ISDA/IIFM Tahawwut Master Agreement
10 March 2010
On 1 March 2010, the International Swaps and Derivatives Association, Inc. (ISDA) and the International Islamic Financial Market (IIFM) announced the publication of its much anticipated ISDA/IIFM Tahawwut Master Agreement (the Agreement). The Agreement is designed to govern the legal and credit relationship between two parties embarking on a bilateral trading relationship involving Shari’a-compliant hedging transactions based on murabaha transactions.
Publication of the Agreement marks the culmination of several years of work and discussions amongst ISDA, IIFM, market participants and advisors to produce an agreement conforming to the requirements of the Shari’a but at the same time being in a form familiar to those active in the derivatives markets. Allen & Overy LLP has been a significant contributor to the development of the Agreement.
The Agreement is a welcome and essential step in the development of the market for Shari’a-compliant hedging transactions. It will provide a benchmark in the market and, just as the development of the original ISDA Master Agreements in the 1980s brought efficiency, certainty and liquidity to the conventional derivatives markets, this Agreement will bring similar benefits to the Islamic finance markets.
Further work remains to be done in order for the framework developed by ISDA and IIFM to realise its potential: template confirmations and, potentially, credit support documentation will need to be developed to work with the Agreement; netting opinions will need to be commissioned in relevant jurisdictions to give comfort as to the enforceability of the close-out provisions of the Agreement; and, ultimately, further versions of the Agreement may need to be developed to cater for non-murabaha based products.
The form and structure of the Agreement is very much based on the ISDA 2002 Master Agreement (the 2002 Agreement) although a number of new features have been added and changes made to ensure that it conforms to the principles of the Shari’a. Of the many individual features added and changes that have been made, we identify and summarise below those we believe to be most important. Terms used but not defined in this Bulletin shall have the meaning given to them in the Agreement. Briefly, the principal features and changes are as follows:
The introduction of the concept of Designated Future transactions, that is, transactions which the parties have agreed to enter into in the future under the Agreement (the distinction between "non-concluded transactions", of which these are examples, and "concluded Transactions" is relevant throughout the Agreement).
The addition of new representations.
Amendments to the Events of Default and Termination Events to capture Designated Future transactions.
Significant changes to the determination and calculation of the amounts payable on close-out to satisfy the requirements of the Shari’a. We consider these provisions in more detail below, but, fundamentally, there is now a split calculation: one in respect of concluded Transactions and another in respect of non-concluded transactions, rather than a single net calculation in respect of all "Transactions". The Early Termination Amount due in respect of concluded Transactions can be set-off against the amounts due in respect of non-concluded transactions. The mechanics by which the mark‑to‑market value (whether determined by Market Quotation or Loss (note that the 2002 Agreement concept of "Close-out Amount" does not feature) of non-concluded transactions is delivered is complex and interesting. Essentially, the in-the-money party has the right to require the other party to purchase assets from it at a price equal to their market value plus the mark-to-market value of the non-concluded transactions that have been terminated.
Amendments to the Set-off clause to allow a Non-defaulting Party or Non-affected Party to elect to defer its obligation to pay that part of the Early Termination Amount (in respect of concluded Transactions only) that is equal to or less than any amount it may be owed in respect of non‑concluded transactions for a certain period of time.
No interest or compensation being payable in respect of defaulted or deferred payments or deliveries.
Providing parties the choice to elect for either court proceedings or arbitration to govern disputes.
The Agreement is available for anyone who wishes to use it. It is expected that market participants will now study the final form closely with regard to their credit, legal and risk management policies before adopting it as the form on which they will do business. In addition, market participants that wish or are required to enter into transactions that are Shari’a-compliant will need to get relevant sign-off from their Shari’a board or advisor with respect to the Agreement. Whether or not institutions will wish to depart from documentation they currently use to document Shari’a-compliant hedging transactions in favour of the Agreement will depend on a careful analysis of the costs and benefits of doing so, although the hope is that there will be an eventual shift towards using one market standard document.
The Agreement is designed for use with Shari’a-compliant hedging transactions that use murabaha contracts. As noted above, further versions of the Agreement may be developed for use with other types of transactions.
A significant aspect of the Agreement is that it includes close-out provisions which are designed to comply with the requirements of the Shari’a. These provisions will need to be tested against applicable insolvency laws. In some jurisdictions, the publication of the Agreement may serve as a stimulus for further focus on the reform of insolvency laws in order to recognise netting and set-off.
