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HEDGING YOUR BET:INTEREST RATE HEDGE AGREEMENTS

IN REAL ESTATE FINANCINGS

Gary A. GoodmanDentons US LLP

Malcolm K. MontgomeryShearman & Sterling LLP

Jeffrey H. KoppeleDentons US LLP

This article is a discussion for the real estate lawyer of the basic considerations of hedging agreements. It raises and addresses several key issues, from both lender and borrower perspectives, including the basic types of hedging agreements, the Dodd-Frank restrictions on eligible contract participants, security and collateral considerations, tax and bankruptcy issues and proper documentation.

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HEDGING YOUR BET:INTEREST RATE HEDGE AGREEMENTS

IN REAL ESTATE FINANCINGS

Gary A. Goodman, Malcolm K. Montgomery and Jeffrey H. Koppele

The expression that “a rising tide lifts all boats” may be easy to disregard in today’s “low tide” of interest rates, but real estate investors who fail to have an appropriate hedge program in place risk being flooded by unanticipated financing costs as the tide inevitably starts to rise. Federal Reserve chair Janet Yellen has said that she expects the Fed to raise its target for short-term interest rates in 2015 should the U.S. economy grow according to expectations1. Although many factors influence long-term rates, increases in short-term rates make material increases in long-term rates more likely. Higher long-term rates in turn could expose certain segments of the real estate industry to considerable hardship.

Liberal underwriting standards and a proliferation of lenders have allowed real estate equity investors to finance huge amounts and to refinance at their convenience2. In addition, many real estate investment trusts have accumulated substantial debt loads as a result of years of acquisitions, rendering them particularly vulnerable to rising interest rates. Effectively managing interest rate risk will be of vital importance to many participants in the real estate industry in the months ahead.

One of the primary ways in which real estate industry participants can mitigate interest rate risk in financing transactions is through the use of interest rate hedge agreements, which provide both borrowers and lenders with protection against escalating rates. This article provides an overview of interest rate hedge agreements and the selected legal points borrowers and lenders should keep in mind. The article seeks to assist readers in ensuring not only that their hedge agreements successfully mitigate interest rate risk, but also that they are not inadvertently exposed to unforeseen risks in the process.

Basic Types of Hedge Agreements

The three most common types of interest rate hedge agreements are caps, swaps and collars3.

1Binyamin Applebaum, “Yellen Expects Fed to Start Raising Rates This Year,” The New York Times (May 23, 2015), p. B1.

2See “Emerging Trends in Real Estate: United States and Canada 2015”, Urban Land Institute and PricewaterhouseCoopers LLP, p. 21.

3Several articles provide good overviews of the different types of hedge products: Joshua Stein, “An Introduction to Interest Rate Hedging In Commercial Real Estate Loans (With Model Hedge Pledge),” The Practical Real Estate Lawyer (January 2009); S.R. Davidson, “Interest Rate Hedging Products,” SH004 ALI-ABA 339 (Jan. 16-18, 2003); “Financing: Interest Rate Caps and Collars,” Mortgage and Real Estate Executives Report, (Sept. 1, 2002), p. 1; M.A. Guinn and W. L. Harvey, “Taking OTC Derivative Contracts as Collateral,” 57 Bus. Law. 1127 (May 2002)

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Under an interest rate cap agreement, the borrower and hedge provider agree to a maximum interest rate, known as the “cap rate”. If the floating interest rate index governing the underlying loan (typically LIBOR) climbs above this maximum interest rate, the hedge provider pays the borrower the difference. In exchange, the borrower pays the hedge provider a one-time fee when the agreement is signed. The result is that the borrower receives protection against any subsequent increase in LIBOR above the cap rate without surrendering the benefits of any subsequent declines in rates.

