedging with BNPP. BNPP was described as Hedging Bank but was not a party to Facility Agreement in this capacity. TRM alleged hedge resulted in significant negative cash flow not in line with requirements.

Holding: English courts held ISDA is entire agreement. Because BNPP was not party to Facility Agreement as Hedging Bank, it could not claim benefit of loan covenants / security. Lender's attempt to cross-default hedge failed.

Lesson: This is classic failure to document hedge collateral sharing. If Intercreditor had said hedge liabilities are secured, BNPP could share. Since not, hedge was standalone.

CASE 4: VCG Special Opportunities Master Fund Ltd v. Citibank NA - "Documentation Disadvantage"

Facts: Fund thought confirmation specifying Independent Amount relieved it of further collateral under CSA.

Court Criticism: "The VCG Fund litigation was based on completely erroneous premise that confirmation specifying Independent Amount relieved VCG Fund of any further obligation to post additional collateral under CSA. The VCG Fund suffered the most avoidable Documentation Disadvantage of all; it failed to read and understand what it had agreed to when it executed CSA"

Principle for Lenders: If your loan agreement says hedge is collateralized but your CSA says Independent Amount = 0 and no sharing, CSA prevails for hedge. Lenders lose.

CASE 5: Credit Suisse International v. Stichting Vestia Groep [2014] EWHC 3103 (Comm) - Capacity and Collateral

Dutch housing association entered into €2Bn swaps, later claimed lack of capacity. CSI claimed €83M.

Holding: Court held additional representations in ISDA Schedule relating to counterparty's ability are enforceable warranties leading to contractual estoppel.

Implication: If you document that borrower represents it has power to grant collateral for hedging liabilities pari passu, borrower is estopped from denying later that hedge was unsecured.

4. What Happens If Not Documented? Real World Impact

Scenario A: Borrower defaults, security enforced.

• Lenders receive $100M from sale of mortgaged property.
• Hedge MTM is $20M owed to swap bank.
• If ICA says "first, Super Senior Debt (pari passu between all indebtedness)" - Hedge gets $16.6M pro rata.
• If NOT documented - Lenders take all $100M, hedge bank sues borrower unsecured, recovers 0. Bank suffers loss, claims mis-selling.

Scenario B: Borrower defaults, hedge is in-the-money to borrower.

• Borrower owed $20M from swap bank.
• If collateral sharing not documented, swap bank will set-off $20M against its loan, depriving other senior lenders of that asset. Other lenders sue security trustee for breach.

5. Checklist to Avoid Failure

1. Use LMA ICA: Super Senior / Pari Passu - Tick whether hedging liabilities are super senior or pari passu
2. In Security Agency Agreement: List Hedge Counterparties as Secured Creditors
3. In ISDA Schedule Para 11(b): Reference ICA - "Hedging Liabilities secured as per Intercreditor dated [...]"
4. One-way CSA: Borrower does not post to hedge bank if hedge is secured by loan collateral, otherwise double collateral
5. Get legal opinion on enforceability of collateral sharing under relevant law (English law / Indian Contract Act + SARFAESI)

Under Indian law, SARFAESI enforcement requires security interest registered with CERSAI in name of Security Trustee for all secured parties including hedge counterparties. If CERSAI entry only shows banks, hedge not secured.