Just as for conventional ISDA Master Agreements, the parties are expected to make key elections and amendments to the Agreement in a Schedule to be negotiated between the parties.
Summary of principal features and changes
We set out below a summary of the principal features of the Agreement and the most important changes in the Agreement relative to the 2002 Agreement. We have attempted to summarise the essential thrust of the change but have not attempted here to reproduce every detail of each change. This note is for general guidance only and should not be relied upon as a substitute for definitive advice in specific cases.
The Agreement introduces the concept of Designated Future transactions. These are either transactions which the parties agree that they will enter into at a future date or transactions which one party undertakes to the other party, pursuant to a wa’ad, to enter into at a future date at the election of the other party. The agreement to enter into such transactions is referred to as a DFT Terms Agreement. Designated Future transactions will be confirmed by a DFT terms confirmation. Until they are entered into, Designated Future transactions do not constitute Transactions for the purposes of the Agreement and are therefore treated differently from concluded Transactions (most notably in relation to close-out). However, once entered into, Designated Future transactions constitute Transactions for the purposes of the Agreement.
In order to better understand the rationale for this feature, it is necessary to put it into context. Imagine a typical vanilla profit rate swap using murabaha contracts. The fixed leg of the swap is a single concluded murabaha transaction pursuant to which the floating rate payer sells assets to the fixed rate payer for deferred payment, such deferred payment being payable in instalments on each payment date. On the other hand, on the floating leg of a profit rate swap, since the floating rate element is only known at the start of each calculation period, the Shari’a only permits a concluded murabaha transaction in respect of that particular calculation period. As such, the parties agree to enter into a series of separate murabaha transactions, one for each calculation period. These separate murabaha transactions to be entered into in the future are the Designated Future transactions. This concept is used for purposes of calculating the amount payable following an early termination, which is discussed further below.
As per the 2002 Agreement, each party represents that it is entering into the Agreement, including each Transaction and DFT Terms Agreement, as principal. An extra limb has been introduced to clarify that where a party enters into the Agreement, a Transaction or DFT Terms Agreement through an agent (which is common in murabaha transactions), such party represents that the obligations that arise are obligations of the party itself and not the agent.
Satisfaction as to compliance with Shari’a
Each party is required to represent that it has satisfied itself as to the Shari’a-compliance of the Agreement and each transaction or DFT Terms Agreement entered into under it. Although IIFM's Shari’a Advisory Panel has approved the Agreement, individual institutions are responsible for ensuring, with their own Shari’a Board or advisor, the Shari’a-compliance of the Agreement together with those transactions.
Each party also represents that it has not relied on the other party or on any documents (including a fatwa) prepared by or on behalf of the other party for the purposes of determining whether the Agreement, each Transaction and each DFT Terms Agreement (and each Designated Future transaction under it) is Shari’a-compliant.
Events of Default and Termination Events
The Events of Default and Termination Events in the Agreement substantially reflect those contained in the 2002 Agreement. Certain amendments have, however, been made to bring DFT Terms Agreements and Designated Future transactions within the scope of certain Events of Default and Termination Events.
Breach of Agreement; Repudiation of Agreement; Failure to enter into a Designated Future transaction
A new Event of Default has been added at Section 5(a)(ii) of the Agreement such that a failure to enter into a Designated Future transaction or any DFT Terms Agreement if such failure is not remedied on or before the first Local Business Day after notice of such failure is given to the relevant party constitutes an Event of Default.
Under the Cross-Default clause contained in the 2002 Agreement, a cross-default can only be triggered in respect of borrowed money obligations. Given the nature of Shari’a driven financing, the clause has been amended in the Agreement to cover default under any transaction having the commercial effect of a borrowing (including Islamic Financing Transactions). The aim, of course, is to capture a default under Shari'a-compliant financing structures such as sukuks, which would not be captured by the equivalent provisions in the 2002 Agreement.
The procedure for terminating Transactions is fundamentally the same as that found in the 2002 Agreement. However, most significantly of all, the calculation of the amounts payable following the occurrence of an Early Termination Date have been completely redesigned to comply with the requirements of the Shari’a. The Agreement splits the calculation of the amounts payable following the occurrence of an Early Termination Date into two, the first being in respect of concluded Transactions for which the assets sold have been fully delivered and the second in respect of concluded Transactions for which the assets sold have not been fully delivered and Designated Future transactions. These amounts are then capable of being set off under the Agreement.