A swap agreement converts a floating interest rate into a fixed rate. Under a swap agreement, the borrower agrees to pay a fixed rate to the hedge provider, and the hedge provider agrees to pay a floating rate (again, usually LIBOR) to the borrower. If the floating interest rate index on the underlying loan (i.e., LIBOR), rises above this fixed interest rate, the hedge provider pays the borrower the difference. If, however, the floating interest rate index falls below the fixed interest rate, the borrower pays the hedge provider the difference. When the payments between the parties under the hedge agreement are combined with the floating rate index payable on the underlying loan, the net amount paid by the borrower in respect of the floating rate index will always be equal to the fixed interest rate specified in the swap agreement. The borrower is, thus, said to have “swapped” its floating rate obligation for a fixed rate obligation. Note that the borrower would also generally be required to pay the margin (typically a fixed number of basis points) set forth in the loan agreement. Although there is generally no upfront fee associated with a swap, the borrower will be required to make payments to the hedge provider during periods when the floating interest rate is below the agreed upon fixed rate. The structure of an interest rate swap used to hedge a floating rate loan is illustrated in Exhibit 1.

A collar agreement sets both a maximum and minimum interest rate. If the floating interest rate index governing the underlying loan (LIBOR) remains between the minimum and maximum interest rates, the borrower neither makes nor receives any payments under the collar. If, however, the floating interest rate index rises above the maximum interest rate, the hedge provider pays the borrower the difference. Conversely, if the floating interest rate dips below the minimum interest rate, the borrower pays the hedge provider the difference. The borrower is thereby exposed only to a confined range of interest rate fluctuations, i.e., fluctuations between the minimum and maximum rates, and is protected in the event rates rise above the prescribed maximum rate. In addition, although the borrower retains some of the potential benefit associated with declining interest rates, the borrower surrenders the savings that would accrue if rates were to dip below the prescribed minimum rate. In exchange for protection in the high rate scenarios, the borrower may pay the hedge provider an upfront fee, which would typically be lower than the fee required under a cap agreement. In some cases the fee may be waived altogether, if the value of potential payments to the hedge provider in the low rate scenario adequately compensates the hedge provider for its potential costs in the high rate scenario.

International Swaps and Derivatives Association Master Agreement

The International Swaps and Derivatives Association, Inc. (“ISDA”) has published a form of master agreement (the “Master Agreement”) that is intended to function as a comprehensive document reflecting the collective experience of the derivatives industry4. The ISDA Master 4The ISDA Master Agreement may be purchased through the ISDA website: http://www.isda.org/publications/isdamasteragrmnt.aspx. ISDA published a revised form of the Master Agreement

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Agreement has been widely accepted and has brought dual benefits of consistency and certainty to the industry5.

The Master Agreement is made up of three components: the standard form Master Agreement, the schedule to the form (the “Schedule”) and one or more confirmations. The standard form Master Agreement is designed to be used in the form published by ISDA, without variance from transaction to transaction. The Schedule is the instrument used by the parties to select among the various options provided for in the form Master Agreement and to tailor the Master Agreement to the specific legal terms to which the parties to the hedge agreement agree. The Schedule is the document into which the parties incorporate any negotiated points. The confirmation sets forth the economic terms of the hedge transaction and is subject to the legal terms included in the Master Agreement and the Schedule6. The parties also may enter into a credit support annex under which a party that is “out of the money” may be obligated to post collateral to the party that is “in the money”.

Key Issues for Real-Estate-Related Hedge Transactions

Adoption of an interest rate hedge agreement can raise many issues. This article focuses on selected key topics.

Eligible Contract Participants

The Commodity Exchange Act, as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”)7, requires that any party to a swap (as defined in the Commodity Exchange Act) be an “eligible contract participant” (“ECP”) unless the swap is entered into through an exchange (referred to as a derivatives contract market) registered with the Commodity Futures Trading Commission. No such exchange has been registered to date, and thus it is currently unlawful for any non-ECP to be a party to a swap or even to act as a guarantor or credit support provider of swap payments.

The Commodity Exchange Act defines the term “swap” quite broadly -- the term includes all three types of hedges described above.

in 2002, but the previous version, published in 1992, remains in use by many market participants.

5On occasion, a borrower or lender may encounter a hedge agreement that does not utilize the ISDA form of master agreement. As such agreements may lack certain provisions included in the form ISDA Master Agreement, parties should proceed cautiously in such cases.

6As an alternative to these three separate documents, hedge providers (who typically control the drafting of the hedge agreement) sometimes use a so-called “long-form confirmation”. The long-form confirmation contains the economic terms typically found in a confirmation as well as the legal terms typically included in the Schedule, and incorporates by reference the standard form ISDA Master Agreement. Thus the long-form confirmation generally is intended merely to simplify the hedge documentation by combining the form Master Agreement, Schedule and confirmation in a single document, and not to effect a change in substance.

