incorporating our exclusive ISDA in a Nutshell™
So, you were wondering “what are the main differences between the 1992 ISDA and the 2002 ISDA?” Well, funny you should ask. I had the same question once upon a time, so I found out. They are below.
The 2002 ISDA, with its Close-Out Amount, is way simpler than the 1992 ISDA which gets bogged down with all this Loss, Market Quotation, First Method, Second Method malarkey. See Section 6(e)(i) - 1992 ISDA provision for more detail though, trust me, if you do you will lament the hours of your life you will never get back.
Two way payments only
The 1992 ISDA offered parties the choice between the outrageous one-way payment (the “First Method”) where only an innocent party could realise its net mark-to-market gain; and two-way payment (the “Second Method”) of the Settlement Amount following early termination, where a Non-defaulting Party could nonetheless find itself having to pay the Defaulting Party on close-out under the 1992 ISDA, where it was overall out-of-the-money on its Transactions. Seeing as no-one with a functioning frontal lobe would (or, in the ten years of the 1992 ISDA, did) agree to the First Method, the 2002 ISDA ditched it and provided instead for only two-way payment, under the “Close-out Amount” concept. Few tears were shed, though the famous transaction manager at a certain US house who, to this day, still insists on the 1987 ISDA, must have bridled a bit.
Likewise, the election of the counter-intuitive and needlessly convoluted Loss/Market Quotation methods in the 1992 ISDA has been replaced with a hybrid valuation method called Close-Out Amount. Close-Out Amount was established in response to the following concerns:
- Reliability: Market Quotation was unreliable (in that few Reference Market-makers would bother putting in a quote) and potentially inaccurate (in that those that did had no skin in the game and could just put in any number they liked, knowing it was never going to be traded on), especially in illiquid markets or at times of market stress (being the typical situations in which you would be closing out ISDA Master Agreements), and
- Objectivity: the inherent subjectivity of the Loss valuation method. Close-Out Amount is a calculation of the gains, losses, and costs incurred in replacing or realizing the economic equivalent of the Terminated Transactions including (i) the cost of terminating, liquidating or re-establishing hedges so long as this value does not duplicate any other amount already included in the Close-Out Amount calculation; and (ii) the value of the option rights of the parties.
- Valuation Process: The Determining Party enjoys flexibility in its choice of price sources, including the option to use internal valuations so long as the internal information used is of the same type used in valuing similar Transactions in the ordinary course of its business. However, regardless of the valuation method used, the Determining Party must use third party quotations or market data in its valuations unless it believes the information is not available or would not provide commercially reasonable results. The Determining Party may consider its creditworthiness and any Credit Support Document ation existing between the Determining Party and the entity providing the quotation when obtaining Market Quotations.
- Force Majeure: Special considerations exist when the Close-Out Amount is calculated following termination due to a Force Majeure or Illegality. When calculating the Close-Out Amount for an Illegality or a Force Majeure, mid-Market Quotations must be used to value the Termination Transaction, and the creditworthiness of the Determining Party may not be considered. The 2002 ISDA requires the Determining Party to use “commercially reasonably procedures to produce a commercially reasonable result” when calculating the Close-Out Amount. This calculation method may be less attractive to some parties than the old Loss method due to concerns that this requirement adds uncertainty and limits the Determining Party ’s discretion in calculating the Close-Out Amount.
Illegality and Force Majeure Termination Events
Although the 2002 ISDA preserves most of the 1992 ISDA’s provisions concerning Termination Events, it extensively changes Illegality and adds Force Majeure as a Termination Event.
- Illegality: The definition of Illegality remains the same with the exception of the clarification that an Illegality exists even if it only affects a single Office so long as the affected Office is the Office through which payments and deliveries are made for the affected Transaction.
