Differences between 1992 and 2002 ISDA Master Agreements

The main reasons for revising the 1992 ISDA Master Agreement were:

  • to make the agreement less "debtor friendly"; and
  • to reflect market experience and changes in market practice.

Set out below, first in summary form, and then in more detail, is how the 2002 ISDA Master Agreement differs from the 1992 version.

Executive summary of the changes

  • The introduction of Close-out Amount as a new measure of damages provision, replacing Market Quotation and Loss. This new approach to closing-out transactions is based on a standard of commercial reasonableness in valuing terminated transactions.
  • A new Termination Event of Force Majeure. This provision enables a party to terminate transactions affected by force majeure events such as natural or man made disasters, labour riots, acts of terrorism or unexpected events that prevent a party from performing its obligations under the agreement.
  • The broadening of transactions captured under the Default under Specified Transaction Event of Default to include newer types of transactions, and transactions not typically traded under an ISDA Master Agreement.
  • The introduction of a Set-off clause.
  • The reduction in Grace Periods and consequent tightening of Events of Default.
  • The bringing together of the Interest and Compensation provisions into a separate section.

More detail on the changes

New measure of damages: Close-out Amount

Arguably the most significant change in the 2002 Agreement is the replacement of "Market Quotation" and "Loss", with "Close-out Amount" as the measure of damages provision. Under the 1992 Agreement, the parties can elect whether to calculate damages according to quotations received from Reference Market Makers (the "Market Quotation" approach ie effectively a liquidated damages concept) or by reference to "Loss", which essentially is an unliquidated damages clause entitling the determining party to calculate their loss based on quite broad criteria.

The new concept of "Close-out Amount" is in a broad sense a combination of these two approaches. While it is no longer a liquidated damages clause (in the sense that it does not provide for a precise procedure for calculating damages), the new concept provides significantly more guidance than the 1992 concept of "Loss" on how the determining party is to calculate damages following early termination.

A key concept is that the determining party must "act in good faith" and use "commercially reasonable procedures" in order to produce a "commercially reasonable result". Importantly, the determining party must take account of external market data and quotations unless they believe, in good faith, that this information is not readily available or would produce a result that would not satisfy the key standards referred to above.

If an Event of Default occurs, the Non-defaulting Party may set a single day which is effective as an Early Termination Date in respect to all outstanding Transactions. However, the concept of Close-out Amount provides the flexibility of allowing the determining party to calculate a Close-out Amount in respect of a single terminated transaction or a group of transactions and hence permits the use of a different method for each transaction or group of transaction. The definition contains a detailed list of things that the determining party may take into account in determining a Close-out Amount. This includes firm or indicative quotes. From an Australian law perspective, as a result of the decision in the Enron v Integral case, some doubt remains as to whether an Australian court would permit quotations at the side of the spread to be taken into account. It is advisable to clarify the determining party's rights in this regard by making it clear that the determining party is not obliged to use mid-market quotations.

Force majeure as a new Termination Event

Another key change in the 2002 Agreement is the introduction of the Force Majeure Termination Event. A corresponding provision was absent from the 1992 Agreement as there was a lack of consensus amongst ISDA members on the need for such a provision at the time.

Underpinning the Force Majeure Termination Event (and likewise the Illegality Termination Event under the 1992 Agreement) is the concept of "no-fault termination". If something happens that is beyond the control of parties and makes it impossible or impracticable for a party to perform its obligations, in the case of force majeure (or, unlawful, in the case of illegality), then, rather than non-performance triggering a default, with consequent risk of cross-default and the close-out of all transactions under the master agreement, the failure should be regarded as a Termination Event, enabling the possibility of terminating only the affected transactions.

Force Majeure Termination Event is triggered if the Office through which a party or its Credit Support Provider is acting is prevented by reason of force majeure or act of state from making or receiving payments or deliveries, or it becomes impossible or impracticable for that Office to make or receive payments or deliveries. "Force Majeure" is not defined, but is intended to cover events such as natural or man-made disasters, labour riots, acts of terrorism and unanticipated events that prevent the performance of a party's obligations under the Agreement.