7The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376, enacted July 21, 2010.

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Generally, an entity is an ECP if it has at least $10,000,000 in total assets (among other possible qualifications).

This restriction on non-ECP entities is broadly interpreted to preclude enforcement of a swap if a non-ECP is a direct party to the swap, and enforcement of a guarantee or pledge supporting swap cash flows from a non-ECP guarantor or pledgor. Thus, it is critical for both borrowers and lenders to ensure that each party to the swap, and each credit support provider of swap cash flows, is an ECP at the time the swap or credit support arrangement is entered into.

In many financings, particularly where the swap provider is the same entity as, or is an affiliate of, the lender, the borrower’s obligations to make ongoing swap payments are included in the waterfall provisions in the loan agreement. In such case, the lender should conduct due diligence to determine if any of the borrowers, guarantors or pledgors do not qualify as ECPs. If there is any question regarding an entity’s ECP status, the lender should consider additional measures to ensure that non-ECP entities do not participate as a guarantor or pledgor. For example, each guarantor or pledgor should make a representation that it is an ECP, and this representation should be deemed repeated at any time a swap or guarantee/pledge is entered into8. The parties may consider contractually excluding any non-ECP entity from the definition of guarantor or pledgor with respect to swap obligations. The Loan Syndications and Trading Association (“LSTA”) has published model language for such circumstances, which is attached as Exhibit 2. Borrowers may favor that approach. Another approach, more likely to be favored by lenders, would be to require certain borrower entities that qualify as ECPs to provide “keepwell” support to any non-ECP entities, the objective being in effect to convert the non-ECPs into ECPs. The LSTA has published model “keepwell” language for such circumstances as well, which is attached as Exhibit 39. In addition, the lender should make certain that any non-swap guaranty that it obtains in connection with its financing is properly drafted to exclude any guarantee of swap obligations by any non-ECP guarantor10.

Real Estate Security for Hedge Obligations

Many real estate borrowers are single purpose entities whose credit alone will often be insufficient to support the obligations under an interest rate swap or collar.11 In such circumstances, the same collateral securing the underlying mortgage loan is often used to collateralize the hedge obligations.12 This can give rise to unexpected issues.

8The test of whether a loan party is an ECP is made at the time a swap or guarantee is entered into.

9These provisions may raise commercial issues that are outside the scope of this article; parties should consult with counsel before agreeing to use one of these approaches.

10See LSTA “Swap Regulations’ Implications for Loan Documentation” Market Advisory, February 15, 2013.

11This issue does not arise in the context of interest rate caps, as the only payment made by the borrower to the hedge provider under a cap occurs upon signing the agreement. Thus, the creditworthiness of the borrower is irrelevant to the hedge provider of an interest rate cap.

12Providing real estate collateral to secure an interest rate hedge may be an alternative to entering into a credit support annex to the ISDA Master Agreement.

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Many lenders will not agree to share a mortgage or waterfall priority with a third-party hedge provider. Borrowers must, therefore, determine early in the process whether the hedge provider will require a mortgage as security, and if so, whether the lender will agree either to share its mortgage or to take pari passu priority with a mortgage securing the hedge. It may be possible to minimize these issues by obtaining a hedge directly from the underlying mortgage lender, in which case either a single mortgage can be used or the two mortgages can be held by the same or affiliated entities.13

Alternatively, it may be possible for the borrower to identify a creditworthy guarantor of the hedge obligations in lieu of providing a mortgage. As noted above, diligence on such guarantors should include confirmation of their ECP-status. If the lender will not permit the hedge provider to be a secured party under the mortgage, another approach is for the hedge provider to enter into the hedge with a creditworthy affiliate of the borrower (whose obligations are not secured by the mortgaged property).

Borrowers with an interest in obtaining the best pricing for their hedge transactions (typically achieved through competitive bidding) should explore the structuring questions described above at the start of the financing transaction rather than deferring them to a stage at which the mortgage lender’s hedge provider affiliate may effectively be the only hedge provider from which a required hedge product can be purchased.

