Nov 13, 2015

In June 2015, Standard & Poor’s – a credit rating agency, downgraded Credit Suisse, Deutsche Bank and Barclays, citing uncertainty around the availability of state aid for systematically important institutions experiencing a period of financial stress. This followed the downgrading of 15 European investment banks in February 2015 on similar grounds. Each downgrade has consequences, not only for the institutions they apply to but also the clients those institutions service. Given the prevalence of contractual terms, designed to free parties from agreements with ailing counterparties, it is necessary that institutions are able to quickly identify both the obligations and liabilities that result from any downgrade. Document digitisation is one method available to easily store legal documents so that pertinent articles can be retrieved quickly and efficiently where needed.

Credit ratings represent the perceived creditworthiness of businesses and governments, taking into account their capacity and willingness to make scheduled repayments and the probability of their default. Typically, such ratings are provided by one of the ‘Big Three’ – Standard & Poor’s, Moody’s and Fitch. To arrive at a particular rating, the agencies will examine an institution’s balance sheet as well as the market conditions it faces. This assists investors, regulators and counterparties in judging the credit risk the institution presents, making credit ratings useful risk mitigation tools.

Given this, it is perhaps unsurprising that credit ratings are often found within legal agreements relating to financial services. The credit ratings serve to quantify a material change in a party’s creditworthiness and often act as a ‘trigger’ within the contracts to create or remove rights and obligations for the contracting parties. Without clearly defined and quantitative definitions, as provided by credit ratings tables, it would be difficult to manage credit risk by enforcing provisions in legal agreements. In this way, both counterparties can remove much of the uncertainty around assessing creditworthiness and subsequently act if a counterparty appears ‘materially weaker’ than it previously was.

Two clauses within the ISDA Master Agreement that warrant closer attention are ‘Additional Termination Events’ (ATE) and ‘Credit Event Upon Merger’, as both frequently use credit rating tables. This is especially true if an ATE clause contains a ‘Credit Rating Downgrade Event’, as a rating table or remediation measure. Usually included in contracts involving large corporates, ATE clauses permit a party to terminate all transactions with the counterparty when the counterparty’s credit rating falls below a set level.

Similarly the ‘Credit Event Upon Merger’ clause takes affect where a specified entity within a contract (the ‘Affected Party’) merges with a separate entity and as a result the surviving or transferee entity is has a fall in its creditworthiness which breaches the limits negotiated between the parties. In such instances, the other party to the contract (the ‘Non-Affected Party’) obtains the right to close out all transactions covered by the Agreement. Given the events of 2008, it is of little surprise that such terms have increased in popularity in recent years.

Financial institutions can help mitigate the resulting risks imposed by such clauses by making sure their legal contracts, and the terms within, are easily accessible. Document digitisation is a readily available solution that allows storage of contracts and easy retrieval of provisions relating to downgrades.

By enabling greater transparency and clear communication with clients, digitisation can only help financial institutions maintain and restore confidence following any downgrade. Furthermore, the more quickly and efficiently a financial institution can respond to such events and limit the consequences of a downgrade, the better it will be able to shield profitability. Document digitization not only increases confidence in financial institutions from clients and investors, but also from the Regulators. Regulators who require transparency, as well as access to information at short notice. Given these advantages, any institution should seriously consider clearing out its old filing cabinets and entering the digital era.