The International Swaps and Derivatives Association published a new Master Agreement in December to replace the 1992 agreement. The new agreement represents the work of ISDA's Documentation Committee, with over 100 different members reviewing earlier drafts and providing comments. The trade association has already arranged for netting opinions on the new agreement in 36 different jurisdictions.
Although the architecture of the 1992 agreement has been retained, literally every substantive provision has been rewritten to reflect all of the different additions, revisions, and clarifications. The 2002 document has also bulked up, growing from 18 to 27 pages of detailed, single-spaced provisions.
Some changes are revolutionary, such as the complete revision of the calculation of early termination payments. Other changes reflect codifying market practice, such as the addition of a contractual set-off clause to the text of the 2002 agreement itself. Finally, many changes were made to clarify and simplify the agreement such as the changes made to the payment netting provision. This discussion focuses principally on those changes that could be a material concern to a party entering into the new document.
Dealers and sophisticated endusers intending to adopt the new agreement can look forward to months of internal meetings as its contents are digested. Changes were made that affect not only legal issues, but also business, credit and operational concerns. Unfortunately, literally every change made to the agreement has some significance that must be understood and weighed prior to using the contract. If past experience is a guide, it may take six months to a year before the agreement is used on a consistent basis.
As with the 1992 agreement, elections, information and amendments to the standard form are made through a "schedule" attached at the end of the document. Although many of the changes made in the 2002 document could be amended and deleted through the schedule, parties generally presume when using a master agreement that the provisions reflect market practice. The netting opinions to be provided to ISDA will also probably presume the parties have not made material amendments to the preprinted form.
Early Termination Payments (Damage)
The drafters of the 2002 Master Agreement have completely revised and rethought how early termination payments, that is damages, are calculated. The so-called First and Second Method and Market Quotation and Loss have been deleted and replaced with what is referred to as the "Close-out Amount." These changes should lead to greater speed, efficiency and (hopefully) objectivity when calculating early termination payments.
The elimination of the First Method should be a non-issue. In fact, parties had generally stopped using it before the ink was dry on the 1992 agreement. Banking regulators effectively killed the election of First Method by prohibiting it use by banks.
Many endusers believed that Market Quotation, however, provided important protection from arbitrary early termination values by requiring dealers to obtain quotations from third parties. Such protections may have been illusory however. For transactions that are readily valued, third party quotations were probably unnecessary given that an improper valuation could be easily challenged. For illiquid and other difficult to value transactions, it may have been impossible to obtain market quotations anyway, permitting a party to make its own determinations under the Loss method.
The Close-Out Amount
Dealers also believed that Market Quotation was ill equipped to deal with difficult market conditions. When all of the major dealers are soliciting quotations for the same type of transaction during times of market stress, it becomes logistically difficult to obtain market quotations. Market Quotation, for example, proved extremely unwieldy during the hedge fund and Russian ruble crisis in 1998.
The Close-out Amount, similar to Market Quotation and Loss, attempts to calculate a payment amount that would provide the non-defaulting party (or the non-affected party in the case of the occurrence of a termination event) the "economic equivalent" of the terminated transactions. Essentially, the process attempts to ensure the non-defaulting party is in the same economic position that it would have been had the transactions not been terminated. It also still requires the non-defaulting party to make a payment if the non-defaulting party was out-of-the money with respect to the terminated transactions. The non-defaulting party is also still the party entitled to calculate the Close-out Amount and is referred to as the "Determining Party."
To determine the Close-out Amount, the Determining Party is required to act in good faith. It is also required to "use commercially reasonable procedures in order to produce a commercially reasonable result." The definition of Close-out Amount fleshes out what information the determining party may consider and also what would constitute commercially reasonable procedures.
The Determining Party is given great flexibility in calculating the Close-out Amount. It may rely upon third party quotations just as it could have done with Market Quotation or Loss. It may also rely upon "relevant market data" provided by third parties. Finally, it may rely upon quotations developed from its own economic models or internally gathered market data assuming that the "information is of the same type used by the Determining Party in the regular course of its business."
Before being able to rely on internal information, the Determining Party is required to take into account quotations and market data from third parties. It is only allowed to rely on internal quotations and market data if it "believes in good faith that quotations or relevant market data are not readily available or would produce a result that would not satisfy those standards." In an unstable illiquid market, however, a determining party would probably know immediately if third party quotations or market data would be useful.
Cure Periods
The cure periods with respect to events of default have been shortened considerably. First, the payment default cure period has been shortened from three local business days to one local business day after notice, a cure period probably more reflective of other finance documents. Many participants believe that the longer cure period simply provides a recalcitrant party with additional days to delay meeting its obligations.
The period to obtain the dismissal of an involuntary bankruptcy or insolvency proceeding has been shortened to 15 days from thirty days. As a general rule, most participants believed that even 30 days was probably insufficient to obtain a dismissal. Participants do seem to believe now, however, that 15 days should be sufficient for a party to communicate with its counterparty and persuade them that, even if it has not been currently dismissed, the involuntary bankruptcy proceeding would be dismissed in the near future.