Counterparty Risk

The description above of typical hedge agreements could be read to suggest that the use of these agreements would eliminate the borrower’s interest rate risk. A more accurate view would be that the borrower entering into a hedge agreement has merely exchanged interest rate risk for another risk: counterparty risk. The borrower’s counterparty risk is the risk that the counterparty, i.e., the hedge provider, will fail to perform its obligations under the hedge agreement. If the hedge provider defaults on its obligations, the borrower generally is required under the loan documents to obtain a replacement interest rate hedge agreement. In the case of an interest rate cap agreement, however, the borrower will have paid the hedge provider at closing. In this circumstance, not only would the borrower have to pay a second time for a hedge agreement that it had already purchased, but the replacement cost may far exceed the cost for the original hedge if interest rates have gone up in the interim14.

A borrower may minimize its counterparty risk by negotiating certain additional terms into the hedge agreement. One way of minimizing counterparty risk is to require the hedge provider to post margin in an amount equal to the value of the hedge agreement; the concept is that, upon a default by the original hedge provider, the borrower would be able to use the collateral it is holding to purchase a new hedge agreement to cover the remaining term of the original hedge agreement. Another approach would be to obligate the hedge provider to replace itself, i.e., 13Lenders must be cautious to avoid violating the Bank Tying Act when requiring hedge products in conjunction with mortgage loan transactions. 12 U.S.C. § 1972.

14The borrower could possibly assert claims against the original hedge provider in this circumstance. There is no certainly that such claims would be resolved quickly. Although most of the hedge claims resulting from the Lehman Brothers bankruptcy filing (circa September 2008) were settled promptly, some claims remain in litigation as of the time of publication of this article.

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cause a new hedge provider to enter into a hedge agreement with the borrower covering the remaining term of the original hedge. A third approach would be to require the hedge provider to supply a guaranty from a creditworthy entity, often an affiliate of the hedge provider. In some cases the parties negotiate that these remedies would be required only if the hedge provider’s credit ratings drop below specified thresholds. These provisions generally protect the lender as well as the borrower, because they minimize the risk that the borrower will have to incur an additional expense to acquire a replacement hedge agreement. Some lenders require borrowers to include these provisions in their interest rate hedge agreements.

Definite Obligation

Under the laws of some states, in order to be recorded and enforced a mortgage must state a specific principal amount or definite obligation. Under a swap agreement, however, the obligations of the borrower are by their nature indefinite. There is no principal obligation at issue and, depending on whether the agreement is “in the money” or “out of the money”, there may or may not be amounts payable by the borrower to the hedge provider under the agreement.

If the hedge provider and the mortgage lender are the same entity, this problem can often be addressed by characterizing any swap payments as additional interest in the documents governing the loan and using a single mortgage to secure both the swap obligations and the obligations under the other loan documents. Alternatively, if the hedge provider is a separate but affiliated legal entity, the mortgage lender may agree in the loan documents to advance, as so-called “obligatory advances”, any payments due from the borrower to the hedge provider under the swap agreement. Such obligatory advances are then secured by the mortgage and, because of the obligatory nature of the advances, the priority of the lien securing them can in some states relate back to the date the mortgage is first recorded.15

If the hedge provider is a third party unaffiliated with the mortgage lender, neither of the above approaches to the indefinite mortgage problem may be available. Therefore, borrowers should consult with local counsel to identify any definite obligation requirements during the early stages of deal structuring.

Mortgage Tax

In states that impose a mortgage recordation or similar tax, two separate taxes will be imposed if the mortgage lender and hedge provider are granted separate mortgages. If the lender and hedge provider are the same entity, the second layer of mortgage tax can often be avoided by using a single mortgage and characterizing any payment obligations under the hedge agreement as additional interest under the loan documents. Such a characterization will not be an available option if the hedge is secured with a separate mortgage. Consulting with appropriate local counsel early can ensure the structure avoids unnecessary taxes, particularly in jurisdictions such as New York City, where the mortgage recording tax is 2.8% of the principal amount of the obligations secured.

15See Davidson, supra note 3.