- Force Majeure: Force Majeure is undefined except as a “Force Majeure or act of state” that prevents a party from performing or causing performance to be impossible or impracticable. A party must use all reasonable efforts to overcome the Force Majeure, but it need not incur a loss in doing so. Either party may terminate the Agreement because of a Force Majeure unless the Force Majeure affects payment obligations under a Credit Support Document, in which case only the Non-affected Party can terminate. The party affected by the Force Majeure is the Affected Party and therefore the party that calculates the Close-Out Amount.
- Waiting Periods: A party is no longer required to attempt to transfer Transactions as a condition to terminating for Illegality. However, for any Transaction affected by an Illegality or a Force Majeure, payment or delivery under the affected Transaction will be deferred until the expiration of a Waiting Period of three Local Business Days (for Illegality) or eight Local Business Days (for Force Majeure). Termination and liquidation of the Affected Transactions cannot occur until the Waiting Period has expired unless the Illegality or Force Majeure affects Credit Support Documents where delivery or payment is required on the relevant day, in which case there is no Waiting Period. Once the Waiting Period expires, the close-out calculation is made on the basis of mid-market values, reflecting the nofault nature of the Illegality and Force Majeure Termination Events. Unless the Illegality or Force Majeure relates to obligations under a Credit Support Document (in which case the Affected Party may not declare an Early Termination Date), either party may declare an Early Termination Date for Transactions affected by an Illegality or a Force Majeure. The party declaring the Early Termination Date may terminate any or all Affected Transactions. However, if a party terminates fewer than all Affected Transactions, the other party can terminate on the declared Early Termination Date all or some of the remaining Affected Transactions.
- Conflict between Provisions: The 2002 ISDA expands upon the hierarchy provisions the 1992 ISDA in response to the new Force Majeure and Illegality provisions by addressing the treatment of occurrences that could constitute both a Force Majeure and an Illegality or a Force Majeure or Illegality and an Event of Default or Termination Event other than Force Majeure or Illegality (such Termination Events referred to as “Other Termination Events”). The hierarchy was revised in response to concerns that the presence of both an Illegality and a Force Majeure Termination Event could muddy the waters as to which provision should be looked to if both could apply and to address the concern that an Illegality or Force Majeure could mask a credit-related default and give a party in default under a credit-related Event of Default more generous rights under the Force Majeure or Illegality provisions.
- Hierarchy Rules: Under the 2002 ISDA, the hierarchy rules are as follows:
- if an occurrence would constitute an Illegality and a Force Majeure, the occurrence will be treated as an Illegality ;
- if an occurrence would constitute an Illegality or Force Majeure and an Event of Default under Section 5(a)(i), Section 5(a)(ii)(1), or 5(a)(iii)(1), it will be treated as an Illegality or Force Majeure so long as the occurrence relates to a failure to make any payment or delivery, failure to comply with a material term of the Agreement, or a failure to comply with a material provision of the 2002 ISDA or any Credit Support Document ; and
- if an occurrence would constitute an Illegality or Force Majeure and an Event of Default (other than an Event of Default as described in clause (ii)) or Other Termination Event, then it will be treated as the applicable Event of Default or Other Termination Event and not as a Force Majeure or Illegality
Events of Default
The Events of Default in the 1992 ISDA were not massively changed in the 2002 ISDA. Some revisions were made to reflect changes in market practice (by which parties would religiously, tediously, amend their 1992 Schedules) including:
Some of the cure periods were reduced out of the concern that these cure periods create undue risk when market volatility increases in times of turmoil in the financial markets. This was addressed in the 2002 ISDA by reducing the cure periods:
- Under Failure to Pay or Deliver from three Local Business Days to one;
- For a payment Default Under Specified Transaction (Section 5(a)(v)(2)) from three Local Business Days to one; and
- For an involuntary Bankruptcy filing pursuant to Section 5(a)(vii)(1)(B) from 30 to 15days.