Concluded Transactions for which assets have been fully delivered
Pursuant to Section 6(d) of the Agreement, upon the occurrence or effective designation of an Early Termination Date, all payment obligations in respect of concluded Transactions for which the relevant assets sold have been fully delivered and which fall due after the Early Termination Date (assuming satisfaction of the condition precedent contained in Section 2(a)(iii) of the Agreement) are accelerated such that those amounts become due and payable on such Early Termination Date. The relevant party will then determine the Close-out Amount as the sum of the Termination Currency Equivalent of all payments due by one party on the Early Termination Date less the sum of the Termination Currency Equivalent of all payments due by the other party on such Early Termination Date.
The Early Termination Amount is then calculated, that is, the amount payable in respect of concluded Transactions for which assets have been fully delivered following the occurrence of the Early Termination Date. The Early Termination Amount calculation takes into account the Close-out Amount (determined as described above) as well as Unpaid Amounts that are owing to each party. Unpaid Amounts are amounts that became payable on or prior to the Early Termination Date but which remain unpaid as at such early Termination Date. The obligation to pay the Early Termination Amount replaces all remaining payment obligations in respect of the Terminated Transactions that would have fallen due following the Early Termination Date.
Designated Future transactions and concluded Transactions in respect of which assets have not been fully delivered
In order to capture the value of Designated Future transactions upon the occurrence of or effective designation of an Early Termination Date, the relevant party determines the value of an index (the Relevant Index) with respect to Terminated DFT Terms Agreements and Transactions in respect of which the assets sold have not been fully delivered. The value of the Relevant Index is calculated to be an amount determined by the relevant Determining Party equal to the sum of (a) the Termination Currency Equivalent of the Market Quotations for each Terminated DFT Terms Agreement or Non-Fully Delivered Terminated Transaction for which a Market Quotation is determined and (b) such Determining Party's Loss for each Terminated DFT Terms Agreement or Non-Fully Delivered Terminated Transaction for which a Market Quotation cannot be determined or would not provide a commercially reasonable result. This is a departure from the preference in the market for using the concept of Close-out Amount contained in the 2002 Agreement as Market Quotation with a fallback to Loss was seen to be a more acceptable method of calculation to some Shari'a scholars.
The concept of Market Quotation and Loss is largely based on that contained in the 1992 ISDA Master Agreement (the 1992 Agreement). In summary, Loss is the Determining Party's losses and costs (or gain) in connection with the Terminated Transaction or Terminated DFT Terms Agreement. In contrast to the 1992 Agreement, Loss does not, due to the requirements of the Shari’a, specifically refer to loss of bargain, cost of funding or losses or costs incurred as a result of terminating, liquidating, obtaining or reestablishing any hedge or related trading position. Market Quotation is an amount determined on the basis of quotations, which will be for an amount that would be paid to the Determining Party or by the Determining Party in consideration of an agreement between such party and the entity providing the quote to enter into a replacement transaction that would have the effect of preserving the economic equivalent of any payment or delivery by the parties in respect of such Terminated Transaction (covering payment and deliveries that would have been required after the Early Termination Date as well as any deliveries that have not been made in respect of Terminated Transactions on or prior to the Early Termination Date) or the economic equivalent in respect of Terminated DFT Terms Agreements (which therefore captures the value of Designated Future transactions).
As highlighted above, the mechanism by which the mark-to-market value of concluded Transactions in respect of which assets have not been fully delivered and Designated Future transactions is captured is complicated. Pursuant to Section 2(e) of the Agreement, at the time the Agreement is entered into, each party gives a separate wa'ad or undertaking to enter into a purchase or musawama transaction in certain circumstances. Upon the occurrence or effective designation of an Early Termination Date, the relevant Determining Party (if the value of the Relevant Index is a positive number, i.e., the Determining Party is in-the-money) or the other party (if the value of the Relevant Index is a negative number, i.e., the Determining Party is out‑of‑the‑money) may, by notice to its counterparty up to the day which is the first anniversary of the Early Termination Date, exercise its rights pursuant to Section 2(e) of the Agreement to require its counterparty to purchase from it certain Designated Assets at the Positive Indexed Value or Negative Indexed value, as applicable (which is the sum of the market value of the Designated Assets, the value of the Relevant Index and any value added or other similar tax or charge chargeable in respect of such Designated Assets). If both parties are determining parties, then each party determines the value of the Relevant Index (whether positive or negative) and the absolute value of the Relevant Index will be equal to the sum of (a) one-half of the difference between the higher absolute value determined and the lower absolute value determined and (b) the absolute value of the lower amount determined. The party for whom the value of the Relevant Index is a positive number (i.e. the party that is in-the-money) then has the right to require the other party to purchase from it the Designated Assets at the relevant value determined.