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Title Insurance

If the hedge provider seeks to secure its hedge with a mortgage, it is likely also to require title insurance to insure the lien securing the hedge obligations. Borrowers find it easier to deflect such requests in transactions in which the hedge obligations are not secured by separate mortgages. Indeed, if a single mortgage is used, some title insurers are willing to issue special endorsements insuring that the obligations under the hedge agreement are secured with the same priority as the other obligations secured by the mortgage loan documents. Assuming the hedge obligations have been characterized in the mortgage as additional interest, hedge providers can generally be convinced that purchasing additional title insurance in respect of those obligations is unnecessary (and arguably redundant) given that title insurance policies by their terms cover interest payment obligations without the payment of additional premiums to the title insurer. If a hedge provider ultimately does require separate title insurance for a swap or other hedge agreement, a debate will likely ensue as to the proper amount of title insurance to purchase. For a swap agreement, the “lore” among New York practitioners is to purchase title insurance in a face amount equal to ten percent of the notional amount of the swap.16 Given the high price of title insurance in many states, however, borrowers are well advised to structure their hedge arrangements to avoid the necessity of separate title insurance.

Cross-Defaults

A default by a borrower under a mortgage loan agreement with respect to which a hedge agreement is in place will typically trigger a cross-default under the related Master Agreement. Similarly, an event of default under the hedge agreement, particularly an event of default that results in an early termination of the hedge, is typically an event of default under the mortgage loan agreement. Hedge providers often propose a broad cross-default provision in the Schedule to the Master Agreement, which may reference defaults by affiliates (broadly defined) of the borrower in respect of separate financial obligations to the hedge provider (or its affiliates) above a certain threshold amount and defaults by affiliates under separate hedge agreements with the same provider. The parties can negotiate which parties should be included in the cross-default provisions as so-called “Specified Entities”, and which parties should be excluded. If the hedge provider and the lender in the mortgage loan are not affiliates, then the lender would prefer the list of “Specified Entities” in the Schedule to the Master Agreement to be as limited as possible. If the hedge provider and the lender are affiliates, however, then they would prefer a broader list of “Specified Entities”.

Borrowers are cautioned to consider carefully the implications of broadly defining the category of Specified Entities that may trigger a cross-default under a hedge agreement. Consider, for example, a situation in which a particular borrower and its affiliates have numerous loans and associated interest rate swap agreements with a particular lender. If the cross-default provisions of the Master Agreements governing the swap transactions refer to affiliates of each borrower, 16The “notional amount” is the principal figure used in the hedge agreement for the purposes of determining payments by one hedge party to the other. Depending on the type of underlying loan and the needs of the parties, the notional amount may be defined to equal (1) the aggregate principal loan balance of a term loan, (2) an increasing amount designed to equal at any given time the amount then outstanding under a construction loan or other multiple-advance facility; (3) an amount that amortizes as an outstanding loan balance amortizes; or (4) a portion of the principal balance of a loan where the borrower is hedging only a portion of its interest payment obligations.

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the lender may be permitted to terminate all of the swap agreements (or, worse for the borrower, be permitted to choose which swaps to terminate and which to leave in place) upon a single event of default by a single affiliate under a single swap agreement. In turn, as noted above, the termination of each swap agreement by the hedge provider would likely trigger an event of default under the related mortgage loan documents. Borrowers should take special care to negotiate the cross-default provisions of the Master Agreement in order to avoid the potential for one underperforming property to trigger an avalanche of cross-defaults on “out of the money” hedges and, by extension, on the related mortgage loans. In addition, borrowers should note that courts have held certain cross-affiliate set-off provisions to be unenforceable in bankruptcy proceedings.17

Treatment in Bankruptcy

The US Bankruptcy Code generally protects parties to swap agreements from the potentially catastrophic effects that could arise from the failure of a financial institution with significant exposure to derivatives. The Bankruptcy Code exempts swap agreements from:

Operation of the automatic stay The right of the bankruptcy trustee to assume or reject executory contracts The prohibition on ipso facto clauses making bankruptcy an event of default Limitations on set-off rights

These “safe harbor” provisions have been expanded to cover a wider range of financial products and eligible participants. The overall effect of these provisions is to permit a party to a hedge agreement to terminate the agreement, offset and net out any payment obligations owed under the agreement (including the netting of termination values or payment amounts across multiple transactions between the same counterparties) and apply any margin collateral held in respect of those obligations notwithstanding the bankruptcy of the hedge counterparty – all without having to obtain permission from the court18.

