The 2002 ISDA Master Agreement

The International Swaps and Derivatives Association, Inc. ("ISDA") has published a new form of Master Agreement (the "2002 Form") to replace the prior 1992 form of Master Agreement (the "1992 Form"). The 2002 Form is a major "rewrite" of the 1992 Form, with most of the substantive changes falling into several types: (i) revising close-out calculations (early termination amounts), (ii) dealing with force majeure and illegality events, (iii) tightening credit-related provisions, and (iv) incorporating various provisions that have become "market practice" modifications to the 1992 Form. In accomplishing the "rewrite," ISDA has substantially increased the length of the form Master Agreement.

This article summarizes the major substantive changes from the 1992 Form and provides a chart that is a section- by-section summary comparison of sections 3 (Representations), 4 (Agreements) and 5 (Events of Default and Termination Events) of the 1992 Form and the 2002 Form. This update does not propose to be an exhaustive comparison of all changes made from the 1992 Form.

We believe that it will take time (several months) for market participants to determine what changes they respectively desire to make to the 2002 Form for their use. Such changes, as is currently the case, are reflected in the "Schedule" to the Master Agreement.

A major change is the calculation of the close-out amount for a transaction which is terminated early because of an Event of Default or a Termination Event. In the 1992 Form, the close-out amount for a terminated transaction was to be determined pursuant to Market Quotation (requiring quotations from dealers) or Loss (which was a party’s determination of loss or gain), as selected in the Schedule to the Master Agreement. Changes to the close-out amount methodology were motivated by concerns that in stressed market conditions meaningful quotations may be difficult to obtain and that the "Loss" standard is too subjective. In the 2002 Form, the Close-out Amount is the amount of losses or costs, or gains (as the case may be) under then prevailing circumstances in replacing or providing for the economic equivalent of the material terms of the terminated transactions and any option rights. In determining the Close-out Amount, the Determining Party (i.e., the party determining the Close-out Amount) is charged with acting in good faith and using commercially reasonable procedures to produce a commercially reasonable result. Subject to that standard, the Determining Party may consider any relevant information, including third-party quotations, third-party supplied market data and certain types of internally-generated information. The Determining Party must consider third-party supplied quotations or market data unless it believes in good faith that they are not readily available or do not satisfy the "commercially reasonable" standard.

Noteworthy in the calculation of Close-out Amount are the following: (i) there is no requirement that existed in "Market Quotation" under the 1992 Form of using leading dealers (Reference Market-makers) for the quotations, and there is no mathematical formula such as the arithmetic mean after throwing out the high and the low quotations, (ii) both indicative and firm quotations are expressly permitted to be used by the Determining Party, (iii) as was the case with "Loss" under the 1992 Form, there may be consideration of losses and costs or gains in terminating or re-establishing hedges, and (iv) the creditworthiness of the Determining Party can be taken into account in obtaining quotations.

In the 2002 Form, there is no ability to select "First Method" or "Second Method" as existed in the 1992 Form. The 2002 Form’s Early Termination Amount is basically calculated pursuant to the Second Method, i.e., there is full two-way payment. Such a change is a recognition of Second Method being the overwhelming market standard, in large part due to various insolvency and regulatory capital issues.

In addition, the close-out mechanics relating to Termination Events (e.g., which party may designate an Early Termination Date, the ability to close out all or some of the Affected Transactions, etc.) have been modified from the 1992 Form. For example, (i) there is no longer an obligation on the part of the Affected Party to attempt to transfer Transactions affected by Illegality and (ii) in the case of Illegality or a Force Majeure Event, either party (subject to the waiting period provisions) can designate an Early Termination Date with respect to all or less than all Affected Transactions subject to the other party designating some or all of the other Affected Transactions.

The 2002 Form makes changes to the definition of Illegality, which is a Termination Event (as was the case with the 1992 Form), to, among other things, clarify its application to "Offices" through which a party is acting and in recognition of recent extraordinarily disruptive events such as September 11th. In addition, "Force Majeure Event" (i.e., a force majeure or an act of state making payments, deliveries or receipts or compliance with material provisions impossible or impracticable) is added as a Termination Event.

If an Illegality or a Force Majeure Event exists, the affected payment or delivery may be deferred for a specified waiting period not exceeding three Local Business Days (for Illegality) or eight Local Business Days (for a Force Majeure Event). Upon expiration of the applicable waiting period, either party may terminate the Affected Transactions. There are ancillary provisions dealing with the right to terminate less than all of the Affected Transactions, a hierarchy of determinations (i.e., whether a specific event is to be treated as (i) an Event of Default, on the one hand, or (ii) an Illegality or Force Majeure Event, on the other hand, or an Illegality or a Force Majeure Event), the obligations of the home office of a Multibranch Party and the use of mid-market quotations or values in determining the Close-out Amounts for terminated transactions.

The 2002 Form contains many provisions intended to "tighten up" the document from a credit perspective. Among such changes are:

• Shortened Cure Periods. The cure period for payment or delivery failures is one local business or delivery day after notice (it was three Local Business Days in the 1992 Form). In the case of involuntary insolvency proceedings or a secured party’s levy of process, the period for dismissal is 15 days (it was 30 days in the 1992 Form).