Where the party to which a notice has been given fails to comply with its undertaking to purchase the Designated Assets (for example, if it were insolvent) or it notifies the other party that it is not willing to comply with its undertaking, the party exercising its right pursuant to the undertaking is discharged from its obligation to deliver the Designated Assets and is entitled, by way of liquidated damages, to payment of an amount equal to the value of the Relevant Index. This mechanism therefore crystallises an amount equal to the mark-to-market value of the concluded Transactions in respect of which assets have not been fully delivered and Designated Future transactions, giving the relevant party a liquidated damages claim for such amount. The end result should therefore economically achieve a similar result to that which would apply under a conventional ISDA Master Agreement.
Whereas under the 2002 Agreement and 1992 Agreement, a single net sum is payable following the occurrence of an Early Termination Date, the Agreement provides for two separate payment amounts: the Close-out Amount which is in respect of concluded Transactions for which assets have been fully delivered; and the Positive Indexed Value or Negative Indexed Value, as applicable, which is in respect of Transactions for which assets have not been delivered and Designated Future transactions.
Once determined and payable, these amounts can then be set off pursuant to the set-off clause in Section 6(h) of the Agreement which is largely based on the set-off clause in the 2002 Agreement.
The set-off clause contains an unusual twist. In order to avoid the Non-defaulting Party having to pay out an Early Termination Amount (i.e. the amount due in respect of concluded Transactions for which assets have been fully delivered) before its reciprocal claim (if any) to payment of the mark-to-market value of concluded Transactions for which assets have not been fully delivered and Designated Future transactions has been crystallised, Section 6(h)(ii) of the Agreement allows the Non-defaulting Party to defer payment of the Early Termination Amount until the reciprocal claim becomes payable (or the expiry of a one year long stop date). Users of the Agreement will need to undertake necessary due diligence and analysis to determine whether such deferral right is enforceable under the insolvency laws of the jurisdiction applicable to its counterparty.
Section 7 of the Agreement, which deals with the transfer of the Agreement or rights and obligations under it is virtually identical to that contained in the 2002 Agreement except that a new subsection has been added which provides that a party may make such transfer of all or part of its entitlement to any purchase price payable in respect of the musawama or purchase transaction entered into with respect to the Designated Future transactions. A party effecting a transfer which it requires to be Shari’ah-compliant will need to determine whether the price at which it transfers satisfies applicable Shari’a requirements.
Interest and Compensation
The 2002 Master Agreement provides for interest on defaulted or deferred payments and compensation for defaulted or deferred deliveries. In order to comply with the principles of the Shari’a, the Agreement does not provide for any interest or compensation for defaulted and deferred payments or deliveries. Parties should therefore note that they cannot recover any amounts for any cost of funding they incur as a result of any late payment or delivery although the possibility of this leading to an Event of Default under the Agreement should at least be a significant deterrent to a party.
No interest payable
In the event that it is determined that any interest is payable in connection with the Agreement as a result of any arbitral or judicial award or by operation of law, each party waives its rights to such interest and if it actually receives it, agrees to donate such interest to a charitable organisation. This feature has been introduced to comply with the requirements of the Shari’a.
Governing Law and dispute resolution forum
The Governing Law and dispute resolution provisions in the Agreement are largely identical to those in the 2002 Agreement such that parties can elect in the Schedule for either English Law or the laws of the State of New York to govern. However, in anticipation of some of the types of jurisdictions in which the Agreement is likely to be used, the parties can elect in the Schedule for disputes to be governed either by court proceedings or by arbitration. This may be advantageous where an arbitral award is perceived to be more easily enforced in a relevant jurisdiction than would be a judgment from English or New York courts.