The International Swaps and Derivatives Association is working on a revised version of the 1992 Master Agreement. Parties should carefully consider the proposed changes because these agreements have become the market standard for documenting over-the-counter derivatives.
The 2002 ISDA Master Agreement is the result of several years of work by various ISDA documentation committees and reflects some of the best thinking in the area. The following column is based upon the July 2002 draft circulated by ISDA. There will only be one or two more drafts to be circulated prior to its anticipated publication in December. Although there will probably be additional changes, it is anticipated that the majority of the principal changes discussed herein will be part of the final agreement.
As with the 1992 agreement, the pre-printed form of the 2002 agreement can be amended and modified as agreed to by the parties. The 2002 Master Agreement also retains the same structure and much of the same wording as the previous form. Many of the changes incorporate current market practice. For example, the preprinted form now includes non-reliance representations and a set-off provision, clauses that were almost universally included in schedules to the 1992 Master Agreement. The drafters have also made numerous minor language changes throughout the agreement to clarify provisions and eliminate ambiguities found in the 1992 Master Agreement.
ISDA has made several important changes that parties should carefully consider. For example, the method of calculating damages has been completely revised and certain cure periods shortened. In addition, the specified transaction event of default and the credit event upon merger termination have been greatly expanded. A force majeure termination event has also been added. This column focuses principally on those changes that could be a material concern to a party entering into the 2002 agreement.
Early Termination Payments (Damages)
The drafters have completely revised the determination of payments made upon early termination of the agreement (i.e. damages). The concepts of First and Second Method and Market Quotation and Loss have been replaced with a concept referred to as the Close Out Amount.
Many dealers had serious concerns about the efficacy of Market Quotation as defined in the 1992 Master Agreement, especially in times of market stress. Dealers were also concerned about delays in the process as they attempt to solicit market quotations. The new provisions go far in eliminating these concerns.
Although significant at first glance, the elimination of the right to elect First Method is probably a non-issue. First Method is often referred to as a walk-away clause, allowing the non-defaulting party to walk away from any obligations where it may have to make payments to the defaulting party. Even under the 1992 agreement, First Method is rarely elected and banking regulators have almost universally opposed its use.
The 2002 Master Agreement now provides for the calculation of the Close Out Amount to determine damages upon early termination. The calculation of the Close Out Amount melds the concepts found in both Market Quotation and Loss, with some important modifications.
In arriving at the Close Out Amount, the determining party (the party entitled to make the calculation) calculates its losses or gains under the prevailing circumstances that reflect the economic equivalent of the material terms of the terminated transactions. As is the case in the 1992 agreement, if the determining party is out of the money, it may end up making a payment to the other party even if the other party is in default.
In determining the close out amount, the determining party may rely on a much wider source of information than was available using Market Quotation. The determining party may still rely on market quotations from third parties to determine the close out amount. In addition, the determining party may also rely on relevant market data supplied by third parties. Finally, the determining party is also permitted under certain circumstances to rely on internal quotations or market data if it uses such information in the "regular course of its business for the valuation of similar transactions."
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." Even given these restrictions, determining damages based upon the Close Out Amount will significantly streamline early terminations. Parties will have much more flexibility and will be able to react much more quickly to existing market conditions.
Cure Periods
The new Master Agreement has shortened several of the cure periods with respect to events of default. First, a party must cure a payment default under a transaction within one local business day after notice as opposed to three after notice provided in the 1992 master. Second, the cure period for a default under a Specified Transaction (if no cure period is provided) has been shorted to one day from three days.
These two changes reflect a fundamental change in philosophy from the previous agreement. This change has substantially tightened how quickly a party must respond to a payment failure and is more reflective of the cure periods provided to borrowers in loan agreements and other finance agreements.
The cure period for having an involuntary bankruptcy or insolvency proceeding dismissed has been shortened to 15 days from 30 days. This is an important change because it was difficult if not impossible for a party subject to an involuntary bankruptcy to have an insolvency proceeding dismissed even if it had 30 days. The current thinking appears to be that 15 days is 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
Under the 1992 Master Agreement, a specified transaction was basically an over-the-counter derivative transaction between the parties but that was not governed by the party's 1992 agreement. If a party were to default under a specified transaction with its counterparty, it would also be in default under the parties' 1992 Master Agreement.
The current draft of the 2002 Master Agreement greatly expands the definition of a Specified Transaction. The definition now also includes credit derivatives, repos, security lending transactions, and commodity and security forwards. The effect of this expansion is to permit a party to terminate the 2002 Master Agreement if its counterparty defaults under any of these other types of OTC transactions, even if they were not governed by the 2002 Master Agreement.
An important clarification has been added to the specified transaction event of default. Under the 1992 Master Agreement, parties were concerned that if there was a technical delivery default under a repo or security lending transaction, that it would constitute an event of default under the 1992 master. The 2002 document clarifies that such a technical delivery failure would not constitute an event of default unless all transactions outstanding under--for example, the Master Repurchase Agreement in the case of a repo--were also terminated.
Credit Event Upon Merger
The Credit Event Upon Merger termination has been expanded to include several other types of merger event. Upon the occurrence of a Credit Event Upon Merger to its counterparty, a party was permitted to terminate the 1992 Master Agreement. The 2002 Master Agreement retains the concept but greatly expands it beyond a consolidation, merger or transfer of substantially all of a party's assets.
Now, the following events also constitute a Credit Event Upon Merger:
* a recognization, 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.
This change will greatly increase the number of possible situations where the Credit Event Upon Merger termination event may become applicable.
Parties will need to analyze the effect of this expansion, especially as they adjust their corporate structures through additional borrowing or the issuance of new securities. It is important to keep in mind, however, that a credit event upon merger does not occur unless, after the occurrence of the merger or other action, the party is materially weaker. Unfortunately, however, the drafters once again chose not to define what is meant by the term materially weaker.
Force Majeure Termination Event
ISDA added a force majeure or impossibility clause as a termination event to the 2002 master. Under this provision, 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 payment. A termination based upon a force majeure event is handled in a manner similar to the occurrence of an illegality.
This week's Learning Curve was written byChristian Johnson, associate professor at Loyola Law School in Chicago. Johnson can be contacted at cjohns6@luc.edu.
