Opinion ID: 779897
Heading Depth: 1
Heading Rank: 1

Heading: introduction

Text: 4 To more thoroughly understand the facts of this case and the legal issues presented, the Court will provide a brief over-view of derivative swap agreements. 1 A swap is a contract between two parties (counterparties) to exchange (swap) cash flows at specified intervals, calculated by reference to an index. Parties can swap payments based on a number of indices including interest rates, currency rates and security or commodity prices. 5 The plain-vanilla interest rate swap, the simplest and most common type of swap contract, obligates one counter-party to make payments equal to the interest which would accrue on an agreed hypothetical principal amount (notional amount), during a given period, at a specified fixed interest rate. The other counterparty must pay an amount equal to the interest which would accrue on the same notional amount, during the same period, but at a floating interest rate. If the fixed rate paid by the first counterparty exceeds the floating rate paid by the second counterparty, then the first counter-party must pay an amount equal to the difference between the two rates multiplied by the notional amount, for the specified interval. Conversely, if the floating rate paid by the second counterparty exceeds the fixed rate paid by the first counter-party, the fixed-rate payor receives payment. The agreed hypothetical or notional amount provides the basis for calculating payment obligations, but does not change hands. 6 For example, suppose Counterparties A and B enter into a five-year interest rate swap with the following characteristics: (1) Counterparty A agrees to pay a floating interest rate equal to LIBOR, the London Interbank Offered Rate; 2 (2) Counterparty B agrees to pay a 10% fixed interest rate; (3) both counterparties base their payments on a $1 million notional amount and agree to make payments semiannually. If LIBOR is 9% upon commencement of the first payment period, Counterparty B must pay A: (10%-9%)  $1 million  (.5) = $5,000. These net payments vary as LIBOR fluctuates and continue every six months for the term of the swap. If interest rates rise, the position of Counterparty B, the fixed-rate payor, improves because the payments it receives increase. For example, if LIBOR rises to 11% at the beginning of the next payment period, Counterparty B receives a net payment of $5,000 from A. Conversely, the position of Counterparty A, the floating-rate payor, improves when interest rates fall. The party whose position retains positive value under the swap is considered in the money while a party with negative value is considered out of the money. As discussed previously, the $1 million notional amount never changes hands. 7 Almost all interest rate swaps are documented with (1) a confirmation and (2) master agreement. Typically, master agreements are standard form agreements prepared by the International Swaps and Derivatives Association (ISDA). The master agreement governs all interest swap transactions between the counterparties. It includes provisions generally applicable to all swap transactions including: payment netting, events of default, cross-default provisions, early termination events and closeout netting. 8 Most master agreements provide that, in the event of an early termination or default, the party in the money is entitled to collect termination damages. Termination damages represent the replacement cost of the terminated swap contract and are generally determined by obtaining market quotations for the cost of replacing the swap at the time of termination. Some master agreements, such as those at issue here, do not permit the defaulting party to collect termination damages. 9 Interest rate swap agreements provide a powerful tool for altering the character of assets and liabilities, fine tuning risk exposure, lowering the cost of financing or speculating on interest rate fluctuations. Borrowers can rely on interest rate swaps to reduce exposure to adverse changes in interest rates or to obtain financing characteristics unavailable through conventional lending. Interest rate swaps can modify a borrower's all-in funding costs from fixed-to-floating, floating-to-fixed or a combination of both. 10 Interest rate swaps have become an important part of international and domestic commerce, and the market for these instruments has experienced explosive growth. The ISDA has estimated that the collective notional amount on interest rate swaps reached $2.3 trillion in 1990, $12.8 trillion in 1995 and $22.3 trillion in 1997. 3