Default Under Specified Transactions
The Default under Specified Transaction provision provides that it will be an event of default under the agreement if a party (or its Credit Support Provider or a Specified Entity) defaults on a "Specified Transaction" with its counterparty (or the counterparty's Credit Support Provider or Specified Entity). Under the 1992 agreement, a Specified Transaction was defined only to include the more common over-the-counter derivatives, such as swaps, between the parties but that was not governed by the party's 1992 agreement.
The new agreement greatly broadens what constitutes a Specified Transaction. The new forms of transactions added to the definition include credit derivatives, repo agreements, buy/sell-back transactions, security lending transactions, weather derivatives and security and commodity forwards. This expansion picks up many of the capital-market type of trading transactions such as repos that previously had no effect on the agreement.
Parties in the past have resisted adding these types of transactions. Parties were concerned that an inadvertent or technical delivery failure under one of these transactions would trigger an event of default under the 1992 Agreement. Repos, in particular, were susceptible to these kinds of defaults and delivery failures. The 2002 Agreement helps to ameliorate this result by requiring that there be a "liquidation of, an acceleration under, or an early termination of, all transactions outstanding under the documentation applicable to that Specified Transaction." In other words, for there to be an event of default under the 2002 agreement, there would have to be an early termination of the documentation governing the Specified Transaction in question.
Credit Event Upon Merger
The 2002 agreement greatly expands the Credit Event Upon Merger termination event. For a credit event upon merger to occur, the affected party must be "materially weaker" after the occurrence of one of three "Designated Events." The drafters have once again chosen not to define what is meant by the phrase "materially weaker". Presumably, it would be interpreted to mean that if the affected party had been "materially weaker" prior to entering into the master agreement, the non-affected party would not have entered the agreement.
The definition Designated Events retains much of the original merger event language. The following, however, also constitute Designated Events:
* a reorganization, reincorporation or reconstitution into
or as another entity;
* a direct or indirect change in the beneficial ownership of
(a) "the equity securities having the power to elect a
majority of the board of directors" or (b) "any other
ownership interest enabling it to exercise control;" or
* a "substantial change" in a party's capital structure through
the "issuance, incurrence or guarantee of debt" or the
issuance of preferred stock or convertible securities.
The new credit event upon merger language goes well beyond the 1992 agreement provision. In particular, the new agreement picks up many indirect changes of control or substantial changes in capital structures, even if no ownership change occurred, that previously were not relevant.
Force Majeure Termination Event
Drafters of the 2002 agreement included a force majeure or impossibility termination event in response to serious world and market events that have recently occurred. The Sept. 11 terrorist event and the 1998 market disruptions signaled a need for a provision that dealt with situations in which it was impossible or impractical, but not illegal, for a party to perform.
Under the force majeure clause, a termination event occurs with respect to a transaction if (i) an office of a party is prevented from making or receiving any payment or delivery, or (ii) it becomes impossible or impractical for such an office to make or receive such a payment. If a force majeure event occurs, the affected party's obligation to perform is deferred until after an eight local business day waiting period, after which either party is generally entitled to terminate the affected transactions. A party's section 10(a) home office obligation is also deferred until the end of the waiting period. Finally, the early termination amount will also be based on mid-market values.
Payee Tax Representations
The drafters have cleaned up the suggested payee tax representations that are suggested in the form of schedule. First, the U.K. payee tax representation in the 1992 schedule has been deleted since it has become obsolete. Second, the new U.S. payee tax representations have been added. Although such representations have been required since the change in U.S. tax law, many foreign counterparties have been resistant to the new language. Hopefully its inclusion in the new form schedule will accelerate their usage.
Interest Accrual Provisions
Although the 1992 Agreement provided for the imposition of interest for failure to pay amounts due both before and after a termination, the drafters of the 2002 agreement considered these short provisions to be inadequate. The new document provides detailed and comprehensive provisions as to when interest accrues on overdue payments and early termination amounts and how that interest is calculated.
This Documentation Focus review was written by Christian Johnson, associate professor at Loyola Law School in Chicago. The author can be contacted at cjohns6@luc.edu
Changes At A Glance
Substantive Material Changes
* replacement of Market Quotation
and Loss with the
"Close-out Amount"
* deletion of First and Second
method
* shortening of the cure period
to one local business day for
payment defaults
* shortening of the cure period to
obtain dismissal of involuntary
bankruptcy to 15 local business days
from 30 local business days.
* expansion of Specified Transaction
event of default
* revision to Illegality provision
* addition of "force majeure"
termination event
* expansion of "credit event upon
merger" termination event
* limitation of "absence of litigation"
representation to Credit Support
Providers and Specified Entities.
* revision to mechanics for early
termination based upon occurrence
of termination event
* revision to English court jurisdiction
provision
Incorporation of Market Practices
* "no agency" representation
* contractual set-off clause
* revised U.S. payee tax representations added to form of schedule
* non-reliance representations added
to form of schedule
* recording of conversations provision
added to form of schedule
* signature block added to form of
schedule
Clarifications
* broadening meaning of
"Confirmation"
* change to prevent disputes
involving "applicable conditions
precedent"
* simplification of election for netting
across transactions
* clarification of calculation of cross
default threshold amount
* clarification of effect upon failure to
pay an early termination amount
* addition of detailed interest accrual
provisions for failure to pay
* clarification of deemed
booking office
* addition of e-mail as a means to
give notice
* deletion of obsolete U.K. payee
tax representation