A party seeking to rely on Force Majeure must show that the event is beyond its control and that neither it nor its Credit Support Provider could overcome the event after using "all reasonable efforts" before a waiting period of eight Local Business Days had expired. This approach was adopted because it was thought to be appropriate to wait and see what happens in the days following a Force Majeure Event before assessing its impact. Some events, although catastrophic at the time, can be overcome quickly by the financial markets. Accordingly, the 2002 Agreement provides for payment or delivery obligations to be deferred for a short period, following the Force Majeure, to enable the parties to wait to see how events unfold.

If, at the end of the waiting period, the event is continuing, a party may move to terminate the transactions affected by the event. A party need not terminate all affected transactions. It may be in the party's best interest to maintain certain transactions, particularly those with expensive up-front costs (and terminate low cost, short dated transactions), although this right effectively to "cherry-pick" is tempered by the other party's reciprocal right to terminate. The reciprocal right arises if one party chooses to terminate some, but not all of the affected transactions. In those circumstances the other party can elect to terminate, on the same Early Termination Date, the remaining affected transactions.

The 2002 Agreement also addresses the relationship between Force Majeure Events, Illegalities and Events of Default, and sets out their ""pecking-order". An event which is both a Force Majeure or an Illegality and also an Event of Default, will be treated only as a Force Majeure or Illegality and not an Event of Default. However, there was a concern within the ISDA working group that Illegality in particular, and to a lesser extent Force Majeure, could mask a credit-related default of a party. Therefore, Force Majeure or Illegality's superior place in the pecking order applies only to failure to pay or deliver, or a failure to perform under a credit support document type of default. So, if a Bankruptcy Event of Default also exists, the Non-defaulting party retains the right to close-out on the basis of an Event of Default, without the requirement to comply with the Illegality/Force Majeure waiting period.

As a Force Majeure Event is regarded as an event where neither party is at fault, the determination of the Close-out Amount on the Early Termination Date is modified slightly so that if quotations are obtained from third parties, the entity giving the quotation should do so without regard to the creditworthiness of the Determining Party or any existing credit support and should provide mid-market quotations.

Default Under Specified Transaction

Default Under Specified Transaction is triggered where a party, any Credit Support Provider of that party or one of its specified entities defaults under (subject to any relevant grace period) or disaffirms its obligations in relation to certain types of financial markets transactions ("Specified Transactions") with the other party or one of its specified entities, regardless of documentation under which the transaction is documented. The definition of "Specified Transaction" has been expanded in the 2002 Agreement. The 1992 Agreement definition did not cover the field of financial markets transactions comprehensively. It now does, by including, for example, repos and securities lending. It also covers newer types of transactions, (e.g. credit derivatives) which have become routinely documented under the ISDA Master Agreement since 1992. The definition also includes wording to cover any new types of transactions that may become commonplace in the future, which should negate the need to amend the definition of "Specified Transaction" in the future.

The default in respect of a "Specified Transaction" must result in acceleration or early termination of all transactions under documentation applicable to the Specified Transaction. This has been included to avoid the situation where a failure to deliver, say, under a single repo (which failure may not be credit related) could lead to an Event of Default under the ISDA document. Under the new wording, a failure in respect of, in the above example, one repo, would lead to an Event of Default only if that failure led to a general default with respect to all applicable repo transactions. This amendment was made particularly because defaults under repo or securities lending transactions are not necessarily indicative of the creditworthiness of the counterparty, but may be a result of isolated difficulties in delivery. Failures of these kinds tend to be relatively common in repo and securities lending transactions and should not result in the close-out of all the transactions documented under the master agreement.

Section 6(f) Set-Off

The 1992 Agreement contemplated set-off between the parties (for example, see the last sentence in the first paragraph of Section 6(e) of the 1992 Agreement). However, in order for the parties to effect a contractual set-off (as opposed to mandatory set-off under section 553C of the Corporations Act), the parties had to provide for this expressly in the schedule to the 1992 Agreement. It has been common market practice in Australia for parties to include a contractual set-off clause in the schedule.

The 2002 Agreement incorporates such a set-off provision in the body of the Agreement.

