23 October 2009 - Post by:Chris Jackson
After recent press articles showing cute photos of pygmy hedgehogs, a number of people are trying to persuade me to buy some of them.
I’m still making up my mind on that, but back in the world of work there is only one type of hedge which is hogging my time, and that is when trustees decide to hedge some of their pension liabilities using swaps.
When I started working on derivative contracts I didn’t imagine that my knowledge of the workings of the Pension Protection Fund (PPF) would stand me in such good stead, but the existence of the PPF has become a key factor when negotiating ISDAs.
When a scheme is taken over by the PPF all of its assets, including ISDA contracts, pass to the PPF by operation of law so the PPF becomes the counterparty in place of the trustees. Banks may have commercial reasons for not wanting the PPF as a counterparty (though many banks have ISDAs in place directly with the PPF) but all banks are aware of a ‘sting in the PPF’s tail’ on contracts that the PPF takes over.
The sting is that the PPF has the power to disapply or substitute any term in a contract taken over from the trustees that it thinks is onerous. One fear is that the PPF could, in theory at least, use this to disapply transactions where it was out of the money and keep ones where it was in the money. This may sound like fanciful stuff but, if you’re a bank with a multi-million pound exposure, you can’t afford to ignore this.
Over the last couple of years banks have sought to protect themselves by inserting events of default (EoD) into ISDAs at appropriate times before the scheme is taken over by the PPF and the PPF gets its powers. Trustees are starting to push back harder against having an EoD at the start of the assessment period as assessment periods can be long (I was involved in the first scheme to go into an assessment period in 2005 – it is still in it). The ‘transfer date’ (i.e. when the scheme is taken over by the PPF) is normally an acceptable back stop for both parties but may be too late in practice for the banks. The market has now therefore embraced an EoD on the date that the scheme’s section 143 valuation is approved – where it shows that the scheme is going into the PPF – as the key date for an EoD. The banks will have at least two months to close out of transactions before the scheme can be taken over by the PPF and the trustees know that the scheme is, in all likelihood, very close to coming to an end.
An even more recent development we are seeing is the concept of back-to-back provisions in the bank’s ISDAs with the trustees and the PPF respectively so that, when the scheme is taken over, transactions will be ‘transferred’ onto the bank’s ISDA with the PPF by creating new transactions under the PPF ISDA and suspending any new payment obligations under the trustee ISDA. It is still early days for this kind of clause but is definitely something to watch and may soon become market standard.
So if you have strong views on hedging, or whether I should buy some pygmy hedgehogs, let me know.
Chris Jackson is a senior associate at Allen & Overy LLP.