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New ISDA agreement will result in increased standardisation Back  
Judith Lawless explains the new ISDA master agreement, which documents the transaction of derivatives, and which was agreed on January 9th, 2003.
Readers are likely to be familiar with the International Swaps and Derivatives Association, Inc. (ISDA), a global trade association representing participants in the privately negotiated derivatives industry. The vast majority of such derivatives currently transacted are documented under ISDA’s 1992 Master Agreement (the 1992 Agreement).

On January 9, 2003, ISDA announced the publication of its new 2002 ISDA Master Agreement (the 2002 Agreement). Whereas the 1992 Agreement proved robust during the financial market volatility experienced in the 1990s, ISDA commenced a documentation review process in the late 1990s to ensure that its documentation reflected market practice and experience and relevant legal developments. That review ultimately led to publication of the 2002 Agreement.

Although the 2002 Agreement does not differ fundamentally from the 1992 Agreement in terms of structure and protection, some significant developments have been incorporated. As will be seen from the below and a close reading of the 2002 Agreement, many of these significant developments (other than as regards Close-out Amount) address issues that, in the case of the 1992 Agreement, are frequently the subject of negotiation. It is hoped that the standardisation of these issues and the reduction of choices to be made by the parties will facilitate document negotiation.

This article merely touches on some of the more significant changes effected in the 2002 Agreement and the Agreement merits close examination by parties considering its use.

Most significant developments
Close-out Amount - the 2002 Agreement’s single valuation measure - seeks to avoid certain difficulties experienced in operating market quotation’s procedures in market distress conditions, whilst providing more objectivity and direction than loss.

Based on a test of standard commercial reasonableness, close-out amount prescribes a non-exclusive list of information that may be used in valuing terminated transactions along with the procedures that may be followed in making those valuations. Briefly:
• The determining party must consider external quotations and market data unless it reasonably believes in good faith that they are not readily available or would not satisfy the 2002 Agreement standards;
• Internal valuation methods may, subject to certain qualifications, be taken into account;
• Hedging costs may be considered, provided it is commercially reasonable to do so and does not result in duplication; and
• Different valuation methods may be applied to different terminated transactions or groups thereof.

The 1992 Agreement’s choice regarding payment method - First Method/Second Method - has also been removed so the Non-defaulting Party may no longer be excluded from the obligation to make a termination payment. Reflecting concerns regarding penalties and systemic risk, Second Method is now the standard.

Force majeure event/illegality
Due to an absence of member consensus on the issue, force majeure was not addressed in the 1992 Agreement. The 2002 Agreement designates ‘Force Majeure Event’ as a termination event. It addresses the occurrence of acts outside of the control of a party, which render impossible or impracticable the performance of its obligations, or those of its credit support provider, under the 2002 Agreement or a credit support document.

The Illegality provisions, as revised in the 2002 Agreement, continue to address events or circumstances that make it unlawful for a party or its credit support provider to perform obligations under that Agreement or a credit support document.

Under the 2002 Agreement, before Illegality or Force Majeure Event triggers a right to terminate affected transactions, a specified waiting period - three, in the case of Illegality, and eight, in the case of Force Majeure, local business days - must expire.

Once the waiting period expires, generally either party can terminate some or all of the affected transactions and the close-out calculation is made on the basis of mid-market values (reflecting the ‘no-fault’ nature of the events). The 1992 Agreement provisions, whereby the parties must attempt to transfer affected transactions as a pre-condition to terminating for Illegality, no longer apply. A party can, if its counterparty chooses to terminate less than all affected transactions, elect to terminate with effect from the same date all or some of the remaining affected transactions, thus avoiding ‘cherrypicking’ of transactions by a terminating party.

Events of default
The grace periods for various events of default have been adjusted (downwards) and refined to reflect current market requirements.

Breach of agreement has been expanded to include repudiatory action by a party, which action is not subject to the usual thirty-day grace period after notice.

Default under a specified transaction (a form of cross-default) has been refined. The specified transactions to which it relates have been expanded and it may now be triggered by default under a credit support arrangement relating to a specified transaction. Delivery failure under a specified transaction will only trigger the event of default if it results in the termination of all transactions outstanding under the applicable documentation. This addresses the fact that delivery failure, in the case of repos and securities lending (which now comprise specified transactions), often results in close-out of the affected transactions only, recognising that such failure can arise from market illiquidity rather than credit issues.

Amendments have been made to the method of determining whether the thresholds triggering cross-default have been reached and merger without assumption now covers a broader range of merger events.

The 1992 Agreement did not provide for the set-off of the net sum due on close-out against obligations arising under other agreements, although the ISDA Users’ Guide to that Agreement included a number of sample provisions. Reflecting market practice, the 2002 Agreement includes a set-off clause. This is based on, but wider than, the ‘basic’ set-off provision contained in the ISDA’s Users’ Guide.

Other developments in the 2002 Agreement include clarification of the settlement netting provisions; updating of the jurisdiction provisions; development of the interest and compensation provisions; clarification of the provisions regarding multibranch parties and the obligations of a head office; and updating of the notice provisions.

The Schedule includes optional provisions addressing ‘non-reliance’ representations and telephone recording consents.

Overall, the 2002 Agreement evidences ISDA’s continuing efforts to ensure that market documentation reflects industry requirements and practices.

Parties may, of course, continue to use the 1992 Agreement but it is expected that the 2002 Agreement will quickly become the standard agreement documenting new relationships. As regards existing relationships, parties will wish to consider the cost/benefit issues of amending/replacing 1992 Agreements. ISDA has published an Amendment Agreement, allowing parties to incorporate in a 1992 Agreement the 2002 Agreement definition of Close-out Amount and certain other consequential changes. A more comprehensive amendment agreement is not currently proposed and it is likely that it would be simpler to replace existing 1992 Agreements than effect more substantial amendments.

Where amending or replacing a 1992 Agreement parties will, of course, need to consider carefully the implications for ancillary documentation such as credit support arrangements.

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