Breach of Agreement
An additional subsection has been added to the Breach of Agreement Event of Default (Section 5(a)(ii) that establishes an Event of Default when “the party disaffirms, disclaims, repudiates or rejects, in whole or in part, or challenges the validity of, this Master Agreement, any Confirmation executed and delivered by that party or any Transaction evidenced by such a Confirmation (or such action is taken by any person or entity appointed or empowered to operate it or act on its behalf).” Although this additional subsection is part of Section 5(a)(ii), the 30 day cure period applies only to Section 5(a)(ii)(1) and not to the new subparagraph (2). This new Event of Default is similar to the Credit Support Default Event of Default in Section 5(a)(iii)(3) of the 1992 ISDA, which was also included in the 2002 ISDA.
DUST has been expanded in five significant ways by the 2002 ISDA:
- Mini-closeout carveout: Defaults require the acceleration of just the Specified Transaction in question (for general defaults) but off all outstanding transactions under the relevant master agreement (for delivery defaults). This change was made with mini-close-out under repos and stock loans in mind — a concept which the stock loan market invented after the 1992 ISDA was published, so you can’t really blame ISDA’s crack drafting squad™ for overlooking it at first — where delivery failures under are common and do not of themselves indicate weakness in the Defaulting Party’s creditworthiness.
- Credit support failures covered: DUST under the 2002 ISDA can be triggered by default under a credit support arrangement relating to a Specified Transaction. These weren’t included for the 1992 ISDA DUST.
- Shortened cure period: The cure period for a failure to make a final or early termination payment ona Specified Transaction has been reduced from three days to one.
- Repudiation evidence: Repudiation was modified in two significant ways:
- The phrase “or challenges the validity of” was added after “disaffirms, disclaims, repudiates or rejects” to reduce ambiguity as to whether a party’s action constitutes a repudiation; and
- to stiffen the criteria for something to count as a repudiation so as to require written evidence from the repudiating party of its extended middle finger. This is really an articulation of common sense, for it would be a brave risk officer indeed who closed out an ISDA Master Agreement based on an oral communication, or the proverbial extended middle finger, for which she could not subsequently produce in fairly compelling evidence. But still.
- Widened definition of Specified Transaction: The “Specified Transaction” concept has been broadened to include additional transaction types such as repos, and to include a catchall clause designed to include any future derivative products that have not been thought of yet.
The formula for determining a Cross Default has been revised to permit the aggregation of amounts owed under multiple defaults. In determining whether the Cross Default threshold has been exceeded, the principal amount of the accelerated obligations in subparagraph (i) and the unpaid amount under subparagraph (ii) are added together to determine whether the Cross Default threshold has been exceeded. In the 1992 ISDA, subparagraphs (i) and (ii) could not be combined to evidence a Cross Default.
Merger Without Assumption
The types of events that constitute a “merger” have been broadened to include reorganization, reincorporation and reconstitution, and the methods by which a resulting, surviving or transferee entity can assume obligations have been deleted.
Credit Support Default
The failure of a security interest granted pursuant to a Credit Support Document now constitutes a Credit Support Default.
The absence of a Set-Off provision is seen by many as the biggest weakness of the 1992 ISDA. Although the User’s Guide to the 1992 ISDA included an optional Set-Off provision, the optional provision was not effective unless the parties added the provision to the Schedule to the 1992 ISDA. The 2002 ISDA remedies this concern by including a Set-Off provision that is similar to the provision included in the User’s Guide. This provision permits the Non- Defaulting Party to Set-Off any amounts owing between the parties against any early termination amount. While cross-product Set-Off is permitted, cross-affiliate Set-Off is not incorporated into this provision. The User’s Guide also suggested adding a representation to satisfy the requirement that mutuality must exist between the parties for a Set-Off to be effected. In response to this concern, the 2002 ISDA includes an additional representation in Section 3(g) that both parties are principals in respect of all Transactions.
- ↑ What is that you say? You weren’t wondering about the differences between the 1992 ISDA and the 2002 ISDA? Well, in that case you might like Otto Büchstein’s uncelebrated opera, La Vittoria della Forma sulla Sostanza.