• Additional Events of Default. Additional Events of Default include (i) the repudiation of or the challenge of the validity of the Master Agreement or any executed Confirmation and (ii) the failure or cessation of a security interest.

• Specified Transaction Event of Default. The Specified Transaction Event of Default has been broadened and clarified in a number of ways. First, the term "Specified Transactions" now covers a broader range of derivatives and other types of transactions. The term "Specified Transactions" includes repos and securities lending transactions and various types of derivatives that were not expressly specified in the 1992 Form (e.g., credit default swaps) and has a "catch-all" for future similar transactions in the financial markets that are derivative-like.

• Cross Default. The Cross Default provision has been modified to expressly provide for the aggregation of actually defaulted Specified Indebtedness and acceleratable Specified Indebtedness in determining whether the Threshold Amount is met.

• Bankruptcy. In addition to the shortened periods described above, language has been added to the Bankruptcy Event of Default to deal with proceedings instituted against regulated entities.
• Merger Without Assumption. Changes have been made to cover reorganizations, reincorporations and reconstitutions.

The "Credit Event Upon Merger" Termination Event has been expanded to include certain types of reorganizations or restructurings (such as change in control and certain changes in capital structures). This expansion had become a common addition by market participants in their Schedules. Of course, the relevant party or entity must still be "materially weaker" (as was the case in the 1992 Form) after the applicable event in order for a Credit Event Upon Merger to occur. The 2002 Form specifies that the times for determining whether an entity is materially weaker is "immediately after" the applicable event.

Some provisions in the 2002 Form reflect "market practice" changes to the 1992 Form, such as:

• No Agency. A "no agency" representation has been added.

• Non-Reliance, etc. Representations regarding non-reliance, a party’s capacity to understand and assume the risks and the non-fiduciary nature of each party to each other. These representations are in the form Schedule, not in the main body of the 2002 Form.

• Set-Off. A "Set-Off" provision has been added to the 2002 Form. This provision is a modified version of the standard ISDA Set-Off provision previously included in the ISDA User’s Guide for the 1992 Form, and does not go as far as various market participants have attempted to obtain. The Set-Off provision applies when an Early Termination Amount is payable due to an Event of Default or a Credit Event Upon Merger or other Termination Event in which all outstanding Transactions are Affected Transactions. It does not cover Affiliates or Specified Entities.

• Termination Currency. Unless otherwise specified in the Schedule, the Termination Currency is (i) the euro if the agreement is expressed to be governed by English law or (ii) U.S. Dollars if the agreement is expressed to be governed by New York law.

• Payee Tax Representations. The Payee Tax Representations commonly used for U.S. persons have been added to the Schedule.

• Recording of Conversations. Consent to the recording of conversations relating to Transactions and potential Transactions and their submission in evidence in Proceedings, has been added to the Schedule.

The 2002 Form overhauls the interest provisions of the Master Agreement. The interest provisions cover interest on late payments, and compensation for and interest in respect of late deliveries. Provisions differ based on whether the payment or delivery is defaulted as opposed to deferred (i.e., due to an Illegality or a Force Majeure Event) or occurs prior to or upon or after the designation of an Early Termination Date.

Perhaps, in reaction to the Enron-Mahonia surety bond controversy, various new provisions are noteworthy for their intent to stave off "challenges" to the Master Agreement or Transactions. As mentioned above, challenging the validity of the Master Agreement or any executed and delivered Confirmation is an Event of Default. In addition, challenging the validity of a Specified Transaction or a Credit Support Document is now an Event of Default.

The "Entire Agreement" provision in the 2002 Form has been expanded from that in the 1992 Form to include (i) an express acknowledgement that no representations (other than those provided for or referred to in the Master Agreement) have been relied on and (ii) an express waiver of all rights and remedies with respect thereto (other than fraud).

The 2002 Form does not have the 1992 Form’s prohibition on providing default and early termination notices by fax. Notices given under Sections 5 and 6 of the 2002 Form can be given by fax, but they expressly cannot be given by e-mail or other electronic communication. Notices sent for other purposes may be sent by e-mail and they will be effective on the date on which the e-mail is delivered. In addition, the 2002 Form provides that a Confirmation may be created by an exchange of e-mails. We believe that the provisions dealing with e-mails will lead to some controversy.

It is anticipated that the 2002 Form will be used by the market going forward but it will take months for participants to sort out the changes made from the 1992 Form and tailor the Schedule to their respective needs and concerns. We would not expect end-users to agree to all the changes made in the 2002 Form without modifications in their Schedules. Furthermore, the process of transition from using a current agreement based on the 1992 Form to using an agreement based on the 2002 Form should include a consideration of, among other things: (i) the interplay between the documents and the trades thereunder, (ii) the need for changes to other related documents, such as the Credit Support Annex which may need modifications to work with the 2002 Form or other credit support documents or related transaction documents, (iii) operational, liquidity and credit issues, (iv) the exact wording of the changes which even in the case of "market practice" may not be the same as the analogous provisions already in executed agreements, and (v) the need for new netting opinions.

ISDA is in the process of finalizing a form of amendment agreement to incorporate the new Close-out Amount provisions into existing Master Agreements using the 1992 Form.

Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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