This is a welcome inclusion for the majority of transactions. However, parties should still consider whether it is appropriate to retain. For example, it is common in securitisation transactions for the rating agencies to require that the parties do not include any set-off provision in the ISDA Master Agreement. This reflects the rating agencies' view that the swap counterparty should be paid in accordance with the cashflow methodology set out in the transaction documents.

Reduction of Grace Periods

The grace periods relating to Events of Default and Termination Events have been shortened in the 2002 Agreement. This change stems from the experience of market participants during the crises of the late 1990s when they received indications that their counterparties were failing, but were constrained by the grace periods in the 1992 Agreement from closing-out or suspending their performance under their transactions. Examples are: Failure to Pay has been reduced from three days to one day; dismissed or stay of insolvency proceedings has been reduced from 30 to 15 days.

Multiple Transaction Payment Netting

Under the 1992 Agreement, the parties may elect that the netting provisions in section 2(c) extend beyond just one transaction. In other words, they may elect that a net amount be determined in respect of all amounts payable on the same date, in the same currency, under any number of transactions identified in the confirmation. This election is called "Multiple Transaction Payment Netting" under the 2002 Agreement and reflects the market practice of OTC participants. As was the case under the 1992 Agreement, parties using the 2002 Agreement are required to specify a starting date for the Multiple Transaction Payment Netting.

Event of Default 5(a)(iii) - Credit Support Default

This Event of Default has been widened in two respects. First, in addition to the expiry, termination, failing or ceasing of a Credit Support Document, an Event of Default now also occurs where the expiry or failure happens in respect of a security interest granted under the document. Second, repudiation of a Credit Support Document constitutes an Event of Default not only where the party, or the Credit Support Provider, repudiates the document but also where a person or entity empowered to act on behalf of one of those entities, does so.

Event of Default 5(a)(vi) - Cross Default

The primary change in relation to this Event of Default is that under the 2002 Agreement the amount to be compared against the Threshold Amount, is the sum of (i) where obligations under any other agreements have been accelerated due to default, the total "Specified Indebtedness" referable to those agreements; and (ii) where the default is a failure to pay, the unpaid amount. In other words, if two types of cross default arise concurrently, the amounts applicable to them can be aggregated under the 2002 Agreement to determine whether cross default has occurred. This is not possible under the 1992 Agreement.

Section 5(b)(v) - Credit Event Upon Merger

A new concept of a "Designated Event" has been incorporated in the Credit Event Upon Merger provision. It extends the range of events which could lead to a Termination Event occurring under the 2002 Agreement.

A Designated Event is defined to include events such as the consolidation or merger of substantially all the assets of one party into or as another entity, the acquisition of shares that leads to one entity carrying the power to elect a majority of the board or to exercise control over that entity, or substantial changes to the structure of an entity by specified means including the issue of convertible debt. This broadly reflects the fact that the 1992 Agreement did not contain concepts common in jurisdictions such as the UK and Australia where the surviving entity of a "takeover" or "merger" is the same as one of the entities before that event.

Section 9(h) - Interest and Compensation

Under the 2002 Agreement, all the interest provisions have been consolidated into a single section. Interest and compensation provisions that were covered in the 1992 Agreement have either been deleted from the 2002 Agreement or consolidated into this new provision. In addition to consolidating existing provisions, the 2002 Agreement includes new provisions addressing compensation for defaulted and deferred deliveries and interest on deferred payments.

Other changes

In order to maintain pace with changing international banking operations, Part 4 of the 2002 Schedule ("Miscellaneous") has added email and specific instructions as notice options and has offered a standard consent to the recording of conversations.

The new Schedule allows counterparties to include Specified Entities in their absence of litigation representation, thereby broadening its scope and transparency. The Schedule also gives counterparties such as trustees or responsible entities space to reveal their corporate identity on the front page and in Part 4 (by removing the No Agency assumption).

Past ambiguity about the definition of "Confirmation" in the preamble to the Master is clarified with an expanded working formula for identifying documents which confirm "and evidence" Transactions under the Master Agreement.

Last Update Date 28 Jun 2011