The filing of a bankruptcy petition will trigger an event of default under the Master Agreement that can be used by the counterparty as a basis for terminating the hedge agreement and exercising its offset and netting rights. The terms of those rights may become particularly important, as they could have a significant impact on the financial value of the hedge transaction both in and outside of a bankruptcy.

Banks, however, are not U.S. Bankruptcy Code eligible entities. The Federal Deposit Insurance Act (“FDIA”)19 would govern the insolvency (or conservatorship) of certain banks, while state law would govern the insolvency/conservatorship of other banks. The FDIA affords hedge counterparties rights that are somewhat similar to those available to hedge counterparties under

17See, e.g., Sass v. Barclays Bank PLC (In re American Home Mortgage, Holdings, Inc.), No. 11-51851 (CSS) (Bankr. D. Del. Nov. 8, 2013); Chevron Products Co. v. SemCrude, L.P. (In re SemCrude, L.P.), 428 B.R. 590 (D. Del. 2010).

1811 U.S.C. §§ 362(b)(17), 556, 560, 561.

19The Federal Deposit Insurance Act of 1950, Pub.L. 81-797, 64 Stat. 873, enacted September 21, 1950, is the statute that governs the FDIC.

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the U.S. Bankruptcy Code, yet differences do exist. For example, under the FDIA, a hedge counterparty must observe a one-business day stay before exercising its right to terminate a hedge contract with a bank in receivership or conservatorship, and in the case of a conservatorship, certain insolvency-related events cannot be used to trigger a termination or other remedies20. This stay provides an opportunity to transfer the “good” assets (including swaps, to the extent the FDIC wants to keep them in place) to a solvent entity while leaving the “bad” assets behind in the insolvent entity.

Dodd-Frank provides an alternative framework for restructuring certain non-bank financial institutions (including non-bank affiliates of banks) deemed capable of jeopardizing the economy. Through an “orderly liquidation authority” (“OLA”) procedure, each applicable counterparty must observe a one-business day stay before exercising its right to terminate a transaction with an OLA eligible insolvent entity (similar to the FDIA provision described above)21.

On October 11, 2014, ISDA announced that 18 major global financial institutions (“G-18”) agreed to sign a new ISDA Resolution Stay Protocol, which has been developed in coordination with the Financial Stability Board to support cross-border resolution and reduce systemic risk. The Protocol imposes a 48-hour stay on cross-default and early termination rights within standard ISDA derivatives contracts between protocol adherents in the event one of them is subject to resolution action in its jurisdiction. The stay is intended to give regulators time to facilitate an orderly resolution of a troubled bank. Although this protocol is not currently binding on parties other than the G-18 firms, regulators may eventually require a much broader group of market participants to adhere to the protocol22.

Offset Rights

Certain offset rights may have a significant negative effect on the value of a hedge agreement. For example, a “disguised walk-away” provision provides that a non-defaulting counterparty has no obligation to pay a derivatives settlement amount to a defaulting party unless all liabilities of any kind then owing by the defaulting party and its affiliates to the non-defaulting party and its affiliates have first been paid23.

Although one can argue about the intrinsic fairness of such a provision outside of a bankruptcy, consider its impact once a bankruptcy has been filed. If the hedge provider is an affiliate of the

20A complete discussion of the treatment of hedge agreements in bankruptcies and bank insolvencies/conservatorships is beyond the scope of this article.

21See “Treatment of a Hedge Fund’s Claims Against and Other Exposures To a Covered Financial Company Under the Orderly Liquidation Authority Created by the Dodd-Frank Act,” The Hedge Fund Law Report, Vol. 4, No. 15 (May 6, 2011).

22See: http://www2.isda.org/news/major-banks-agree-to-sign-isda-resolution-stay-protocol.And for the buy-side perspective: http://www.thetradenews.com/news/Asset_Classes/Derivatives/Buy-siders_up_in_arms_over_new_ISDA_derivatives_protocol.aspx?l=tl.

23 See, e.g., Sections 6(e)(i)(1) and (2) of the 1992 version of the ISDA Master Agreement (where parties have selected the "First Method" for payments on early termination, the non-defaulting party is not required to make a payment to the defaulting party, even where the defaulting party is "in the money.").

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bankrupt borrower’s mortgage lender (as is often the case), the effect of the provision is to permit the hedge provider to argue that it has no payment obligations under the hedge agreement (even where the hedge is “in the money” for the borrower) unless the mortgage loan is paid in full, notwithstanding the existence of the bankruptcy case.

