ISDA Comparison

Close-Out Amount

Two way payments only

The 1992 ISDA offered parties the choice between one-way payment (the “First Method”) and two-way payment (the “Second Method”) of a settlement amount following the early termination and liquidation of the 1992 ISDA. The 2002 ISDA provides for only two-way payment.

Valuation Method

Likewise, the election of the Loss or Market Quotation method 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: the Market Quotation valuation method is unreliable and potentially inaccurate in markets lacking adequate liquidity or in situations of market distress, 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:

1. if an occurrence would constitute an Illegality and a Force Majeure , the occurrence will be treated as an Illegality ;
2. 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
3. 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 have proven successful and were spared major modification in the 2002 ISDA. Many participants have observed that changing market conditions merit some changes to the Events of Default however, and some revisions have been made to reflect these changes. These changes include

• Cure Periods: 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:

1. reducing the cure period for a failure to pay or deliver pursuant to Section 5(a)(i) from three Local Business Days to one Local Business Day following notice of such failure;
2. reducing the cure period for a payment Default Under Specified Transaction pursuant to Section 5(a)(v)(2) from three Local Business Days to one Local Business Day; and
3. reducing the cure period for an involuntary bankruptcy filing pursuant to Section 5(a)(vii)(1)(B) from thirty to fifteen days.

• Breach of Agreement: An additional subsection has been added to the Breach of Agreement Event of Default in 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 thirty 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.
• Default under Specified Transaction: This Event of Default was expanded in five significant ways:

1. Delivery and other general defaults require the liquidation or early termination of the Specified Transaction (for general defaults) or the liquidation or early termination of all outstanding Transactions under the documentation supporting the Specified Transaction (for a delivery default). This change was made with repos in mind because a failure under a repo is not uncommon and may not be indicative of the Defaulting Party’s creditworthiness, particularly when the default concerns delivery obligations.
2. This Event of Default may now be triggered by a default under a credit support arrangement relating to a Specified Transaction . Specified Transaction credit support arrangements were not addressed in the 1992 ISDA.
3. As discussed above, the cure period for the failure to make a final payment or early termination payment in respect of a Specified Transaction has been reduced from three days to one.
4. The repudiation subsection was modified in two significant ways: (i) 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 Page 5 constitutes a repudiation; and (ii) a Non-Defaulting Party is now required to possess evidence of such repudiation that is executed and delivered by the Defaulting Party, its Credit Support Provider, or a Specified Entity; (iii) The definition of Specified Transaction has been broadened to include additional types of Transactions market participants commonly add to Schedules to the Master Agreement, such as repos, and includes a catchall clause designed to include any future derivative products that are not specifically enumerated in this definition.

• Cross Default: 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.
• Set-Off: 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.