Such provisions, however, may not be enforceable in an insolvency or conservatorship proceeding. For example, the FDIA explicitly provides that such a provision is not enforceable against an institution in default that takes Federally-insured deposits24. As noted above, not all banks are regulated by the FDIA and courts applying state law have been divided on this issue25. As a result of the uncertainty surrounding enforceability, most hedge providers have eliminated walkaway clauses from their hedge agreements. Nonetheless, given their potentially harsh result, borrowers would be well served to remain vigilant on this point and eliminate onerous offset provisions from their agreements.

Conclusion

Interest rate hedge agreements are complex and should be entered into only after receiving advice from qualified counsel. The topics discussed in this article are some of the more important issues of which real estate market participants should be aware when working with hedge agreements. Bearing these points in mind will help ensure that one is not taking on unforeseen risks when attempting to manage one’s exposure to interest rate fluctuations.

About the Authors

Gary A. Goodman is a Real Estate partner with Dentons US LLP with extensive experience with real estate financing transactions, representing domestic and foreign institutional lenders and borrowers in fee and leasehold construction and term financings, refinancings, mezzanine financings and workouts. He routinely represents agent banks in syndicated loans and in dealing with the co-lenders not only during the syndication process, but also during the term of the loan. He also represents prospective co-lenders and participating banks who are considering becoming part of existing bank groups. Mr. Goodman received his B.A. from University of Rochester in 1970 and his J.D. from New York University in 1973. Mr. Goodman is a fellow of the American College of Real Estate Lawyers and the American College of Mortgage Attorneys and a member of the Association of Foreign Investors in Real Estate, the International Council of Shopping Centers, the Real Estate Board of New York, the Mortgage Bankers Association of American and the CRE Finance Council.

Malcolm K. Montgomery is a partner in the Real Estate Group of Shearman & Sterling LLP where he leads the Real Estate Finance practice and co-leads the REIT Affinity Group. He regularly represents real estate investment funds and other equity investors, as well as lenders to

24 12 U.S.C. §1821(e)(8)(G). See also 12 U.S.C. § 5390(c)(8)(F) (similar provision in OLA proceedings).

25 See In re Lehman Bros. Holdings Inc. v. BNY Corporate Tr. Servs. Ltd., 422 B.R. 407 (S.D.N.Y. 2010) (holding that a provision seeking to modify payment priority upon a bankruptcy-related event of default is unenforceable in a bankruptcy proceeding). See also Brookfield Asset Mgmt. Inc. v. AIG Fin. Prods. Corp., 2010 U.S. Dist. LEXIS 103272 (S.D.N.Y. 2010) (holding that defendant failed to establish that a walkway clause was not an unenforceable penalty or liquidated damages provision under New York State law).

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such investors, in transactions throughout the United States and abroad. Real estate finance transactions handled by Mr. Montgomery include multi-state secured credit facilities mezzanine financings, construction financings for single- and mixed-use projects, investment fund subscription financings, debt portfolio financings and hotel and resort financings. Mr. Montgomery received his B.A. from Princeton University in 1986 and his J.D. from New York University in 1989. He is a fellow of the American College of Real Estate Lawyers and the American College of Mortgage Attorneys, an associate member of the National Association of Real Estate Investment Trusts, on the Regional Advisory Board of Directions of the U.S.-Mexico Chamber of Commerce, and a member of the Association of the Bar of the City of New York, the Real Estate Financing Committee of the New York State Bar Association, the CRE Finance Council, the Real Estate Board of New York, the Princeton Alumni Real Estate Network and the Association of Foreign Investors in Real Estate.

Jeffrey H. Koppele is a member of Dentons’ Tax practice. He provides advice on both tax and derivatives matters in a wide variety of financial transactions. In his derivatives practice, Mr. Koppele advises swap dealers, hedge funds and other market participants in a wide variety of derivatives transactions and structures. He advises on multiple aspects of derivatives, including product structuring and new product development, documentation matters, closeouts and insolvency issues, and taxation of financial products. He advises clients on the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act on derivatives and other financial products and services. Mr. Koppele received his B.S. from University of Virginia in 1984, his J.D. from New York University in 1989 and his LL.M. from New York University in 1992.

This memorandum is intended only as a general discussion of these issues. It should not be regarded as legal advice. Any party contemplating entering into a hedge agreement should consult with competent counsel before doing so. We would be pleased to provide additional details or advice about specific situations if desired.

For more information on the topics covered in this issue, please contact:

Gary A. Goodman+1.212.768.6916gary.goodman@dentons.com

Malcolm K. Montgomery+1.212.848.7587mmontgomery@shearman.com

Jeffrey H. Koppele+1.212.768.6844jeffrey.koppele@dentons.com

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©2015 Gary A. Goodman, Malcolm K. Montgomery and Jeffrey H. Koppele.

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Exhibit 1

Fixed-for-Floating Interest Rate Swap

Exhibit 1-1

Fixed Rate

Hedge ProviderBorrower

Floating Rate

Lender

Loan

Floating Rate

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Exhibit 2

LSTA Model Non-ECP Language26

New Definitions to Carve Out Non-ECPs:

“Commodity Exchange Act” means the Commodity Exchange Act (7 U.S.C. § 1 et seq.), as amended from time to time, and any successor statute.

“Excluded Swap Obligation” means, with respect to any Guarantor, any Swap Obligation if, and to the extent that, all or a portion of the Guarantee of such Guarantor of, or the grant by such Guarantor of a security interest to secure, such Swap Obligation (or any Guarantee thereof) is or becomes illegal under the Commodity Exchange Act or any rule, regulation or order of the Commodity Futures Trading Commission (or the application or official interpretation of any thereof) by virtue of such Guarantor’s failure for any reason to constitute an “eligible contract participant” as defined in the Commodity Exchange Act and the regulations thereunder at the time the Guarantee of such Guarantor or the grant of such security interest becomes effective with respect to such Swap Obligation. If a Swap Obligation arises under a master agreement governing more than one swap, such exclusion shall apply only to the portion of such Swap Obligation that is attributable to swaps for which such Guarantee or security interest is or becomes illegal.

“Swap Obligation” means, with respect to any Guarantor, any obligation to pay or perform under any agreement, contract or transaction that constitutes a “swap” within the meaning of Section 1a(47) of the Commodity Exchange Act.

Related Changes to Existing Definitions:

The defined term or terms used in the guarantee or security agreement to identify the obligations guaranteed or secured, typically terms like “Obligations” or “Guaranteed Obligations” and “Secured Obligations” should specifically exclude all Excluded Swap Obligations.

26See LSTA Market Advisory February 15, 2013 “Swap Regulations’ Implications for Loan Documentation”.

Exhibit 2-1

84114973\V-7

Exhibit 3

LSTA Model Keepwell Language27

Each Qualified ECP Guarantor hereby jointly and severally absolutely, unconditionally and irrevocably undertakes to provide such funds or other support as may be needed from time to time by each other [Loan Party] to honor all of its obligations under this Guaranty in respect of Swap Obligations (provided, however, that each Qualified ECP Guarantor shall only be liable under this Section ___ for the maximum amount of such liability that can be hereby incurred without rendering its obligations under this Section ___, or otherwise under this Guaranty, voidable under applicable law relating to fraudulent conveyance or fraudulent transfer, and not for any greater amount). The obligations of each Qualified ECP Guarantor under this Section shall remain in full force and effect until a [Discharge of Guaranteed Obligations]. Each Qualified ECP Guarantor intends that this Section __ constitute, and this Section ___ shall be deemed to constitute, a “keepwell, support, or other agreement” for the benefit of each other Loan Party for all purposes of Section 1a(18)(A)(v)(II) of the Commodity Exchange Act.

“Qualified ECP Guarantor” means, in respect of any Swap Obligation, each [Loan Party] that has total assets exceeding $10,000,000 at the time the relevant Guarantee or grant of the relevant security interest becomes effective with respect to such Swap Obligation or such other person as constitutes an “eligible contract participant” under the Commodity Exchange Act or any regulations promulgated thereunder and can cause another person to qualify as an “eligible contract participant” at such time by entering into a keepwell under Section 1a(18)(A)(v)(II) of the Commodity Exchange Act.

27See LSTA Market Advisory February 15, 2013 “Swap Regulations’ Implications for Loan Documentation”.

Exhibit 3-1